B. Improve the Accuracy of Pension Liability Measures

Present Law

In general

Under present law, the interest rate on 30-year Treasury securities is used for several
purposes related to defined benefit pension plans. Specifically, the interest rate on 30-year
Treasury securities is used: (1) in determining current liability for purposes of the funding and
deduction rules; (2) in determining unfunded vested benefits for purposes of Pension Benefit
Guaranty Corporation (“PBGC”) variable rate premiums; and (3) in determining the minimum
required value of lump-sum distributions from a defined benefit pension plan and maximum
lump-sum values for purposes of the limits on benefits payable under a defined benefit pension
plan.

The IRS publishes the interest rate on 30-year Treasury securities on a monthly basis.
The Department of the Treasury does not currently issue 30-year Treasury securities. As of
March 2002, the IRS publishes the average yield on the 30-year Treasury bond maturing in
February 2031 as a substitute.

Funding rules
In general

The Internal Revenue Code (the “Code”) and the Employee Retirement Income Security
Act of 1974 (“ERISA”) impose minimum funding requirements with respect to defined benefit
pension plans.*'? Under the funding rules, the amount of contributions required for a plan year is
generally the plan’s normal cost for the year (i.e., the cost of benefits allocated to the year under
the plan’s funding method) plus that year’s portion of other liabilities that are amortized over a
period of years, such as benefits resulting from a grant of past service credit.

Additional contributions for underfunded plans

Under special funding rules (referred to as the “deficit reduction contribution” tules),?2°

an additional contribution to a plan is generally required if the plan’s funded current liability
percentage is less than 90 percent.' A plan’s “funded current liability percentage” is the

319 Code sec. 412; ERISA sec. 302. The Code also imposes limits on deductible
contributions, as discussed below.

320 The deficit reduction contribution rules apply to single-employer plans, other than
single-employer plans with no more than 100 participants on any day in the preceding plan year.
Single-employer plans with more than 100 but not more than 150 participants are generally
subject to lower contribution requirements under these rules.

321 Under an alternative test, a plan is not subject to the deficit reduction contribution

tules for a plan year if (1) the plan’s funded current liability percentage for the plan year is at
least 80 percent, and (2) the plan’s funded current liability percentage was at least 90 percent for

227


Other rules

The work opportunity tax credit is not allowed for wages paid to a relative or dependent
of the taxpayer. Similarly wages paid to replacement workers during a strike or lockout are not
eligible for the work opportunity tax credit. Wages paid to any employee during any period for
which the employer received on-the-job training program payments with respect to that
employee are not eligible for the work opportunity tax credit. The work opportunity tax credit
generally is not allowed for wages paid to individuals who had previously been employed by the
employer. In addition, many other technical rules apply.

Welfare-to-work tax credit

Targeted group eligible for the credit

The welfare-to-work tax credit is available on an elective basis to employers of qualified
long-term family assistance recipients. Qualified long-term family assistance recipients are:
(1) members of a family that has received family assistance for at least 18 consecutive months
ending on the hiring date; (2) members of a family that has received such family assistance for a
total of at least 18 months (whether or not consecutive) after August 5, 1997 (the date of
enactment of the welfare-to-work tax credit) if they are hired within 2 years after the date that the
18-month total is reached; and (3) members of a family who are no longer eligible for family
assistance because of either Federal or State time limits, if they are hired within 2 years after the
Federal or State time limits made the family ineligible for family assistance.

Qualified wages

Qualified wages for purposes of the welfare-to-work tax credit are defined more broadly
than the work opportunity tax credit. Unlike the definition of wages for the work opportunity tax
credit which includes simply cash wages, the definition of wages for the welfare-to-work tax
credit includes cash wages paid to an employee plus amounts paid by the employer for:

(1) educational assistance excludable under a section 127 program (or that would be excludable
but for the expiration of sec. 127); (2) health plan coverage for the employee, but not more than
the applicable premium defined under section 4980B(f)(4); and (3) dependent care assistance
excludable under section 129. The employer’s deduction for wages is reduced by the amount of
the credit.

Calculation of the credit

The welfare-to-work tax credit is available on an elective basis to employers of qualified
long-term family assistance recipients during the first two years of employment. The maximum
credit is 35 percent of the first $10,000 of qualified first-year wages and 50 percent of the first
$10,000 of qualified second-year wages. Qualified first-year wages are defined as qualified
wages (not in excess of $10,000) attributable to service rendered by a member of the targeted
group during the one-year period beginning with the day the individual began work for the
employer. Qualified second-year wages are defined as qualified wages (not in excess of
$10,000) attributable to service rendered by a member of the targeted group during the one-year
period beginning immediately after the first year of that individual’s employment for the
employer. The maximum credit is $8,500 per qualified employee.

383


Prior Action

Substantially similar proposals were included in the President’s fiscal year 2002, 2003,
and 2004 budget proposals and in the Taxpayer Refund and Relief Act of 1999 as passed by the
106" Congress and vetoed by the President.

4. Provide an additional personal exemption to home caregivers of family members
Present Law

In order to determine taxable income, an individual reduces adjusted gross income by a
dollar amount ($3,050 for 2003) for the personal exemption with respect to each of the
individual’s dependents that meet certain requirements. To qualify as a dependent under present
law, an individual must: (1) be a specified relative or member of the taxpayer’s household;

(2) be a citizen or resident of the U.S. or resident of Canada or Mexico; (3) not be required to file
a joint tax return with his or her spouse; (4) have gross income below the dependent exemption
amount ($3,050 in 2003) if not the taxpayer’s child; and (5) receive over half of his or her
support from the taxpayer. If no one person contributes over half the support of an individual,
the taxpayer is treated as meeting the support requirement if: (a) over half the support is
received from persons each of whom, but for the fact that he or she did not provide over half
such support, could claim the individual as a dependent, (b) the taxpayer contributes over 10
percent of such support; and (c) the other caregivers who provide over 10 percent of the support
file written declarations stating that they will not claim the individual as a dependent.

Description of Proposal

The proposal allows an additional personal exemption for each qualified family member
with long-term care needs who resides with the taxpayer in the household the taxpayer
maintains. A taxpayer is treated as maintaining the household for the year only if the taxpayer
furnishes more than one-half the cost of maintaining the household for the entire year.

Qualified family members include an individual with long-term care needs who: (1) is the
taxpayer’s spouse or an ancestor of the taxpayer (or, if married an ancestor of the taxpayer’s
spouse); and (2) is a member of the taxpayer’s household for the entire taxable year.

An individual is considered to have long-term care needs if he or she were certified by a
licensed physician (prior to the filing of a return claiming the credit) as being unable for at least
180 consecutive days to perform at least two activities of daily living (“ADLs”) without
substantial assistance from another individual, due to a loss of functional capacity (including
individuals born with a condition that is comparable to a loss of functional capacity). As under
the present-law rules relating to long-term care, ADLs are eating, toileting, transferring, bathing,
dressing, and continence. Substantial assistance includes both hands-on assistance (that is, the
physical assistance of another person without which the individual is unable to perform the
ADL) and stand-by assistance (that is, the presence of another person within arm’s reach of the
individual that is necessary to prevent, by physical intervention, injury to the individual when
performing the ADL).

57


achieved when a U.S. corporation paid deductible amounts to its new foreign parent or other
foreign affiliates constituted the primary intended tax benefit of the transaction.°** The proposal
would further limit the opportunities for earnings stripping by reducing the adjusted taxable
income threshold from 50 percent to 25 percent for interest on related-party debt and limiting the
indefinite carryforward of disallowed interest to 10 years. In addition, the proposal eliminates
the safe harbor and the three-year carryforward of excess limitation.

The proposal does not address, however, earnings stripping transactions involving the
payment of deductible amounts other than interest (e.g., rents, royalties, and service fees) or the
payment of deductible amounts by taxpayers other than corporations. These transactions may
also erode the U.S. tax base. Accordingly, some may argue that a more comprehensive response
to earnings stripping transactions is needed.

In contrast, others argue there is no empirical evidence of abuse outside the context of
inversion transactions, and thus, the proposal is too broad because it tightens the rules of section
163(j) outside the inversion context. As a result of its breadth, the proposal may penalize
legitimate transactions. For example, the capital structures of multinational companies often
vary by line of business and the amount of leverage the market permits. The proposal does not
take these differences into account.*”? Others may be concerned that the proposal may cause
foreign-based multinationals to reduce their direct investments in the United States because the
proposal may increase the cost of such investments. Some may argue that the proposal needs to
provide that the amount of interest expense allowed is consistent with arm’s-length principles.
Others may argue that guaranteed debt does not increase the likelihood of base erosion as
compared with non-guaranteed debt because borrowers typically obtain guarantees to reduce the
interest rate on a loan and such interest is paid to an unrelated third party.“ Although the
proposal does not tighten the earnings stripping rules with respect to guaranteed debt, some may

available to reduce inappropriately the U.S. tax on income earned from U.S. operations through
the use of foreign related-party debt. Tightening the rules of section 163()) is necessary to
eliminate these inappropriate income-reduction opportunities.”); Department of the Treasury,
Office of Tax Policy, Corporate Inversion Transactions: Tax Policy Implications, May 17, 2002,
Part VILA (“Treasury study”) (“The prevalent use of foreign related-party debt in inversion
transactions is evidence that [the rules of section 163(j)] should be revisited”).

388 See, e.g., Treasury study, Part VIIA; Joint Committee on Taxation, Background and
Description of Present-Law Rules and Proposals Relating to Corporate Inversion Transactions
(JCX-52-02), June 5, 2002, 3-4.

399 The President’s Fiscal Year 2004 Budget Proposal contained a section 163(j)
proposal, which included a replacement of the safe harbor with a new safe harbor based on a
series of debt-to-asset ratios that varied by asset class.

409 However, the rules for guaranteed debt under section 163(j) are often described as a
backstop to the earnings stripping rules on related-party debt because guaranteed debt may serve
as a substitute for a direct loan from a foreign affiliate to a U.S. corporation, which would be
subject to section 163(j).

256


Prior Action

A similar proposal was included in the President’s fiscal year 2002 and fiscal year 2003
budget proposals, which included less detail regarding the penalty and bargain-sale provisions,
and in the President’s fiscal year 2004 budget proposal.

A similar proposal was included in section 107 of S. 476, the “CARE Act of 2003,”
passed by the Senate on April 9, 2003, which would exclude 25 percent of long-term capital gain
on certain sales or exchanges to eligible entities for conservation purposes.

121


X. RESPOND TO FOREIGN SALES CORPORATION / EXTRATERRITORIAL
INCOME DECISIONS

Present Law

Like many other countries, the United States has long provided export-related benefits
under its tax law. In the United States, for most of the last two decades, these benefits were
provided under the foreign sales corporation (“FSC”) regime. In 2000, the European Union
(“EU”) succeeded in having the FSC regime declared a prohibited export subsidy by the World
Trade Organization (“WTO”). Later that year, in response to this WTO ruling, the United States
repealed the FSC rules and enacted the extraterritorial income (“ETT”) regime.

Under the ETI regime, an exclusion from gross income applies with respect to
“extraterritorial income,” which is a taxpayer’s gross income attributable to “foreign trading
gross receipts.” This income is eligible for the exclusion to the extent that it is “qualifying
foreign trade income.” Qualifying foreign trade income is the amount of gross income that, if
excluded, would result in a reduction of taxable income by the greatest of: (1) 1.2 percent of the
foreign trading gross receipts derived by the taxpayer from the transaction; (2) 15 percent of the
“foreign trade income” derived by the taxpayer from the transaction;®® or (3) 30 percent of the
“foreign sale and leasing income” derived by the taxpayer from the transaction.°>

Foreign trading gross receipts are gross receipts derived from certain activities in
connection with “qualifying foreign trade property” with respect to which certain economic
processes take place outside of the United States. Specifically, the gross receipts must be:

(1) from the sale, exchange, or other disposition of qualifying foreign trade property; (2) from
the lease or rental of qualifying foreign trade property for use by the lessee outside the United
States; (3) for services which are related and subsidiary to the sale, exchange, disposition, lease,
or rental of qualifying foreign trade property (as described above); (4) for engineering or
architectural services for construction projects located outside the United States; or (5) for the
performance of certain managerial services for unrelated persons. A taxpayer may elect to treat
gross receipts from a transaction as not foreign trading gross receipts. As a result of such an
election, a taxpayer may use any related foreign tax credits in lieu of the exclusion.

Qualifying foreign trade property generally is property manufactured, produced, grown,
or extracted within or outside the United States that is held primarily for sale, lease, or rental in
the ordinary course of a trade or business for direct use, consumption, or disposition outside the

653 «Foreign trade income” is the taxable income of the taxpayer (determined without
regard to the exclusion of qualifying foreign trade income) attributable to foreign trading gross
receipts.

654 “Foreign sale and leasing income” is the amount of the taxpayer’s foreign trade
income (with respect to a transaction) that is properly allocable to activities that constitute
foreign economic processes. Foreign sale and leasing income also includes foreign trade income
derived by the taxpayer in connection with the lease or rental of qualifying foreign trade property
for use by the lessee outside the United States.

414


From an economic perspective, both LSAs and RSAs receive tax treatment generally
equivalent to Roth IRAs. While the taxpayer does not deduct contributions to LSAs, tax is never
paid on the income earned on the investment. The same is generally true for RSAs as long as
amounts are withdrawn in qualified distributions. However, while LSAs and RSAs receive
similar tax treatment to Roth IRAs, the maximum allowable annual contribution is greater than
the amount of contributions currently permitted to Roth IRAs. The increase in the amounts that
may be contributed to tax-preferred savings accounts provides a tax incentive for further saving
for those who have already contributed the maximum to existing tax-favored savings accounts.
However, for taxpayers not already contributing the maximum amounts, the new accounts
provide no additional inducement to save." Opponents of proposals to increase tax-favored
saving thus argue that the only beneficiaries are likely to be wealthy taxpayers with existing
savings that will be shifted to the tax-favored accounts, since most taxpayers have not taken full
advantage of existing saving incentives.

RSAs also replace traditional IRAs and thereby eliminate taxpayers’ ability to make
deductible contributions. From an economic perspective, RSAs receive tax treatment generally
equivalent to traditional IRAs to which deductible contributions are made.” However, some
would argue that the upfront deduction provides a greater psychological inducement to save, and
that the elimination of traditional IRAs may reduce saving by those who would have been able to
make deductible contributions.

Taxpayers may convert balances under Coverdell education savings accounts and
qualified tuition programs into LSAs before January 1, 2006. Under the proposal, existing
balances in Coverdell education savings accounts and existing balances in qualified tuition
programs (up to $50,000) may be converted to LSA balances with no income tax consequences.
This means that earnings accumulated on Coverdell education savings accounts and qualified
tuition program balances that are converted to LSAs may be withdrawn and spent for purposes
other than education without the income tax consequences applicable to Coverdell education
savings account and qualified tuition program distributions that are used for nonqualifying
expenses. There is some scope for abuse of this conversion option. Conversion allows the

38 Some argue that contributions to deductible IRAs declined substantially after 1986 for
taxpayers whose eligibility to contribute to deductible IRAs was not affected by the income-
related limits introduced in 1986, because financial institutions cut back on promoting
contributions as a result of the general limits on deductibility. Thus, they would argue,
universally available tax-preferred accounts such as LSAs and RSAs will increase saving at all
income levels.

3° Whether an RSA and a traditional IRA to which deductible contributions are made are
in fact economically equivalent depends on the difference between the taxpayer’s marginal tax
rate in the year contributions are made and the marginal tax rate in the year IRA funds are
withdrawn. When marginal rates decrease over time (because tax rates change generally or
taxpayers fall into lower tax brackets), a traditional IRA to which deductible contributions are
made is more advantageous than an RSA because the traditional IRA permits taxpayer to defer
payment of tax until rates are lower. When marginal tax rates increase over time, an RSA is
more advantageous.

23


Description of Proposal

The proposal extends the $13.25-per-proof-gallon cover over rate for two additional
years, through December 31, 2005.

Effective date The proposal is effective for articles brought into the United States after
December 31, 2003.

Analysis

The fiscal needs of Puerto Rico and the Virgin Islands were the impetus to extend the
increased cover over rate to bolster the Treasuries in those possessions. Rather than rely on rum
consumption in the United States, increased revenue could be achieved by intergovernmental
support through a direct appropriation. The advantage of a direct appropriation is that it provides
for annual oversight. Some might argue that a cover over is akin to an entitlement in terms of the
annual budget process and making it permanent ensures a steady flow of revenue. Although the
cover over may provide a more stable revenue stream, it may be more difficult to administer than
a direct appropriation.

Prior Action
The President’s fiscal year 2001 budget proposal included a proposal that would have
repealed the $20 million limit on amounts attributable to the increased cover over rate that could

be paid to Puerto Rico and the Virgin Islands in fiscal year 2001. An identical proposal was also
included in the President’s fiscal year 2004 budget proposals.

418


Finally, the proposal grants the States access to the National Directory of New Hires.
This is intended to provide information to the States so that unemployment benefits may be
stopped when an individual finds employment.

Effective date.The proposals would be effective on January 1, 2005.

Analysis

Experience rating under State unemployment systems serves to set an employer’s State
unemployment taxes at a level commensurate with the amount of unemployment benefits
expected to be paid to the former employees of that employer. Schemes to artificially lower an
employer’s experience rating, and thus the employer’s State unemployment taxes, can have a
negative impact on the solvency of State unemployment systems. This may result in greater
demands on State and Federal funds in order to provide unemployment benefits, higher
unemployment taxes for other employers, and reduced unemployment benefits for individuals.
Similar fiscal concerns can arise in connection with unemployment benefits improperly paid to
individuals who are again employed. The proposal addresses these concerns by transferring an
employer’s experience rate in certain circumstances and by granting access to current
information about individual employment in the National Directory of New Hires.

The proposal to transfer an employer’s experience rate if the transfer of a business (or a
part thereof) is engaged in solely or primarily for the purpose of attaining a lower rate of
unemployment taxes presents issues of the administrability of such a standard. It may be
difficult for a State to determine whether the transfer was engaged in solely or primarily for the
purpose of attaining a lower rate of unemployment taxes. Criteria for making this determination
would help in its administration.

The proposal to share information from the National Directory of New Hires raises
concerns as to whether the potential benefit to the administration of unemployment tax benefits
outweighs the risk of unauthorized disclosure or use of such information by or through the State
unemployment agencies.

Prior Action

No prior action

344


cooperatives in two ways. First, the proposal excludes from the test certain non-member income
eamed by a rural electric cooperative from the provision of certain transmission and distribution
services if the cooperative enters a competitive electricity market by providing open access.
Second, the proposal treats as member income, for purposes of the 85-percent test and for a 10-
year period of time, income earned by a rural electric cooperative from the sale of electric energy
to non-members to the extent that member income is lost following (but not necessarily as a
result of) the entry of the cooperative into a competitive electricity market through the provision
of open access.

While proponents believe that the proposals regarding open access and load loss
transactions are necessary to the survival of rural electric cooperatives in a competitive market
environment, opponents believe that the proposal would inappropriately facilitate the
encroachment of electric cooperatives--with their competitive advantage of tax exemption--into
energy markets already served by electric utilities that are subject to the corporate tax on their net
income.'®® More generally, some may argue that the need for proposals to facilitate the
participation of rural electric cooperatives in electricity markets that are competitive actually
suggests that tax incentives (such as tax exemption) are no longer necessary to ensure the
provision of electricity to such markets at reasonable rates.

The purpose of the 85-percent member income test for rural electric cooperatives is to
ensure that the primary activities of a rural electric cooperative fulfill the statutory tax-exempt
purpose of providing electricity services to the members of the cooperative. Similarly, the
present-law fundamental cooperative principles described above are the defining characteristics
of a cooperative upon which the Federal tax tules condition conduit treatment. Proposals to relax
these requirements and principles tend to obscure the distinction between tax-exempt rural
electric cooperatives and taxable electric utilities, thus diminishing the policy justifications for
extending tax benefits (such as tax exemption) to companies that operate as rural electric
cooperatives. Consequently, to the extent such proposals permit rural electric cooperatives to
earn more income that otherwise would be taxable if earned by a taxable electric utility, they
impair the tax policy objective of horizontal equity (i.e., equal taxation of similarly situated
taxpayers).

Certain provisions of the proposal, relating to nuclear decommissioning transactions and
asset exchange or conversion transactions, do not raise significant policy issues and, as described
below, tend to reduce the complexity of the Code by clarifying present law.

Complexity issues

In general, the proposals regarding open access and load loss transactions can be
expected to add complexity to the Code. These proposals attempt to further certain non-tax
policy objectives (i.e., electric industry restructuring) by permitting rural electric cooperatives to
earn non-member income in limited circumstances without detrimentally impacting the ability of

196 While tax-exempt electric cooperatives generally are referred to as “rural” electric
cooperatives, there is no statutory or administrative requirement limiting the operation of such
cooperatives to any particular geographic area (rural or otherwise).

152


is approved by that Commission as consistent with Texas State law regarding an independent
transmission organization, or (ii) a political subdivision, or affiliate thereof, whose transmission
facilities are under the operational control of such an entity.

If a taxpayer elects the application of the proposal, then the statutory period for the
assessment of any deficiency attributable to such gain shall not expire prior to the expiration of
three years from the date the Secretary of the Treasury is notified by the taxpayer of the
reinvestment property or an intention not to reinvest.

Effective date The proposal is effective to sales or other dispositions occurring after the
date of enactment and before January 1, 2007.

Analysis

Policy issues

Electric deregulation has been occurring, and is continuing to occur, at both the Federal
and State level. Federal and State energy regulators are calling for the “unbundling” of electric
transmission assets held by vertically integrated utilities, with the transmission assets ultimately
placed under the ownership or control of independent transmission providers (or other similarly-
approved operators). This policy is intended to improve transmission management and facilitate
the formation of competitive markets.

To facilitate the implementation of these policy objectives, the proponents assert it is
appropriate to assist taxpayers in moving forward with industry restructuring by providing a tax
deferral for gain associated with certain dispositions of electric transmission assets. In addition,
because the proposal requires the proceeds of such dispositions to be reinvested in utility
property the proponents argue that it will assist in modemizing our energy infrastructure.
However, some may argue that providing special rules for certain industries and situations
increases complexity and indirectly increases the tax burden on other taxpayers.

Complexity issues

The proposal permits gain to be recognized over an eight year period if the proceeds are
reinvested within four years in certain utility property. The proposal would likely require
additional effort and audit resources in auditing taxpayers that have undertaken a transaction
eligible for the proposal. In addition, additional records and computations will be required by
the taxpayer to properly reflect the tax basis in the reinvested utility property. However, the
number of transactions eligible should not be significant and taxpayers likely to benefit from
proposal will have the resources to comply with the additional records and computations
necessary.

Prior Action

A similar proposal was included in section 1327 of the Conference Report to H.R. 6, the
“Energy Policy Act of 2003.”

147


JOINT COMMITTEE ON TAXATION

108TH CONGRESS
HOUSE SENATE
WILLIAM M. THOMAS, California, CHARLES E. GRASSLEY, Iowa,
Chairman Vice Chairman
PHILIP M. CRANE, Illinois ORRIN G. HATCH, Utah
E. CLAY SHAW, Jr., Florida DON NICKLES, Oklahoma
CHARLES B. RANGEL, New York MAX BAUCUS, Montana
FORTNEY PETE STARK, California JOHN D. ROCKEFELLER IV, West Virginia

George K. Yin, Chief of Staff
Bernard A. Schmitt, Deputy Chief of Staff
Mary M. Schmitt, Deputy Chief of Staff


as: (1) the entire interest of the donor other than a qualified mineral interest; (2) a remainder
interest; or (3) a restriction (granted in perpetuity) on the use that may be made of the real
property. Qualified organizations include certain governmental units, public charities that meet
certain public support tests, and certain supporting organizations. Conservation purposes
include: (1) the preservation of land areas for outdoor recreation by, or for the education of, the
general public; (2) the protection of a relatively natural habitat of fish, wildlife, or plants, or
similar ecosystem; (3) the preservation of open space (including farmland and forest land) where
such preservation will yield a significant public benefit and is either for the scenic enjoyment of
the general public or pursuant to a clearly delineated Federal, State, or local governmental
conservation policy; and (4) the preservation of a historically important land area or a certified
historic structure.

Qualified conservation contributions of capital gain property are subject to the same
limitations and carryforward rules applicable to other charitable contributions of capital gain
property.

Description of Proposal

The proposal provides that a taxpayer may exclude from income 50 percent of the gain
realized from the sale of land (or an interest in land or water) to a qualified conservation
organization for conservation purposes. The income not excluded is taxed as capital gain
eligible for the alternative rate schedule of present law. The exclusion is computed without
regard to improvements.

To be eligible for the exclusion, the taxpayer or a member of the taxpayer’s family has to
have owned the property for the three years immediately preceding the date of the sale. The
taxpayer is not eligible for the exclusion in the case of property sold pursuant to a condemnation
order, but the taxpayer is eligible for the exclusion in the case of property sold in response to the
threat or imminence of a condemnation order.

A qualified conservation organization is either a governmental unit or a charity that is a
qualified organization under present-law section 170(h)(3) and that is organized and operated
primarily for conservation purposes. Conservation purposes include the preservation of land
areas for outdoor recreation by, or the education of, the general public; the protection of a
relatively natural habitat of fish, wildlife, or plants, or similar ecosystem; or the preservation of
open space where the preservation is for the scenic enjoyment of the general public or pursuant
to a clearly delineated Federal, State, or local governmental conservation policy.

The buyer must provide a written statement representing that it is a qualified conservation
organization and that it intends to hold the property exclusively for conservation purposes and
not to transfer it for valuable consideration other than to a qualified conservation organization in
a transaction that would qualify under the proposal if the qualified conservation organization
(ie., the buyer in the transaction that is the subject of the written statement) were a taxable
person.

117


While residents of the possessions and commonwealths are U.S. citizens,’ special tax
rules apply. Some question whether it is appropriate to provide a refundable health tax credit to
residents of possessions and commonwealths who may never pay U.S. tax. Certain other tax
credits are not available to such individuals. For example, the earned income credit and child tax
credit are generally not available to such residents.'”"

Expanded disclosure

Proponents argue that modifying the disclosure provisions is necessary to make the
advance payment program administrable. The proposal would eliminate uncertainty regarding
disclosures permitted for purposes of the credit. Under present law, disclosure is permitted only
to providers of health insurance. Proponents argue that in order to facilitate operation of the
advance payment program it is necessary that disclosure of certain information be permitted to
employers and administrators of health plans and to contractors of providers of health insurance.

Since advance payment of the credit became available August 1, 2003, a consent
mechanism has been used to the extent that disclosures not technically permitted under the
statute are necessary. Proponents argue that clarifying the disclosure provisions statutorily
would simplify administration of the credit.

Many believe that taxpayer information should be highly safeguarded and that any
expansion of the disclosure rules should be as narrow as possible. For example, some argue that,
given the breadth of the present-law statute, the use of contractors could expand significantly the
risk of unauthorized disclosure of sensitive information. Some argue that if present law were
narrowed to the discrete items relating to the health program, such risk would be diminished.
Others argue that items such as taxpayer identification numbers and health insurance
membership are commonly obtained by the health plans and are not as sensitive as other return
information.

State continuation coverage

The proposal providing that State continuation coverage automatically qualifies as
qualified health insurance results in removing certain State-based coverage requirements from
State continuation coverage. These requirements include guaranteed issue, no imposition of
preexisting conditions, nondiscriminatory premiums and similar benefits. Proponents argue that
many States lack qualified State-based coverage and allowing State continuation coverage to
automatically qualify would allow more individuals to use the credit. Proponents also argue that
since State continuation coverage is similar to COBRA continuation, which is not subject to the
State-based coverage requirements, it is appropriate to waive such requirements for State
continuation coverage. Proponents argue that it is inappropriate for the State-based coverage

100 There is an exception for those on American Samoa who are U.S. nationals.

101 The refundable child tax credit is available to residents of the possessions if the
individual has three of more qualifying children and pays FICA or SECA taxes. However, the
President’s fiscal year 2005 budget proposal includes a proposal to repeal this rule and to require
the taxpayer to reside in the United States to be eligible for the credit.

66


would be more appropriate than repeal of the present-law rule altogether. This approach would
permit Congress to monitor the level of and treatment of policyholder dividends, as well as the
segment balance within the industry, to ascertain whether either modifications to the present-law
rule or repeal would be more appropriate.

Prior Action

An identical proposal was included in the President's fiscal year 2004 budget proposals.

376


rate will be used in determining actuarial equivalent forms of benefit, but may not give the
employer discretion to choose the interest rate.

Statutory assumptions must be used in determining the minimum value of certain
optional forms of benefit, such as a lump sum.?*” That is, the lump sum payable under the plan
may not be less than the amount of the lump sum that is actuarially equivalent to the life annuity
payable to the participant, determined using the statutory assumptions. The statutory
assumptions consist of an applicable mortality table (as published by the IRS) and an applicable
interest rate.

The applicable interest rate is the annual interest rate on 30-year Treasury securities,
determined as of the time that is permitted under regulations. The regulations provide various
options for determining the interest rate to be used under the plan, such as the period for which
the interest rate will remain constant (“stability period”) and the use of averaging.

Limits on benefits

Annual benefits payable under a defined benefit pension plan generally may not exceed
the lesser of (1) 100 percent of average compensation, or (2) $165,000 (for 2004).*8 The dollar
limit generally applies to a benefit payable in the form of a straight life annuity beginning no
earlier than age 62. The limit is reduced if benefits are paid before age 62. In addition, if the
benefit is not in the form of a straight life annuity, the benefit generally is adjusted to an
equivalent straight life annuity. In making these reductions and adjustments, the interest rate
used generally must be not less than the greater of: (1) five percent; or (2) the interest rate
specified in the plan. However, for purposes of adjusting a benefit in a form that is subject to the
minimum value rules (including the use of the interest rate on 30-year Treasury securities), such
as a lump-sum benefit, the interest rate used must be not less than the greater of: (1) the interest
rate on 30-year Treasury securities; or (2) the interest rate specified in the plan.

Description of Proposal

In general

The proposal replaces the interest rate on 30-year Treasury securities with the rate of
interest on high-quality corporate bonds for Purposes of determining a defined benefit pension
: aon : 39 a
plan’s current liability for funding purposes’”” and determining the value of lump sums payable

337 Code sec. 417(e)(3); ERISA sec. 205(g)(3).
338 Code sec. 415(b).

33° The proposal does not provide for a change in the interest rate used to determine
unfunded vested benefits for purposes of PBGC variable rate premiums.

232


Description of Proposal

Treatment of income from open access transactions

The proposal provides that certain income received or accrued by a rural electric
cooperative (other than income received or accrued directly or indirectly from a member of the
cooperative) is excluded in determining whether a rural electric cooperative satisfies the 85-
percent test for tax exemption under section 501(c)(12). Such income includes income that is
received or accrued: (1) from the provision or sale of electric energy transmission services or
ancillary services on a nondiscriminatory open access basis under a tariff filed with the Federal
Energy Regulatory Commission (“FERC”) 55 or an independent transmission provider agreement
approved or accepted by FERC (including an agreement providing for the transfer of control--but
not ownership--of transmission facilities); or (2) from the provision or sale of open access
distribution services (i) to deliver electricity to end-users served by distribution facilities not
owned by the cooperative or any of its members, or (ii) to deliver to third parties electricity
generated by a facility that is not owned or leased by the cooperative or any of its members and
is directly connected to distribution facilities owned by the cooperative or any of its members.

Treatment of income from nuclear decommissioning transactions

The proposal provides that income received or accrued by a rural electric cooperative
from any “nuclear decommissioning transaction” also is excluded in determining whether a rural
electric cooperative satisfies the 85-percent test for tax exemption under section 501(c)(12). The
term “nuclear decommissioning transaction” is defined as: (1) any transfer into a trust, fund, or
instrument established to pay any nuclear decommissioning costs if the transfer is in connection
with the transfer of the cooperative’s interest in a nuclear powerplant or nuclear powerplant unit;
(2) any distribution from a trust, fund, or instrument established to pay any nuclear
decommissioning costs; or (3) any earnings from a trust, fund, or instrument established to pay
any nuclear decommissioning costs.

Treatment of income from asset exchange or conversion transactions

The proposal provides that gain realized by a tax-exempt rural electric cooperative from a
voluntary exchange or involuntary conversion of certain property is excluded in determining
whether a rural electric cooperative satisfies the 85-percent test for tax exemption under section
501(c)(12). This proposal only applies to the extent that: (1) the gain would qualify for deferred
recognition under section 1031 (relating to voluntary exchanges of property held for productive
use or investment) or section 1033 (relating to involuntary conversions); and (2) the replacement
property that is acquired by the cooperative pursuant to section 1031 or section 1033 (as the case
may be) constitutes property that is used, or to be used, for the purpose of generating,
transmitting, distributing, or selling electricity or methane-based natural gas.

'5 Under the proposal, references to FERC are treated as including references to the
Public Utility Commission of Texas.

150


receives a contribution exceeding $75 made partly as a gift and partly as consideration for goods
or services furnished by the charity (a “quid pro quo” contribution) is required to inform the
contributor in writing of an estimate of the value of the goods or services furnished by the charity
and that only the portion exceeding the value of the goods or services is deductible as a
charitable contribution.'!”

Under present law, total deductible contributions of an individual taxpayer to public
charities, private operating foundations, and certain types of private nonoperating foundations
may not exceed 50 percent of the taxpayer’s contribution base, which is the taxpayer’s adjusted
gross income for a taxable year (disregarding any net operating loss carryback). To the extent a
taxpayer has not exceeded the 50-percent limitation, (1) contributions of capital gain property to
public charities generally may be deducted up to 30 percent of the taxpayer’s contribution base;
(2) contributions of cash to private foundations and certain other charitable organizations
generally may be deducted up to 30 percent of the taxpayer’s contribution base; and
(3) contributions of capital gain property to private foundations and certain other charitable
organizations generally may be deducted up to 20 percent of the taxpayer’s contribution base.

Contributions by individuals in excess of the 50-percent, 30-percent, and 20-percent
limits may be carried over and deducted over the next five taxable years, subject to the relevant
percentage limitations on the deduction in each of those years.

In addition to the percentage limitations imposed specifically on charitable contributions,
present law imposes an overall limitation on most itemized deductions, including charitable
contribution deductions, for taxpayers with adjusted gross income in excess of a threshold
amount, which is indexed annually for inflation. The threshold amount for 2004 is $142,700
($71,350 for married individuals filing separate returns). For those deductions that are subject to
the limit, the total amount of itemized deductions is reduced by three percent of adjusted gross
income over the threshold amount, but not by more than 80 percent of itemized deductions
subject to the limit. Beginning in 2006, the Economic Growth and Tax Relief Reconciliation Act
of 2001 phases out the overall limitation on itemized deductions for all taxpayers. The overall
limitation on itemized deductions is reduced by one-third in taxable years beginning in 2006 and
2007, and by two-thirds in taxable years beginning in 2008 and 2009. The overall limitation on
itemized deductions is eliminated for taxable years beginning after December 31, 2009; however,
this elimination of the limitation sunsets on December 31, 2010.

In general, a charitable deduction is not allowed for income, estate, or gift tax purposes if
the donor transfers an interest in property to a charity (e.g., a remainder) while also either
retaining an interest in that property (e.g., an income interest) or transferring an interest in that
property to a noncharity for less than full and adequate consideration.!2° Exceptions to this
general rule are provided for, among other interests, remainder interests in charitable remainder
annuity trusts, charitable remainder unitrusts, and pooled income funds, and present interests in

"9 Sec. 6115.

120 Sees. 170(£), 2055(e)(2), and 2522(c)(2).

77


E. Modify Charitable Contribution Rules for Donations
of Patents and Other Intellectual Property

Present Law

In general, a deduction is permitted for charitable contributions, subject to certain
limitations that depend on the type of taxpayer, the property contributed, and the donee
organization.‘"' In the case of non-cash contributions, the amount of the deduction generally
equals the fair market value of the contributed property on the date of the contribution.

For certain contributions of property, the taxpayer is required to reduce the deduction
amount by any gain, generally resulting in a deduction equal to the taxpayer’s basis. This rule
applies to contributions of: (1) property that, at the time of contribution, would not have resulted
in long-term capital gain if the property was sold by the taxpayer on the contribution date; (2)
tangible personal property that is used by the donee in a manner unrelated to the donee’s exempt
(or governmental) purpose; and (3) property to or for the use of a private foundation (other than a
foundation defined in section 170(b)(1)(E)).

Charitable contributions of capital gain property generally are deductible at fair market
value. Capital gain property means any capital asset or property used in the taxpayer’s trade or
business the sale of which at its fair market value, at the time of contribution, would have
resulted in gain that would have been long-term capital gain. Contributions of capital gain
property are subject to different percentage limitations than other contributions of property.
Under present law, certain copyrights are not considered capital assets, in which case the
charitable deduction for such copyrights generally is limited to the taxpayer’s basis."

In general, a charitable contribution deduction is allowed only for contributions of the
donor’s entire interest in the contributed property, and not for contributions of a partial
interest.“ If a taxpayer sells property to a charitable organization for less than the property’s
fair market value, the amount of any charitable contribution deduction is determined in
accordance with the bargain sale rules.*!* In general, if a donor receives a benefit or quid pro
quo in return for a contribution, any charitable contribution deduction is reduced by the amount
of the benefit received. For contributions of $250 or more, no charitable contribution deduction
is allowed unless the donee organization provides a contemporaneous written acknowledgement
of the contribution that describes and provides a good faith estimate of the value of any goods or
services provided by the donee organization in exchange for the contribution.‘!°

411 Charitable deductions are provided for income, estate, and gift tax purposes. Secs.
170, 2055, and 2522, respectively.

412 See sec. 1221(a)(3), 1231(b)(1)(C).

413 Sec, 170(f)(3).

414 Sec, 1011(b) and Treas. Reg, sec. 1.1011-2.
415 Sec. 170(£)(8).

266


II. TAX INCENTIVES
A. Provisions Related to Savings
1, Expansion of tax-free savings opportunities

Present Law

In general

Present law provides for a number of vehicles that permit individuals to save on a tax-
favored basis. These savings vehicles have a variety of purposes, including encouraging saving
for retirement, encouraging saving for particular purposes such as education or health care, and
encouraging saving generally.

The present-law provisions include individual retirement arrangements, qualified
retirement plans and similar employer-sponsored arrangements, Coverdell education savings
accounts, qualified tuition programs, health savings accounts, Archer medical savings accounts,
annuity contracts, and life insurance. Certain of these arrangements are discussed in more detail
below.

Individual retirement arrangements (“IRAs”)

In general

There are two general types of individual retirement arrangements (“IRAs”) under
present law: traditional IRAs,”” to which both deductible and nondeductible contributions may be
made,” and Roth IRAs.” The Federal income tax rules regarding each type of IRA (and IRA
contributions) differ.

The maximum annual deductible and nondeductible contributions that can be made to a
traditional IRA and the maximum contribution that can be made to a Roth IRA by or on behalf of
an individual varies depending on the particular circumstances, including the individual’s
income. However, the contribution limits for IRAs are coordinated so that the maximum annual
contribution that can be made to all of an individual’s IRAs is the lesser of a certain dollar
amount ($3,000 for 2004)? or the individual’s compensation. In the case of a married couple,

29 Sec. 408.

>! Sec. 219.

? Sec. 408A.

23 The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”)
increased the dollar limit on IRA contributions to $3,000 for 2004, $4,000 for 2005 through
2007, and $5,000 for 2008, After 2008, the limit is adjusted for inflation in $500 increments.

The provisions of EGTRRA generally do not apply for years beginning after December 31, 2010.
Thus, the dollar limit on annual IRA contributions returns to $2,000 in 2011. A proposal to

13


actuarial value of plan assets*” as a percentage of the plan’s current liability. In general, a plan’s

current liability means all liabilities to employees and their beneficiaries under the plan.

The amount of the additional contribution required under the deficit reduction
contribution rules is the sum of two amounts: (1) the excess, if any, of (a) the deficit reduction
contribution (as described below), over (b) the contribution required under the normal funding
rules; and (2) the amount (if any) required with respect to unpredictable contingent event
benefits.°”> The amount of the additional contribution cannot exceed the amount needed to
increase the plan’s funded current liability percentage to 100 percent.

The deficit reduction contribution is the sum of (1) the “unfunded old liability amount,”
(2) the “unfunded new liability amount,” and (3) the expected increase in current liability due to
benefits accruing during the plan year.“ The “unfunded old liability amount” is the amount
needed to amortize certain unfunded liabilities under 1987 and 1994 transition rules. The
“unfunded new liability amount” is the applicable percentage of the plan’s unfunded new
liability. Unfunded new liability generally means the unfunded current liability of the plan (i.e.,
the amount by which the plan’s current liability exceeds the actuarial value of plan assets), but
determined without regard to certain liabilities (such as the plan’s unfunded old liability and
unpredictable contingent event benefits). The applicable percentage is generally 30 percent, but
is reduced if the plan’s funded current liability percentage is greater than 60 percent.

Required interest rate and mortality table

Specific interest rate and mortality assumptions must be used in determining a plan’s
current liability for purposes of the special funding rule. The interest rate used to determine a

each of the two immediately preceding plan years or each of the second and third immediately
preceding plan years.

322 The actuarial value of plan assets is the value determined under an actuarial valuation
method that takes into account fair market value and meets certain other requirements. The use
of an actuarial valuation method allows appreciation or depreciation in the market value of plan
assets to be recognized gradually over several plan years. Sec. 412(c)(2); Treas. reg.
sec. 1.412(c)(2)-1.

33 A plan may provide for unpredictable contingent event benefits, which are benefits
that depend on contingencies that are not reliably and reasonably predictable, such as facility
shutdowns or reductions in workforce. An additional contribution is generally not required with
respect to unpredictable contingent event benefits unless the event giving rise to the benefits has
occurred.

324 Tf the Secretary of the Treasury prescribes a new mortality table to be used in

determining current liability, as described below, the deficit reduction contribution may include
an additional amount.

228


If and when the property demonstrates its economic potential, the donor reaps the benefit --
either in the form of a revenue stream or additional deductions. Although critics might respond
that such a benefit, unlike the present law deduction, will not help finance donor’s efforts to
transfer to the marketplace intellectual property that does not fit within the donor’s core business,
it can be argued that donors have sufficient economic incentive to undertake such activity even
without any charitable deduction. Donation is merely one of several options for a holder of
intellectual property; certain of the other existing options, for example, sale or joint-venture,
provide an arguably greater economic incentive than donation for taxpayer’s to mine their
intellectual property portfolios to determine the best use of non-core intellectual property.

The President’s proposal and the recent Senate proposal are similar conceptually but
differ in terms of the future benefit provided to the donor. The President’s proposal provides the
donor future charitable deductions based on revenues received by the charity (including any sales
proceeds) that are properly allocable to the contributed intellectual property. The future
charitable deductions are a sliding-scale percentage of the revenue received, with a higher
percentage in the years closer in time to the contribution. No future benefit inures to the donor
beyond ten years (or the expiration of the property) from the contribution date. The recent
Senate proposal provides for future payments from the charity to the donor, up to 50 percent of
the payments received by the charity (the percentage is negotiated by the charity and the donor
prior to contribution). Payments may be made up to the earlier of the legal life of the property or
twenty years from the contribution date, though the donor may not share in any sales proceeds.
The Senate proposal also provides that the donor may receive revenues, in a manner determined
by the Secretary of the Treasury, for contributed property used by the charity in a manner that
does not generate revenue.

One salient difference between the Administration and Senate proposals is who bears the
cost of the future economic benefit provided to the donor if the property generates future
income.” Under the President’s proposal, the cost is borne by the Federal government in the
form of a future tax deduction. Under the Senate proposal, the cost is borne by the charity,
which pays out a percentage of revenue received to the donor. The future benefit provided under
the President’s proposal generally is of shorter duration (maximum 10 versus 20 years, but in
neither case beyond the legal life of the property). Arguably, the shorter time period of the
President’s proposal is more appropriate because the further in time from the date of the gift, the
more likely that the value that inures to the charity from its use of the property is attributable to
value added to the property by the charity since the time of the contribution. The President’s
proposal permits donors to derive a benefit from the sale of the contributed property; whereas the
Senate proposal does not. To the extent a sale occurs close in time to the contribution, the sale
may approximate the value of the property at the time of contribution and the donor arguably
should share in the proceeds. However, if a sale occurs many years subsequent to the
contribution, the donor arguably should not benefit from the sale because the value at such time
is more likely to be due to the charity’s investment in the property.

420 Tf the donated property does not generate future income, the effects of the President’s
proposal and the Senate proposal on the donor, donee, and the fisc should be the same (i.¢., a
charitable deduction equal to the lesser of basis or fair market value with no future income
derived by the charity).

271


M. Extend the Authority to Issue Liberty Zone Bonds

Present Law

In general

Interest on debt incurred by States or local governments is excluded from income if the
proceeds of the borrowing are used to carry out governmental functions of those entities or the
debt is repaid with governmental funds (sec. 103). Interest on bonds that nominally are issued by
States or local governments, but the proceeds of which are used (directly or indirectly) by a
private person and payment of which is derived from funds of such a private person is taxable
unless the purpose of the borrowing is approved specifically in the Code or in a non-Code
provision of a revenue Act. These bonds are called “private activity bonds.” The term “private
person” includes the Federal Government and all other individuals and entities other than States
or local governments.

In most cases, the aggregate volume of tax-exempt private activity bonds that may be
issued in a State is restricted by annual volume limits. For calendar year 2004, these annual
volume limits are equal to the greater of $80 per resident of the State or $234 million.

Tax-exempt private activity bonds

Interest on private activity bonds is tax-exempt only for qualified bonds. Qualified bonds
include: (1) exempt facility bonds; (2) qualified mortgage bonds; (3) qualified veteran mortgage
bonds; (4) qualified small-issue bonds; (5) qualified student loan bonds; (6) qualified
redevelopment bonds; and (7) qualified 501(c)(3) bonds. A further provision allows tax-exempt
financing for “environmental enhancements of hydro-electric generating facilities.” Tax-exempt
financing also is authorized for capital expenditures for small manufacturing facilities and land
and equipment for first-time farmers (“qualified small-issue bonds”), local redevelopment
activities (“qualified redevelopment bonds”), and eligible empowerment zone and enterprise
community businesses.

Tax-exempt financing is also allowed for qualified New York Liberty Bonds issued
during calendar years before January 1, 2005. An aggregate limit of $8 billion of tax-exempt
private activity bonds to finance the construction and rehabilitation of nonresidential real
propertyTM? and residential rental real propertyTM in a newly designated “Liberty Zone” (the

43 No more than $800 million of the authorized bond amount may be used to finance
property used for retail sales of tangible property (e.g., department stores, restaurants, etc.) and
functionally related and subordinate property. The term nonresidential real property includes
structural components of such property if the taxpayer treats such components as part of the real
property structure for all Federal income tax purposes (¢.g., cost recovery). The $800 million
limit is divided equally between the Mayor and the Governor.

644 No more than $1.6 billion of the authorized bond amount may be used to finance

residential rental property. The $1.6 billion limit is divided equally between the Mayor and the
Governor.

406


Analysis
Complexity issues

Under the proposal, taxpayers would be required to perform additional analysis with
respect to leasing transactions with tax-exempt entities. For leases subject to the proposal,
businesses would have to perform additional computations and keep additional records. In
addition, regulatory guidance likely would be necessary to clarify certain aspects of the proposal.
However, it is likely that the proposal will significantly reduce the amount of tax-advantaged
leasing to tax exempt entities, thus limiting the number of taxpayers affected by the complexity
of the proposal. Additionally, taxpayers engaging in the types of transactions subject to the
proposal generally are sophisticated corporate taxpayers with the expertise and resources to
comply with the additional requirements.

Policy issues
Background

The recent focus on certain leasing transactions with tax-exempt entities raises a number
of significant tax policy issues. The relative importance of these issues varies according to
whether the lessee is a Federal agency, a State or local governmental agency, a nonprofit
organization, or a foreign government or person. Congress analyzed many of these issues in the
early to mid-1980s and enacted significant reforms with respect to the leasing of property by tax-
exempt entities. However, taxpayers have been able to structure leasing transactions with tax-
exempt entities that circumvent the present-law rules, often through the unanticipated
exploitation of certain exceptions to the rules. Before reviewing the specific policy issues of the
proposal, it is useful to review some of the general tax policy issues that are relevant to tax-
exempt leasing transactions. These tax policy issues were relevant over 20 years ago and remain
relevant today to determine the merits of updating and altering the present-law rules to address
leasing transactions with tax-exempt entities.

Efficiency.—The first issue is whether leasing arrangements are an efficient way to
provide Federal assistance to tax-exempt entities. The dollar value of the tax benefits from such
transactions is shared by the tax-exempt entity, the lessor (a taxable entity), and the lawyers,
investment bankers, leasing companies, and other agents or investors that are involved in the
transaction. Because the benefits to the tax-exempt entity are only a portion of the total benefits
derived from the transaction, the cost to the Federal government is greater than the benefits
provided to the tax-exempt entity. For example, a review of over 30 transactions approved by
the Federal Transit Authority“? indicated that, on average, fees paid to lawyers, investment
bankers, leasing companies, and other agents advising or assisting tax-exempt entities equaled
approximately 24 percent of the benefits received by the tax-exempt entities. With respect to the
sharing of the benefits between the lessor and a tax-exempt entity, promotional materials
describing long-term lease/leaseback arrangements indicate that the tax-exempt entity is entitled

449 The Federal Transit Authority is an agency within the U. S. Department of
Transportation.

284


2. Simplify the definitions of a qualifying higher educational institution and qualified
higher education expenses

Present Law

Present law contains a number of tax benefits for higher education expenses or with
respect to students at institutions of higher education. These include the provisions relating to
the:

qd) Hope credit;
(2) lifetime learning credit;

(3) exclusion from income for distributions from Coverdell education savings
accounts;

(4) exclusion from income for distributions from qualified tuition programs;
(5) exclusion from gross income for interest on savings bonds;

(6) _ above-the-line deduction for interest on educational loans;

(7) __ temporary above-the-line deduction for higher education expenses;

(8) exclusion from gross income for scholarships and fellowships;

(9) exclusion from gross income for qualified tuition reductions;

(10) _ exclusion from gift tax for amounts paid as tuition to an educational institution,
and

(11) _ personal exemption for dependent children who are full time students and age 19
through 23.

These provisions generally require that the relevant individual be a student at an
education institution. However, there is not a consistent definition of an eligible education
institution. Similarly, the provisions providing tax benefits for higher education expenses
contain varying definitions of qualifying expenses. The group of individuals that may benefit
also differs in some cases. For example, in some cases the student must be a full-time student
and there is not a consistent definition of how the student must be related to the taxpayer.

With respect to the definition of an education institution, seven of the above-listed 11
provisions define a qualifying higher education institution to mean institutions eligible to
participate in Federal student aid programs under Title IV of the Higher Education Act of
1965.2’° Such institutions generally are accredited post-secondary educational institutions

216 Provisions that use this definition are the: (1) Hope credit; (2) Lifetime learning
credit; (3) exclusion from gross income for distributions from Coverdell education savings

195


the qualified appraiser; and (e) the signature and TIN of such appraiser; and (4) does not involve
an appraisal fee that violates certain prescribed rules.“

Description of Proposal

The proposal requires increased donor reporting for certain charitable contributions of
property other than cash, inventory, or publicly traded securities. The proposal extends to C
corporations the present law requirement, applicable to an individual, closely-held corporation,
personal service corporation, partnership, or S corporation, that the donor must obtain a qualified
appraisal of the property if the amount of the deduction claimed exceeds $5,000. The proposal
also provides that if the amount of the contribution of property other than cash, inventory, or
publicly traded securities exceeds $500,000, then the donor (whether an individual, a closely-
held corporation, a personal services corporation, a partnership, an S corporation, or a C
corporation) must attach either a copy of the qualified appraisal or an executive summary of the
qualified appraisal to the donor’s tax return. The executive summary must contain a description
of the donated property, the methodology used by the appraiser, a description of the critical facts
relied upon, and such additional information as the Secretary may require by form or regulation.

Under the proposal, the $5,000 and $500,000 amounts are indexed for inflation after
December 2003.

Effective date —The proposal is effective for taxable years beginning after December 31,
2003.

Analysis

The proposal addresses an anomaly of present law that excepts certain C corporations
from the substantiation requirements applicable to other taxpayers that contribute property to
charity. In addition, by requiring that additional information be disclosed for gifts in excess of
$500,000, the proposal provides the IRS with more information about contributions, which could
help prevent abusive valuations. The requirement that appraisers prepare an executive summary
and state the appraisal methodology used could result in more informed appraisals in some
cases.*”? Some might argue that if the central policy goal of the proposal is to prevent abuse in
the valuation process, additional measures could be adopted -- for example, strengthening the
substantial valuation misstatement penalty under section 6662, denying a deduction if all
substantiation requirements are not met (e.g., filing Form 8283), and revisiting the standard of
who is qualified to make appraisals under present law. The President’s proposal also provides an
exception from the qualified appraisal requirement for contributions of inventory property.
Although some might argue that such an exception has merit because C corporations are in the
best position to determine the value of their inventory, others argue that contributions of
inventory are a potential area of abuse and that measures should be taken to ensure that
appropriate values are being claimed for inventory contributions.

478 Treas. Reg. sec. 1.170A-13(c)(3).

479 An alternative to providing an executive summary might be attaching a copy of the
appraisal with the donor’s return, as is required for artwork valued at more than $20,000.

304


value of money were addressed generally. Under general tax accounting rules, a deduction for
accrual basis taxpayers is deferred until there is economic performance for the item for which the
deduction is claimed. However, the 1984 Act contains an exception under which a taxpayer
responsible for nuclear powerplant decommissioning may elect to deduct contributions made to a
qualified nuclear decommissioning fund for future decommissioning costs. Taxpayers who do
not elect this provision are subject to general tax accounting rules.

Qualified nuclear decommissioning fund

A qualified nuclear decommissioning fund (a “qualified fund”) is a segregated fund
established by a taxpayer that is used exclusively for the payment of decommissioning costs,
taxes on fund income, management costs of the fund, and for making investments. The income
of the fund is taxed at a reduced rate of 20 percent for taxable years beginning after December
31, 1995.

Contributions to a qualified fund are deductible in the year made to the extent that these
amounts were collected as part of the cost of service to ratepayers (the “cost of service
requirement”).'”* Funds withdrawn by the taxpayer to pay for decommissioning costs are
included in the taxpayer’s income, but the taxpayer also is entitled to a deduction for
decommissioning costs as economic performance for such costs occurs.

Accumulations in a qualified fund are limited to the amount required to fund
decommissioning costs of a nuclear powerplant for the period during which the qualified fund is
in existence (generally post-1984 decommissioning costs of a nuclear powerplant). For this
purpose, decommissioning costs are considered to accrue ratably over a nuclear powerplant’s
estimated useful life. In order to prevent accumulations of funds over the remaining life of a
nuclear powerplant in excess of those required to pay future decommissioning costs of such
nuclear powerplant and to ensure that contributions to a qualified fund are not deducted more
rapidly than level funding (taking into account an appropriate discount rate), taxpayers must
obtain a ruling from the IRS to establish the maximum annual contribution that may be made to a
qualified fund (the “ruling amount”). In certain instances (e.g., change in estimates), a taxpayer
is required to obtain a new ruling amount to reflect updated information.

A qualified fund may be transferred in connection with the sale, exchange or other
transfer of the nuclear powerplant to which it relates. If the transferee is a regulated public utility
and meets certain other requirements, the transfer will be treated as a nontaxable transaction. No

173 As originally enacted in 1984, a qualified fund paid tax on its earnings at the top
corporate rate and, as a result, there was no present-value tax benefit of making deductible
contributions to a qualified fund. Also, as originally enacted, the funds in the trust could be
invested only in certain low risk investments. Subsequent amendments to the provision have
reduced the rate of tax on a qualified fund to 20 percent and removed the restrictions on the types
of permitted investments that a qualified fund can make.

"74 ‘Taxpayers are required to include in gross income customer charges for
decommissioning costs (sec. 88).

126


I. Modify Tax Rules for Individuals Who Give Up U.S. Citizenship
or Green Card Status

Present Law

In general

USS. citizens and residents generally are subject to U.S income taxation on their
worldwide income. The U.S. tax may be reduced or offset by a credit allowed for foreign
income taxes paid with respect to foreign source income. Nonresident aliens are taxed at a flat
rate of 30 percent (or a lower treaty rate) on certain types of passive income derived from U.S.
sources, and at regular graduated rates on net profits derived from a U.S. trade or business. The
estates of nonresident aliens generally are subject to estate tax on U.S.-situated property (e.g.,
real estate and tangible property located within the United States and stock in a U.S.
corporation). Nonresident aliens generally are subject to gift tax on transfers by gift of U.S.-
situated property (e.g., real estate and tangible property located within the United States, but
excluding intangibles, such as stock, regardless of where they are located).

Income tax rules with respect to expatriates

For the 10 taxable years after an individual relinquishes his or her U.S. citizenship or
terminates his or her U.S. residency with a principal purpose of avoiding U.S. taxes, the
individuals is subject to an alternative method of income taxation than that generally applicable
to nonresident aliens (the “alternative tax regime”). Generally, the individual is subject to
income tax only on U.S.-source income*® at the rates applicable to U.S. citizens for the 10-year
period.

An individual who relinquishes citizenship or terminates residency is treated as having
done so with a principal purpose of tax avoidance and is generally subject to the alternative tax
regime if: (1) the individual’s average annual US. Federal income tax liability for the five
taxable years preceding citizenship relinquishment or residency termination exceeds $100,000;
or (2) the individual’s net worth on the date of citizenship relinquishment or residency
termination equals or exceeds $500,000. These amounts are adjusted annually for inflation.“
Certain categories of individuals (e.g., dual residents) may avoid being deemed to have a tax
avoidance purpose for relinquishing citizenship or terminating residency by submitting a ruling

464 Under present law, an individual’s U.S. residency is considered terminated for U.S.
Federal tax purposes when the individual ceases to be a lawful permanent resident under the
immigration law (or is treated as a resident of another country under a tax treaty and does not
waive the benefits of such treaty).

465 For this purpose, however, U.S.-source income has a broader scope than it does
typically in the Code.

466 The income tax liability and net worth thresholds under section 877(a)(2) for 2004 are
$124,000 and $622,000, respectively. See Rev. Proc. 2003-85, 2003-49 LR.B. 1184.

295


prior to use. The amount of credit for the purchase of a fuel cell vehicle is $4,000 plus an
additional credit determined by the rated fuel economy of the vehicle compared to a base fuel
economy. For these purposes the base fuel economy is the 2000 model year city fuel economy
rating for vehicles of various weight classes (see below). Table 6, below, shows the proposed
credits for qualifying fuel cell vehicles.

Table 6.-Additional Fuel Economy Credit for Fuel Cell Vehicles

If Fuel Economy of the Fuel Cell Vehicle Is:
Credit at least But less than
$1,000 150% of base fuel economy 175% of base fuel economy
$1,500 175% of base fuel economy 200% of base fuel economy
$2,000 200% of base fuel economy 225% of base fuel economy
$2,500 225% of base fuel economy 250% of base fuel economy
$3,000 250% of base fuel economy 275% of base fuel economy
$3,500 275% of base fuel economy 300% of base fuel economy
$4,000 300% of base fuel economy
Base fuel economy

The base fuel economy is the 2000 model year city fuel economy for vehicles by inertia
weight class by vehicle type. The “vehicle inertia weight class” is that defined in regulations
prescribed by the Environmental Protection Agency for purposes of Title II of the Clean Air Act.
Table 7, below, shows the 2000 model year city fuel economy for vehicles by type and by inertia
weight class.

132



tax-exempt issuers' interest saving.” 78 The difference accrues to investors in tax brackets higher
than those that would be implied by the yield spread between taxable and tax exempt bonds.

International bridges and tunnels

The proposal permits private activity bonds to be issued for inteational bridges or
tunnels for which an international entity authorized under Federal or State law is responsible.
Proponents of the proposal might argue that a private entity might be able to more effectively
and efficiently manage such structures. In addition, having a private entity own the structure
may provide additional capital for maintenance and upkeep. On the other hand, opponents might
argue that the benefit from such international projects does not justify the decrease in Federal
revenues that would result from the proposal.

Prior Action

On February 12, 2004, the Senate passed a similar proposal as part of S. 1072, the “Safe,
Accountable, Flexible and Efficient Transportation Equity Act of 2004”.

578 The Federal income tax has graduated marginal tax rates. Thus, $100 of interest
income forgone to a taxpayer in the 33-percent bracket costs the Federal Government $33, while
the same amount of interest income forgone to a taxpayer in the 25-percent bracket costs the
Federal Government $25. If a taxpayer in the 25-percent bracket finds it profitable to hold a
tax-exempt security, a taxpayer in the 33-percent bracket will find it even more profitable. This
conclusion implies that the Federal Government will lose more in revenue than the tax-exempt
issuer gains in reduced interest payments.

354


transactions with respect to common stock or other equity interests (other than preferred
stock).*

Stripped bonds

Special rules are provided with respect to the purchaser and “stripper” of stripped
bonds.*®° A “stripped bond” is defined as a debt instrument in which there has been a separation
in ownership between the underlying debt instrument and any interest coupon that has not yet
become payable.” 4 In general, upon the disposition of either the stripped bond or the detached
interest coupons, the retained portion and the portion that is disposed each is treated as a new
bond that is purchased at a discount and is payable at a fixed amount on a future date.
Accordingly, section 1286 treats both the stripped bond and the detached interest coupons as
individual bonds that are newly issued with original issue discount (“OID”) on the date of
disposition. Consequently, section 1286 effectively subjects the stripped bond and the detached
interest coupons to the general OID periodic income inclusion rules.

A taxpayer who purchases a stripped bond or one or more stripped coupons is treated as
holding a new bond that is issued on the purchase date with OID in an amount that is equal to the
excess of the stated redemption price at maturity (or in the case of a coupon, the amount payable
on the due date) over the ratable share of the purchase price of the stripped bond or coupon,
determined on the basis of the respective fair market values of the stripped bond and coupons on
the purchase date.**° The OID on the stripped bond or coupon is includible in gross income
under the general OID periodic income inclusion rules.

A taxpayer who strips a bond and disposes either the stripped bond or one or more
stripped coupons must allocate pre-disposition basis in the bond (with the coupons attached)
between the retained and disposed items.°®* Special rules apply to require that interest or market
discount accrued on the bond prior to such disposition must be included in the taxpayer’s gross
income (to the extent that it had not been previously included in income) at the time the stripping
occurs, and the taxpayer increases basis in the bond by the amount of such accrued interest or
market discount. The adjusted basis (as increased by any accrued interest or market discount) is
then allocated between the stripped bond and the stripped interest coupons in relation to their
respective fair market values. Amounts realized from the sale of stripped coupons or bonds
constitute income to the taxpayer only to the extent such amounts exceed the basis allocated to

382 However, in Estate of Stranahan v. Commissioner, 472 F.2d 867 (6th Cir. 1973), the
court held that where a taxpayer sold a carved-out interest of stock dividends, with no personal
obligation to produce the income, the transaction was treated as a sale of an income interest.

38 Sec. 1286.

384 Sec, 1286(e).

385 Sec, 1286(a).

386 Sec. 1286(b). Similar rules apply in the case of any person whose basis in any bond
or coupon is determined by reference to the basis in the hands of a person who strips the bond.

250


F. Simplify the Taxation of Dependents

Present Law

Filing requirements for children

A single unmarried individual eligible to be claimed as a dependent on another taxpayer’s
return generally must file an individual income tax return if he or she has: (1) earned income
only over $4,850 (for 2004); (2) unearned income only over the minimum standard deduction
amount for dependents ($800 in 2004); or (3) both earned income and unearned income totaling
more than the smaller of @ $4,850 (for 2004) or (b) the larger of (i) $800 (for 2004), or (ii)
earned income plus $250. 3 Thus, if a dependent child has less than $800 in gross income, the
child does not have to file an individual income tax return for 2004.

A child who cannot be claimed as a dependent on another person’s tax return (¢.g.,
because the support test is not satisfied by any other person) is subject to the generally applicable
filing requirements. That is, such an individual generally must file a return if the individual’s
gross income exceeds the sum of the standard deduction and the personal exemption amounts
applicable to the individual.

Taxation of unearned income under section 1(g)

Special rules apply to the uneamed income of a child under age 14. These tules,
generally referred to as the “kiddie tax,” tax certain uneamed income of a child at the parent’s
rate, regardless of whether the child can be claimed as a dependent on the parent’s retumn.” The
kiddie tax applies if: (1) the child has not reached the age of 14 by the close of the taxable year;
(2) the child’s investment income was more than $1,600 (for 2004); and (3) the child is required
to file a return for the year. The kiddie tax applies regardless of the source of the property
generating the income or when the property giving rise to the income was transferred to or
otherwise acquired by the child. Thus, for example, the kiddie tax may apply to income from
property acquired by the child with compensation derived from the child’s personal services or
from property given to the child by someone other than the child’s parent.

The kiddie tax is calculated by computing the “allocable parental tax.” This involves
adding the net unearned income of the child to the parent’s income and then applying the
parent’s tax rate. A child’s “net unearned income” is the child’s unearned income less the sum
of (1) the minimum standard deduction allowed to dependents ($800 for 2004), and (2) the
greater of (a) such minimum standard deduction amount or (b) the amount of allowable itemized

263 Sec, 6012(a)(1)(C). Other filing requirements apply to dependents who are married,
elderly, or blind. See, Internal Revenue Service, Publication 929, Tax Rules for Children and
Dependents, at 3, Table 1 (2003).

264 Sec. 1(g).

187


process cases. The judicial appeals structure of present law was designed in recognition of these
jurisdictional limitations; all appeals must be brought in the Tax Court unless that court does not
have jurisdiction over the underlying tax liability. Accordingly, the proposal would give the Tax
Court jurisdiction over issues arising from a collection due process hearing, while the Tax Court
will not have jurisdiction over an identical issue arising in a different context.

The proposal would provide simplification benefits to taxpayers and to the IRS by
requiring that all appeals be brought in the Tax Court, because doing so will eliminate confusion
over which court is the proper venue for an appeal and will significantly reduce the period of
time before judicial review.°**

Some believe that present law “entitles a taxpayer patently seeking delay to achieve his
goal by refiling in the District Court.”””° The proposal would provide simplification benefits by
eliminating this opportunity for delay.

Prior Action

A substantially similar proposal was included in the President’s fiscal year 2003 and
2004 budget proposals.°°° An identical proposal was contained in the “Tax Administration Good
Government Act of 2004,” as passed by the Senate Committee on Finance on February 2, 2004.
The right to a hearing and judicial review of the determinations made at these hearings were
enacted in the IRS Restructuring and Reform Act of 1998.53!

6. Office of Chief Counsel review of offers-in-compromise
Present Law

The IRS has the authority to settle a tax debt pursuant to an offer-in-compromise. IRS
regulations provide that such offers can be accepted if the taxpayer is unable to pay the full
amount of the tax liability and it is doubtful that the tax, interest, and penalties can be collected
or there is doubt as to the validity of the actual tax liability. Amounts of $50,000 or more can
only be accepted if the reasons for the acceptance are documented in detail and supported by a
written opinion from the IRS Chief Counsel (sec. 7122).

328 This reduction is attributable to the elimination of time periods built into the judicial
review process to permit the refiling of appeals that have been filed with the wrong court.

529 Nestor v. Commissioner, 118 T.C. No. 10 (February 19, 2002), concurring opinion by
Judge Beghe.

530 There was a slight difference in the effective dates of those proposals.

531 Sec, 3401(b) of P.L. 105-206 (July 22, 1998).

328


C. Eliminate Household Maintenance Test for Head-of-Household Filing Status

Present Law

Head of household filing status”**

There are four different filing statuses for individuals who file Federal income tax
returns: single, married filing separately, married filing jointly, and head of household. A
taxpayer filing as a head of household is able to claim a larger basic standard deduction than a
taxpayer who files as single or as married filing separately. For example, the basic standard
deduction for calendar year 2004 for head of household filing status is $7,150, compared to
$4,850 for taxpayers who file as single or as married filing separately. In addition, head of
household filing status provides a taxpayer with more favorable rate brackets than if the taxpayer
filed as single or as married filing separately.

A taxpayer may claim head of household filing status if the taxpayer is unmarried (and
not a surviving spouse) and pays more than one half of the cost of maintaining as his or her home
a household which is the principal place of abode for more than one half of the year of (1) an
unmarried son, daughter, stepson or stepdaughter of the taxpayer or an unmarried descendant of
the taxpayer’s son or daughter, (2) an individual described in (1) who is married, if the taxpayer
may claim a dependency exemption with respect to the individual (or could claim the exemption
if the taxpayer had not waived the exemption to the noncustodial parent), or (3) a relative with
respect to whom the taxpayer may claim a dependency exemption.”TM If certain other
requirements are satisfied, head of household filing status also may be claimed if the taxpayer is
entitled to a dependency exemption with respect to one of the taxpayer’s parents.

Surviving spouse rules

A taxpayer who qualifies as a surviving spouse may use the basic standard deduction and
rate brackets that are applicable to married taxpayers filing jointly. A taxpayer may qualify as a
surviving spouse if his or her spouse died during either of the two years immediately preceding
the current taxable year, and the taxpayer maintains as his or her home the household that
constitutes for the taxable year the principal place of abode for a dependent who is the taxpayer’s
son, daughter, or stepchild. For this purpose, an individual is considered as maintaining a
household only if the individual furnishes over half the cost of maintaining the household during
the taxable year.

Description of Proposal

The proposal eliminates the requirement that the taxpayer pay more than half the cost of
maintaining the household in order to claim head of household filing status. An unmarried

253 Sec. 2(b).
254 Sec, 2(b)(1)(A)(ii), as qualified by sec. 2(b)(3)(B). An individual for whom the

taxpayer is entitled to claim a dependency exemption by reason of a multiple support agreement
does not qualify the taxpayer for head of household filing status.

176


deductions. Inferences drawn from such studies may be inappropriate when applied to taxpayers
who currently claim the standard deduction. Some evidence suggests that higher-income
taxpayers are more responsive to the incentives provided by the tax deduction.’

If taxpayers do respond to the proposal by making additional gifts, then the charitable
sector would become larger because it would receive more donations under the proposal than it
would in the absence of the preferential tax treatment provided by the proposal. Depending upon
the magnitude of the additional or induced donations, the increase in the size of the charitable
sector may be less than, equal to, or greater than the tax revenue forgone. If the increase in
donations to the charitable sector induced by the tax deduction exceeds the revenue lost to the
government, then the tax deduction could be said to be an efficient means of providing public
support to such charitable functions.'!°

Opponents of proposals to expand charitable deductions argue that many charitable
contributions are not tax motivated, but would be made in any event for non-tax reasons.
Accordingly, for such contributions, a tax deduction amounts to a windfall reduction in the
taxpayer’s liability with no change in the taxpayer’s behavior. Thus, critics of the proposal argue
that many taxpayers who take the standard deduction already make charitable contributions and
that providing an additional deduction will not induce additional giving by such individuals, but
rather would reward existing levels of giving -- effectively increasing the amount of the standard
deduction.

Charitable organizations often are described as providing many services at little or no
direct cost to taxpayers, which services otherwise would have to be provided by the government
at full cost to taxpayers. In this view, the tax deduction for voluntary charitable donations is seen
as equivalent to deductions permitted for many State and local taxes. The charitable contribution
tax deduction could be said to provide neutrality in the choice to provide certain services to the
public through direct government operation and financing or through the private operation and
mixed private and public financing of a charitable organization. In this view, opponents of the
proposal would argue that an additional deduction for charitable contributions is unwarranted as
the taxpayer has chosen to claim the standard deduction in lieu of claiming an itemized
deduction for State and local taxes and no additional deduction is necessary to maintain
neutrality of choice.

The tax deduction for charitable contributions sometimes is referred to as a tax
expenditure in that it may be considered to be analogous to a direct outlay program that would

109 See, Charles Clotfelter, “The Impact of Tax Reform on Charitable Giving: A 1989
Perspective.”

110 Tn the empirical economics literature, the notion of elasticity is used as a measure of
taxpayer response to a change in the “tax price” or value of the tax deduction. An elasticity
greater than one in absolute value (that is, a value smaller than negative one or a value greater
than positive one) implies that recipients of charitable donations receive more increased funding
than the government loses in forgone revenue. See Clotfelter, Federal Tax Policy and
Charitable Giving.

72


2004 Budget Proposal. During 2002, 2003 and 2004, several legislative proposals have included
various aspects of these proposals.°”°

35 See, e.g., Joint Committee on Taxation, Description of the “Highway Reauthorization
and Excise Tax Simplification Act of 2004” (JCX-5-04), January 29, 2004; House Ways and
Means Committee Report of H.R. 2896, American Jobs Creation Act of 2003, (H. Rep. 108-393,
November 21, 2003); Senate Finance Committee Report of S. 1637, Jumpstart our Business
Strength (JOBS) Act, (S. Rep. 108-192, November 7, 2003); Jobs and Growth Tax Relief
Reconciliation Act of 2003 (H.R. 2), as passed by the Senate on May 15, 2003.

254


of returns, such as employment tax and excise tax returns. Applying this penalty to all taxpayers
and all types of tax returns would make this IRS-imposed penalty more parallel to the Tax Court
penalty, where these constraints do not apply.

Complexity issues

Increasing the amount of an existing penalty arguably would have no impact on tax law
complexity. It could be argued that the procedural changes made by the proposal, taken as a
whole, would simplify tax administration by speeding the disposition of frivolous submissions,
despite the fact that some elements of the proposals (such as the requirement to publish a list of
frivolous positions) may entail increased administrative burdens.

Prior Action

A substantially similar proposal was included in the President’s fiscal year 2003 budget
proposal.*!° An identical proposal was included in the President’s fiscal year 2004 budget
proposal. A substantially similar proposal was contained in the “Taxpayer Protection and IRS
Accountability Act of 2003,” as passed by the House of Representatives on June 19, 2003. A
substantially similar proposal was contained in the “Tax Administration Good Government Act
of 2004,” as passed by the Senate Committee on Finance on February 2, 2004.

3. Authorize IRS to enter into installment agreements that provide for partial payment
Present Law

The Code authorizes the IRS to enter into written agreements with any taxpayer under
which the taxpayer is allowed to pay taxes owed, as well as interest and penalties, in installment
payments if the IRS determines that doing so will facilitate collection of the amounts owed (sec.
6159). An installment agreement does not reduce the amount of taxes, interest, or penalties
owed. Generally, during the period installment payments are being made, other IRS enforcement
actions (such as levies or seizures) with respect to the taxes included in that agreement are held
in abeyance.”

Prior to 1998, the IRS administratively entered into installment agreements that provided
for partial payment (rather than full payment) of the total amount owed over the period of the
agreement. In that year, the IRS Chief Counsel issued a memorandum concluding that partial
payment installment agreements were not permitted.

Description of Proposal

The proposal clarifies that the IRS is authorized to enter into installment agreements with
taxpayers that do not provide for full payment of the taxpayer’s liability over the life of the
agreement.

519 ‘The fiscal year 2003 budget proposal also applied to taxpayer assistance orders.

520 Sec. 6331(k).

323


present value according to the length of time between when it actually is earned and the time it
actually is used to reduce tax liability.

Under present law, firms with research expenditures substantially in excess of their base
amount may be subject to the 50-percent base amount limitation. In general, although these
firms receive the largest amount of credit when measured as a percentage of their total qualified
research expenses, their marginal effective rate of credit is exactly one half of the statutory credit
rate of 20 percent (i.e., firms subject to the base limitation effectively are governed by a 10-
percent credit rate).

Although the statutory rate of the research credit is currently 20 percent, it is likely that
the average marginal effective rate may be substantially below 20 percent. Reasonable
assumptions about the frequency that firms are subject to various limitations discussed above
yield estimates of an average effective rate of credit between 25 and 40 percent below the
statutory rate, i.e., between 12 and 15 percent.°!

Since sales growth over a long time frame will rarely track research growth, it can be
expected that over time each firm’s base will drift from the firm’s actual current qualified
research expenditures. Therefore, increasingly over time there will be a larger number of firms
either substantially above or below their calculated base. This could gradually create an
undesirable situation where many firms receive no credit and have no reasonable prospect of
ever receiving a credit, while other firms receive large credits (despite the 50-percent base
amount limitation). Thus, over time, it can be expected that, for those firms eligible for the
credit, the average marginal effective rate of credit will decline while the revenue cost to the
Federal Government increases.

Complexity and the research tax credit

Administrative and compliance burdens also result from the present-law research tax
credit. The General Accounting Office (“GAO”) has testified that the research tax credit is
difficult for the IRS to administer. The GAO reports that the IRS view is that it is required to
make difficult technical judgments in audits concerning whether research was directed to
produce truly innovative products or processes. While the IRS employs engineers in such audits,
the companies engaged in the research typically employ personnel with greater technical
expertise and, as would be expected, personnel with greater expertise regarding the intended
application of the specific research conducted by the company under audit. Such audits create a
burden for both the IRS and taxpayers. The credit generally requires taxpayers to maintain
records more detailed than those necessary to support the deduction of research expenses under

600 As with any tax credit that is carried forward, its full incentive effect could be
restored, absent other limitations, by allowing the credit to accumulate interest that is paid by the
Treasury to the taxpayer when the credit ultimately is utilized.

6°! For a more complete discussion of this point see Joint Committee on Taxation,

Description and Analysis of Tax Provisions Expiring in 1992 (JCS-2-92), January 27, 1992, pp.
65-66.

372


Analysis

One significant policy concern is whether the collection of taxes is so inherently a
governmental function that it should not be delegated to the private sector. Similarly, there may
be a constitutional issue. Proponents would respond that the actions being delegated to private
sector debt collection companies: (1) are limited in scope; (2) are specific and do not permit the
exercise of discretionary authority; and (3) do not encompass enforcement actions. Accordingly,
proponents believe that neither a policy concern nor a constitutional issue exists.

Another policy issue relates to the method by which private sector debt collection
companies will be paid. One alternative is to pay them a flat fee for services rendered. Another
alternative is to pay them a variable fee based, at least in part, on their success in actually
collecting taxes that are due (by, for example, paying them a percentage of what they collect).
This second alternative is generally the method by which the private sector debt collection
companies prefer to be paid. Some may question whether it is appropriate to use a payment
formula based in whole or in part on the success in collecting taxes that are due.

The use of private debt collectors may free up IRS resources to focus on more recent
taxpayer delinquencies where the collection potential is greater. On the other hand, the use of
private debt collectors also raises concerns about the ability of the IRS to properly supervise
these contractors and protect taxpayer privacy. The IRS has a finite amount of resources to
devote to contractor supervision. As the number of private debt collectors increases, the ability
of the IRS to closely supervise those collectors and ensure that the collectors are using
appropriate safeguards and computer security decreases. As aresult, the potential for abuse of
taxpayer return information could increase.

Some have argued that the use of private debt collectors will displace government
employees from their jobs. The IRS reports that it currently has $75.7 billion in uncollected
receivables,°5’ owed by over 6.1 million individuals and businesses.** Others might respond
that these numbers may be so large that the possibility of displacement of government employees
may be remote for at least the foreseeable future.

Prior Action

A substantially similar proposal was included in the President’s fiscal year 2004 budget
proposal.

557 This is the dollar value of what the IRS calls the “Potentially Collectible Inventory;”
it excludes amounts deemed to be uncollectible or duplicative assessments.

558 -TIRNO-03-H-0001 (February 14, 2003), at www.procurement.irs.treas. gov.
Attachment #3.

340


home health service agency, health and welfare service agency, church or convention of
churches in the case of employees who have completed 15 years of service.

Section 403(b) plans are generally subject to the minimum coverage and general
nondiscrimination rules that apply to qualified defined contribution plans. In addition, employer
matching contributions and after-tax employee contributions are subject to the ACP test.
However, pretax contributions made by an employee under a salary reduction agreement (i.e.,
contributions that are comparable to elective deferrals under a section 401(k) plan) are not
subject to nondiscrimination rules similar to those applicable to section 401(k) plans. Instead, all
employees generally must be eligible to make salary reduction contributions. Certain employees
may be disregarded for purposes of this rule.°°

Eligible deferred compensation plans of State and local governments (section 457 plans)

Compensation deferred under a section 457 plan of a State or local governmental
employer is includible in income when paid. The maximum annual deferral under such a plan
generally is the lesser of (1) $13,000 for 2004 (increasing to $15,000 by 2006) or (2) 100 percent
of compensation. A special, higher limit applies for the last three years before a participant
reaches normal retirement age (the “section 457 catch-up limit”). In the case of a section 457
plan of a governmental employer, a participant who has attained age 50 before the end of the
taxable year may also make catch-up contributions up to a limit of $3,000 for 2004 (increasing to
$5,000 by 2006), unless a higher section 457 catch-up limit applies. Only contributions to
section 457 plans are taken into account in applying these limits; contributions made to a
qualified retirement plan or section 403(b) plan for an employee do not affect the amount that
may be contributed to a section 457 plan for that employee.

SIMPLE retirement plans

Under present law, a small business that employs fewer than 100 employees can establish
a simplified retirement plan called the savings incentive match plan for employees (“SIMPLE”)
retirement plan. A SIMPLE plan can be either an individual retirement arrangement for each
employee (a “SIMPLE IRA”) or part of a section 401(k) plan (a “SIMPLE section 401(k) plan”).

A SIMPLE retirement plan allows employees to make elective deferrals, subject to a limit
of $9,000 for 2004 (increasing to $10,000 in 2005). An individual who has attained age 50
before the end of the taxable year may also make catch-up contributions to a SIMPLE plan up to
a limit of $1,500 for 2004 (increasing to $2,500 by 2006).

Employer contributions to a SIMPLE plan must satisfy one of two contribution formulas.
Under the matching contribution formula, the employer generally is required to match employee

55 As in the case of a qualified retirement plan, a section 403(b) plan of a State or local
governmental employer is not subject to the nondiscrimination rules.

56 Section 457 applies also to deferred compensation plans of tax-exempt entities. Those

plans are not affected by the proposal; only the rules for governmental section 457 plans are
relevant for purposes of this discussion.

30


permanent decision could be made as to its effectiveness, providing certainty on the extent of the
disclosure of return information relating to terrorist activities.

Prior Action

An identical proposal was included in the President's fiscal year 2004 budget proposals.

405


Those who hold this view argue that cash balance plans are more beneficial to many employees
than a traditional defined benefit pension plan and should be a permitted plan design option.

Unlike traditional defined benefit pension plans, which tend to benefit long-service
participants who remain with a company until retirement, cash balance plans often benefit
shorter service, more mobile workers. Cash balance plans also provide a more portable benefit
than the traditional defined benefit pension plan. Thus, cash balance plans may be popular in
industries or markets in which workers are relatively mobile or among groups of workers who go
in and out of the workforce. Some participants also find cash balance plans easier to understand
than a traditional defined benefit pension plan--their benefit statement shows an account balance.

The adoption of a cash balance plan may be beneficial from the employer’s perspective.
Some employers are concerned about the level of contributions that may be required to fund
traditional defined benefit pension plans, especially if the required contributions may fluctuate
over time. They argue that a cash balance plan design makes it easier for employers to manage
pension liabilities, The easier it is for an employer to manage pension liabilities, the more likely
it is that an employer may adopt or continue a plan.

On the other hand, some are concerned that cash balance plans are primarily adopted by
employers who wish to cut costs and reduce future benefits. They argue that reductions in
benefits are not as obvious with a conversion to a cash balance plan compared to plan changes
within the traditional defined benefit pension plan structure. Even with the present-law
requirements relating to notices of reductions in future benefit accruals, it is argued that plan
participants do not understand how to compare cash balance benefits with traditional defined
benefit pension plan benefits and that many employees mistakenly think that the cash balance
formula, expressed as an account balance, provides comparable benefits when it does not. It is
also argued that cash balance plans inherently discriminate against longer service older workers,
and thus should not be encouraged as a plan design.

It is countered that if an employer wishes to reduce benefits, or eliminate benefits
altogether, they could do so within the traditional defined benefit pension plan structure.
Moreover, some argue, employers generally sponsor qualified retirement plans voluntarily; tax
incentives encourage employers to establish and maintain such plans but they are not required to
do so. It is argued that the flexibility allowed by employers by cash balance plans enables
employers to continue a defined benefit pension plan, as well as in many cases also provide a
defined contribution plan, thus enhancing retirement income security.

Some also note that cash balance plans, while legally defined benefit pension plans,
operate in a way that does not deliver the full protections of a traditional defined benefit pension
plan. For example, many traditional defined benefit pension plans do not offer lump-sum
distributions. In contrast, cash balance plans typically do. While some argue that this increases
portability of benefits, others argue that cash balance plans discourage annuity benefits, which
may erode retirement income security and may undermine spousal rights.

Some also comment that the risk of investment loss borne by employers, and the

protections against such losses for employees, are fundamentally different in cash balance plans
than in traditional defined benefit pension plans. In particular, it is argued that the risk

222


they relate to certain minimum educational requirements or to education or training that enables
a taxpayer to begin working in a new trade or business.

An individual is allowed an above-the-line deduction for qualified tuition and related
expenses for higher education paid by the individual during a taxable year that are required for
the enrollment or attendance of the taxpayer, the taxpayer’s spouse, or any dependent of the
taxpayer with respect to whom the taxpayer may claim a personal exemption, at an eligible
educational institution of higher education for courses of instruction of such individual at such
institution.'*°

Unreimbursed educational expenses incurred by employees

In the case of an employee, education expenses (if not reimbursed by the employer) may
be claimed as an itemized deduction only if such expenses meet the above-described criteria for
deductibility under section 162 and only to the extent that the expenses, along with other
miscellaneous itemized deductions, exceed two percent of the taxpayer’s adjusted gross income.
Itemized deductions subject to the two-percent floor are not deductible for minimum tax
purposes. In addition, present law imposes a reduction on most itemized deductions, including
the employee business expense deduction, for taxpayers with adjusted gross income in excess of
a threshold amount, which is indexed annually for inflation. The threshold amount for 2004 is
$142,700 ($71,350 for married individuals filing separate returns). For those deductions that are
subject to the limit, the total amount of itemized deductions is reduced by three percent of
adjusted gross income over the threshold amount, but not by more than 80 percent of itemized
deductions subject to the limit. Beginning in 2006, the Economic Growth and Tax Relief
Reconciliation Act of 2001 phases-out the overall limitation on itemized deductions for all
taxpayers. The overall limitation on itemized deductions is reduced by one-third in taxable years
beginning in 2006 and 2007, and by two-thirds in taxable years beginning in 2008 and 2009.
The overall limitation on itemized deductions is eliminated for taxable years beginning after
December 31, 2009, although this elimination of the limitation sunsets on December 31, 2010.'”

Contributions to a school may be eligible for a charitable contribution deduction under
section 170. A contribution that qualifies both as a business expense and a charitable
contribution may be deducted only as one or the other, but not both.

Description of Proposal

The temporary provision allowing eligible educators an above-the-line deduction for
certain expenses is made permanent, and the maximum deduction is increased to $400. As under
current law, the provision applies to teachers and other school personnel employed by public
entities, charter schools or private schools (as determined under State law). The current-law 900-
hour rule is clarified to refer to a school year ending during the taxable year. Eligible,
unreimbursed expenses are expanded to include teacher training expenses related to current

186 Sec, 222.

157 separate proposal contained in the President’s fiscal year 2005 budget permanently
extends the elimination of the overall limitation on itemized deductions after 2010.

101


involve administrative costs, which some employers may not view as commensurate with
simplification benefits.

Many view the different rules for different types of plans as largely historical in nature
and as adding complexity without serving an overriding policy objective. On the other hand,
some argue that the differences in the rules serve different employment objectives and policies of
different types of employers.

Some may be concerned that the proposal, in combination with the proposals for
expanded individual savings opportunities (i.e., Lifetime Savings Accounts and Retirement
Savings Accounts), will further reduce the incentive for small employers to offer retirement
plans to their employees.” Although higher contributions may be made to an employer-
sponsored retirement plan than to these other arrangements, comparable contributions must be
made by or on behalf of rank-and-file employees. The opportunity to contribute $5,000 a year to
both a Lifetime Savings Account and a Retirement Savings Account for both the business owner
and his or her spouse, without regard to adjusted gross income or contributions for rank-and-file
employees, may be a more attractive alternative to maintaining a qualified retirement plan. On
the other hand, the excludability of ERSA contributions and the availability of the ERSA safe
harbor, coupled with the higher contribution levels permitted under a qualified plan, may be
viewed as providing an adequate incentive for a small employer to establish an ERSA.

Prior Action

The President’s fiscal year 2004 budget proposal included a similar proposal. In
addition, the President’s fiscal year 2004 budget included several proposals to simplify the rules
for defined contribution plans generally.

3. Individual development accounts
Present Law

Individual development accounts were first authorized by the Personal Work and
Responsibility Act of 1996. In 1998, the Assets for Independence Act established a five-year
$125 million demonstration program to permit certain eligible individuals to open and make
contributions to an individual development account. Contributions by an individual to an
individual development account do not receive a tax preference but are matched by contributions
from a State program, a participating nonprofit organization, or other “qualified entity.” The IRS
has ruled that matching contributions by a qualified entity are a gift and not taxable to the
account owner.®! The qualified entity chooses a matching rate, which must be between 50 and
400 percent. Withdrawals from individual development account can be made for certain higher
education expenses, a first home purchase, or small business capitalization expenses. Matching
contributions (and earnings thereon) typically are held separately from the individuals’

© The proposals relating to Lifetime Savings Accounts and Retirement Savings
Accounts are discussed in Part II.A.1 of this document.

5! Rey, Rul. 99-44, 1999-2 C.B. 549.

37


Description of Proposal

The proposal adds an additional civil penalty that may be imposed on any person who
violates this reporting requirement (without regard to willfulness). This new civil penalty is up
to $5,000. The penalty may be waived if any income from the account was properly reported on
the income tax return and there was reasonable cause for the failure to report.

Effective date.—The proposal generally is effective after the date of enactment.
6. Foreign tax credit transactions

Present Law

The United States provides a credit for foreign income taxes paid or accrued. The
foreign tax credit generally is limited to the U.S. tax liability on a taxpayer’s foreign-source
income, in order to ensure that the credit serves the purpose of mitigating double taxation of
foreign-source income without offsetting the U.S. tax on U.S.-source income. This overall
limitation is calculated by prorating a taxpayer's pre-credit U.S. tax on its worldwide income
between its U.S.-source and foreign-source taxable income. Separate limitations are applied to
specific categories of income.

Present law denies a U.S. shareholder the foreign tax credits normally available with
respect to a dividend from a corporation if the shareholder has not held the stock for more than
15 days (within a 30-day testing period) in the case of common stock or more than 45 days
(within a 90-day testing period) in the case of preferred stock (sec. 901(k)). The disallowance
applies both to foreign tax credits for foreign withholding taxes that are paid on the dividend
where the dividend-paying stock is held for less than these holding periods, and to indirect
foreign tax credits for taxes paid by a lower-tier foreign corporation where any of the required
stock in the chain of ownership is held for less than these holding periods. Periods during which
a taxpayer is protected from risk of loss (e.g., by purchasing a put option or entering into a short
sale with respect to the stock) generally are not counted toward the holding period requirement.
In the case of a bona fide contract to sell stock, a special rule applies for purposes of indirect
foreign tax credits. The disallowance does not apply to foreign tax credits with respect to certain
dividends received by active dealers in securities. If a taxpayer is denied foreign tax credits
because the applicable holding period is not satisfied, the taxpayer is entitled to a deduction for
the foreign taxes for which the credit is disallowed.

Description of Proposal

The proposal expands the present-law disallowance of foreign tax credits to include
credits for gross-basis foreign withholding taxes with respect to any item of income or gain from
property if the taxpayer who receives the income or gain has not held the property for more than
15 days (within a 30-day testing period), exclusive of periods during which the taxpayer is
protected from risk of loss. In addition, the proposal authorizes the Treasury Department to issue
regulations providing that the proposal does not apply in appropriate cases.

The proposal also provides regulatory authority for the Treasury Department to address
certain transactions that involve the inappropriate separation of foreign taxes from the related

248


Gift and generation-skipping transfer (GST) tax treatment

A contribution to a qualified tuition account (or with respect to a prepaid tuition contract)
is treated as a completed gift of a present interest from the contributor to the designated
beneficiary.’”* Such contributions qualify for the per-donee annual gift tax exclusion ($11,000
for 2004), and, to the extent of such exclusions, also are exempt from the generation-skipping
transfer (GST) tax. A contributor may contribute up to five times the per-donee annual gift tax
exclusion amount to a qualified tuition account and, for gift tax and GST tax purposes, treat the
contribution as having been made ratably over the five-year period beginning with the calendar
year in which the contribution is made.*”

A distribution from a qualified tuition account or prepaid tuition contract generally is not
subject to gift tax or GST tax. °0 ‘Those taxes may apply, however, to a change of designated
beneficiary if the new designated beneficiary is in a generation below that of the old
beneficiary.”

Estate tax treatment

Qualified tuition program account balances or prepaid tuition benefits generally are
excluded from the gross estate of any individual.’ Amounts distributed on account of the death
of the designated beneficiary, however, are includible in the designated beneficiary’s gross
estate.“ If the contributor elected the special five-year allocation rule for gift tax annual
exclusion purposes, any amounts contributed that are allocable to the years within the five-year
period remaining after the year of the contributor’s death are includible in the contributor’s gross
estate.

Powers of appointment

Special income tax and transfer tax rules apply to instances where a person holds a power
of appointment or certain other powers with respect to property. In general, a power of
appointment includes all powers which are in substance and effect powers of appointment

48 Sec, 529(c)(2)(A).

9 Sec. 529(c)(2)(B).

500 Sec. 529(c)(5)(A).

501 See, §29(c)(5)(B). A technical correction has been introduced that also would impose
gift tax and GST tax on a change in the designated beneficiary if the new beneficiary is not a
member of the family of the old beneficiary.

5 Sec, $29(c)(4)(A).

5 Sec. $29(c)(4)(B).

504 Sec, 529(c)(4)(C).

309


greater of $10,000 or 50 percent of the fees payable to any promoter with respect to offerings
prior to the date of late registration. Intentional disregard of the requirement to register increases
the penalty to 75 percent of the applicable fees.

Section 6707 also imposes (1) a $100 penalty on the promoter for each failure to furnish
the investor with the required tax shelter identification number, and (2) a $250 penalty on the
investor for each failure to include the tax shelter identification number on a return.

Description of Proposal

Disclosure of reportable transactions

The proposal repeals the present law rules with respect to registration of tax shelters.
Instead, the proposal requires that an information return be filed with respect to any entity,
investment plan or arrangement or other plan or arrangement that is of a type determined by the
Treasury Department to have the potential for tax avoidance or evasion. The proposal also
modifies present-law to confirm that the requirements and penalties may apply to all organizers
and sellers of reportable transactions, including persons who assist such persons.

Penalty for failing to furnish information regarding reportable transactions

The proposal repeals the present law penalty for failure to register tax shelters. Instead,
the proposal imposes a penalty on any material advisor who fails to file an information return, or
who files a false or incomplete information return, with respect to a reportable transaction. The
amount of the penalty is $50,000. If the penalty is with respect to a listed transaction, the
amount of the penalty is increased to the greater of (1) $200,000, or (2) 50 percent of the fees
paid to the promoter. Intentional disregard by a material advisor of the requirement to disclose a
reportable transaction increases the penalty to 75 percent of the fees paid to the promoter.

Effective date
The proposal generally is effective after the date of enactment.
3. Investor lists and modification of penalty for failure to maintain investor lists

Present Law

Investor lists
Any organizer or seller of a potentially abusive tax shelter must maintain a list identifying

each person who was sold an interest in any such tax shelter with respect to which registration
was required under section 6111 (even though the particular party may not have been subject to

244


Age test

Under the proposal, the age test varies depending upon the tax benefit involved. In
general, a child must be under age 19 (or under age 24 in the case of a full-time student) in order
to be a qualifying child. In general, no age limit applies with respect to individuals who are
totally and permanently disabled. The proposal retains the present-law requirements that a child
must be under age 13 (if he or she is not disabled) for purposes of the dependent care credit, and
under age 17 (whether or not disabled) for purposes of the child credit.

Children who support themselves

Under the proposal, a child who provides over one half of his or her own support is not
considered a dependent of another taxpayer.

Tie-breaking rules

Ifa child would be a qualifying child with respect to more than one individual (¢.g., a
child lives with his or her mother and grandmother in the same residence) and more than one
person claims a benefit with respect to that child, then the following “tie-breaking” rules apply.
First, if only one of the individuals claiming the child as a qualifying child is the child’s parent,
the child is deemed the qualifying child of the parent. Second, if both parents claim the child and
the parents do not file a joint return, then the child is deemed a qualifying child first with respect
to the parent with whom the child resides for the longest period of time, and second with respect
to the parent with the highest adjusted gross income. Third, if the child’s parents do not claim
the child, then the child is deemed a qualifying child with respect to the claimant with the highest
adjusted gross income.

Interaction with present-law rules

Taxpayers may continue to claim an individual who does not meet the proposed uniform
definition of qualifying child as a dependent if the present-law dependency requirements are
satisfied. Thus, for example, a taxpayer may claim a parent as a dependent if the taxpayer
provides more than one half of the support of the parent and the parent’s gross income is less
than the exemption amount. As another example, as is the case under present law, taxpayers
may claim an unrelated child as a dependent if the child resides in the taxpayer’s home for the
full year and meets the present-law dependency requirements.””° If one taxpayer claims a child
as a dependent under present law, and another taxpayer claims the same child as a dependent
under the proposed uniform definition of qualifying child, the proposal provides that the
proposed residency-based tests supersede present law.

The present-law dependency tests continue to apply to children who are U.S. citizens
living abroad or non-U.S. citizens living in Canada or Mexico.

229 ‘The proposal retains the present-law rule that such children would not qualify the
taxpayer for the child credit or the earned income credit unless they were placed in the taxpayer’s
home by an authorized placement agency.

162


quarterly installment payments, the IRS has no procedure for ensuring that installments
subsequent to the first one actually are paid. Thus, it is possible for taxpayers to receive State
registrations when only the first quarterly installment is paid with the return. Similarly, it is
possible for taxpayers repeatedly to pay the first quarterly installment and continue to receive
State registrations because the IRS has no computerized system for checking past compliance
when it issues certificates of payment for the current year. In the case of taxpayers owning only
one or a few vehicles, it is not cost effective for the IRS to monitor and enforce compliance.

Eliminating the quarterly installment option would eliminate current opportunities for tax
evasion without requiring devotion of IRS resources to non-cost-effective enforcement activities.
On the other hand, law-abiding taxpayers will be denied the opportunity to pay their tax liability
in installments and opponents might argue that the law should be changed so as to require the
IRS to check for past compliance.

Prior Action

On February 12, 2004, the Senate passed a similar proposal as part of S. 1072, the “Safe,
Accountable, Flexible and Efficient Transportation Equity Act of 2004”.

351


Except to the extent provided in regulations, individuals who would otherwise be subject
to the alternative tax regime in a calendar year during the 10-year period following expatriation
but who are physically present in the United States for more than 30 days in that calendar year
generally are subject to U.S. tax on their worldwide income as though they were U.S. citizens or
residents in that taxable year.

Certain gifts of stock of closely-held foreign corporations by a former citizens or former
long-term resident are subject to U.S. gift tax. Annual reporting is required for individuals
subject to the alternative tax regime, even if they have no U.S. tax liability that year.

Effective date.The changes apply to individuals losing U.S. citizenship or long-term
residency on or after date of first committee action.

Analysis

The proposal replaces the present-law subjective determination of tax avoidance as a
principal purpose for citizenship relinquishment or residency termination with objective rules.
One of the difficulties in administering the present-law alternative tax regime is that the IRS is
required to determine the subject intent of taxpayers who wish to relinquish citizenship or
terminate residency if (1) taxpayers fall below the income tax liability or net worth thresholds or
(2) the taxpayers exceed the thresholds but nevertheless are allowed to seek a ruling from the
IRS to the effect that they did not have a principle purpose of tax avoidance. An objective rule
may simplify the taxation of expatriates, but such a rule is more inflexible. However, because
estate and gift taxes are often the principal motivating factors for persons who relinquish
citizenship or terminate residency for tax-avoidance purposes, the higher net worth test may
alleviate concerns about subjecting non-tax-motivated individuals to the regime. The $2 million
net worth threshold is twice the unified credit exclusion amount for gift tax purposes, a level
above which the transfer tax can be significant enough to be a motivating factor for relinquishing
citizenship or terminating residency.

If a former citizen exceeds the monetary thresholds, that person is excluded from the
alternative tax regime if he or she falls within exceptions for certain dual citizens and minors.
Thus, objective exceptions for cases particularly likely to involve significant non-tax motivation
replace the intent-based inquiry applicable to these cases under present law.

Under the proposal, tax-based rules are used to determine when an individual is no longer
a USS. citizen or long-term resident for U.S. Federal tax purposes. Under present law, an
individual’s U.S. residency is considered terminated for U.S. Federal tax purposes when the
individual ceases to be a lawful permanent resident under the immigration law (or is treated as a
resident of another country under a tax treaty and does not waive the benefits of such treaty).
The proposal strengthens the present-law rules by denying the tax benefits of citizenship
relinquishment or termination of long-term residency unless and until the IRS is provided the
information necessary to enforce the alternative tax regime.

Individuals who are subject to the alternative tax regime in a calendar year during the 10-

year period following expatriation but who are physically present in the United States for more
than 30 days in that calendar year are subject to U.S. tax on their worldwide income as though

297


An otherwise eligible taxpayer is not eligible for the credit for a month if, as of the first
day of the month the individual has other specified coverage. Other specified coverage is
(1) coverage under any insurance which constitutes medical care (except for insurance
substantially all of the coverage of which is for excepted benefits)’ maintained by an employer
(or former employer) if at least 50 percent of the cost of the coverage is paid by an employer”
(or former employer) of the individual or his or her spouse or (2) coverage under certain
governmental health programs.”° A tule aggregating plans of the same employer applies in
determining whether the employer pays at least 50 percent of the cost of coverage. A person is
not an eligible individual if he or she may be claimed as a dependent on another person’s tax
return. A special rule applies with respect to alternative TAA recipients. For eligible alternative
TAA recipients, an individual has other specified coverage if the individual is (1) eligible for
coverage under any qualified health insurance (other than coverage under a COBRA
continuation provision, State-based continuation coverage, or coverage through certain State
arrangements) under which at least 50 percent of the cost of coverage is paid or incurred by an
employer of the taxpayer or the taxpayer’s spouse or (2) covered under any such qualified health
insurance under which any portion of the cost of coverage is paid or incurred by an employer of
the taxpayer or the taxpayer’s spouse.

Qualified health insurance

Qualified health insurance eligible for the credit is: (1) COBRA continuation coverage;
(2) State-based continuation coverage provided by the State under a State law that requires such
coverage; (3) coverage offered through a qualified State high risk pool; (4) coverage under a

4 Excepted benefits are: (1) coverage only for accident or disability income or any
combination thereof: (2) coverage issued as a supplement to liability insurance; (3) liability
insurance, including general liability insurance and automobile liability insurance; (4) worker’s
compensation or similar insurance; (5) automobile medical payment insurance; (6) credit-only
insurance; (7) coverage for on-site medical clinics; (8) other insurance coverage similar to the
coverages in (1)-(7) specified in regulations under which benefits for medical care are secondary
or incidental to other insurance benefits; (9) limited scope dental or vision benefits; (10) benefits
for long-term care, nursing home care, home health care, community-based care, or any
combination thereof: and (11) other benefits similar to those in (9) and (10) as specified in
regulations; (12) coverage only for a specified disease or illness; (13) hospital indemnity or other
fixed indemnity insurance; and (14) Medicare supplemental insurance.

°° An amount is considered paid by the employer if it is excludable from income. Thus,
for example, amounts paid for health coverage on a salary reduction basis under an employer
plan are considered paid by the employer.

% Specifically, an individual is not eligible for the credit if, as of the first day of the
month, the individual is (1) entitled to benefits under Medicare Part A, enrolled in Medicare Part
B, or enrolled in Medicaid or SCHIP, (2) enrolled in a health benefits plan under the Federal
Employees Health Benefit Plan, or (3) entitled to receive benefits under chapter 55 of title 10 of
the United States Code (relating to military personnel). An individual is not considered to be
enrolled in Medicaid solely by reason of receiving immunizations.

62


Definition of insurance company

Advocates of conforming the definition of an insurance company so that it is consistent
for property and casualty insurance companies and life insurance companies argue that
consistency in the definition would improve administration and enforcement of the law and
reduce the likelihood of disputes and litigation over the meaning of an insurance company. It is
further argued that the definition currently used under the life insurance company tules is
quantifiable, unambiguous, and preferable to the vaguer rule that applies to property and casualty
insurers under Treasury regulations. It is argued that a clear, enforceable definition would
benefit both taxpayers and the government. In particular, it would facilitate identification of
those companies entitled to tax exempt status and provide a straightforward test for
distinguishing those that are not eligible.

Opponents of the proposal relating to the definition of a life insurance company might
argue that a definition applicable to property and casualty insurers already exists in the law
(albeit in regulations), and that changing it is not necessary or does not clarify the law
significantly. They might argue that the regulatory definition is sufficiently similar to the
statutory definition that would be applied under the proposal to property and casualty insurers
that little simplification or additional clarity is provided. Nevertheless, on the other hand,
advocates of the proposal may argue that a uniform definition serves to eliminate questions of
interpretation and improves the predictability of the result under the law in any particular case.

Prior Action

A similar provision was included in President Clinton's fiscal year 2001 budget
proposals. That proposal would modify the eligibility requirement for tax-exempt status for an
insurance company so the $350,000 threshold would be based on gross receipts rather than
premiums, and would limit eligibility to domestic companies. That proposal (like the current
proposal) would also eliminate the lower dollar threshold for eligibility to elect to be taxed only
on taxable investment income.

Several recent bills include a similar provision that applies a gross receipts test and
requires that premiums received for the taxable year be greater than 50 percent of gross receipts
in order for a property and casualty insurance company to be eligible for tax-exempt status. The
bills generally provide for conforming the definition of an insurance company so that it is
consistent for property and casualty insurance companies and life insurance companies, “*

408 See sections 493 and 494 of S. 1637, the "Jumpstart our Business Strength (JOBS)
Act, S. Rep No. 108-192, 214-217; and sections 3028 and 3029 of H.R. 2896, the "American
Jobs Creation Act of 2003," H.R. Rep No. 108-393, 214-218.

264


are entitled. Further simplicity could be achieved by providing a truly uniform definition of
qualified higher education expenses.

While providing a uniform definition of qualifying higher education expenses for all
education provisions would provide additional simplification, it would also involve policy issues.
For example, allowing room and board expenses as qualified expenses for all education tax
incentives would significantly expand the scope of the education tax incentives that do not
currently cover such expenses. Similarly, excluding room and board expenses from the
education tax incentives that allow such expenses would significantly reduce the benefits
currently provided by those provisions.

Providing a definition of special needs services may reduce disputes between taxpayers
and the IRS as to what are qualifying expenses. Additional simplification could also be achieved
by providing a statutory definition of a special needs beneficiary.

Eliminating the two-prong test for room and board expenses for those provisions that
allow such expenses raises simplification issues and policy issues. From a simplification
standpoint, the proposal may reduce disputes between taxpayers and the IRS by providing an
objective standard by which to judge whether such expenses are qualified. The proposal may
also ease tax administration, as well as reduce record keeping on the part of taxpayers.

From a policy perspective, the proposal may reduce the amount that may be excluded in
those cases in which actual expenses for room and board exceed the allowance for such
expenses. Some argue that such a result is appropriate in order to prevent taxpayer subsidy of
inappropriate levels of expenses.

Prior Action

No prior action.

3. Repeal Coverdell income limits

Present Law

Section 530 of the Code provides tax-exempt status to Coverdell education savings
accounts (“ESAs”), meaning certain trusts or custodial accounts which are created or organized
in the United States exclusively for the purpose of paying the qualified education expenses of a
designated beneficiary. Contributions to ESAs may be made only in cash.”*? Annual
contributions to ESAs may not exceed $2,000 per beneficiary (except in cases involving certain
tax-free rollovers) and may not be made after the designated beneficiary reaches age 18.

Individuals who make contributions to Coverdell education savings accounts are subject
to an income limitation regarding the maximum contribution of $2,000 per year. The allowable
contribution phases out between $95,000 and $110,000 of modified AGI ($190,000 to $220,000
for married taxpayers filing joint returns). There is, however, no limit on the number of accounts

282 Special estate and gift tax rules apply to qualified tuition programs and ESAs.

201


J. Tax Shelter Exception to Confidentiality Privileges Relating
to Taxpayer Communications

Present Law

In general, a common law privilege of confidentiality exists for communications between
an attorney and client with respect to the legal advice the attorney gives the client. The Code
provides that, with respect to tax advice, the same common law protections of confidentiality that
apply to a communication between a taxpayer and an attorney also apply to a communication
between a taxpayer and a federally authorized tax practitioner to the extent the communication
would be considered a privileged communication if it were between a taxpayer and an attorney.
This rule is inapplicable to written communications regarding corporate tax shelters.

Description of Proposal

The proposal modifies the rule relating to corporate tax shelters by making it applicable
to all tax shelters, whether entered into by corporations, individuals, partnerships, tax-exempt
entities, or any other entity. Accordingly, written communications with respect to tax shelters
are not subject to the confidentiality provision of the Code that otherwise applies to a
communication between a taxpayer and a federally authorized tax practitioner. The proposal
also confirms that for purposes of the list maintenance requirements of section 6112, the identity
of any person is not privileged.

Effective date—The proposal generally is effective after the date of enactment.

Analysis

See the general discussion in section V.A. following the description of the proposals to
combat tax avoidance transactions above.

Prior Action

The proposal was included in the President’s Fiscal Year 2004 budget proposal. A
number of legislative proposals have included the proposal.“

4© See, e.g., Joint Committee on Taxation, Description of the “Highway Reauthorization
and Excise Tax Simplification Act of 2004” (JCX-5-04), January 29, 2004; House Ways and
Means Committee Report of H.R. 2896, American Jobs Creation Act of 2003, (H. Rep. 108-393,
November 21, 2003); Senate Finance Committee Report of S. 1637, Jumpstart our Business
Strength (JOBS) Act, (S. Rep. 108-192, November 7, 2003).

300


Service (“IRS”), the tax component of the price typically is lower; if the blenders are not
registered or the fuel is removed pursuant to a terminal exchange agreement between suppliers,
the full amount of the tax is due. In the latter case, an expedited refund is available to blenders.
Possible uncertainty as to a blender’s status and administrative issues associated with the
expedited refunds are sources of complexity in the excise tax system resulting from the alcohol
fuels credit provisions.

Additionally, ETBE, an ether produced using ethanol, may be blended by refiners before
the gasoline leaves the refinery for a terminal. Because gasoline from many sources is
commingled during pipeline transport, the regular alcohol component requirements for claiming
the benefit through the excise tax system may not be satisfied. For such cases, the IRS has
prescribed special “election” and deposit rules for refiners to allow them to capture the benefit of
the income tax credit through the excise tax system. These rules further increase complexity.

Prior Action

The alcohol fuels tax provisions (credit and excise tax rate reduction) were last extended
and modified in 1998 as part of the Transportation Equity for the 21st Century Act. That act
authorized Highway Trust Fund expenditures through September 30, 2003. A similar provision
was included in H.R. 6, the Energy Policy Act of 2003, as passed by the Senate on July 31, 2003.

8. Allow deferral of gain on sales or dispositions to Implement Federal Energy Regulatory
Commission or state electric restructuring policy

Present Law

Generally, a taxpayer recognizes gain to the extent the sales price (and any other
consideration received) exceeds the seller’s basis in the property. The recognized gain is subject
to current income tax unless the gain is deferred or not recognized under a special tax provision.

Description of Proposal

The proposal permits a taxpayer to elect to recognize gain from sales of electric
transmission property to an independent transmission company ratably over an eight-year period
beginning in the year of sale if the amount realized from such sale is used to purchase electric or
gas utility property within an applicable period.'®”

In general, an independent transmission company is defined as: (1) any FERC-approved
regional transmission organization, independent system operator, or independent transmission
company; (2) a person (i) who the FERC determines under section 203 of the Federal Power Act
(or by declaratory order) is not a “market participant” and (ii) whose transmission facilities are
placed under the operational control of a FERC-approved regional transmission organization,
independent system operator, or independent transmission company; and (3) in the case of
facilities subject to the jurisdiction of the Public Utility Commission of Texas, (i) a person which

'87 The applicable period for a taxpayer to reinvest the proceeds is four years after the
close of the taxable year in which the qualifying electric transmission transaction occurs.

146


ERSAs and continue to operate under the new rules. Existing section 403(b) plans,
governmental section 457 plans, SARSEPs, and SIMPLE IRAs and SIMPLE section 401(k)
plans may be renamed ERSAs and operate under the new rules. Alternatively, such
arrangements may continue to be maintained in their current form, but may not accept any new
employee deferrals or after-tax contributions after December 31, 2005.°”

Types of contributions and treatment of distributions

An ERSA may provide for an employee to make pretax elective contributions and catch-
up contributions up to the present-law limits applicable to a section 401(k) plan, that is, a limit of
$13,000 for elective deferrals made in 2004 (increasing to $15,000 by 2006) and a limit of
$3,000 for catch-up contributions in 2004 (increasing to $5,000 by 2006). An ERSA may also
allow an employee to designate his or her elective contributions as Roth contributions or to make
other after-tax employee contributions. An ERSA may also provide for matching contributions
and nonelective contributions. Total annual contributions to an ERSA for an employee
(including employee and employer contributions) may not exceed the present-law limit of the
lesser of 100 percent of compensation or $41,000 (as indexed for future years).

Distributions from an ERSA of after-tax employee contributions (including Roth
contributions) and qualified distributions of earnings on Roth contributions are not includible in
income. All other distributions are includible in income.

Nondiscrimination requirements

The present-law ADP and ACP tests are replaced with a single nondiscrimination test. If
the average contribution percentage for nonhighly compensated employees is six percent or less,
the average contribution percentage for highly compensated employees cannot exceed 200
percent of the nonhighly compensated employees’ average contribution percentage. If the
average contribution percentage for nonhighly compensated employees exceeds six percent, the
nondiscrimination test is met. For this purpose, a “contribution percentage” is calculated for
each employee as the sum of employee pretax and after-tax contributions, employer matching
contributions, and qualified nonelective contributions made for the employee, divided by the
employee’s compensation.

A design-based safe harbor is available for an ERSA to satisfy the nondiscrimination test.
Similar to the section 401(k) safe harbor under present law, under the ERSA safe harbor, the plan
must be designed to provide all eligible nonhighly compensated employees with either (1) a fully
vested nonelective contribution of at least three percent of compensation, or (2) fully vested
matching contributions of at least three percent of compensation, determined under one of two
formulas. The ERSA safe harbor provides new formulas for determining required matching
contributions. Under the first formula, matching contributions must be made at a rate of 50
percent of an employee’s elective contributions up to six percent of the employee’s
compensation. Alternatively, matching contributions may be made under any other formula

57 Special transition rules are to be provided for plans maintained pursuant to collective
bargaining agreements and for plans sponsored by State and local governments.

33


The proposal also changes the definition of other specified coverage for eligible
alternative TAA recipients by removing the special rule that applies only to alternative TAA
recipients.

Effective date —The proposal is effective as if included in the Trade Act of 2002.

Analysis
In general

The credit was enacted to assist certain individuals in paying for qualified health
insurance. The various aspects of the proposal will make the credit available to more
individuals. Some aspects of the proposal may be considered clarifications of present law based
on current IRS administrative positions.

Eligible individuals

While the IRS has interpreted the credit as applying to individuals who receive a one-
time lump sum from the PBGC and certain alternative PBGC payees, clarifying statutorily that
such individuals are eligible individuals will simplify administration of the credit. Many believe
that individuals who receive a single-sum pension payment in lieu of an annuity should not be
ineligible for the credit simply because they are not receiving payments on a monthly basis. In
general, lump-sum payments are only received if the value of the benefit is $5,000 or less. Given
the relatively small amount of the payments, most agree that requiring participants to take an
annuity in order to qualify for the credit is not desirable. In general, alternative PBGC payees
include alternative payees under a qualified domestic relations order and beneficiaries of
deceased employees who are receiving payments from the PBGC. Many believe that fairness
requires that such individuals should be treated as eligible PBGC pension recipients.

Certain commonwealths and possessions

The proposal providing that the Commonwealths of Puerto Rico and the Northern
Mariana Islands, American Samoa, Guam, and the U.S. Virgin islands are deemed to be States
for purposes of the State-based coverage rules allows such possessions and commonwealths to
elect a State-based coverage option, which will allow residents greater access to the credit.
Under present law, if an individual meets the definition of an eligible individual, residents of the
possessions and commonwealths may be eligible for the credit; however, because the possession
or commonwealth in which they live is not able to offer qualified health insurance, such
individuals are generally unable to access the credit. The proposal would allow certain
possessions and commonwealths to offer qualified health insurance. Proponents argue that since
the credit is targeted to specific groups of individuals (i.e., individuals receiving benefits under
TAA or from the PBGC), residents of such commonwealths and possessions who are eligible
individuals should not be denied the credit because their residence cannot offer a qualified State-
based option.

65


deductions that are directly connected with the production of the unearned income.” A child’s
net unearned income cannot exceed the child’s taxable income.

The allocable parental tax equals the hypothetical increase in tax to the parent that results
from adding the child’s net unearned income to the parent’s taxable income. Ifa parent has more
than one child subject to the kiddie tax, the net unearned income of all children is combined, and
a single kiddie tax is calculated. Each child is then allocated a proportionate share of the
hypothetical increase.

If the parents file a joint return, the allocable parental tax is calculated using the income
reported on the joint return. In the case of parents who are married but file separate returns, the
allocable parental tax is calculated using the income of the parent with the greater amount of
taxable income. In the case of unmarried parents, the child’s custodial parent is the parent whose
taxable income is taken into account in determining the child’s liability. If the custodial parent
has remarried, the stepparent is treated as the child’s other parent. Thus, if the custodial parent
and stepparent file a joint return, the kiddie tax is calculated using that joint return. If the
custodial parent and stepparent file separate returns, the return of the one with the greater taxable
income is used. If the parents are unmarried but lived together all year, the return of the parent
with the greater taxable income is used.

Unless the parent elects to include the child’s income on the parent’s return (as described
below) the child files a separate return. In this case, items on the parent’s return are not affected
by the child’s income. The total tax due from a child is the greater of:

(1) the sum of (a) the tax payable by the child on the child’s earned income plus (b)
the allocable parental tax or;

(2) the tax on the child’s income without regard to the kiddie tax provisions.
Parental election to include child’s unearned income

Under certain circumstances, a parent may elect to report a child’s unearned income on
the parent’s return. If the election is made, the child is treated as having no income for the year

and the child does not have to file a return. The requirements for the election are that:

(1) __ the child has gross income only from interest and dividends (including capital
gains distributions and Alaska Permanent Fund Dividends);?°”

265 Sec. 1(g)(4).

266 Sec. 1(g)(5); Internal Revenue Service, Publication 929, Tax Rules for Children and
Dependents, at 6 (2003).

267 Internal Revenue Service, Publication 929, Tax Rules for Children and Dependents,
at 7 (2003).

188


request to the IRS regarding whether the individual relinquished citizenship or terminated
residency principally for tax reasons.

Anti-abuse rules are provided to prevent the circumvention of the alternative tax regime.

Estate tax rules with respect to expatriates

Special estate tax rules apply to individual’s who relinquish their citizenship or long-term
residency within the 10 years prior to the date of death, unless he or she did not have a tax
avoidance purpose (as determined under the test above). Under these special rules, certain
closely-held foreign stock owned by the former citizen or former long-term resident is includible
in his or her gross estate to the extent that the foreign corporation owns U.S.-situated assets.

Gift tax rules with respect to expatriates

Special gift tax rules apply to individual’s who relinquish their citizenship or long-term
residency within the 10 years prior to the date of death, unless he or she did not have a tax
avoidance purpose (as determined under the rules above). The individual is subject to gift tax on
gifts of U.S.-situated intangibles made during the 10 years following citizenship relinquishment
or residency termination.

Information reporting

Under present law, U.S. citizens who relinquish citizenship and long-term residents who
terminate residency generally are required to provide information about their assets held at the
time of expatriation. However, this information is only required once.

Description of Proposal

The proposal replaces the present-law subjective determination of tax avoidance as a
principal purpose for citizenship relinquishment or residency termination with objective rules.
Under the proposal, a former citizen or former long-term resident is subject to the alternative tax
regime for a 10-year period following citizenship relinquishment or residency termination, unless
the former citizen or former long-term resident: (1) establishes that his or her average annual net
income tax liability for the five preceding years does not exceed $122,000 (adjusted for inflation
after 2004) and his or her net worth does not exceed $2 million (adjusted for inflation after
2004); and (2) certifies under penalties of perjury that he or she has complied with all U.S.
Federal tax obligations for the preceding five years and provides such evidence of compliance as
the Secretary may require. Ifa former citizen or long-term resident exceeds the monetary
thresholds, that person also is excluded from the alternative tax regime if he or she falls within
the exceptions for certain dual citizens and minors.

Under the proposal, an individual continues to be treated as a U.S. citizen or long-term
resident for U.S. Federal tax purposes, including for purposes of section 7701(b)(10), until the
individual: (1) gives notice of an expatriating act or termination of residency (with the requisite
intent to relinquish citizenship or terminate residency) to the Secretary of State or the Secretary
of Homeland Security, respectively; and (2) provides a statement in accordance with section
6039G.

296


United States. No more than 50 percent of the fair market value of such property can be
attributable to the sum of: (1) the fair market value of articles manufactured outside the United
States; and (2) the direct costs of labor performed outside the United States. With respect to
property that is manufactured outside the United States, certain rules are provided to ensure
consistent U.S. tax treatment with respect to manufacturers.

Shortly after enactment of the ETI regime, the EU brought a case against the United
States in the WTO. In August of 2001, a WTO panel held that the ETI regime constituted a
prohibited export subsidy under the relevant WTO agreements,°°> and a WTO Appellate Body
later affirmed the Panel’s findings (but modified the Panel’s reasoning in part).°°° The BU has
received authorization from a WTO arbitration panel to impose up to $4 billion per year in trade
sanctions against U.S. exports in connection with the case. In response, the EU Council of
Foreign Affairs Ministers adopted a regulation providing for sanctions against U.S. exports to be
phased in beginning March 2004 if the United States has not come into compliance with the
WTO decision by such date.

Description of Proposal

The President’s budget submission proposes the repeal of the ETI regime and proposes
that the regime be replaced with tax law changes that enhance the global competitiveness of
U.S.-based businesses and increase the competitiveness of American manufacturers and other
job creating sectors of the economy. The submission identifies several possible tax law changes
that are “deserving of consideration,” including: (1) the permanent extension and simplification
of the research and experimentation tax credit; (2) the permanent extension of increased
expensing for small businesses; (3) the extension through 2005 of the waiver on the use of net
operating losses under the alternative minimum tax; (4) the reduction of the corporate income tax
rates; (5) the reform of the alternative minimum tax; (6) the reform of the depreciation rules, (7)
the simplification of the business tax rules, generally; and (8) the rationalization and
simplification of the international tax rules (including reform of the interest allocation rules).

Analysis

The budget submission proposes the repeal of the ETI regime and its replacement with
various tax law changes. In describing the possible tax law changes worthy of consideration,
Treasury describes several areas of the Code that it believes are in need of reform, rather than

55 United States -- Tax Treatment for “Foreign Sales Corporations” -- Recourse to
Article 21.5 of the DSU by the European Communities, WT/DS108/RW, Report of the Panel,
August 20, 2001.

656 United States -- Tax Treatment for “Foreign Sales Corporations” -- Recourse to

Article 21.5 of the DSU by the European Communities, WT/DS108/RW, Report of the Panel, as
modified by the Appellate Body, January 14, 2002, adopted January 29, 2002.

415


from subsuming the deduction into the lifetime learning credit per se. As a result, only one
worksheet is necessary to determine the impact of the phaseout.

The proposal substantially expands the amount of the lifetime learning credit available by
making it apply on a per-taxpayer basis rather than a per-tax return basis. Additionally, both the
lifetime learning credit and the Hope credit are made available to more taxpayers by the
increased starting point of the phaseout and by the generally slower phascout that results from
the change in the phaseout from one that phases out all of the credit over a fixed dollar income
range to the proposed phaseout that reduces the credit by an amount equal to five percent of the
extent to which AGI exceeds a threshold level.

The change to the student loan interest deduction will benefit certain taxpayers and harm
others. Taxpayers with marginal tax rates below the 20-percent credit rate will generally be
better off under the proposal, while those with marginal tax rates above 20 percent will be worse
off. Some taxpayers would find the full value of the interest deduction eliminated by the
proposed treatment under the lifetime learning credit. For example, a taxpayer who claims
$10,000 of education expenses under the lifetime learning credit with respect to a dependent
child in his senior year of college might also incur interest expense with respect to funds
borrowed to pay for earlier years of college, and such taxpayer would get no value from treating
such interest expenses as eligible expenses under the lifetime learning credit since they already
had education expenses equal to the maximum allowed under the lifetime learning credit.
Additionally, although the phaseout of the present-law student loan interest deduction and the
proposed credit begin at the same point, the phaseout of the maximum $2,500 interest expense
deduction is more favorable (i.e., occurs more slowly) than the phaseout of the maximum $500
credit that would result from $2,500 of interest expense. Some taxpayers eligible for a partial
interest deduction would be completely phased out of any credit.

Many taxpayers taking the deduction for higher education expenses would find that they
receive little or no lifetime learning credit under the proposal. The reason for this is that
eligibility for the deduction generally extends further up the income distribution than does
eligibility for the proposed lifetime learning credit. For example, a family with $120,000
modified AGI and $5,000 of deductible higher education expenses is able to deduct $4,000 of
such expenses under present law. If such family is in the 25-percent marginal rate bracket, the
deduction is worth $1,000. Under the proposal, the potential lifetime learning credit for such
expenses would be 20 percent of $5,000, or $1,000. However, since the phaseout of the credit
begins at $100,000 of modified AGI and reduces the credit amount by 5 percent of the amount
by which modified AGI exceeds $100,000, the $1,000 credit would be fully phased out at an
income of $120,000.

Prior Action

No prior action.

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M. Modify Certain Tax Rules for Qualified Tuition Programs

Present Law

Overview

Section 529 provides specified income tax and transfer tax rules for the treatment of
accounts and contracts established under qualified tuition programs.*®° A qualified tuition
program is a program established and maintained by a State or agency or instrumentality thereof,
or by one or more eligible educational institutions, which satisfies certain requirements and
under which a person may purchase tuition credits or certificates on behalf of a designated
beneficiary that entitle the beneficiary to the waiver or payment of qualified higher education
expenses of the beneficiary (a “prepaid tuition program”)."* In the case of a program
established and maintained by a State or agency or instrumentality thereof, a qualified tuition
program also includes a program under which a person may make contributions to an account
that is established for the purpose of satisfying the qualified higher education expenses of the
designated beneficiary of the account, provided it satisfies certain specified requirements (a
“savings account program”).*® Under both types of qualified tuition programs, a contributor
establishes an account for the benefit of a particular designated beneficiary to provide for that
beneficiary’s higher education expenses.

For this purpose, qualified higher education expenses means tuition, fees, books,
supplies, and equipment required for the enrollment or attendance of a designated beneficiary at
an eligible educational institution, and expenses for special needs services in the case of a special
needs beneficiary that are incurred in connection with such enrollment or attendance."
Qualified higher education expenses generally also include room and board for students who are
enrolled at least half-time.***

In general, prepaid tuition contracts and tuition savings accounts established under a
qualified tuition program involve prepayments or contributions made by one or more individuals
for the benefit of a designated beneficiary, with decisions with respect to the contract or account
to be made by an individual who is not the designated beneficiary. Qualified tuition accounts or
contracts generally require the designation of a person (generally referred to as an “account
owner”) whom the program administrator (oftentimes a third party administrator retained by the
State or by the educational institution that established the program) may look to for decisions,

480 For purposes of this description, the term “account” is used interchangeably to refer
to a prepaid tuition benefit contract or a tuition savings account established pursuant to a
qualified tuition program.

48 Sec, 529(b)(1)(A).

482 Sec, 529(b)(1)(A).

“83 Sec, 529(e)(3)(A).

484 Sec. 529(e)(3)(B).

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teaching positions. Neither travel nor lodging expenses nor expenditures related to religious
instruction or activities are eligible. Expenses claimed as an above-the-line deduction may not be
claimed as an itemized deduction or taken into account in determining any other tax benefit such
as Hope or lifetime learning credits. Taxpayers are required to retain receipts for eligible
expenditures along with a certification from a principal or other school official that the
expenditures qualified.

Effective date —The proposal is effective for expenses incurred in taxable years beginning
after December 31, 2003.

Analysis

Policy issues

The proposal and the present-law section 62 above-the-line deduction attempt to make
fully deductible many of the legitimate business expenses of eligible schoolteachers. As
described below, and absent an above-the-line deduction, the expenses might otherwise be
deductible except for the two-percent floor that applies to miscellaneous itemized deductions.
Some have observed that the two-percent floor increases pressure to enact above-the-line
deductions on an expense-by-expense basis. In addition to increasing complexity, the expense-
by-expense approach is not fair to other taxpayers with legitimate business expenses that remain
subject to the two-percent floor. For example, emergency response professionals incur similar
unreimbursed expenses related to their employment, a deduction for which also has been
separately proposed.'**

The proposal expands the present-law above-the-line deduction for eligible educators by
increasing the maximum deduction from $250 to $400, thereby making additional legitimate
business expenses deductible. As is the case with the present-law above-the-line deduction, the
proposal presents compliance issues. One reason the two-percent floor was introduced was to
reduce the administrative burden on the IRS to monitor compliance with small deductions.
Some argue that any proposal that circumvents the two-percent floor will encourage cheating.
Others argue that although cheating is a risk, the risk is the same for similarly situated taxpayers
(e.g., independent contractors or taxpayers with trade or business income) who are not subject to
the two-percent floor on similar expenses.

Complexity issues

Three provisions of present law restrict the ability of teachers to deduct as itemized
deductions those expenses covered by the proposal: (1) the two-percent floor on itemized
deductions; (2) the overall limitation on itemized deductions; and (3) the alternative minimum
tax. The staff of the Joint Committee on Taxation has previously identified these provisions as

158 See the conference report to H.R. 1836, the “Economic Growth and Tax Relief
Reconciliation Act of 2001,” H. Rep. No. 107-84, at 169-70 (2001).

102


A separate proposal contained in the President’s budget proposal repeals the present-law
requirement that the taxpayer provide over one half the cost of maintaining the household.

Effective date

The proposal is effective for taxable years beginning after December 31, 2004.

Analysis
Complexity issues
In general

For many taxpayers, the issue of whether a child qualifies for one or more of the present-
law child-related tax benefits is relatively straightforward and does not raise significant
complexity issues. However, the use of different tests to determine whether a taxpayer may
claim various tax benefits relating to children has long been recognized as a source of
complexity for a significant number of taxpayers and the IRS.”*' Under present law, in order to
determine whether a child qualifies a taxpayer for each of the relevant provisions, the taxpayer
must apply up to five different tests (in addition to applying the other rules applicable to the
particular provision). In IRS Publication 17, Your Federal Income Tax (for Individuals), the
explanations of whether a child qualifies under each of these provisions total approximately 38
pages,” comprised of the following:

¢ Dependency exemption: nine pages, including one flowchart for use in determining
whether someone is a dependent, a worksheet for use in applying the support test, and
one flowchart for use in determining the support test for children of divorced or
separated parents;”**

e Earned income credit: thirteen pages, including a chart illustrating the definition of
qualifying child, an eligibility checklist, and a description of 15 separate rules
applicable to the credit (seven that apply to all claimants, three that apply to claimants

231 See, e.g., Joint Committee on Taxation, Study of the Overall State of the Fe ederal Tax
System and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal
Revenue Code of 1986, Volume II, 44-66 (JCS-3-01), April 2001. See also American Bar
Association, American Institute of Certified Public Accountants Tax Division and the Tax
Executives Institute, American Bar Association Section of Taxation, Government Submissions,
available at http://www.abanet.org/tax/pubpolicy/2001/01simple/home.html.

232 ‘The page number total has increased from 17 pages since the Joint Committee on
Taxation simplification study was released in April 2001. The page number total nearly doubled
from 2002 to 2003, with the increase attributable to the earned income credit (an additional 10
pages), the child credit (an additional three pages), and the dependent care credit (an additional
six pages).

233 IRS Publication 17, Your Federal Income Tax (for Individuals), 28-36.

165


Analysis

See the general discussion following the description of the proposed tax credit for
combined heat and power property, below.

Prior Action

The President’s fiscal year 2003 and 2004 budgets proposed a similar proposal to the
current proposal (identical except for several effective dates). The President’s fiscal year 2001
and 2002 budgets also proposed extending and expanding the categories of facilities that would
qualify for the production credit under section 45.

The conference agreement to H.R. 6, “The Energy Policy Act of 2003,” as passed by the
House of Representatives on November 18, 2003, H.R. 6 as passed by the House of
Representative on April 11, 2003, and S. 1149, as passed by the Senate on July 31, 2003, each
contain a similar provision with respect to the extension of present-law section 45. Each bill
would extend the production credit to open-loop biomass facilities. The conference agreement to
H.R. 6 and S. 1149 would provide that certain facilities that co-fire closed-loop biomass with
another fuel qualify for the production credit. In addition, the conference agreement to H.R. 6
and S. 1149 would extend the credit for poultry waste facilities. Also each bill defines further
additional facilities, beyond open-loop biomass facilities, as qualifying for the production credit.

Division C of H.R. 4, the “Energy Tax Policy Act of 2001,” as passed by the House of
Representatives on August 2, 2001, would have extended the placed in service dates for wind
facilities and closed-loop biomass facilities, but not poultry waste facilities. In addition, the
House bill would have added two new types of qualifying facilities. Division H of H.R. 4, the
“Energy Tax Incentives Act of 2002,” as amended by the Senate on April 25, 2002, would have
extended the placed in service date for all qualifying facilities and would have added eight new
types of qualifying facilities.

2. Provide a tax credit for residential solar energy systems
Present Law

A nonrefundable, 10-percent business energy credit is allowed for the cost of new
property that is equipment (1) that uses solar energy to generate electricity, to heat or cool a
structure, or to provide solar process heat, or (2) used to produce, distribute, or use energy
derived from a geothermal deposit, but only, in the case of electricity generated by geothermal
power, up to the electric transmission stage.

The business energy tax credits are components of the general business credit (sec.
38(b)(1)). The business energy tax credits, when combined with all other components of the
general business credit, generally may not exceed for any taxable year the excess of the
taxpayer's net income tax over the greater of (1) 25 percent of net regular tax liability above
$25,000 or (2) the tentative minimum tax. For credits arising in taxable years beginning after
December 31, 1997, an unused general business credit generally may be carried back one year
and carried forward 20 years (sec. 39).

124


foreign income in cases where taxes are imposed on any person in respect of income of an entity.
This proposal responds to certain foreign tax credit structures that allow taxpayers to manipulate
the foreign tax credit rules in a manner inconsistent with providing relief from double taxation?”

Effective dateThe proposal generally is effective after the date of enactment.
7. Income separation transactions

Present Law

Assignment of income in general

In general, an “income stripping” transaction involves a transaction in which the right to
receive future income from income-producing property is separated from the property itself. In
such transactions, it may be possible to generate artificial losses from the disposition of certain
property or to defer the recognition of taxable income associated with such property.

Common law has developed a rule (referred to as the “assignment of income” doctrine)
that income may not be transferred without also transferring the underlying property. A leading
judicial decision relating to the assignment of income doctrine involved a case in which a
taxpayer made a gift of detachable interest coupons before their due date while retaining the
bearer bond. The U.S. Supreme Court ruled that the donor was taxable on the entire amount of
interest when paid to the donee on the grounds that the transferor had “assigned” to the donee the
right to receive the income.*®°

In addition to general common law assignment of income principles, specific statutory
rules have been enacted to address certain specific types of income stripping transactions, such
as transactions involving stripped bonds and stripped preferred stock (which are discussed
below).?*! However, there are no specific statutory rules that address income stripping

379 See, e.g., cross-border tax arbitrage transactions described in Notice 98-5, 1998-1
C.B. 334, withdrawn by Notice 2004-19, 2004-11 I R.B. 1.

389 Helvering v. Horst, 311 U.S. 112 (1940).

38! Depending on the facts, the IRS also could determine that a variety of other Code-
based and common law-based authorities could apply to income stripping transactions,
including: (1) sections 269, 382, 446(b), 482, 701, or 704 and the regulations thereunder; (2)
authorities that recharacterize certain assignments or accelerations of future payments as
financings; (3) business purpose, economic substance, and sham transaction doctrines; (4) the
step transaction doctrine; and (5) the substance-over-form doctrine. See Notice 95-53, 1995-2
C.B. 334 (accounting for lease strips and other stripping transactions).

249


December 31, 2003. Within limits, contributions to an HSA made by or on behalf of an eligible
individual are deductible by the individual. Eligible individuals are individuals who are covered
by a high deductible health plan and no other health plan that is not a high deductible health plan.
Contributions to an HSA are excludable from income and employment taxes if made by the
employer. Earnings on amounts in HSAs are not taxable. Distributions from an HSA for
qualified medical expenses are not includible in gross income. Distributions from an HSA that
are not used for qualified medical expenses are includible in gross income and are subject to an
additional tax of 10 percent, unless the distribution is made after death, disability, or the
individual attains the age of Medicare eligibility (i.e., age 65).

Description of Proposal

The proposal provides a refundable tax credit for health insurance purchased by
individuals who are under age 65 and do not participate in a public or employer-provided health
plan. The maximum annual amount of the credit is 90 percent of premiums, up to a maximum
premium of $1,111 per adult and $556 per child (for up to two children). These dollar amounts
are indexed in accordance with the medical care component of the Consumer Price Index based
on all-urban consumers. Thus, the maximum annual credit prior to any indexing of the premium
limits is $1,000 per adult and $500 per child (up to two children), for a total possible maximum
credit of $3,000 per tax return.

The 90 percent credit rate is phased-down for higher income taxpayers. Individual
taxpayers filing a single return with no dependents and modified adjusted gross income of
$15,000 or less are eligible for the maximum credit rate of 90 percent. The credit percentage for
individuals filing a single return with no dependents is phased-down ratably from 90 percent to
50 percent for modified adjusted gross income between $15,000 and $20,000, and phased-out
completely at modified adjusted gross income of $30,000.

Other taxpayers with modified adjusted gross income up to $25,000 are eligible for the
maximum credit rate of 90 percent. The credit percentage is phased-out ratably for modified
adjusted gross income between $25,000 and $40,000 if the policy covers only one adult, and for
modified adjusted gross income between $25,000 and $60,000 if the policy (or policies) covers
more than one adult.

Taxpayers claiming the credit are not allowed to make contributions to an HSA or an
Archer MSA for the year the credit is claimed. Additionally, taxpayers claiming the credit are
not eligible for the deduction for high deductible health plan premiums included in the
President’s fiscal year 2005 budget proposal.

The credit can be claimed on the individual’s tax return or on an advanced basis, as part
of the premium payment process, by reducing the premium amount paid to the insurer. After
implementation of the advanced payment option, the benefit of the credit will be available at the
time that the individual purchases health insurance, rather than later when the individual files his
or her tax return the following year. Health insurers will be reimbursed by the Department of the
Treasury for the amount of the credit. Eligibility for the advanced credit option is based on the
individual’s prior year return and there is no reconciliation on the current year return.

43


Complexity issues

The proposal has elements that may both add to and reduce complexity of the charitable
contribution deduction rules. Under present law, the general rule is that charitable gifts of
inventory provide the donor with a deduction in the amount of the donor’s basis in the inventory.
The Code currently contains several exceptions: a special rule for contributions of inventory that
is used by the donee solely for the care of the ill, the needy, or infants, a special rule for
contributions of scientific property used for research, and a special rule for contributions of
computer technology and equipment used for educational purposes. Each special rule has
distinct requirements. The proposal would add another special rule, with its own distinct
requirements, thereby increasing the complexity of an already complex section of the Code. The
proposal also could decrease complexity, however, because it would provide a definition of fair
market value. Under current law, valuation of food inventory has been a disputed issue between
taxpayers and the IRS and a cause of uncertainty for taxpayers when claiming the deduction.
Another interpretative issue could arise in deciding whether the contributed food is
“substantially” the same as other food items sold by the taxpayer for purposes of determining fair
market value of the food.

Taxpayers who contribute food inventory must consider multiple factors to ensure that
they deduct the permitted amount (and no more than the permitted amount) with respect to
contributed food. Taxpayers who are required to maintain inventories for their food purchases
must compare the fair market value of the contributed food with the basis of the food (and twice
the basis of the food), and coordinate the resulting contribution deduction with the determination
of cost of goods sold.!® Taxpayers who are not required to maintain inventories for their food
purchases generally will have a zero or low basis in the contributed food, but are permitted to use
a deemed basis rule that provides such taxpayers a contribution deduction equal to 50 percent of
the food’s fair market value. Taxpayers who are not required to maintain inventories need not
coordinate cost of goods sold deductions or inventory adjustments with contribution deductions,
and are not required to recapture the previously expensed costs associated with the contributed
food.

Prior Action

The President’s fiscal year 2003 and 2004 budget proposals contained a similar proposal.

The “CARE Act of 2003,” S. 476, passed by the Senate on April 9, 2003, contains a
similar proposal.

The “Charitable Giving Act of 2003,” H.R. 7, passed by the House of Representatives on
September 17, 2003, contains a proposal that is similar with respect to defining the fair market
value of contributed food and with respect to extending the enhanced deduction to taxpayers
other than C corporations.

28 Such taxpayers must remove the amount of the contribution deduction for the
contributed food inventory from opening inventory, and do not treat the removal as a part of cost
of goods sold. IRS Publication 526, Charitable Contributions, 7-8.

85


An advocate of marriage neutrality could respond that the relevant comparison is not
between a two-earner married couple where the spouses have equal incomes and a two-earner
married couple with an unequal income division, but rather between a two-earner married couple
and a one-earner married couple with the same total income. Here, the case for equal taxation of
the two couples may be weaker, because the non-earner in the one-earner married couple
benefits from more time that may be used for unpaid work inside the home, other activities or
leisure. It could, of course, be argued in response that the “leisure” of the non-earner may in fact
consist of necessary job hunting or child care, in which case the one-earner married couple may
not have more ability to pay income tax than the two-earner married couple with the same
income.

Under present law, beginning in 2005 the sum of the basic standard deductions two
unmarried individuals would receive exceeds the standard deduction they would receive as a
married couple filing a joint return. Thus, their taxable income as joint filers may exceed the sum
of their taxable incomes as unmarried individuals.!! Furthermore, because of the way the bracket
breakpoints are structured, particularly beginning in 2005, taxpayers filing joint returns may have
more of their taxable income pushed into a higher marginal tax bracket than when they were
unmarried. In order for there to be no marriage penalties as a result of the rate structure and the
basic standard deduction, the basic standard deduction and the bracket breakpoints for married
taxpayers filing joint returns would have to be at least twice that for both single and head of
household filers. Such a structure would enhance marriage bonuses, however. By maintaining
the increased standard deduction for married couples and the increased size of the 15-percent
bracket for married couples filing a joint return, the President’s proposal eliminates the marriage
penalty arising from the rate structure for most taxpayers.'? It does not necessarily improve the
marriage-neutrality of the tax system, as the proposal enhances marriage bonuses.

Marriage penalty efficiency issues

Most analysts discuss the marriage penalty as an issue of fairness, but the marriage
penalty also may create economic inefficiencies. The marriage penalty may distort taxpayer
behavior. The most obvious decision that may be distorted is the decision to marry. For
taxpayers for whom the marriage penalty exists, the tax system increases the “price” of marriage.
For taxpayers for whom the marriage bonus exists, the tax system reduces the “price” of
marriage. Most of what is offered as evidence of distorted choice is anecdotal. Research finds
that marriage penalties have little or no effect on taxpayers’ decisions to marry. Even if the

10 If the two-earner couple had child care expenses many would think that the single-
earner couple with children and the same income would have a greater ability to pay taxes as the
family would benefit from the unpaid labor of the stay-at-home spouse with regard to child care.

| Because lower-income taxpayers are more likely to use the standard deduction, this
feature of present law is a more significant part of the marriage penalty for lower-income
taxpayers relative to higher-income taxpayers.

2 The 10-percent bracket for married taxpayers filing jointly is already twice that of
singles. Marriage penalties will still exist for certain upper bracket taxpayers.


Additionally, they argue that the claim that penalty guidelines are necessary is inconsistent with
the proposal to remove from the list the two violations that are said to most often warrant
punishment other than that required under section 1203 (late filed refund retums and employee
versus employee allegations).

Complexity issues

The proposal has elements that may both increase and decrease complexity. The IRS
must review and investigate every allegation of a section 1203 violation. Removing late filing of
refund returns and employee versus employee allegations from the list of section 1203 violations
may make it easier for the IRS to administer section 1203, as there would be fewer types of
allegations that would require section 1203 review and investigation. Similarly, adding
unauthorized inspection of returns to the list of violations may complicate IRS administration, as
there would likely be an increase in the number of 1203 violations requiring IRS review and
investigation. Additionally, because unauthorized inspection of returns violations under Code
section 7213A are currently subject to discipline based on administrative determination by the
IRS, adding such violations to the list of section 1203 violations would require the IRS to change
current practice and follow section 1203 procedures instead.

Additional penalty guidelines may also either increase or decrease complexity.
Additional guidelines may increase complexity by creating more rules for the IRS to establish
and follow. The guidelines would also have to be periodically updated to ensure that
punishments for specific violations continue to be appropriate. On the other hand, additional
penalty guidelines may decrease complexity by providing clarity as to specific punishments for
specific employee violations, which may enhance the IRS’ effectiveness in administering section
1203.

Prior Action

An identical proposal was included in the President’s fiscal year 2003 and 2004 budget
proposals.*"* An identical proposal was contained in the “Taxpayer Protection and IRS
Accountability Act of 2003,” as passed by the House of Representatives on June 19, 2003. A
substantially similar proposal was contained in the “Tax Administration Good Government Act
of 2004,” as passed by the Senate Committee on Finance on February 2, 2004.

2. Modifications with respect to frivolous returns and submissions
Present Law

The Code provides that an individual who files a frivolous income tax return is subject to
a penalty of $500 imposed by the IRS (sec. 6702). The Code also permits the Tax CourtTM"” to

516 The original provisions were enacted in the IRS Restructuring and Reform Act of
1998.

517 Because in general the Tax Court is the only pre-payment forum available to

taxpayers, it deals with most of the frivolous, groundless, or dilatory arguments raised in tax
cases.

321


C. Modify Qualification Rules for Tax-Exempt Property and Casualty Insurance
Companies.
D. Increase Penalties for False or Fraudulent Statements Made to Promote Abusive
Tax Shelters
E. Modify Charitable Contribution Rules for Donations of Patents and Other
Intellectual Property
F. Require Qualified Appraisals for Charitable Contributions of Vehicles
G. Reform the Tax Treatment of Leasing Transactions with Tax-Indifferent Partie
H. Ensure Foreign Subsidiaries of U.S. Companies Cannot Inappropriately Avoid
US. Tax on Foreign Earnings Invested in U.S. Property Through Use of the
Exceptions for Bank Deposits.
I. Modify Tax Rules for Individuals

0 Give Up U.S. Citizenship or Green Card

Stattis..ccccccccccccssssssvsesecsescesesesseccsseseeeseeesncsesneseseessessseseeeesesneneresenesesssasessesssesseessnensensreenees 295
J. Tax Shelter Exception to Confidentiality Privileges Relating to Taxpayer
Communications 300

K. Extend the Statute of Limitations for Reportable Transactions Where a Taxpayer
Fails to Disclose on Return as Required

L. Require Increased Reporting for Noncash Charitable Contributions

M. Modify Certain Tax Rules for Qualified Tuition Programs.......sceessessseiscccees

VL TAX ADMINISTRATION PROVISIONS AND UNEMPLOYMENT INSURANCE...... 318

A. IRS Restructuring and Reform Act Of 1998 ......:.sssesssesssesserseesenttees
1. Modify section 1203 of the IRS Restructuring and Reform Act of 1998

2. Modifications with respect to frivolous returns and submissions

3. Authorize IRS to enter into installment agreements that provide for partial
payment

4. Termination of installment agreements

5. Consolidate review of collection due process cases in the Tax Cow

6. Office of Chief Counsel review of offers-in-compromise

B. Initiate IRS Cost Saving Measures
1, Allow the Financial Management Service to retain transaction fees from levied
AMOUNLS ......essecceeeseseseesssessvessecsseessensneesneseeseareeneeneeess

2. Extend the due date for electronically filed tax returns

C. Repeal of Section 132 of the Revenue Act of 1978..... 33
D. Permit Private Sector Debt Collection Companies to Collect Tax Debts.
E. Increase Continuous Levy for Certain Federal Payments..........
F. Strengthen the Financial Integrity of Unemployment Insurance
VII. REAUTHORIZE FUNDING FOR THE HIGHWAY TRUST FUND

A. Deposit Full Amount of Excise Tax Imposed on Gasohol in the Highway Trust

Fund 345
B. Impose Additional Registration Requirements on the Transfer of Tax-Exempt Fuel

by Pipeline, Vessel or Barge 347
C. Repeal Installment Method for Payment of Heavy Highway Vehicle Use Tax.

iti


Some may argue, however, that the IRS has the authority under present law to prevent
abuse of the rule permitting tax-exempt status. They may argue that the definition of an
insurance company applicable under Treasury regulations to property and casualty insurance
companies permits the IRS to deny or rescind tax-exempt status of an entity with very high
investment income in relation to premium income if that entity's insurance activities are not
sufficient for it to be treated as an insurance company.

In response, it could be said that the legislative proposal specifically provides that no
inference is intended as to whether such companies could be insurance companies under the
present-law rules, but that a clarification would be appropriate in light of the abuses that have
proliferated.

The proposal eliminates the exemption from income tax for property and casualty
insurance companies organized as stock companies, retaining it only for mutual companies in
limited circumstances. Advocates of this approach may argue that it returns to the origins of the
provision as a rule of administrative convenience for very small local mutual farm insurers.
They may argue that reports of abuse of the provision through sheltering investment income
seem primarily to involve stock companies, perhaps because the legal structure of mutual
companies is more restrictive. It is argued that limiting tax-exempt status to mutual companies,
combined with the other requirements of the proposal, narrows eligibility for tax exemption so
substantially that the potential for abuse of the provision would be remote. Others, however,
might argue that stock companies and mutual companies should be treated equally for this
purpose, and that the rationale for imposing additional restrictions on tax-exempt mutual
companies applies equally to stock companies. By the same token, if tax-exempt status is
repealed for stock companies, it should be repealed for mutual companies as well. In either case,
proponents of the view that mutual and stock companies should be treated equally might argue
that distinguishing between mutual and stock companies for this purpose is contrary to the
policies of the past 20 years, which generally have attempted to treat the two types of companies
similarly for most Federal income tax purposes. Some might also note that the proposed changes
to eligibility to make the election to be taxed only on taxable investment income, discussed
below, apply equally both to mutual and stock companies.

Some might argue that whether the insurance company is organized and regulated only in
one State does not directly relate to its ability to avoid tax on investment income. States differ
somewhat in their regulatory standards. While a one-State company may be somewhat more
likely to be a small local insurer, no such limitation is directly imposed. Advocates of the
proposal might counter that the proposal requires the company not only to be organized and
regulated within one State, but also to be a domestic mutual company (not a foreign one electing
to be treated as domestic), which should serve to limit opportunities for abuse that take
advantage of offshore vehicles and foreign regulatory regimes that are more lenient than State
regulation.

The proposal uses gross income rather than gross receipts as the determinant for
eligibility for tax-exempt status. Depending upon how the gross income test is interpreted or
implemented, it could be argued that companies might attempt to manipulate the $350,000 gross
income test (perhaps by using losses from other trades or businesses to reduce total gross income
below $350,000) in order to avail themselves of the exemption from income tax. Thus, it is

262


9. Modify tax treatment of certain income of electric cooperatives

Present Law

In general

Under present law, an entity must be operated on a cooperative basis in order to be
treated as a cooperative for Federal income tax purposes. Although not specified by statute or
regulation, the two principal criteria for determining whether an entity is operating on a
cooperative basis are: (1) ownership of the cooperative by persons who patronize the
cooperative; and (2) return of earnings to patrons in proportion to their patronage. The IRS
requires that cooperatives must operate under the following principles: (1) subordination of
capital in control over the cooperative undertaking and in ownership of the financial benefits
from ownership; (2) democratic control by the members of the cooperative; (3) vesting in and
allocation among the members of all excess of operating revenues over the expenses incurred to
generate revenues in proportion to their participation in the cooperative (patronage), and (4)
operation at cost (not operating for profit or below cost).'**

In general, cooperative members are those who participate in the management of the
cooperative and who share in patronage capital. As described below, income from the sale of
electric energy by an electric cooperative may be member or non-member income to the
cooperative, depending on the membership status of the purchaser. A municipal corporation
may be a member of a cooperative.

For Federal income tax purposes, a cooperative generally computes its income as if it
were a taxable corporation, with one exception--the cooperative may exclude from its taxable
income distributions of patronage dividends. In general, patronage dividends are the profits of
the cooperative that are rebated to its patrons pursuant to a pre-existing obligation of the
cooperative to do so. The rebate must be made in some equitable fashion on the basis of the
quantity or value of business done with the cooperative.

Except for tax-exempt farmers’ cooperatives, cooperatives that are subject to the
cooperative tax rules of subchapter T of the Code!® are permitted a deduction for patronage
dividends from their taxable income only to the extent of net income that is derived from
transactions with patrons who are members of the cooperative. '°° The availability of such
deductions from taxable income has the effect of allowing the cooperative to be treated like a
conduit with respect to profits derived from transactions with patrons who are members of the
cooperative.

188 Announcement 96-24, “Proposed Examination Guidelines Regarding Rural Electric
Cooperatives,” 1996-16 LR.B. 35.

18 Sec. 1381, et seq.

199 Sec, 1382.

148


payment undertaking agreement, a lease prepayment, a sinking fund arrangement, any similar
arrangement, and any other arrangement identified by the Secretary in regulations. The
Secretary is authorized to promulgate regulations providing that this requirement is satisfied even
if a tax-exempt party provides cash-equivalent credit support in excess of 20 percent of the
taxpayer’s cost of the leased property if the creditworthiness of the tax-exempt party would not
otherwise satisfy the lessor’s customary underwriting standards. Such credit support would not
be permitted to exceed 50 percent of the taxpayer’s cost of the property. In addition, on the
purchase option exercise date, if any, such credit support would not be permitted to exceed 50
percent of the lessee’s purchase option price.

(G) Lessor maintains a substantial equity investment in property

The lessor must make and maintain a substantial equity investment in the leased property.
For this purpose, a lessor would not have made or maintained a substantial equity investment
unless the lessor makes an unconditional initial equity investment in the property of at least 20
percent of the cost of the leased property and such equity investment continues throughout the
lease term.

(4) Tax-exempt entity does not retain more than minimal risk of loss

The tax-exempt party must not assume or retain more than a minimal risk of loss (other
than the obligation to pay rent and insurance premiums, to maintain the property or other similar
conventional obligations of a net lease) through a put option, a residual value guarantee, residual
value insurance, any similar agreement (such as a service contract), or any other arrangement
identified by the Secretary in regulations. For this purpose, a tax-exempt party would have
assumed or retained more than a minimal risk of loss if: (1) as a result of obligations assumed or
retained by, on behalf of, or pursuant to an agreement with the tax-exempt party, the taxpayer is
insulated from any portion of the loss that would occur if the value of the leased property were
25 percent less than the leased property’s projected fair market value at lease termination; (2) as
a result of obligations assumed or retained by, on behalf of, or pursuant to an agreement with the
tax-exempt party, the taxpayer is insulated from a risk of loss in the aggregate that is greater than
50 percent of the loss that would occur if the value of the leased property were zero at lease
termination; or (3) the tax-exempt party assumes or retains a risk of loss described by the
Secretary in regulations.

(5) Secretary does not otherwise describe the lease
The Secretary in regulations does not otherwise describe the lease.
Effective dateThe proposal is effective for leases entered into after December 31, 2003.

No inference should be drawn regarding the appropriate tax treatment of similar transactions
entered into prior to January 1, 2004.

283


open accounts. The Secretary is also authorized to provide rules to recapture credits claimed
with respect to individuals who forfeit matching funds.

Effective date —The proposal is effective for taxable years ending after December 31,
2004, and beginning before January 1, 2012.

Analysis

Policy issues

The proposal is intended to encourage individuals to save by providing a subsidy to
saving. Proponents argue that many individuals have sufficiently low income that saving is
difficult, and that the subsidy will help these individuals to accumulate savings, as well as to
become more financially literate through the programs required to be provided by the eligible
entities that may offer IDAs.

Opponents may argue that the generosity of the subsidy, which provides an immediate
100 percent return to the individual’s contribution, makes the program more like an income
transfer program and does not provide a realistic picture of the normal returns to saving. Others
note that the cap on the number of accounts to which the credit applies creates the potential for
unequal tax treatment of similarly situated individuals, and may effectively allow financial and
other eligible institutions to pick and choose among potential beneficiaries of the individual
development account program. Additionally, individuals without ready access to eligible
institutions are disadvantaged with respect to the ability to benefit under the proposal.

Complexity issues

In general, adding a new credit to the tax law will tend to increase the complexity of the
tax law and will require additional Treasury or other Governmental resources to be devoted to
administration of the provisions and to enforcement activities. The individual development
account proposal requires additional record keeping by financial institutions benefiting from the
credit and also by account holders. The annual reporting requirements of the individual
development account program will increase the paperwork burden on individuals and financial
institutions utilizing the provision. Arguably, the proposal will also add complexity in that it will
increase the number of savings incentives in the tax law, each with different requirements. Some
might argue that consolidation of these incentives will serve to simplify tax law and tax
administration.

Prior Action

Similar proposals were included in the President’s fiscal year 2002, 2003, and 2004
budget proposals.

40


fair market value of the computer technology.**° With the rapid advances in the field, such
determinations are difficult at times. However, third-party tracking of prices for used computer
equipment do exist. In this regard, the limitation to equipment less than three years old may aid
taxpayer compliance and Internal Revenue Service administration.

Taxpayers who contribute computer equipment from inventory must consider multiple
factors to ensure that they deduct the permitted amount (and no more than the permitted amount)
with respect to contributed equipment. Taxpayers who are required to maintain inventories for
such items must consider the fair market value of the contributed equipment, the basis of the
equipment (and twice the basis of the equipment), and the resulting income that would be
realized if the equipment were sold, and coordinate the resulting contribution deduction with the
determination of cost of goods sold.°*

Prior Action
An identical proposal was part of the President’s fiscal year 2004 budget.

The “CARE Act of 2003,” S. 476, as passed by the Senate on April 9, 2003, contains a
similar proposal that would modify and extend the enhanced deduction beyond the present-law
expiration date to contributions made during any taxable year beginning before January 1, 2006.

The “Charitable Giving Act of 2003,” H.R. 7 as passed by the House of Representatives
on September 17, 2003, contains a proposal that would make the present-law deduction for
computer equipment permanent.

H.R. 3521, the “Tax Relief Extension Act of 2003,” as passed by the House of
Representatives on November 20, 2003, would extend the present-law deduction for computer
equipment through December 31, 2004.

5 The enhanced deduction is equal to the lesser of basis plus one-half of the item’s
appreciated value (that is, one-half basis plus one-half fair market value) or two times basis. The
two times basis limitation is binding only if the fair market value of the item exceeds three times
the item’s basis. Thus, a measure of fair market value always is necessary.

636 Such taxpayers must remove the amount of the contribution deduction for the

contributed equipment inventory from opening inventory, and do not treat the removal as a part
of cost of goods sold. IRS Publication 526, Charitable Contributions, pp. 7-8.

399


determines that: (1) there is reasonable cause to believe, based upon information believed to be
reliable, that the return or return information may be relevant to a matter relating to such terrorist
incident, threat, or activity; and (2) the return or return information is sought exclusively for the
use in a Federal investigation, analysis, or proceeding concerning any terrorist incident, threat, or
activity.

Special rule for ex parte court ordered disclosure initiated by the IRS

If the Secretary of Treasury possesses returns or return information that may be related to
a terrorist incident, threat, or activity, the Secretary of the Treasury (or his delegate), may on his
own initiative, authorize an application for an ex parte court order to permit disclosure to Federal
law enforcement. In order to grant the order, the Federal district court judge or magistrate must
determine that there is reasonable cause to believe, based upon information believed to be
reliable, that the return or return information may be relevant to a matter relating to such terrorist
incident, threat, or activity. The information may be disclosed only to the extent necessary to
apprise the appropriate Federal law enforcement agency responsible for investigating or
responding to a terrorist incident, threat, or activity and for officers and employees of that agency
to investigate or respond to such terrorist incident, threat, or activity. Further, use of the
information is limited to use in a Federal investigation, analysis, or proceeding concerning a
terrorist incident, threat, or activity. Because the Department of Justice represents the Secretary
of the Treasury in Federal district court, the Secretary is permitted to disclose returns and return
information to the Department of Justice as necessary and solely for the purpose of obtaining the
special IRS ex parte court order.

Disclosure of return information other than by ex parte court order
Disclosure by the IRS without a request

The Code permits the IRS to disclose return information, other than taxpayer return
information, related to a terrorist incident, threat, or activity to the extent necessary to apprise the
head of the appropriate Federal law enforcement agency responsible for investigating or
responding to such terrorist incident, threat, or activity. The IRS on its own initiative and
without a written request may make this disclosure. The head of the Federal law enforcement
agency may disclose information to officers and employees of such agency to the extent
necessary to investigate or respond to such terrorist incident, threat, or activity. A taxpayer’s
identity is not treated as return information supplied by the taxpayer or his or her representative.

Disclosure upon written request of a Federal law enforcement agency

The Code permits the IRS to disclose return information, other than taxpayer return
information, to officers and employees of Federal law enforcement upon a written request
satisfying certain requirements. The request must: (1) be made by the head of the Federal law
enforcement agency (or his delegate) involved in the response to or investigation of terrorist
incidents, threats, or activities, and (2) set forth the specific reason or reasons why such
disclosure may be relevant to a terrorist incident, threat, or activity. The information is to be
disclosed to officers and employees of the Federal law enforcement agency who would be
personally and directly involved in the response to or investigation of terrorist incidents, threats,

403


B. Merge Treasury Inspector General for Tax Administration and Treasury Inspector
General into New Inspector General for Treasury

Present Law

In general

The IRS Restructuring and Reform Act of 1998 (“the Act”) established a new,
independent, Treasury Inspector General for Tax Administration (“Treasury IG for Tax
Administration”) within the Department of Treasury. The IRS Office of the Chief Inspector®®
was eliminated, and all of its powers and responsibilities were transferred to the Treasury IG for

665 The IRS Office of the Chief Inspector (also known as the “Inspection Service”) was
established on October 1, 1951, in response to publicity revealing widespread corruption in the
IRS. At the time of its creation, President Harry S. Truman stated, “A strong, vigorous
inspection service will be established and will be made completely independent of the rest of the
Internal Revenue Service.” In 1952, the Office of the Assistant Commissioner (Inspection) was
established. The office was redesignated as the Office of the Chief Inspector on March 25, 1990.
The Chief Inspector was appointed by the Commissioner.

The Office of the Chief Inspector generally was responsible for carrying out internal
audits and investigations that: (1) promote the economic, efficient, and effective administration
of the nation’s tax laws; (2) detect and deter fraud and abuse in IRS programs and operations;
and (3) protect the IRS against external attempts to corrupt or threaten its employees. The Chief
Inspector reported directly to the Commissioner and Deputy Commissioner of the IRS.

The IRS Inspection Service was divided into three functions: Internal Security, Internal
Audit, and Integrity Investigations and Activities. Internal Security’s responsibilities include
criminal investigations (employee conduct, bribery, assault and threat and investigations of non-
IRS employees for acts such as impersonation, theft, enrolled agent misconduct, disclosure, and
anti-domestic terrorism) investigative support activities (including forensic lab, computer
investigative support, and maintenance of law enforcement equipment), protection, and
background investigations.

Internal Audit was responsible for providing IRS management with independent reviews
and appraisals of all IRS activities and operations. In addition, Internal Audit made
recommendations to improve the efficiency and effectiveness of programs and to assist IRS
officials in carrying out their program and operational responsibilities. In this regard, Internal
Audit generally conducted performance reviews (program audits, system development audits,
internal control audits) and financial reviews (financial statement audits and financial related
reviews).

Integrity Investigations and Activities were joint internal audit and internal security
operations undertaken as a proactive effort to detect and deter fraud and abuse within the IRS.

The Office of the Chief Inspector had full access to taxpayer returns and return
information.

419


beginning in 2010.2” The credit declines to $500 in taxable year 2011.7! For purposes of this
credit, a qualifying child is an individual: (1) with respect to whom the taxpayer is entitled to a
dependency exemption for the year; (2) who satisfies the same relationship test applicable to the
earned income credit; and (3) who has not attained age 17 as of the close of the calendar year.””
In addition, the child must be a citizen or resident of the United States.”° A portion of the child
credit is refundable under certain circumstances.””!

Dependent care credit”

The dependent care credit may be claimed by a taxpayer who maintains a household that
includes one or more qualifying individuals and who has employment-related expenses. A
qualifying individual means (1) a dependent of the taxpayer under age 13 for whom the taxpayer
is entitled to a dependency exemption,” (2) a dependent of the taxpayer who is physically or

217 A separate proposal contained in the President’s fiscal year 2005 budget proposal
(extending through 2010 certain provisions of the 2003 Jobs and Growth Tax Cut) extends the
$1,000 credit amount through 2010.

218 Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), Pub. L.
No. 107-16, sec. 901(a) (2001) (making, by way of the EGTRRA sunset provision, the increase
in the child credit inapplicable to taxable years beginning after December 31, 2010). A separate
proposal contained in the President’s fiscal year 2005 budget proposal (permanently extending
certain provisions of the 2001 Tax Cut and the 2003 Jobs Growth and Tax Cut) makes permanent
the $1,000 credit amount after 2010.

219 The IRS has issued guidance stating that for purposes of the child credit, an individual
attains a specified age on the anniversary of the date that the child was born (¢.g., a child born on
January 1, 1987, attains the age of 17 on January 1, 2004). Rev. Rul. 2003-72, 2003-33 I.R.B.
346.

220 The child credit does not apply with respect to a child who is a resident of Canada or
Mexico and is not a U.S. citizen, even if a dependency exemption is available with respect to the
child. Sec. 24(c)(2). The child credit is, however, available with respect to a child dependent
who is not a resident or citizen of the United States if: (1) the child has been legally adopted by
the taxpayer; (2) the child’s principal place of abode is the taxpayer’s home; and (3) the taxpayer
is a U.S. citizen or national. See sec. 24(c)(2) and sec. 152(b)(3).

221 Sec. 24(d).
222 Sec. 21.

223 The IRS has issued guidance stating that for purposes of the dependent care credit, an
individual attains a specified age on the anniversary of the date that the child was born (¢.g., a
child born on January 1, 1987, attains the age of 17 on January 1, 2004). Rev. Rul. 2003-72,
2003-33 LR.B. 346.

159


applicable amount. The tax price of giving is only reduced for contribution amounts above the
required floor and below the cap. Nonitemizers who make contributions to charity less than the
applicable floor amount do not face a reduced tax price for additional giving, until their
contributions exceed the floor amount. Nonitemizers who give amounts in excess of the cap to
charity do not face a reduced tax price for additional giving until it becomes advantageous for
them to itemize deductions. In addition, in some limited cases, taxpayers could find it beneficial
to reduce charitable donations.'””

While factors other than tax benefits also motivate charitable giving, the preponderance
of evidence suggests that the charitable donation tax deduction has been a stimulant to charitable
giving, at least for higher-income individuals. Economic studies generally have established that
charitable giving responds to the price of giving. While the economic literature suggests that
individuals alter their giving in response to changes in the price of giving, there is less consensus
as to how large are the changes in donations induced by the tax deductibility of charitable
donations.!°8 In addition, most studies rely upon data relating to taxpayers who itemize

107 Take, for example, a taxpayer, not filing a joint return, who finds it beneficial to
itemize all qualifying deductions under present law but who, under the proposal, would find it
more beneficial to claim the standard deduction and additional deduction for charitable
contributions (e.g,, a taxpayer with more than $250 ($500 for joint filers) in charitable
contributions and total other qualifying itemized deductions that are less than the standard
deduction plus $250 ($500 for joint filers)). In such a case, the proposal reduces the incentive to
make additional charitable contributions and also could encourage a taxpayer to reduce
contributions to no more than $500 ($1,000 for joint filers) (assuming the tax incentive was a
determinative factor for gifts over $250 ($500 for joint filers)). As an itemizer, each additional
dollar of charitable donation carries with it a tax benefit; however, forgoing itemization for the
standard deduction results in additional dollars of charitable donation conferring no tax benefit,
at least over some range of potential additional donations. Because of the proposal’s design with
the floor and cap separated by $250 ($500 in the case of a joint return), the number of taxpayers
who find themselves in such circumstances is likely to be limited.

108 See, Charles Clotfelter, Federal Tax Policy and Charitable Giving (Chicago:
University of Chicago Press), 1985, for a review of the literature. Martin Feldstein and Charles
Clotfelter, “Tax Incentives and Charitable Contributions in the United States,” Journal of Public
Economics, vol. 5, 1976, argue that the deduction for charitable contributions induces charitable
contributions in amounts exceeding the revenue lost to the government from the tax deduction.
More recently, William C. Randolph, “Dynamic Income, Progressive Taxes, and the Timing of
Charitable Contributions,” Journal of Political Economy, vol. 103, August 1995, at 709-738,
argues the opposite. Randolph argues that earlier studies inadvertently confused timing effects
that may be the result of an individual taxpayer’s circumstances in a particular year or the result
of changes from one tax regime to another with the permanent effects. Randolph’s estimates
suggest that on a permanent basis, charitable donations are much less responsive to the tax price
than previously believed. Charles T. Clotfelter, “The Impact of Tax Reform on Charitable
Giving: A 1989 Perspective,” in Joel Slemrod, ed., Do Taxes Matter? The Impact of the Tax
Reform Act of 1986 (Cambridge: MIT Press), 1990, at 228, points to the surge in giving in 1986
prior to enactment of the Tax Reform Act of 1986 as evidence of the tax-sensitive timing of gifts.

71


money for nonretirement purposes than under present law. Some also argue that, in the early
years of retirement, an individual might not accurately assess his or her long-term retirement
income needs. For example, the individual might not make adequate provision for health care or
long-term care costs later in life. Some therefore argue that IRA distributions to charity should
be permitted, if at all, only after age 70.

Complexity issues

The proposal adds complexity to the tax law by creating an additional set of rules
applicable to charitable donations. Taxpayers who own IRAs and make such donations will need
to review two sets of rules in order to determine which applies to them and which is the most
advantageous. The proposal may increase the complexity of making charitable contributions
because individuals who are able and wish to take advantage of the tax benefits provided by the
proposal will need to make the donation through the IRA rather than directly. The proposal also
may increase complexity in tax planning as the proposal might make it beneficial for some
taxpayers to take the standard deduction and make all charitable contributions through their
IRAs.

In some cases, taxpayers may need to apply both sets of rules to a single contribution
from an IRA. This will occur if the IRA distribution includes both taxable amounts (which
would be subject to the rules in the proposal) and nontaxable amounts (which would be subject
to the present-law rules). As discussed above, the effect of the proposal is to eliminate certain
present-law limits on charitable deductions for IRA owners. A simpler approach is to eliminate
such limits with respect to all charitable contributions. Providing a single rule for charitable
contributions would make the charitable deduction rules easier to understand for all taxpayers
making such contributions.

Prior Action

A similar proposal was included in the President’s fiscal year 2004 budget proposal. The
President’s fiscal year 2002 and 2003 budget proposals included a similar proposal, except that
the exclusion would have applied to distributions made on or after the date the IRA owner
attained age 59-4.

In the 107th Congress, H.R. 7, the “Community Solutions Act of 2001,” as passed by the
House of Representatives on July 19, 2001, included a similar provision, except the H.R. 7
provision would have applied only to distributions on or after the date the IRA owner attained
age 70-%. H.R. 7 also provided for a similar exclusion for transfers to split-interest entities,
including charitable remainder trusts, pooled income funds, and charitable gift annuities. Under
H.R. 7 as reported by the Senate Finance Committee on July 16, 2002, the exclusion for transfers
to split interest entities would have applied to distributions made on or after the date the TRA
owner attained age 59-1.

In the current Congress, S. 476, the “CARE Act of 2003,” as passed by the Senate on
April 9, 2003, includes a similar provision that provides an exclusion for an otherwise taxable
distribution from an IRA that is made (1) directly to a charitable organization on or after the date
the IRA owner attains age 70-1, or (2) to a split-interest entity on or after the date the IRA

80


[JOINT COMMITTEE PRINT]

DESCRIPTION OF REVENUE PROVISIONS
CONTAINED IN THE PRESIDENT’S
FISCAL YEAR 2005 BUDGET PROPOSAL

Prepared by the Staff
of the
JOINT COMMITTEE ON TAXATION

February 2004

U.S. Government Printing Office
Washington: 2004

JCS-3-04



hardware and software, some employees may purchase more computer hardware and software
than they need. By favoring computers, the proposal favors certain methods of enabling
employees (those based on computer applications) over others. As a result, other strategies that
could raise the well being of employees may be forgone.

Prior Action

A similar proposal was included in the President’s fiscal year 2002, 2003 and 2004
budget proposals.

106


The modified definition would allow Puerto Ricans with fewer than three children to claim the
refundable child credit but for the President’s proposal that eligibility for the refundable credit be
conditioned on United States residency (discussed below).

An alternative proposal that only modifies the EIC earned income definition by requiring
that self-employment income be included in gross income (as is required for non self-
employment income) would appear to achieve similar simplification without affecting the child
credit for residents of Puerto Rico with children. The alternative proposal would result in the
same definition of earned income for purposes of the EIC and refundable child credit for all
persons with self-employment earnings regardless of whether any self-employment earnings is
excluded from gross income for income tax purposes (such as is the case for parsons with
parsonage allowances). Additionally, the proposal would treat employees and the self-employed
equivalently in determining both the EIC and refundable child credit.

The President’s proposal requires taxpayers to reside in the United States in order to
claim the refundable child credit. The principal effect of this proposal is to prevent the
expansion of the refundable child credit to residents of Puerto Rico with fewer than three
children that would occur under the President’s proposal to conform the earned income
definition for purposes of the EIC and the refundable child credit. There does not appear to be
any particular simplification that results from the proposal other than to prevent Puerto Ricans,
who are not required to file a U.S. income tax return, from filing such a return for the sole
purpose of claiming a refundable credit.

The President’s proposal to require U.S. residency in order to claim a refundable child
credit would deny the refundable child tax credit to certain taxpayers living abroad who may
currently claim it. In some cases this may not be considered desirable, such as in the case of a
low-income U.S. citizen who works in the U.S. but who happens to live in Canada or Mexico. In
other cases the result may be viewed as desirable. For example, a married U.S. taxpayer with
two children who lives and works in a foreign country with $100,000 foreign earned income
would have a gross income of only $20,000 as a result of the $80,000 foreign earned income
(section 911) exclusion. As a result of other provisions of U.S. law such as the personal
exemptions and child credits, such a taxpayer would have no USS. income tax liability.

However, because the refundable child credit is based on only earned income included in taxable
income, the taxpayer is eligible for a refundable credit of 10 percent of the amount by which
such income (in this case $20,000) exceeds $10,750, or $9,250, for a refundable credit of $925.
Under present law, and under the proposal, the taxpayer is not eligible for the EIC. The policy
for paying a refundable child credit in such a case is questionable, especially considering the
refundable credit is only payable once the taxpayer’s earned income reaches $90,750 ($80,000
section 911 exclusion plus refundable child credit earned income threshold of $10,750).

Prior Action

No prior action.

180


future nuclear decommissioning costs was of national importance.!® Tf deregulation continues,
the deduction of such contributions may be prevented unless the cost of service limitation is
repealed. The loss of deductibility may reduce the amount of funds available for
decommissioning in the future.

In addition, the proposal allows taxpayers to transfer to a qualified fund decommissioning
costs for the period prior to the qualified fund’s existence (generally pre-1984 decommissioning
costs of a nuclear powerplant). Proponents of this aspect of the proposal argue that it provides
equal treatment to all decommissioning costs and provides an incentive for taxpayers to ensure
that sufficient funds are being reserved for decommissioning costs. However, some may argue
that safeguards are already in place that require funds to be available for decommissioning and
that this aspect of the proposal merely reduces the effective tax rate on earnings associated with
the reserved funds. Finally, clarifying the treatment of transfers of qualified funds removes a tax
barrier that may be hindering taxpayers from fulfilling various policy goals of electricity
deregulation.

Complexity issues

Many aspects of the proposal provide clarification to issues that would simplify the
administration of the present-law provision and likely reduce the cost of complying with the tax
law and minimize disputes between taxpayers and the IRS.

Prior Action

An identical proposal was included in the President’s fiscal year 2004 and 2003 budget
proposal. A similar proposal was included in section 1328 of the Conference Report to H.R. 6,
the “Energy Policy Act of 2003.”

4. Provide a tax credit for purchase of certain hybrid and fuel cell vehicles
Present Law'”

A 10-percent tax credit is provided for the cost of a qualified electric vehicle, up to a
maximum credit of $4,000 (sec. 30). A qualified electric vehicle is a motor vehicle that is
powered primarily by an electric motor drawing current from rechargeable batteries, fuel cells, or
other portable sources of electrical current, the original use of which commences with the
taxpayer, and that is acquired for the use by the taxpayer and not for resale. The full amount of
the credit is available for purchases prior to 2004. The credit phases down in the years 2004
through 2006, and is unavailable for purchases after December 31, 2006. The credit rate is 7.5
percent and the maximum credit amount is $3,000 for 2004. There is no carry forward or carry
back of the credit for electric vehicles.

18 Joint Committee on Taxation, General Explanation of the Revenue Provisions of the
Deficit Reduction Act of 1984, p. 270.

79 Code sections 30 and 179A were enacted as part of the Energy Policy Act of 1992
and were extended by the Job Creation and Worker Assistance Act of 2002.

129


Gross income test

In general, an individual may not be claimed as a dependent of a taxpayer if the
individual has gross income that is at least equal to the personal exemption amount for the
taxable year?” If the individual is the child of the taxpayer and under age 19 (or under age 24, if
a full-time student), the gross income test does not apply.” For purposes of this rule, a “child”
means a son, daughter, stepson, or stepdaughter (including an adopted child of the taxpayer, a
foster child who resides with the taxpayer for the entire year, or a child placed with the taxpayer
for adoption by an authorized adoption agency).

Earned income credit””’

In general

In general, the eamed income credit is a refundable credit for low-income workers. The
amount of the credit depends on the earned income of the taxpayer and whether the taxpayer has
one, more than one, or no “qualifying children.” In order to be a qualifying child for the earned
income credit, an individual must satisfy a relationship test, a residency test, and an age test. In
addition, the name, age, and taxpayer identification number of the qualifying child must be
included on the return.

Relationship test

An individual satisfies the relationship test under the earned income credit if the
individual is the taxpayer’s: (1) son, daughter, stepson, or stepdaughter, or a descendant of any
such individual;2"! (2) brother, sister, stepbrother, or stepsister, or a descendant of any such
individual, who the taxpayer cares for as the taxpayer’s own child; or (3) eligible foster child.

An eligible foster child is an individual (1) who is placed with the taxpayer by an authorized
placement agency, and (2) who the taxpayer cares for as her or his own child. A married child of

208 Certain income from sheltered workshops is not taken into account in determining the
gross income of permanently and totally disabled individuals. Sec. 151(c)(5).

209 Sec, 151(c). The IRS has issued guidance stating that for purposes of the dependency
exemption, an individual attains a specified age on the anniversary of the date that the child was
born (e.g., a child born on January 1, 1987, attains the age of 17 on January 1, 2004). Rev. Rul.
2003-72, 2003-33 L.R.B. 346.

210 Sec. 32. A separate proposal of the President’s 2005 budget proposal would modify
certain requirements regarding the earned income credit in an attempt to simplify the credit with
respect to certain taxpayers. Such modifications include allowing certain separated spouses to
claim the credit, simplifying the rules regarding the presence of a qualifying child for taxpayers
in extended family situations, eliminating the disqualified investment income test, and clarifying
when a social security number is a valid TIN for earned income credit purposes.

21 A child who is legally adopted or placed with the taxpayer for adoption by an
authorized adoption agency is treated as the taxpayer’s own child. Sec. 32(c)(3)(B)(v).

157


H.

Energy Provisions
1. Extend and modify the tax credit for producing electricity from certain sources
2. Provide a tax credit for residential solar energy systems.....
3. Modify the tax treatment of nuclear decommissioning funds
4. Provide a tax credit for purchase of certain hybrid and fuel cell vehicles
5. Provide a tax credit for energy produced from landfill gas .
6. Provide a tax credit for combined heat and power property
7. Extend excise tax exemption (credit) for ethanol
8. Allow deferral of gain on sales or dispositions to Implement Federal Energy

Regulatory Commission or state electric restructuring policy...
9. Modify tax treatment of certain income of electric cooperatives

Ill. SIMPLIFY THE TAX LAWS FOR FAMILIES. ......cscscsessssssseeeeeeeesnesseessessesseeareesreenseaneens 154

moAD>

an

I,

Establish Uniform Definition of a Qualifying Child
Repeal Phase-Out for Adoption Provisions
Eliminate Household Maintenance Test for Head-of-Household Filing Statu:
Reduce Computational Complexity of Refundable Child Tax Credit
Simplify EIC Eligibility Requirements Regarding Filing Status, Presence of
Children, Investment Income and Work and Immigrant Status .
Simplify the Taxation of Dependent:
Education Proposals.
1. Consolidate higher education credits and deductions.........
2. Simplify the definitions of a qualifying higher educational institution and

qualified higher education expenses . 195
3. Repeal Coverdell income limits...
Allow Employers of Household Employees to Report and Pay Combine
and State Unemployment Insurance Taxes on the Form 1040
Simplify Taxation of Capital Gains of Individuals

IV. PROVISIONS RELATED TO THE EMPLOYER-BASED PENSION SYSTEM............. 211

A.
B.

Proposals Relating to Cash Balance Plans
Improve the Accuracy of Pension Liability Measures

V. TAX SHELTERS, ABUSIVE TRANSACTIONS AND TAX COMPLIANCE. ....esesssseees 240

A.

Proposals Designed to Combat Abusive Tax Avoidance Transactions..........--sse 240
1. Penalty for failure to disclose reportable transactions
2. Disclosure of reportable transactions by material advisors
3. Investor lists and modification of penalty for failure to maintain investor lists .
4. Actions to enjoin conduct with respect to tax shelters and reportable transactions... 246
5. Penalty for failure to report interests in foreign financial account 247
6. Foreign tax credit transactions...
7. Income separation transactions.......
Limit Related-Party Interest Deductions



(2) such income is more than the minimum standard deduction amount for
dependents ($800 in 2004) and less than 10 times that amount,

(3) no estimated tax payments for the year were made in the child's name and
taxpayer identification number;

(4) no backup withholding occurred; and
(5) the child is required to file a return if the parent does not make the election.

Only the parent whose return must be used when calculating the kiddie tax may make the
election. The parent includes in income the child's gross income in excess of twice the minimum
standard deduction amount for dependents (i.e., the child’s gross income in excess of $1,600 for
2004). This amount is taxed at the parent’s rate. The parent also must report an additional tax
liability equal to the lesser of: (1) $80 (in 2004), or (2) 10 percent of the child’s gross income
exceeding the child’s standard deduction ($800 in 2004).

Including the child’s income on the parent’s return can affect the parent’s deductions and
credits that are based on adjusted gross income, as well as income-based phaseouts, limitations,
and floors.2® In addition, certain deductions that the child would have been entitled to take on
his or her own return are lost.2” Further, if the child received tax-exempt interest from a private
activity bond, that item is considered a tax preference of the parent for alternative minimum tax
purposes.

Taxation of compensation for services under section 1(g)

Compensation for a child’s services is considered the gross income of the child, not the
parent, even if the compensation is not received or retained by the child (e.g. is the parent’s
income under local law)27! If the child’s income tax is not paid, however, an assessment against
the child will be considered as also made against the parent to the extent the assessment is
attributable to amounts received for the child’s services.””

268 Internal Revenue Service, Publication 929, Tax Rules for Children and Dependents,
at 7 (2003).

269 Internal Revenue Service, Publication 929, Tax Rules for Children and Dependents,
at 7 (2003).

27 Sec. 1(g)(7)(B).
271 Sec, 73(a).

272 Sec. 6201(c).

189


Table 9.Tax Rates Applicable Under Present Law
to Certain Categories of Capital Gain

Minimum Tax
Regular Tax Rate Bracket Rate Bracket
Category of income 10% 15% 25% 28% 33% 35% 26% 28%
Unrecaptured section
1250 gain 10 15 25 25 25 25 25 25
Collectibles gain 10 15 25 28 28 28 26 28
Small business stock gain 5 1S 12.5 14 14 14 13.91 14.98
Empowerment zone small
business stock gain 4 6 10 11.2 11.2 11.2 11.592 12.476
Table 10.-Tax Rates Applicable Under President's Proposal
to Certain Categories of Capital Gain”®
Minimum Tax
Regular Tax Rate Bracket Rate Bracket”
Category of income 10% 15% 25% 28% 33% 35% 26% 28%
Unrecaptured section
1250 gain 75 10 20 21.5 24 25 20.5 21.5
Collectibles gain 715 10 20 21.5 24 25 20.5 21.5
Small business stock gain 5 5 15 15 15 15 15 15
Empowerment zone small
business stock gain 5 5 15 15 15 15 15 15

Effective date —The proposal is effective for taxable years beginning after December 31,

2003.

The proposal reduces the number of lines on the tax calculation portion of schedule D
that individuals with net capital gain or dividends must fill out. Also, the alternative minimum
tax computation form for taxpayers with capital gains or dividends will be simplified.

287 Under the proposal, for taxable years beginning after 2007, the tax rates in the 10-

Analysis

and 15-percent rate brackets will be lower than shown in the table.

288 These rates are for taxpayers with incomes taxed in the regular tax brackets of 25-

percent or higher.

209



N. Extend Excise Tax on Coal at Current Rates
Present Law

A $1.10 per ton excise tax is imposed on coal sold by the producer from underground
mines in the United States. The rate is 55 cents per ton on coal sold by the producer from
surface mining operations. The tax cannot exceed 4.4 percent of the coal producer's selling
price. No tax is imposed on lignite.

Gross receipts from the excise tax are dedicated to the Black Lung Disability Trust Fund
to finance benefits under the Federal Black Lung Benefits Act. Currently, the Black Lung
Disability Trust Fund is in a deficit position because previous spending was financed with
interest-bearing advances from the General Fund.

The coal excise tax rates are scheduled to decline to 50 cents per ton for underground-
mined coal and 25 cents per ton for surface-mined coal (and the cap is scheduled to decline to
two percent of the selling price) for sales after January 1, 2014, or after any earlier January 1 on
which there is no balance of repayable advances from the Black Lung Disability Trust Fund to
the General Fund and no unpaid interest on such advances.

Description of Proposal

The proposal retains the excise tax on coal at the current rates until the date on which the
Black Lung Disability Trust Fund has repaid, with interest, all amounts borrowed from the
General Fund. After repayment of the Trust Fund’s debt the reduced rates of $.50 per ton for
coal from underground mines and $.25 per ton for coal from surface mines apply and the tax per
ton of coal is capped at 2 percent of the amount for which it is sold by the producer.

Effective date.—The proposal would be effective for coal sales after December 31, 2003.

Analysis

Trust fund financing of benefits was established in 1977 to reduce reliance on the
Treasury and to recover costs from the mining industry. Claims were much more numerous than
expected and it was difficult to find responsible operators, litigate their challenges and collect
from them. Therefore, deficits were financed with interest-bearing advances from the General
Fund. During each year of the period 1992-2002, the expenses of the program covered by the
trust fund (benefits, administration and interest) have exceeded Tevenues, sith an advance from
the General Fund making up the difference and accumulating as a debt. Direct costs (benefits
and administration), however, have been less than revenues. According to the Congressional
Research Service, if it were not for the interest on the accumulated deficit, the trust fund would

649 Congressional Research Service, RS21239 The Black Lung Benefits Program (June
12, 2002) at 6.

409


The scope of present-law tax expenditures on research activi ies

The tax expenditure related to the research and experimentation tax credit was estimated
to be $5.1 billion for 2003. The related tax expenditure for expensing of research and
development expenditures was estimated to be $3.8 billion for 2003 growing to $6.2 billion for
2007283 As noted above, the Federal Government also directly subsidizes research activities.
For example, in fiscal 2003 the National Science Foundation made $3.8 billion in grants,
subsidies, and contributions to research activities, the Department of Defense financed $10.6
billion in basic research, applied research, and advanced technology development, and the
Department of Energy financed $1.0 billion in research in high energy physics, $1.0 billion in
basic research in the sciences, $0.5 billion in biological and environmental research, and $166
million for research in advance scientific computing.°"*

Table 15 and Table 16 present data for 2001 on those industries that utilized the research
tax credit and the distribution of the credit claimants by firm size. In 2001, more than 15,000
taxpayers claimed more than $6.5 billion in research tax credits,°> Taxpayers whose primary
activity is manufacturing claimed nearly two thirds of the research tax credits claimed. Firms
with assets of $50 million or more claimed more than 85 percent of the credits claimed.
Nevertheless, as Table 16 documents, a large number of small firms are engaged in research and
were able to claim the research tax credit.

53 Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years
2003-2007 (JCS-5-03), December 19, 2002, p. 18. Projections for 2004 are not presented in the
text because with the scheduled expiration of the research and experimentation tax credit, such a
projection would not reflect a full year of research activity.

594 Office of Management and Budget, Budget of the United States Government, Fiscal
Year 2005, Appendix, pp.1052, 292-297, and 388-391.

595 The $6.5 billion figure reported for 2001 is not directly comparable to the $5.1 billion
tax expenditure estimate for 2003 reported in the preceding paragraph. The tax expenditure
estimate accounts for the present-law requirement that deductions for research expenditures be
reduced by research credits claimed.

366


F. Provide a Tax Credit for Developers of Affordable Single-Family Housing
Present Law

The low-income housing tax credit (the “LIHC”) may be claimed over a 10-year period for
the cost of rental housing occupied by tenants having incomes below specified levels. The credit
percentage for newly constructed or substantially rehabilitated housing that is not Federally
subsidized is adjusted monthly by the Internal Revenue Service so that the 10 annual installments
have a present value of 70 percent of the total qualified expenditures. The credit percentage for
new substantially rehabilitated housing that is Federally subsidized and for existing housing that
is substantially rehabilitated is calculated to have a present value of 30 percent qualified
expenditures. The aggregate credit authority provided annually to each State is $1.75 per
resident, except in the case of projects that also receive financing with proceeds of tax-exempt
bonds issued subject to the private activity bond volume limit and certain carry-over amounts.
The $1.75 per resident cap is indexed for inflation.

Description of Proposal

The proposal creates a single-family housing tax credit. Pursuant to a plan of allocation,
State or local housing credit agencies will award first-year credits to new or rehabilitated housing
units comprising a project for the development of single-family housing in census tracts with
medium incomes of 80 percent or less of the greater of area or statewide median income or areas
of chronic economic distress designated within five years prior to allocation.

Eligible taxpayers generally are the developer or investor partnership owning the
qualified housing unit immediately prior to the date of sale to a qualified buyer. The maximum
credit for each unit cannot exceed the present value of 50-percent of the eligible basis of that
housing unit. Rules similar to the present-law rules for the LIHC determine eligible basis for this
credit. Neither land nor existing structures are included in eligible basis for purposes of this
credit. Units in rehabilitated structures qualify for the credit only if rehabilitation expenditures
exceeded $25,000. This credit is claimed over the five-year period beginning the later of the date
of sale of the unit to a qualified buyer or the date a certificate of occupancy for that unit is issued.
A qualified buyer means an individual with income of 80 percent (70 percent for families with
less than three members) or less of area median income. A qualified buyer will not have to be a
first-time homebuyer.

Similar to the present-law low-income rental housing tax credit, this credit provides the
greater of $1.80 per capita or $2.075 million of tax credit authority annually to each State
beginning in calendar year 2005. These amounts are indexed for inflation. Each State (or local
government) allocates its credit authority to the qualified developers or investor partnerships that
own the housing unit immediately prior to the date of sale to a qualified buyer (or, if later, the
date a certificate of occupancy was issued). Units in condominiums and cooperatives are treated
as single-family housing for purposes of the credit. Credits allocated to a housing unit will revert
to the allocating agency unless expenditures equal to at least 10 percent of the total reasonably
expected qualifying costs with respect to that housing unit were expended during the first six
months after the allocation. Rules similar to the present-law LIHC rules will apply regarding

107


Special nondiscrimination tests

A special nondiscrimination test applies to elective deferrals under a section 401(k) plan,
called the actual deferral percentage test or the “ADP” test.’ The ADP test compares the actual
deferral percentages (“ADPs”) of the highly compensated employee group and the nonhighly
compensated employee group. The ADP for each group generally is the average of the deferral
percentages separately calculated for the employees in the group who are eligible to make
elective deferrals for all or a portion of the relevant plan year. Each eligible employee’s deferral
percentage generally is the employee’s elective deferrals for the year divided by the employee’s
compensation for the year.

The plan generally satisfies the ADP test if the ADP of the highly compensated employee
group for the current plan year is either (1) not more than 125 percent of the ADP of the
nonhighly compensated employee group for the prior plan year, or (2) not more than 200 percent
of the ADP of the nonhighly compensated employee group for the prior plan year and not more
than two percentage points greater than the ADP of the nonhighly compensated employee group
for the prior plan year.

Under a safe harbor, a section 401(k) plan is deemed to satisfy the special
nondiscrimination test if the plan satisfies one of two contribution requirements and satisfies a
notice requirement (a “safe harbor section 401(k) plan”). A plan satisfies the contribution
requirement under the safe harbor rule if the employer either (1) satisfies a matching contribution
requirement or (2) makes a nonelective contribution to a defined contribution plan of at least
three percent of an employee’s compensation on behalf of each nonhighly compensated
employee who is eligible to participate in the arrangement.

A plan satisfies the matching contribution requirement if, under the arrangement: (1) the
employer makes a matching contribution on behalf of each nonhighly compensated employee
that is equal to (a) 100 percent of the employee’s elective deferrals up to three percent of
compensation and (b) 50 percent of the employee’s elective deferrals from three to five percent
of compensation; and (2) the rate of match with respect to any elective deferrals for highly
compensated employees is not greater than the rate of match for nonhighly compensated
employees. Alternatively, the matching contribution requirement is met if (1) the rate of
matching contribution does not increase as the rate of an employee’s elective deferrals increases,
and (2) the aggregate amount of matching contributions at such rate of employee elective
deferral is at least equal to the aggregate amount of matching contributions that would be made if
matching contributions were made on the basis of the percentages described in the preceding
formula. A plan does not meet the contributions requirement if the rate of matching contribution
with respect to any rate of elective deferral of a highly compensated employee is greater than the
rate of matching contribution with respect to the same rate of elective deferral of a nonhighly
compensated employee.

2 Sec, 401(k)(3).

33 Sec. 401(k)(12).

28


IV. PROVISIONS RELATED TO THE EMPLOYER-BASED PENSION SYSTEM”
A. Proposals Relating to Cash Balance Plans

Present Law

Overview

Types of qualified plans in general

Qualified retirement plans are broadly classified into two categories, defined benefit
pension plans and defined contributions plans, based on the nature of the benefits provided. In
some cases, the qualification requirements apply differently depending on whether a plan is a
defined benefit pension plan or a defined contribution plan.

Under a defined benefit pension plan, benefits are determined under a plan formula,
generally based on compensation and years of service. For example, a defined benefit pension
plan might provide an annual retirement benefit of two percent of final average compensation
multiplied by total years of service completed by an employee. Benefits under a defined benefit
pension plan are funded by the general assets of the trust established under the plan; individual
accounts are not maintained for employees participating in the plan.

Employer contributions to a defined benefit pension plan are subject to minimum funding
requirements under the Internal Revenue Code and ERISA to ensure that plan assets are
sufficient to pay the benefits under the plan. An employer is generally subject to an excise tax
for a failure to make required contributions. Benefits under a defined benefit pension plan are
guaranteed (within limits) by the PBGC.

Benefits under defined contribution plans are based solely on the contributions (and
earnings thereon) allocated to separate accounts maintained for each plan participant.
Profit-sharing plans and qualified cash or deferred arrangements (commonly called “401(k)
plans” after the section of the Internal Revenue Code regulating such plans) are examples of
defined contribution plans.

289 tn addition to the proposals discussed in this part, the President’s fiscal year 2005
budget proposal also states that the Administration will continue to press for enactment of the
President’s retirement security plan, which includes several proposals. These proposals require
that retirement plan participants receive additional information about their retirement savings,
modify the fiduciary rules with respect to the provision of investment advice, and provide
participants in defined contribution plans with greater diversification rights with respect to the
investment of their accounts in employer securities. See “Safeguarding Workers’ Retirement and
Health Benefits Security,” Office of Management and Budget, Budget of the United States
Government, Fiscal Year 2005 (H. Doc. 108-146, Vol. I), at 229-230.

211


distributions a foundation has to make to avoid tax under section 4942 is reduced by the amount
of section 4940 excise taxes paid.'*

Description of Proposal

The proposal replaces the two rates of tax with a single rate of tax and sets such rate of
tax at one percent. A tax-exempt private foundation is subject to tax on one percent of its net
investment income. A taxable private foundation is subject to tax on the excess of the sum of the
one percent excise tax and the amount of the unrelated business income tax (both calculated as if
the foundation were tax-exempt) over the income tax imposed on the foundation. The proposal
repeals the special one-percent excise tax for private foundations that exceed their historical level
of qualifying distributions.

Effective date The proposal is effective for taxable years beginning after December 31,
2003.

Analysis

The proposal has the effect of increasing the required minimum charitable payout for
private foundations that pay the excise tax at the two-percent rate.'* This may result in
increased charitable distributions for private foundations that pay only the minimum in charitable
distributions under present law. For example, if a foundation is subject to the two-percent excise
tax on net investment income, the foundation reduces the amount of required charitable
distributions by the amount of excise tax paid. Because the proposal decreases the amount of
excise tax paid on net investment income for such foundations, the proposal increases such
foundations’ required minimum amount of charitable distributions by an amount equal to one
percent of the foundation’s net investment income. Thus, the proposal results in an increase of
charitable distributions in the case of foundations paying the two-percent rate and distributing no
greater than the required minimum under present law. Foundations paying the two-percent rate
that exceed the required minimum under present law generally would not have to increase their
charitable distributions as a result of the proposal. Although the required minimum amount of
charitable distributions would increase for such foundations, such foundations already make
distributions exceeding the minimum and so generally would not have to increase charitable
distributions as a result of the proposal (except to the extent that the increase in the required
minimum amount was greater than the excess of a private foundation’s charitable distributions
over the required minimum amount of present law). However, a reduction in the excise tax rate
from 2 percent to 1 percent may result in increased charitable distributions to the extent that a
foundation decides to pay out the amount that otherwise would be paid in tax for charitable
purposes.

The proposal also eliminates the present-law two-tier tax structure. Some have suggested
that the two-tier excise tax is an incentive for foundations to increase the amounts they distribute

'33 Sec, 4942(d)(2).

134 Operating foundations are not subject to the minimum charitable payout rules. Sec.
4942(a)(1).

87


E. Extend and Modify the Work Opportunity Tax Credit
and Welfare-to-Work Tax Credit

Present Law

Work opportunity tax credit
Targeted groups eligible for the credit

The work opportunity tax credit is available on an elective basis for employers hiring
individuals from one or more of eight targeted groups. The eight targeted groups are: (1) certain
families eligible to receive benefits under the Temporary Assistance for Needy Families
Program; (2) high-risk youth; (3) qualified ex-felons; (4) vocational rehabilitation referrals;

(5) qualified summer youth employees; (6) qualified veterans; (7) families receiving food
stamps; and (8) persons receiving certain Supplemental Security Income (SSI) benefits.

A qualified ex-felon is an individual certified as: (1) haven been convicted of a felony
under State or Federal law; (2) being a member of an economically disadvantaged family; and
(3) having a hiring date within one year of release from prison or conviction.

Qualified wages

Generally, qualified wages are defined as cash wages paid by the employer to a member
ofa targeted group. The employer’s deduction for wages is reduced by the amount of the credit.

Calculation of the credit

The credit equals 40 percent (25 percent for employment of 400 hours or less) of
qualified first-year wages. Generally, qualified first-year wages are qualified wages (not in
excess of $6,000) attributable to service rendered by a member of a targeted group during the
one-year period beginning with the day the individual began work for the employer. Therefore,
the maximum credit per employee is $2,400 (40 percent of the first $6,000 of qualified first-year
wages). With respect to qualified summer youth employees, the maximum credit is $1,200 (40
percent of the first $3,000 of qualified first-year wages).

Minimum employment period

No credit is allowed for qualified wages paid to employees who work less than 120 hours
in the first year of employment.

Coordination of the work opportunity tax credit and the welfare-to-work tax credit

An employer cannot claim the work opportunity tax credit with respect to wages of any
employee on which the employer claims the welfare-to-work tax credit.

382


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use the cash method of accounting for purchases and sales, and taxpayers that are not required to
capitalize indirect costs) to assume a basis equal to 25 percent of the food’s fair market value. In
such cases, the allowable charitable deduction will equal 50 percent of the food’s fair market
value. The enhanced deduction for food inventory will be available only for food that qualifies
as “apparently wholesome food” (defined as food that is intended for human consumption that
meets all quality and labeling standards imposed by Federal, State, and local laws and
regulations even though the food may not be readily marketable due to appearance, age,
freshness, grade, size, surplus, or other conditions). The proposal provides that the fair market
value of apparently wholesome food that cannot or will not be sold solely due to internal
standards of the taxpayer or lack of market would be determined by taking into account the price
at which the same or substantially the same food items (taking into account both type and
quality) are sold by the taxpayer at the time of the contribution or, if not so sold at such time, in
the recent past.

Effective date The proposal is effective for taxable years beginning after December 31,
2003.

Analysis
Policy issues

In the absence of the enhanced deduction of present law, if the taxpayer were to dispose
of excess inventory by dumping the excess food in a garbage dumpster, the taxpayer generally
could claim the purchase price of the inventory (the taxpayer’s basis in the property) as an
expense against his or her gross income. In the absence of the enhanced deduction of present
law, if the taxpayer were to donate the excess food inventory to a charitable organization that
maintains a food bank, the taxpayer generally would be able to claim a charitable deduction
equal to the taxpayer’s basis in the food inventory (subject to certain limits on charitable
contributions). Viewed from the taxpayer’s profit motive, the taxpayer would be indifferent
between donating the food or dumping the food in a garbage dumpster. If the taxpayer must
incur cost to deliver the food to the charity that maintains the food bank, the taxpayer would not
find it in his or her financial interest to donate the excess food inventory to the food bank. The
enhanced deduction creates an incentive for the taxpayer to contribute excess food inventory to
charitable organizations that provide hunger relief.

In general, the proposal is intended to give businesses greater incentive to contribute food
to those in need. By increasing the value of the enhanced deduction, up to the fair market value
of the food, and by clarifying the definition of fair market value, the proposal is intended to
encourage more businesses to donate more food to charitable organizations that provide hunger
relief, However, some argue that if the intended policy is to support food programs for the
needy, it would be more direct and efficient to provide a direct government subsidy instead of
making a tax expenditure through the tax system, which may result in abuse and cannot be
monitored under the annual budgetary process. On the other hand, proponents of the proposal

82


$200,000 amount at which the phase-out begins is increased to $400,000 for property placed in
service in taxable years beginning before 2006. The dollar limitations are indexed annually for
inflation for taxable years beginning before 2006. The provision also includes off-the-shelf
computer software placed in service in a taxable year beginning before 2006 as qualifying
property. With respect to taxable years beginning before 2006, the provision permits taxpayers
to revoke expensing elections on amended returns without the consent of the Commissioner.

Individual capital gains rates

Under JGTRRA, for taxable years beginning before January 1, 2009, generally the
maximum rate of tax on net capital gain of a non-corporate taxpayer is 15 percent. In addition,
any net capital gain which otherwise would have been taxed at a 10- or 15-percent rate generally
is taxed at a five-percent rate (zero for taxable years beginning after 2007). For taxable years
beginning after December 31, 2008, generally the rates on net capital gain are 20-percent and 10-
percent, respectively. Any gain from the sale or exchange of property held more than five years
that would otherwise be taxed at the 10-percent rate is taxed at an 8-percent rate. Any gain from
the sale or exchange of property held more than five years and the holding period for which
began after December 31, 2000, which would otherwise be taxed at a 20-percent rate is taxed at
an 18-percent rate.

Taxation of dividends received by individuals

Under JGTRRA, dividends received by a non-corporate shareholder from domestic
corporations and qualified foreign corporations generally are taxed at the same rates that apply to
net capital gain. Thus, dividends received by an individual, estate, or trust are taxed at rates of
five (zero for taxable years beginning after 2007) and 15 percent. This treatment applies to
taxable years beginning before January 1, 2009.

For taxable years beginning after December 31, 2008, dividends received by a non-
corporate shareholder are taxed at the same rates as ordinary income.

Description of Proposal
The proposal repeals the sunset provisions of EGTRRA and JGTRRA.

Specifically, the proposal permanently extends all provisions of EGTRRA that expire at
the end of 2010. Thus, the estate tax remains repealed after 2010, and the individual rate
reductions and other provisions of the Act that are in effect in 2010 will remain in place after
2010.

Also, the proposal permanently extends the provisions of JGTRRA relating to expensing,
capital gains, and dividends.

'9 However, certain provisions expire separately under the Act before the end of 2010.
For example, the increased AMT exemption amounts expire after 2004 and thus is unaffected by
the proposal.

10


account, and that other comparable tax free investments are available that do not have income
limits (e.g., qualified tuition programs), undermines the case for maintaining the income limits in
this instance.’**

Prior Action

No prior action.

283 The staff of the Joint Committee on Taxation, in its statutorily mandated
simplification study, recommended eliminating the phaseout for contributions to education-
IRAs, as the Coverdell education savings accounts were then known. While the Joint Committee
recommended elimination on the grounds that the limits were ineffective, the rationale for the
staff’s recommendation to eliminate other phaseouts would also apply here to the extent the
phaseout was effective. See Joint Committee on Taxation, Study of the Overall State of the
Federal Tax System and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of
the Internal Revenue Code of 1986 (JCS-3-01), April 2001, volume ii, at 79-91 and 586.

203


sufficient protections to purchasers, and that any tax incentive for the purchase of coverage in the
individual market should only be adopted if accompanied by reforms (¢.g., guaranteed issue).

Some argue that the tax laws should not provide a subsidy only for one particular type of
plan, because a targeted subsidy inappropriately causes tax considerations to enter into the choice
of insurance. Those who hold this view include some who view high deductible insurance as
preferable from a health policy perspective, but who believe the tax laws should be neutral with
respect to economic choices.

Proponents also argue that the proposal will reduce the number of uninsured individuals.
Many uninsured individuals may purchase high deductible health plans given the tax advantages
of HSAs and the deduction under the proposal. Others argue that because the proposal is limited
to a certain type of plan, it may have a minimal effect on reducing the number of uninsured.
Some may argue that those who are uninsured because they cannot afford coverage still may not
have sufficient resources to afford a high deductible plan even on a tax-subsidized basis. Other
younger healthier uninsured individuals who can afford health insurance may choose to continue
to remain uninsured even with the tax incentive.

Some criticize the proposal as providing a targeted subsidy for one type of insurance
product for which there has been a weak market, rather than directly addressing the social policy
issue of the rising cost of health care and number of uninsured individuals. On the other hand,
some point out that Congress has already provided subsidies to high deductible health plans
through the tax law (i.e., HSAs) to encourage people to use such plans and save for health
expenses, and that this proposal is consistent with the policy already expressed by Congress.

Proponents argue that the proposal will reduce the inequities under present law regarding
the tax treatment of health insurance expenses. Proponents argue that providing a deduction for
high deductible health plans will level the playing field for those who are not self-employed or
do not have employer-provided coverage. While the proposal addresses some of the present-law
differences in the tax treatment between employer-subsidized health insurance and insurance
purchased by individuals, critics argue that it is not appropriate for a tax subsidy for the purchase
of insurance to be limited to one particular type of plan. Critics argue that limiting the subsidy to
high deductible health plans will further contribute to the inequitable tax treatment of health
expenses and may actually increase inequities by providing, in connection with HSAs, a very
generous subsidy for one particular type of plan.

Some argue that the present-law differences in the tax treatment between employer-
subsidized health insurance and insurance purchased by individuals could be more equitably
addressed by limiting the exclusion for employer-provided health coverage. Others question
whether an exclusion for employer-provided health expenses should exist, as such preference
leads to a tax system which is not neutral with respect to similar expenses. Some argue that a tax
preference should exist only to the extent extraordinary medical expenses affect an individual’s
ability to pay and that this is already sufficiently addressed with the present-law itemized
deduction (to the extent of 7.5 percent of adjusted gross income) for medical expenses.

Even if one agrees that high deductible health plans are preferable from a health policy
perspective and should be tax-favored, some argue that inequities will result because the

52


Under present law, the IRS is permitted to terminate an installment agreement only if:
(1) the taxpayer fails to pay an installment at the time the payment is due; (2) the taxpayer fails
to pay any other tax liability at the time when such liability is due; (3) the taxpayer fails to
provide a financial condition update as required by the IRS; (4) the taxpayer provides inadequate
or incomplete information when applying for an installment agreement; (5) there has been a
significant change in the financial condition of the taxpayer; or (6) the collection of the tax is in
jeopardy.>**

Description of Proposal

The proposal grants the IRS authority to terminate an installment agreement when a
taxpayer fails to timely make a required Federal tax depositTM or fails to timely file a tax return
(including extensions). The termination could occur even if the taxpayer remained current with
payments under the installment agreement.

Effective date—The proposal is effective for failures occurring on or after the date of
enactment.

Analysis

The proposal may lead to some additional complexity in the administration of installment
agreements. For example, taxpayers might not understand why their installment agreement is
being terminated, leading to additional phone calls to the IRS. In addition, the proposal would
require that additional explanatory information be provided to taxpayers, which will increase
complexity. It might be possible to reduce this increase in complexity by implementing these
termination procedures in a manner as parallel as possible to the similar termination procedures
for offers in compromise. It may also be beneficial to permit the reinstatement of terminated
installment agreements for reasonable cause, parallel to the procedures applicable to offers in
compromise.

The proposal reflects the policy determination that taxpayers who are permitted to pay
their tax obligations through an installment agreement should also be required to remain current
with their other Federal tax obligations. Some might be concerned that this does not take into
account the benefits of making continued installment payments. A key benefit to the
government of continued installment payments is that the government continues to receive
payments, whereas if the installment agreement is terminated payments stop. Some might note
that termination of the installment agreement permits the IRS to begin immediate collection
actions, such as reinstating liens and levies, which could increase government receipts. In the
past several years, however, there has been a significant decline in IRS’ enforced collection
activities, so that others might respond that terminating installment agreements might not lead to

524 Sec. 6159(b).

525 Failure to timely make a required Federal tax deposit is not considered to be a failure
to pay any other tax liability at the time such liability is due under section 6159(b)(4)(B) because
liability for tax generally does not accrue until the end of the taxable period, and deposits are
required to be made prior to that date (sec. 6302).

326


Further, adopting a residency test places additional pressure on the definition of
temporary absence. Determining whether an absence is temporary can be difficult for taxpayers,
because there is little published guidance and the issue is inherently a factual determination that
may hinge on intent, which is difficult to demonstrate.

Replacing the present-law support test with a residency test also creates the need for tie-
breaking rules that may increase complexity. Because only one taxpayer may provide over one
half of a child’s support, there is no need for a tie-breaker rule to allocate the tax benefit to one
of multiple claimants when support is the determining factor. The proposed residency test may
be satisfied with respect to a particular child by two or more taxpayers (¢.g., a child who satisfies
the age and relationship tests may reside in the same principal place of abode with two or more
taxpayers, such as a female child living in the same principal place of abode as her mother and
grandmother). The proposal provides a tie-breaker rule to address such cases where multiple
taxpayers actually claim the same child, but requires the IRS to apply rules regarding adjusted
gross income and length of residency to allocate the child to a single taxpayer.

The staff of the Joint Committee on Taxation concluded that a support test would be
more difficult to apply than a residency test."“° The proposal generally adopts the residency test
for the uniform definition of qualifying child, but retains the support test for individuals who
provide over one half of their own support.

Relationship test —The proposal provides that certain individuals (a taxpayer’s sibling or
stepsibling or a descendant of any such individual) may not constitute a qualifying child unless
the taxpayer cares for that individual as the taxpayer’s own child. Some argue that this “care
for” requirement is vague and hard to administer, and introduces a type of support test into the
definition of qualifying child because it will require a showing of activities such as purchasing
food, clothing, medical care, and other items. Others argue that a standard such as the “care for”
test is required in certain family situations, such as those where there are siblings residing
together without a parent, to determine which of the siblings should be entitled to claim the other
sibling as a qualifying child.

Age test-The proposal adopts a uniform age rule for purposes of the dependency
exemption, the earned income credit, and head of household filing status, but retains the present-
law age differences for child credit (under age 17) and the dependent care credit (under age 13 if
not disabled). Many argue that determining a child’s age generally is not difficult to do, and that
differences in age rules that are justifiable on policy grounds or because of revenue constraints
do not introduce significant complexity.

Interaction with present-law rules and taxpayer selectivity—The proposal permits
taxpayers who are eligible to claim the same individual as a qualifying child to choose which
taxpayer will claim the dependency exemption with respect to the qualifying child, so long as
only one taxpayer actually claims that qualifying child. Although permitting taxpayers to choose

245 Joint Committee on Taxation, Study of the Overall State of the Federal Tax System
and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal
Revenue Code of 1986, Volume II, 52-53 (JCS-3-01), April 2001.

169


incentives for government agencies to lease rather than purchase property reduces distortions in
the budget process and enables Congress to more effectively oversee the appropriation of funds.

Public perception.—A third issue relates to whether the use of tax-motivated arrangements
by tax-exempt entities creates perceptions that the tax system is unfair or dysfunctional. This
possibility seems especially likely when highly visible assets, such as municipal buildings or
transportation assets, are offered in sale-leaseback transactions, or when US. tax benefits are
allowed for assets that are neither produced nor used domestically. With regard to certain cross-
border leasing transactions, the U.S. taxpayers essentially are subsidizing the purchase of

property for a foreign government or business for which the U.S. taxpayers obtain no benefit.4*!

Neutrality—A fourth issue is the extent to which the ability of a tax-exempt entity to
transfer depreciation and interest expense deductions through a lease with a taxable entity
economically distorts the decision of the tax-exempt entity between purchasing and leasing
property. Many believe that the tax system should not influence a tax-exempt entity’s decision
to purchase an asset (e.g., in the case of a State or local government through the proceeds of tax-
exempt bonds) or lease the asset. In accordance with this view, prior tax legislation (generally
the approach taken by Congress in 1984) attempted to minimize the potential distortion of
depreciation on the decision by decelerating the depreciation deductions associated with property
leased to tax-exempt entities. However, the effectiveness of this legislation has been questioned
as new and innovative structures have been designed to minimize or circumvent such
restrictions.

According to another view, tax subsidies should be made equally available to both
taxable and tax-exempt entities. Under this view, it is inappropriate to prevent tax-exempt
entities from receiving the benefits of tax incentives through leasing. For example, if Congress
wants to subsidize certain types of investments, Congress should not care who is making the
investment, Under this concept, there should be neutrality regardless of whether the investor is a
tax-exempt entity or a taxable entity.

However, critics of this view cite at least two problems with this analysis. First, the
notion that taxable and tax-exempt entities should be given equal incentives ultimately leads to
the conclusion that these entities should be treated equally in all respects (i.e., tax-exempt status
should be repealed). Second, providing tax-exempt entities with additional financial benefits
through leasing could result in tax-exempt entities leasing, rather than owning, most or all of
their buildings and equipment.

45! For example, in discussing the benefits of certain U.S./German leasing transactions a
leasing industry trade publication stated “inaccurate reporting [by the German press] has created
a wave of anti-leasing sentiment that is both unwarranted and the public purse equivalent of
looking a gift horse in the mouth.” It went on to state “part of the problem rests with the failure
of the [leasing] industry to sell itself clearly and loudly. Lease product needs to be clearly
marked -- a gift from the U.S.” See “The Lease Experience,” Asset Finance International, May
2003.

286


in the stock of the S corporation by the amount of the charitable contribution that flows through
to the shareholder.'“* As a result of the reduction of the stock basis by the value of the
contributed property, the shareholder may lose the benefit of the charitable contribution
deduction for the amount of any appreciation in the asset contributed.

Description of Proposal

The proposal allows a shareholder in an S corporation to increase the basis of the S
corporation stock by an amount equal to the excess of the charitable contribution deduction that
flows through to the shareholder over the shareholder’s pro rata share of the adjusted basis of the
property contributed.'?

Effective date —The proposal applies to taxable years beginning after December 31, 2003.

Analysis

The proposal preserves the benefit of providing a charitable contribution deduction for
contributions of property by an S corporation with a fair market value in excess of its adjusted
basis by limiting the reduction in the shareholder’s basis in S corporation stock to the
proportionate share of the adjusted basis of the contributed property. Under the proposal, the
treatment of contributions of appreciated property made by an S corporation is similar to the
treatment of contributions made by a partnership.

The net reduction in basis of stock by the amount of the adjusted basis of contributed
property rather than the fair market value will have little effect on tax law complexity.

Prior Action

The President’s fiscal year 2003 and 2004 budget proposals contained a substantially
similar proposal.

HR. 7, the “Charitable Giving Act of 2003,” as passed by the House of Representatives
on September 17, 2003, included a similar proposal.

S. 476, The “CARE Act of 2003,” as agreed to by the Senate on April 4, 2003, contained
a similar proposal.

148 Sec. 1367(a)(2)(B).

49 See Rev. Rul. 96-11 (1996-1 C.B. 140) for a similar rule applicable to contributions
made by a partnership.

94


no banking business and, thus, cannot utilize the bank deposit exception to repatriate foreign
earnings.

Another possible option would be to clarify the exception by reference to the status of the
deposit recipient. The President’s budget proposal reflects this approach by requiring that the
deposit recipient be an institution regulated as a bank. Relying upon the regulatory definition of
a “bank” to clarify the intended scope of the bank deposit exception generally would preclude
the exception from applying to special purpose subsidiaries such as the one that was utilized
successfully in The Limited case, while preserving the present-law application of the exception to
USS. banks with foreign operations. However, limiting the bank deposit exception to regulated
banks would preclude the exception from applying to deposits with certain financial institutions
that are not regulated as banks but nevertheless engage in providing active financial services to
customers.

Another possible option would be to combine certain elements of the other options so that
the bank deposit exception is limited to deposits with recipients that primarily earn banking or
active financial services income from unrelated parties. Such an approach could curtail abuse of
the bank deposit exception by taxpayers that are not viewed appropriately as financial
institutions, while preserving the present-law application of the exception to US. banks and
other financial institutions with foreign operations.

Complexity issues

The proposal can be expected to reduce the complexity of the tax law. By replacing the
vague term “carrying on the banking business” with a more precise definition of the types of
persons that may receive deposits under the exception, the proposal substantially eliminates the
ambiguity that spawned the litigation resulting in The Limited decision.

Prior Action

H.R. 2896, American Jobs Creation Act of 2003, as favorably reported by the House
Committee on Ways and Means on October 28, 2003, and S. 1637, Jumpstart our Business
Strength (JOBS) Act, as favorably reported by the Senate Finance Committee on October 1,
2003, include a similar provision.

294


household must be located in the United States. The age test requires that the individual be
under 19 (24 for a full time student) or be permanently and totally disabled. 258

Taxpayer identification number requirements

Individuals are ineligible for the credit if they do not include their taxpayer identification
number (TIN) and their qualifying child’s TIN (and, if married, their spouse’s TIN) on their tax
return. Solely for these purposes and for purposes of the present-law identification test for a
qualifying child, a TIN is defined as a Social Security number issued to an individual by the
Social Security Administration other than a number issued under section 205(c)(2)(B)(i)(ID (or
that portion of sec. 205(c)(2)(B)(i)(IID) relating to it) 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 taxpayer identification number, such omission will be treated
as a mathematical or clerical error by the IRS.

A taxpayer who resides with a qualifying child may not claim the EIC with respect to the
qualifying child if such child does not have a valid TIN. The taxpayer also is ineligible for the
EIC for workers without children because he or she resides with a qualifying child.

Description of Proposal

Overview

The proposal modifies present law EIC rules by (1) altering the rules with respect to EIC
claims made by separated spouses;”*? (2) simplifying the rules regarding claiming the EIC for
workers without children; (3) eliminating the disqualified investment income test; and (4)
changing the taxpayer identification number requirements for taxpayers and their qualifying
children with respect to the EIC.

Claims by separated spouses

The proposal modifies present law regarding EIC claims made by separated spouses.
Under the proposal, a married taxpayer who files a separate return (as married filing separately)
is allowed to claim the EIC if he or she lives with a qualifying child for over half the year,
provided the taxpayer lives apart from his or her spouse for the last six months of the taxable
year and otherwise satisfies the generally applicable EIC provisions.”* © Under the proposal, a
married taxpayer who satisfies these requirements, and files as married filing separately, is not

258 The IRS has issued guidance stating that for purposes of the earned income credit, an
individual attains a specified age on the anniversary of the date that the child was born (e.g., a
child born on January 1, 1987, attains the age of 17 on January 1, 2004). Rev. Rul. 2003-72,
2003-33 LR.B. 346.

259 Secs. 32(d) and 7703(b).

260 The proposal adopts the qualifying child test for this purpose, rather than the
“dependent child” test that applies under present law.

183


The substantive proposals regarding foreign tax credit holding period requirements and
income separation transactions appear to respond to certain specific categories of tax avoidance
transactions in which taxpayers either acquire foreign tax credits or generate immediate tax
losses while converting current ordinary income into deferred capital gain. In each case, it may
be difficult to develop specific operative rules that appropriately distinguish between legitimate
transactions and abusive transactions.

The foreign tax credit proposal related to the inappropriate separation of foreign taxes
from the related foreign income would expand existing regulatory authority to allow the
Treasury Department and IRS to address the second class of transactions described in Notice 98-
5 as well as other abusive transactions involving foreign tax credits.°** The proposal gives the
Treasury Department broad authority to stop foreign tax credit abuses, but does not identify in
great detail the scope of transactions that would be covered. The proposal states that the types of
transactions involved vary and, therefore, the regulations could provide for either the
disallowance of a credit for all or a portion of the foreign taxes, or the allocation of the foreign
taxes among the participants to the transaction in a manner that is more consistent with the
underlying economics of the transaction. If such regulatory authority were granted, the
effectiveness of these rules would depend upon the Treasury Department providing greater detail
with respect to the scope of transactions covered and exactly how such transactions would be
curtailed.

Complexity issues

The proposals regarding increased disclosure of tax avoidance transactions can be
expected to increase the complexity of the tax law. The difficulty in identifying and defining the
types of transactions that will require disclosure means that taxpayers will have to consider the
application of these rules to a potentially broad class of transactions. However, the Treasury
Department is focusing its efforts on limiting the types of transactions that will require disclosure
so that amount of disclosure requested by the Treasury Department is not burdensome.

The substantive proposals regarding foreign tax credit transactions and income separation
transactions also can be expected to increase the complexity of the tax law. Appropriately
tailoring the scope of these proposals potentially will entail the development of complex rules
that taxpayers would need to examine and apply in order to determine whether a particular
transaction is subject to these proposals. In addition, determining the tax consequences of
transactions that are subject to these proposals potentially will require complex rules that are
flexible enough to accommodate a wide variety of circumstances without producing unintended
or unwarranted results.

Prior Action
As previously noted, the proposals (except for the proposal concerning foreign tax credit

separation transactions) generally were contained in a Treasury shelter initiative released in
March 2002. In addition, these proposals generally were included in the President’s Fiscal Year

394 See Notices 2004-19 and 2004-20, 2004-11 I.R.B. 1.

253


Description of Proposal
Qualification rules for property and casualty insurance companies
In general

The proposal modifies the requirements for a property and casualty insurance company to
be eligible for tax-exempt status, and to elect to be taxed only on taxable investment income.

Tax-exempt insurance companies

The proposal limits tax-exempt status under section 501(c)(15) to mutual companies, and
imposes additional requirements for eligibility. Under the proposal, a property and casualty
insurance company is eligible to be exempt from Federal income tax only if (a) it is a domestic
mutual company organized in and subject to regulation in a single State, and it writes insurance
or reinsurance only on risks located within that State, and (b) its gross income for the taxable
year does not exceed $350,000. A foreign company, including one that has made the election to
be treated as a domestic company under section 953(d), does not qualify under the proposal. For
purposes of the proposal, gross income includes premiums earned, investment income, and other
types of gross income. The proposal expands the present-law controlled group rule so that it also
takes into account gross income of foreign and tax-exempt corporations, as well as the gross
income of any related non-insurance companies. The proposal repeals eligibility for tax-exempt
status for stock property and casualty insurance companies.

Election to be taxed only on taxable investment income

The proposal provides that a property and casualty insurance company may elect to be
taxed only on taxable investment income if its net written premiums or direct written premiums
(whichever is greater) do not exceed $1.2 million (without regard to whether such premiums
exceed $350,000) (sec. 831(b)). For purposes of determining the amount of a company’s net
written premiums or direct written premiums under this rule, premiums received by all members
of a controlled group of corporations (including U.S., foreign, and related tax-exempt insurance
companies) are taken into account. The proposed changes to the election to be taxed only on
taxable investment income apply both to mutual companies and stock companies.

Definition of insurance company

The proposal provides that, for purposes of determining whether a company is a property
and casualty insurance company for U.S. tax purposes, the term “insurance company” is defined
to mean a company, more than half of the business of which during the taxable year is the
issuing of insurance or annuity contracts or the reinsuring of risks underwritten by insurance
companies. Thus, the proposal conforms the definition of an insurance company for purposes of
the rules taxing property and casualty insurance companies to the rules taxing life insurance
companies, so that the definition is uniform, and adopts a stricter and more precise standard than
the “primary and predominant business activity” test contained in Treasury Regulations.

The proposed changes to the definition of insurance company apply both to mutual
companies and stock companies.

260


confusion due to differing definitions of qualifying child. A uniform definition also makes the
applicable provisions easier for the IRS to administer.

Complexity of specific rules

In general.—Certain of the rules for each tax benefit are themselves complex. In
particular, the support test for the dependency exemption (and by extension, the child credit) and
separate maintenance of household tests for the dependent care credit and head of household
filing status can require significant information gathering and calculations by the taxpayer. In
some cases, it may be extremely difficult for the taxpayer to correctly apply these tests, because
the taxpayer may require information not readily available (or even inaccessible), such as support
provided by third parties and government subsidies.

Residency and support tests—A definition of child or qualifying child for child-related tax
benefits must include factors other than age and relationship. Failure to do so would create
unnecessarily numerous multiple claimants to the same tax benefits, and award tax benefits to
taxpayers without regard to who bears the economic and other burdens associated with raising a
child. Support and residency tests oftentimes are regarded as the most feasible alternatives for
this purpose.

Many argue that a residency test is easier to apply than a support test. A support test
generally involves calculations that do not arise under a residency test, 243 and tax; ayers may not
know whether they have provided over one half the support of another individual. 4 Tn some
cases, however, both tests present difficult issues. Replacing the support test with a residency
test may place additional emphasis on counting days in certain circumstances in which more than
one half year of residency is not clearly satisfied with respect to the taxpayer. For this reason,
some have argued that guidance will be required with respect to the residency test, such as safe
harbors or rebuttable presumptions that taxpayers could rely upon without having to count the
precise number of days the child resided with the taxpayer.

243 The present-law dependency exemption support test generally requires the
completion of a 22-line worksheet, contained in IRS Publication 17, Your Federal Income Tax,
and IRS Publication 501, Exemptions, Standard Deduction, and Filing Information. The
President’s budget proposal states that a 1993 General Accounting Office study found that in
1988, taxpayers erroneously claimed dependency exemptions for an estimated nine million
individuals, and that failing to satisfy the support test was the cause in nearly 75 percent of these
cases. Of those failures to satisfy the support test, 57 percent involved a failure to provide
sufficient financial support, and the remainder involved a lack of adequate records to
demonstrate satisfaction of the support test.

244 Some argue that this is especially the case if the taxpayer receives public benefits,
which under present law are treated as support provided by a third party rather than by the
taxpayer. Schenk, Deborah H., Old Wine in Old Bottles: Simplification of Family Status Tax
Issues, presented at the NYU/Tax Analysts Government Tax Policy Workshop, Tax Code
Complexity (February 9, 2001), published in Tax Notes, Vol. 91, No. 9 (May 28, 2001), 1437,
1449.

168


funds from the Federal Government to States and local governments. This would enable States
and local governments to spend the savings on other government functions or to reduce taxes.°%8
In this event, the stated objective of the proposals would not be achieved.

Though called a tax credit, the Federal subsidy for tax credit bonds is equivalent to the
Federal Government directly paying the interest on a taxable bond issue on behalf of the State or
local government that benefits from the bond proceeds.” To see this, consider any taxable bond
that bears an interest rate of 10 percent. A thousand dollar bond would thus produce an interest
payment of $100 annually. The owner of the bond that receives this payment would receive a
net payment of $100 less the taxes owed on that interest. If the taxpayer were in the 28-percent
Federal tax bracket, such taxpayer would receive $72 after Federal taxes. Regardless of whether
the State government or the Federal Government pays the interest, the taxpayer receives the
same net of tax return of $72. In the case of tax credit bonds, no formal interest is paid by the
Federal Government. Rather, a tax credit of $100 is allowed to be taken by the holder of the
bond. In general, a $100 tax credit would be worth $100 to a taxpayer, provided that the
taxpayer had at least $100 in tax liability. However, for tax credit bonds, the $100 credit also has
to be claimed as income. Claiming an additional $100 in income costs a taxpayer in the 28-
percent tax bracket an additional $28 in income taxes, payable to the Federal Government. With
the $100 tax credit that is ultimately claimed, the taxpayer nets $72 on the bond. The Federal
Government loses $100 on the credit, but recoups $28 of that by the requirement that it be
included in income, for a net cost of $72, which is exactly the net return to the taxpayer. If the
Federal Government had simply agreed to pay the interest on behalf of the State or local
government, both the Federal Government and the bondholder/taxpayer would be in the same
situation. The Federal Government would make outlays of $100 in interest payments, but would
recoup $28 of that in tax receipts, for a net budgetary cost of $72, as before. Similarly, the
bondholder/taxpayer would receive a taxable $100 in interest, and would owe $28 in taxes, for a
net gain of $72, as before. The State or local government also would be in the same situation in
both cases.

The proposed tax credit regime to subsidize public school investment raises some
questions of administrative efficiencies and tax complexity (see above). Because potential
purchasers of the zone academy bonds must educate themselves as to whether the bonds qualify
for the credit, certain “information costs” are imposed on the buyer. Additionally, since the
determination as to whether the bond is qualified for the credit ultimately rests with the Federal

©8 Most economic studies have found that when additional funding is made available to
localities from outside sources, there is indeed an increase in public spending (this is known as
the “fly-paper” effect, as the funding tends to “stick” where it is applied). The additional
spending is not dollar for dollar, however, implying that there is some reduction of local taxes to
offset the outside funding. See Harvey Rosen, Public Finance, second ed., 1988, p. 530 for a
discussion of this issue.

9 This is true provided that the taxpayer faces tax liability of at least the amount of the
credit. Without sufficient tax liability, the proposed tax credit arrangement would not be as
advantageous. Presumably, only taxpayers who anticipate having sufficient tax liability to be
offset by the proposed credit would hold these bonds.

395


Proposal relating to limits on benefit accruals and lump-sum distributions under certain
underfunded plans

Under the proposal, additional benefit accruals and lump-sum distributions are precluded
in the case of a plan sponsored by an employer with a credit rating below investment grade if the
value of the plan’s assets is less than 50 percent of termination liability under the plan. Some
argue that, if an employer has failed to adequately fund the benefits already earned under a plan
and also presents a measurable risk of going out of business while the plan is underfunded, it is
inappropriate to allow plan liabilities to increase as a result of additional accruals or for plan
assets to be depleted by lump-sum distributions. They argue that such a plan presents an undue
risk to the PBGC that the plan will terminate and that insufficient assets will be available (from
the plan or from the employer) to provide benefits due under the plan. Accordingly, the proposal
limits the PBGC’s potential liability in such circumstances.

Others argue that it is not unusual for an employer to experience temporary financial
problems that do not in fact threaten the long-term viability of the employer’s pension plan.
They also argue that limiting benefit accruals and distributions from the plan as required under
the proposal unfairly penalizes plan participants and may cause unnecessary concern about their
retirement income security. On the other hand, if the employer’s financial problems are in fact
temporary and the funded status of the plan improves, benefit accruals and lump-sum.
distributions may resume and plan participants can be made whole.

Prior Action

H.R. 3108, the “Pension Funding Equity Act of 2003,” as passed by the House of
Representatives on October 8, 2003, includes a provision under which, for plan years beginning
after December 31, 2003, and before January 1, 2006, for purposes of determining current
liability, the interest rate on 30-year Treasury securities is replaced with the rate of interest on
amounts conservatively invested in long-term corporate bonds. On January 28, 2004, the Senate
passed an amendment to HLR. 3108, the “Pension Stability Act,” which contains a similar
provision.

The National Employee Savings and Trust Equity Guarantee Act, as ordered reported by
the Committee on Finance on September 17, 2003, and (with amendments) on February 2, 2004,
includes a provision relating to the interest rate used to determine current liability and lump-sum
distributions. Under that provision, for plan years beginning after December 31, 2003, and
before January 1, 2007, for purposes of determining current liability, the interest rate on 30-year
Treasury securities is replaced with the rate of interest on amounts invested in conservative long-
term corporate bonds. For plan years beginning after December 31, 2010, for purposes of
determining current liability and lump-sum distributions, the interest rate on 30-year Treasury
securities is replaced with a yield curve reflecting interest rates on corporate bonds of durations
the rate of interest on amounts invested in conservative long-term corporate bonds. Phase-in
tules apply for years beginning after December 31, 2006, and before January 1, 2011.

239


impose a penalty of up to $25,000 if a taxpayer has instituted or maintained proceedings
primarily for delay or if the taxpayer’s position in the proceeding is frivolous or groundless (sec.
6673(a)).

Description of Proposal

The proposal modifies this IRS-imposed penalty by increasing the amount of the penalty
to $5,000.

The proposal also modifies present law with respect to certain submissions that raise
frivolous arguments or that are intended to delay or impede tax administration. The submissions
to which this provision applies are: (1) requests for a collection due process hearing;

(2) installment agreements; and (3) offers-in-compromise. First, the proposal permits the IRS to
dismiss such requests. Second, the proposal permits the IRS to impose a penalty of $5,000 for
repeat behavior or failing to withdraw the request after being given an opportunity to do so.

The proposal permits the IRS to maintain records of frivolous submissions by
taxpayers.° 18 The proposal also requires that this designation be removed after a reasonable
period of time if the taxpayer makes no further frivolous submissions to the IRS.

The proposal requires the IRS to publish (at least annually) a list of positions, arguments,
requests, and proposals determined to be frivolous for purposes of these provisions.

Effective date —The proposal is effective for submissions made on or after the date of
enactment.

Analysis

In general

Genuinely frivolous returns and submissions are those that raise arguments that have
been repeatedly rejected by the courts. Dealing with genuinely frivolous returns and submissions
consumes resources at the IRS and in the courts that can better be utilized in resolving legitimate
disputes with taxpayers. Accordingly, the proposals may improve the overall functioning of the
tax system and improve the level of service provided to taxpayers who do not raise these
frivolous arguments.

Some may question why this IRS-imposed penalty should be applied only to individuals
instead of applying it to all taxpayers who raise frivolous arguments. Expanding the scope of the
penalty to cover all taxpayers would treat similarly situated taxpayers who raise identical
arguments in the same manner, which would promote fairness in the tax system. Similarly, some
may question why this penalty should apply only to income tax returns and not to all other types

518 It is unclear how this portion of the proposal is intended to interact with the statutory
prohibition on the designation of taxpayers by the IRS as “jIlegal tax protesters (or any similar
designation)” (sec. 3707 of the Internal Revenue Service Restructuring and Reform Act of 1998;
P.L, 105-206 (July 22, 1998)).

322


direct Federal funds to charitable organizations. Applying this analogy, the tax deduction for
charitable contributions is most similar to those direct spending programs that have no spending
limits,'!! and that are available as entitlements to those organizations that meet the statutory
criteria established under section 170(c). The proposal would expand the tax expenditure of
present law by increasing the number of taxpayers who qualify to claim a tax deduction.

A substantial amount of charitable donations made by individuals is not claimed as
itemized deductions. However, there are no data that directly measure the magnitude of
charitable donations by non-itemizers. Table 3 below offers some indirect evidence on the
magnitude of such giving. The second column of Table 3 presents estimates of the American
Association of Fund-Raising Counsel Trust for Philanthropy of the total amount of charitable
donations received by qualifying organizations from individuals. By contrast, the third column
of Table 3 reports itemized deductions claimed for charitable donations as reported to the
Internal Revenue Service. Comparison of the two columns would suggest that in 2000, nearly
$35 billion in charitable contributions made by individuals were not claimed as itemized
deductions. Unfortunately, differences in the amounts reported in columns two and three of
Table 3 cannot be interpreted as measures of amounts of contributions made by non-itemizers.
Evidence from audits and in taxpayer compliance studies establishes that many taxpayers
overstate their actual donations when claiming itemized deductions.''? These findings suggest
that if one were to use the difference in the amounts reported in columns two and three to
estimate the magnitude of charitable donations by non-itemizers that the result would be to
under-estimate actual donations by non-itemizers.''? Moreover, experience among taxpayers
who itemize suggests that, if non-itemizers were allowed to claim a deduction for their charitable
donations, many non-itemizers likely would overstate their actual donations for the purpose of
claiming a tax benefit.

11 Charitable contribution deductions are subject to the applicable percentage limitation.
In general, contributions in excess of the percentage limitation may be carried forward and
deducted for five years.

12. Joel Slemrod, “Are Estimated Tax Elasticities Really Just Tax Evasion Elasticities?
The Case of Charitable Contributions,” The Review of Economics and Statistics, vol. 71,
August 1989, at 517-522. Slemrod examined data from the IRS’s Taxpayer Compliance
Measurement Program. In this sample, more than one quarter of the taxpayers who itemized
deductions for charitable contributions were found, on audit, to have overstated their charitable
contributions. (Some taxpayers also were found to have understated their charitable
contributions.) The evidence on overstatement of actual contributions may call into question the
estimates cited previously of the extent to which the charitable deduction encourages taxpayers
to donate to charities. Slemrod’s study found that, while in theory estimated behavioral
responses may be biased upwards by taxpayers overstating their contributions, the data he
examined showed no material mismeasurement of the extent to which the charitable deduction
encourages taxpayers to make actual contributions.

113 Such a conclusion assumes that the figures reported in the second column of Table 3

are accurate estimates of total giving by individuals. Errors in these estimates of total donations
could raise or lower estimates of donations by non-itemizers.

73


The minimum funding rules are designed to promote benefit security by helping to ensure
that plan assets will be sufficient to pay promised benefits when due. The minimum funding
tules also address moral hazard concems relating to the PBGC insurance program by preventing
employers from purposely underfunding plans. Such underfunding can increase costs to the
Federal government as well as PBGC premium payors.

On the other hand, the minimum funding rules recognize that pension benefits are often
long-term liabilities that can be funded over a period of time. Some argue that if minimum
funding requirements are too stringent, funds may be unnecessarily diverted from the employer’s
other business needs and may cause financial problems for the business, thus jeopardizing the
future of not just the employees’ retirement benefits, but also their jobs. This suggestion tends to
arise during a period of economic downturn, either generally or in a particular industry. Some
also argue that overly stringent funding requirements may discourage the establishment or
continuation of defined benefit pension plans.

The limits on deductible contributions, the excise tax on nondeductible contributions, and
the rules relating to reversions of defined benefit pension plan assets have as a major objective
preventing the use of defined benefit pension plans as a tax-favored funding mechanism for the
business needs of the employer. They also serve to limit the tax expenditure associated with
defined benefit pension plans. Some argue that if the maximum limits on plan funding are too
low, then benefit security will be jeopardized. They argue that employers need flexibility to
make greater contributions when possible, in order to ensure adequate funding in years in which
the business may not be as profitable. In addition, some argue that if restrictions on reversions
are too strict, employers may be discouraged from making contributions in excess of the required
minimums.

The desire to achieve the proper balance between these competing policy objectives has
resulted in a variety of legislative changes to address the concerns arising at particular times. For
example, the Omnibus Budget Reconciliation Act of 1987 made comprehensive changes to the
minimum funding rules (including enactment of the deficit reduction contribution rules)
prompted by concerns regarding the solvency of the defined benefit pension plan system. That
Act also added the current liability full funding limit. Legislation enacted in 1990 allowed
employers access to excess assets in defined benefit pension plans in order to pay retiree health
liabilities. The Retirement Protection Act of 1994 again made comprehensive changes to the
funding rules. Recent changes to the funding rules have focused on increasing the maximum
deductible contribution, and on the interest rate that must be used to calculate required
contributions. For example, EGTRRA increased the current liability full funding limit and then
repeals the current liability full funding limit for 2004 and thereafter.

Background relating to interest rate used to measure pension liabilities

Recent attention has focused on the issue of the rate of interest used to determine the
present value of benefits under defined benefit pension plans for purposes of the plan’s current
liability (and hence the amount of contributions required under the funding rules) and the amount
of lump-sum benefits under the plan. The theoretical basis for the interest rate to be used to
determine the present value of pension plan benefits is an interest rate that would be used in
setting the price for private annuity contracts that provide similar benefits. Some studies have

235


Grandfathering

For older and longer-service participants, benefits under a cash balance formula may be
lower than the benefits a participant may have expected to receive under the traditional defined
benefit formula (the “old” formula).*°° The employer might therefore provide some type of
“grandfather” to participants already in the plan or to older or longer-service employees. For
example, the participants might be given a choice between the old formula and the cash balance
formula for future benefit accruals, or, in the case or a final average pay plan, the plan may stop
crediting service under the old formula, but continue to apply post-conversion pay increases, so
the employee’s preconversion benefit increases with post-conversion pay increases. This
approach goes beyond preserving the benefit protected by the anticutback rules.

Calculating lump-sum distributions

Defined benefit pension plans are required to provide benefits in the form of a life
annuity commencing at a participant’s normal retirement age.°° If the plan permits benefits to be
paid in another form, e.g., a lump-sum distribution, the alternative form of benefit cannot be less
than the present value of the life annuity payable at normal retirement age, determined using
certain statutorily prescribed interest and mortality assumptions.

Although a participant’s benefit under a cash balance plan is described in terms of a
hypothetical account balance, like other defined benefit pension plans, a cash balance plan is
required to provide benefits in the form of an annuity payable at normal retirement age. Most
cash balance plans are designed to permit lump-sum distributions of the participant’s
hypothetical account balance upon determination of employment. As is the case with defined
benefit pension plans generally, such a lump-sum amount is required to be the actuarial
equivalent to the annuity payable at normal retirement age, determined using the statutory
interest and mortality assumptions.

IRS Notice 96-8 provides that determination of an employee’s minimum lump sum under
acash balance plan which provides for frontloaded interest credits is calculated by: (1) projecting
the participant’s hypothetical account balance to normal retirement age by crediting future
interest credits, the right to which has already accrued; (2) converting the projected account
balance to an actuarially equivalent life annuity payable at normal retirement age, using the
interest and mortality assumptions specified in the plan; and (3) determining the present value of
the annuity (i.e., the lump-sum value) using the statutory interest and mortality assumptions.*”

A difference in the rate of interest credits provided under the plan, which may be used to
project the account balance forward to normal retirement age, and the statutory rate used to
determine the lump-sum value (i.e., present value) of the accrued benefit will cause a

305 This is sometimes the reduction in benefits that is referred to in connection with cash
balance conversions, i.e., a reduction in expected benefits, not accrued benefits.

306 Code sec. 401(a)(11); ERISA sec. 205.

3°7 Section IILB and C of Notice 96-8, 1996-1 C.B. 359 (Feb. 5, 1996).

216


under which the rate of matching contribution does not increase as the rate of an employee’s
elective contributions increases, and the aggregate amount of matching contributions at such rate
of elective contribution is at least equal to the aggregate amount of matching contributions that
would be made if matching contributions were made on the basis of the percentages described in
the first formula. In addition, the rate of matching contribution with respect to any rate of
elective contribution cannot be higher for a highly compensated employee than for a nonhighly
compensated employee.

A plan sponsored by a State or local government is not subject to the nondiscrimination
requirements. In addition, a plan sponsored by an organization exempt from tax under section
501(c)(3) is not subject to the ERSA nondiscrimination tests (unless the plan permits after-tax or
matching contributions), but must permit all employees of the organization to participate.

Special rule for small employers

Under the proposal, an employer that employed 10 or fewer employees with
compensation of at least $5,000 in the prior year is able to offer an ERSA in the form of
custodial accounts for employees (similar to a present-law IRA), provided the employer’s
contributions satisfy the ERSA design-based safe harbor described above. The option of using
custodial accounts under the proposal provides annual reporting relief for small employers as
well as relief from most fiduciary requirements under the Employee Retirement Income Security
Act of 1974 (“ERISA”) under circumstances similar to the relief provided to sponsors of
SIMPLE IRAs under present law.

Effective date

The proposal is effective for years beginning after December 31, 2004, including the
option of designating employee elective contributions as Roth contributions (which is effective
in 2006 under present law).

Analysis
Policy and complexity issues relating to employer-sponsored retirement plans*

An employer's decision to establish or continue a retirement plan for employees is
voluntary. The Federal tax laws provide favorable tax treatment for certain employer-sponsored
retirement plans in order to further retirement income policy by encouraging the establishment
and continuance of plans that provide broad coverage, including rank-and-file employees. On
the other hand, tax policy is concemed also with the level of tax subsidy provided to retirement
plans. Thus, the tax law limits the total amount that may be provided to any one employee under
a tax-favored retirement plan and includes strict nondiscrimination rules to prevent highly

58 For a detailed discussion of complexity issues related to retirement savings, see, Joint
Committee on Taxation, Study of the Overall State of the Federal Tax System and
Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue
Code of 1986 (JCS-3-01), April 2001.

34


Description of Proposal

The proposal repeals the alternative formula based on the excess of the social security
taxes paid over the amount of the EIC. Thus, the additional child tax credit will be based solely
on the earned income formula, regardless of the number of children in a taxpayer’s family.

Also, the proposal eliminates the requirement that earned income be included in taxable
income for purposes of computing the additional child tax credit. This conforms the definition of
earned income for purposes of the refundable child credit and the EIC (i-e., earned income for
both credits equals the sum of wages, salaries, tips, and other taxable employee compensation
plus net self-employment earnings). Thus, net self-employment earnings that are not included in
taxable income will be included in earned income for purposes the additional child credit.

Finally, the proposal requires taxpayers to reside with a child in the United States to
claim the additional child tax credit. For these purposes, the principal place of abode for
members of the U.S. Armed Forces is treated as in the United States for any period the member
is stationed outside the United States while serving on extended active duty. Extended active
duty includes a call or order to such duty for a period in excess of 90 days.

Effective date—The proposal is effective for taxable years beginning after December 31,
2004.

Analysis

A single rule for calculating the refundable child credit will provide simplification for
taxpayers with three or more children who otherwise must make two separate calculations: the
earned income formula and the alternative formula. The vast majority of such taxpayers find that
the alternative formula calculation does not yield a higher credit amount so its repeal would
make the credit calculation simpler without changing total benefits. While the vast majority of
taxpayers benefit from the simplification of this change, taxpayers for whom the alternative
formula produces the greater benefit would receive a smaller refundable child credit than that
provided by current law. In general, taxpayers who find the alternative formula more valuable
are: (1) residents of Puerto Rico, who do not pay U.S. income taxes and are not eligible to claim
the EIC, but who may nonetheless may file a U.S. income tax return to claim a refundable child
credit, and (2) taxpayers in the United States who are eligible for the child credit but not eligible
to claim the EIC.

Use of the same measure of earned income for both the refundable child credit and the
EIC will provide simplification for all taxpayers claiming both credits. While for virtually all
taxpayers the two measures of income yield the same result under present law, the fact that this is
not true of all taxpayers requires additional instructions for all. Taxpayers for whom the two
measures of earned income differ are those who have certain self-employment earnings, such as
a parsonage allowance, that is excluded from gross income for individual income tax purposes.
The President’s proposal to adopt the EIC definition of earned income for purposes of the
refundable child credit (that is, to eliminate the requirement that the earned income be included
in taxable income) will expand the availability of the refundable child credit to income not
subject to the individual income tax, which some might view as an undesirable policy result.

179


acash balance formula that provides all participants with the same rate of pay credit generally
will not violate the prohibition on age discrimination. In the case of a plan that is converted to a
cash balance plan, the conversion generally must be accomplished in one of two ways in order to
use the special rule. That is, in general, the converted plan must either: (1) determine each
participant’s benefit as not less than the sum of the participant’s benefits accrued under the
traditional defined benefit pension plan formula and the cash balance formula; or (2) establish
each participant’s opening account balance as an amount not less than the actuarial present value
of the participant’s prior accrued benefit, using reasonable actuarial assumptions. The proposed
regulations also allow a converted plan to continue to apply the traditional defined benefit
formula to some participants.

After the proposed regulations were issued, a Federal district court in Cooper v. IBM
Personal Pension Plan*" held that that cash balance formulas are inherently age discriminatory
because identical interest credits necessarily buy a smaller age annuity at normal retirement age
for older workers than for younger workers due to the time value of money. Prior to the decision
in JBM, other district courts had reached the contrary result, i.e., that the cash balance formula
was not age discriminatory.*"*

Section 205 of the Consolidated Appropriations Act, 2004 (the “Appropriations Act”),’!°
enacted January 24, 2004, provides that none of the funds made available in the Appropriations
Act may be used by the Secretary of the Treasury, or his designee, to issue any tule or regulation
implementing the proposed Treasury regulations or any regulation reaching similar results.
Additionally, the Appropriations Act requires the Secretary of the Treasury within 180 days of
enactment to present to Congress a legislative proposal for providing transition relief for older
and longer-service participants affected by conversions of their employers’ traditional pension
plans to cash balance plans. The proposal is intended to satisfy this requirement.

Description of Proposal

In general

The proposal provides rules for conversions of defined benefit pension plans to cash
balance plans, prescribes age discrimination requirements for cash balance plans, and specifies
rules for calculating lump-sum distributions from cash balance plans. The proposal makes
conforming amendments to applicable rules under ERISA and ADEA.

defined benefit plan or rate of allocation under a defined contribution plan. The proposed
regulations also address a number of other issues, including nondiscrimination testing for cash
balance plans under section 401(a)(4). In April 2003, the Treasury Department announced it
would withdraw the proposed regulations under section 401(a)(4). Announcement 2003-22,
2002-17 LLR.B. 846 (April 28, 2003).

313 274 F. Supp. 2d 1010 (S.D. Ill. 2003).
314 See e.g, Eaton v. Onan Corp., 117 F. Supp. 2d 812 (S.D. Ind. 2000).

315 Bub, L. No. 108-199 (2004).

218


year information may make the advanced payment option easier to administer, however, using
the prior year data and not requiring reconciliation means that the credit will in some cases not
reach those intended to receive it. For example, individuals can have low income in the current
year when they need assistance in purchasing health insurance, but prior year income that is too
high to qualify for the advanced payment of the credit. Such individuals are not eligible to
receive the credit on the advanced basis and in many cases, because of their decreased income,
will remain uninsured.

Some argue that the advanced payment mechanism of the proposal is flawed because an
individual could receive the credit as an advanced payment based on the prior year’s income,
even though ineligible for the credit because of the current year’s income. Because there is no
reconciliation required on the current year return, such individual is not required to repay the
amount of the advanced payment of the credit to the government. For example, a recently
graduated student could have current year income of over $100,000, but prior year income of
less than $15,000 because the individual was in school on a full-time basis. Such individual
could be entitled to the $1,000 advanced payment of the credit even though the current year
income exceeds the credit income limitation. Thus, using prior year income may result in
inefficiency regarding delivery of the credit to the intended target population.

Using current year data or requiring reconciliation would reduce this problem. Using
current year data could, however, create other issues, such as making the mechanics of the
advanced payment system work and enforcement issues. For example, it may be difficult in
some cases to collect the additional tax owed by people who erroneously claimed the advance
credit. Experience with the earned income credit shows that this could be the case.

The fact that the tax credit is refundable could lead to fraud and abuse by taxpayers, as it
may be difficult for the IRS to successfully enforce against taxpayers claiming the credit even
though ineligible. Similar to the earned income credit, it would be difficult for the IRS to timely
detect fraudulent refunds issued to taxpayers.

Complexity issues

Creating a new tax credit adds complexity to the Code. By providing additional options
to individuals, the proposal may increase complexity because individuals will have to determine
which option is best for them. A new tax credit will increase complexity in IRS forms and
instructions, by requiring new lines on several tax forms and additional information in
instructions regarding the tax credit. The new credit would also require IRS programming
modifications. Taxpayers covered by high-deductibles plans that are not part of a public or
employer-provided plan will need to calculate their tax liability twice to determine whether the
proposed credit exceeds the value of the alternative premium deduction (as provided in the
President’s fiscal year 2005 budget proposal) and the present-law deduction for contributions to
an HSA.

The Code contains several provisions that provide benefits to taxpayers with children.
These provisions have different criteria for determining whether the taxpayer qualifies for the
applicable tax benefit with respect to a particular child. The use of different tests to determine
eligibility for a provision with respect to a child causes complexity for taxpayers and the IRS.

46


identical expenditures at other geographic locations. Such distinctions generally require
additional record keeping on the part of taxpayers and more complex tax return filings.
Concomitantly, such distinctions increase the difficulty of IRS audits.

Prior Action

Proposals to make section 198 permanent were included in the President’s fiscal year
1999, fiscal year 2000, fiscal year 2001, fiscal year 2002, fiscal year 2003, and fiscal year 2004
budget proposals.

H.R. 3521, the “Tax Relief Extension Act of 2003,” as passed by the House of
Representatives on November 20, 2003, would extend the present-law deduction for
environmental remediation expenditures through December 31, 2004.

2. Exclude 50 percent of gains from the sale of property for conservation purposes

Present Law

Income tax treatment of dispositions of land

Capital gains treatment

In general, gain or loss reflected in the value of an asset is recognized for income tax
purposes at the time the taxpayer disposes of the property. On the sale or exchange of capital
assets held for more than one year, gain generally is taxed to an individual taxpayer at a
maximum marginal rate of 15 percent. However, gain attributable to real estate depreciation
deductions that were previously claimed against ordinary income is taxed at a maximum
marginal rate of 25 percent. Losses from the sale or exchange of capital assets are deductible
only to the extent of the gains from the sale or exchange of other capital assets, plus, in the case
of individuals, $3,000.

Land is a capital asset, unless it is held primarily for sale to customers in the ordinary
course of the taxpayer’s trade or business, or it is used in the taxpayer’s trade or business. In
addition, if the gains from property, including land, used in a taxpayer’s trade or business exceed
the losses from such property, the gains and losses are treated as capital gains.

Deferral of gain or loss

Several provisions allow a taxpayer to defer gain when property, including land, is
disposed of. For example, gain or loss is deferred if land held for investment or business use is
exchanged for property of a like kind (generally defined to include other real estate) (sec. 1031).
Likewise, gain is deferred if land is condemned and replaced with other property ofa like kind
(sec. 1033(g)).

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Description of Proposal

The proposal provides an above-the-line deduction for high deductible health insurance
premiums for individuals who contribute to an HSA. As under the present-law rules relating to
HSA eligibility, an individual does not qualify for the deduction if the individual is covered by
any health plan other than the high deductible plan for which the deduction is claimed, except for
certain permitted coverage. The deduction is only allowed for insurance purchased in the
individual insurance market and is not allowed for individuals covered by employer plans or
public plans. Additionally, the deduction is not allowed to an individual claiming the refundable
tax credit for the purchase of health insurance included in the President’s fiscal year 2005 budget
proposal.

Effective date —The proposal is effective for taxable years beginning after December 31,
2004.

Analysis
Policy issues

The proposal is intended to provide an incentive for individuals to purchase high
deductible health plans in connection with the use of HSAs. Allowing a deduction for premiums
of high deductible health plans provides a subsidy for the purchase of such plans, thus making
them more affordable. The proposal raises both health policy issues and tax policy issues.

Proponents believe that the use of high deductible health plans promotes responsible
health policy. Proponents argue that the use of high deductible health plans (together with
HSAs) will encourage cost consciousness and result in better decision-making with respect to
health care expenses because such plans make individuals more aware of their health care
expenses.

Critics argue that it is inappropriate to favor high deductible health plans. Critics argue
that providing a preference for the purchase of high deductible health insurance purchased in the
individual market undermines the current group-based health insurance system by encouraging
healthier individuals who can obtain less expensive coverage in the individual market to leave
the employee pool, thus increasing the cost of insurance for the employees remaining in the pool.
Critics also argue that any cost reductions hoped for due to the use of high deductible health
plans are undermined by the availability of HSAs.

Critics have concerns with favoring any insurance purchased in the individual market.
Some argue that favoring plans purchased in the individual market and excluding employer
plans, may even cause some employers to not offer health benefits for their employees if they
feel that significant tax incentives exist in the individual market. Critics argue that this could
cause the insurance market to turn into a predominantly individual market, which could result in
an increase in the cost of health coverage for some individuals. Critics argue that individuals
who are unable to obtain coverage in the individual market will be greatly disadvantaged by the
proposal. Critics are also concerned about the focus of the deduction on insurance purchased in
the individual market because they believe the individual market does not presently offer

51


that may be established for a single beneficiary. Also, persons other than individuals, e¢.g.,
corporations or charities, can make contributions up to the $2,000 per year limit with respect to
any single beneficiary.

Earnings on contributions to an ESA generally are subject to tax when withdrawn.
However, distributions from an ESA are excludable from the gross income of the distribute to
the extent that the total distribution does not exceed the qualified education expenses incurred by
the beneficiary during the year the distribution is made.

If the qualified education expenses of the beneficiary for the year are less than the total
amount of the distribution from an ESA, then the qualified education expenses are deemed to be
paid from a pro-rata share of both the principal and earnings components of the distribution. In
such a case, only a portion of the earnings is excludable (i.c., the portion of the earnings based on
the ratio that the qualified education expenses bear to the total amount of the distribution) and the
remaining portion of the earnings is includible in the beneficiary’s gross income.

The earnings portion of a distribution from an ESA that is includible in income is
generally subject to an additional 10-percent tax. The 10-percent additional tax does not apply if
a distribution is made on account of the death or disability of the designated beneficiary, or on
account of a scholarship received by the designated beneficiary (to the extent it does not exceed
the amount of the scholarship). Appointments to the United States Military Academy, the United
States Naval Academy, the United States Air Force Academy, the United States Coast Guard
Academy, or the United States Merchant Marine Academy are treated in the same manner as
scholarships for purposes of the waiver of the additional 10 percent tax on withdrawals from
ESAs that are not used for qualified education purposes.

Description of Proposal

This proposal repeals the current-law phase out of the maximum contribution that could
be made to a Coverdell education savings account by individuals. Contributions may continue to
be made by corporations, charitable organizations, and other entities without regard to their
income. Multiple accounts may continue to be established for the same beneficiary (as long as
aggregate annual contributions do not exceed $2,000).

Effective date.—The proposal is effective for taxable years beginning after December 31,
2004.

Analysis

Eliminating the phaseout of the maximum contribution amount would simplify the tax
code by eliminating the instructions and worksheets necessary to learn about the phaseout as well
as calculate the impact of the phaseout. By eliminating the phaseout, however, more taxpayers
are eligible to contribute to Coverdell accounts, which for these taxpayers could complicate their
tax planning as more tax-prefered saving choices would now be available to them.

Some might argue the income limits should remain in place to prevent the benefits from

accruing to upper income taxpayers. However, the fact that the income limits may be avoided by
having other family members with income below the limits make the contributions to the

202


The President’s fiscal year 2001 and 2002 budgets proposed adding landfill gas to the electricity
production credit under section 45.

The conference agreement to H.R. 6, “The Energy Policy Act of 2003,” as passed by the
House of Representatives on November 18, 2003, H.R. 6 as passed by the House of
Representative on April 11, 2003, and S. 1149, as passed by the Senate on July 31, 2003, each
contain a similar provision with respect to landfill gas. In addition, each bill would reduce the
amount of the credit per barrel of oil equivalent for gas from new facilities and limit the amount
of gas eligible for credit from any facility.

Division C of H.R. 4, the “Energy Tax Policy Act of 2001,” as passed by the House of
Representatives on August 2, 2001, contained a similar provision with a reduced value of credit
for landfill gas from newly qualifying facilities. Division H of H.R. 4, the “Energy Tax
Incentives Act of 2002,” as amended by the Senate on April 25, 2002, contained a similar
provision with a reduced value of credit for landfill gas from newly qualifying facilities.

6. Provide a tax credit for combined heat and power property

Present Law

A nonrefundable, 10-percent business energy credit is allowed for the cost of new
property that is equipment (1) that uses solar energy to generate electricity, to heat or cool a
structure, or to provide solar process heat, or (2) used to produce, distribute, or use energy
derived from a geothermal deposit, but only, in the case of electricity generated by geothermal
power, up to the electric transmission stage.

The business energy tax credits are components of the general business credit (sec.
38(b)(1)). The business energy tax credits, when combined with all other components of the
general business credit, generally may not exceed for any taxable year the excess of the
taxpayer's net income tax over the greater of (1) 25 percent of net regular tax liability above
$25,000 or (2) the tentative minimum tax. For credits arising in taxable years beginning after
December 31, 1997, an unused general business credit generally may be carried back one year
and carried forward 20 years (sec. 39).

A taxpayer may exclude from income the value of any subsidy provided by a public
utility for the purchase or installation of an energy conservation measure. An energy
conservation measure means any installation or modification primarily designed to reduce
consumption of electricity or natural gas or to improve the management of energy demand with
respect to a dwelling unit (sec. 136).

There is no present-law credit for combined heat and power (“CHP”) property.

Description of Proposal

The proposal would establish a 10-percent investment credit for qualified CHP systems
with an electrical capacity in excess of 50 kilowatts or with a capacity to produce mechanical
power in excess of 67 horsepower (or an equivalent combination of electrical and mechanical
energy capacities). CHP property is defined as property comprising a system that uses the same

136


regardless of the nomenclature used in creating the power and regardless of local property law
connotations, and may include, for example, the power to consume or appropriate the property,
or to affect the beneficial enjoyment of principal or income through a power to revoke, alter or
amend the terms of the instrument.°°> The nature of the power held by a person affects whether
the holder of the power is taxed on the income on the property, and whether the property subject
to the power is treated as includible within the estate of the holder of the power or subject to gift
tax.

Description of Proposal
Overview

The proposal modifies certain income tax, gift tax, generation-skipping transfer tax, and
estate tax rules with respect to changes in designated beneficiaries of qualified tuition accounts.
The proposal also modifies the requirements of a qualified tuition program by imposing new
eligibility rules for designated beneficiaries, and requiring that a savings account or prepaid
tuition contract established under a qualified tuition program be a custodial arrangement
maintained for the benefit of a designated beneficiary. The proposal modifies the present law
provisions regarding the imposition of the 10-percent additional tax, and imposes new excise
taxes on amounts that are used other than for qualified higher education expenses.

New eligibility requirements for designated beneficiaries

The proposal imposes new eligibility requirements for designated beneficiaries of
qualified tuition accounts. Only an individual under age 35 is permitted to be the designated
beneficiary of a qualified tuition account. When a designated beneficiary reaches age 35, anew
eligible designated beneficiary must be appointed, or the account or prepaid benefit is treated as
distributed to the designated beneficiary, thereby triggering potential income taxes, and either the
10-percent additional tax or an excise tax relating to the failure to use the distributed amounts for
qualified higher education expenses. Failure to satisfy the under age 35 rule at the time the
account is established results in the account failing to constitute a qualified tuition account.°””

Changes in designated beneficiaries

The proposal modifies present law by providing that a change in the designated
beneficiary of a qualified tuition account does not cause the imposition of gift tax or GST tax,
regardless of whether the new designated beneficiary is in a generation below that of the former
designated beneficiary. The proposal also provides that gift tax and GST tax would not be
imposed even if the new designated beneficiary is not a member of the family of the old

505 See, 20.2041-1(b)(1). See also secs. 674, 2041, and 2514.

596 Powers of appointment are often classified as “general powers of appointment” or as
“limited” or “special” powers of appointment.

507 Tn such cases, the otherwise generally applicable income tax and transfer tax rules,
rather than section 529, would apply to the account or contract.

310


Under the proposal, the definition of child for purposes of the credit is unclear. Depending on
the definition of child used for purposes of the credit, additionally complexity may arise.
Additionally, the credit adds new phase-outs to the numerous existing phase-outs in the Code,
which increases complexity.

The advanced payment aspect of the credit also adds additional complexity to the Code.
Taxpayers would have to use different income amounts to calculate the credit depending whether
the credit is claimed on an advanced basis or on the current year tax return. The proposal may
also increase complexity for insurance companies by adding administrative burdens with respect
to the advanced payment of the credit. Health insurers would be required to provide information
statements to taxpayers receiving the credit on an advanced payment basis and to the IRS,
including the policy number, the policy premium, and that the policy meets the requirements for
a qualified policy.

Prior Action

Substantially similar proposals were included in the President’s fiscal year 2002, 2003,
and 2004 budget proposals.

2. Provide an above-the-line deduction for certain high deductible insurance premiums

Present Law

Tax treatment of health insurance premiums

Under present law, the tax treatment of health insurance expenses depends on an
individual’s circumstances.

In general, employer contributions to an accident or health plan are excludable from an
employee’s gross income (and wages for employment tax purposes). This exclusion generally
applies to coverage provided to employees (including former employees) and their spouses,
dependents, and survivors. If certain requirements are satisfied, employer-provided accident or
health coverage offered under a cafeteria plan or through a health reimbursement account
(“HRA”)” is also excludable from an employee’s gross income and wages.’”®

TM Secs. 106, 3121(a)(2), and 3306(b)(2).

75 An HRA is an arrangement that (1) is paid for solely by the employer and not provided
pursuant to a salary reduction election or otherwise under a cafeteria plan; (2) reimburses the
employee for medical expenses incurred by the employee and the employee’s spouse and
dependents; and (3) provides reimbursements up to a maximum dollar amount for a coverage
period and any unused portion of the maximum dollar amount at the end of the coverage period
is carried forward to increase the maximum reimbursement amount in subsequent coverage
periods. Notice 2002-45, 2002-28 LR.B. 93.

7 Secs, 125, 3121(a)(5)(G), and 3306(b)(5)(G). Long-term care insurance and services
may not be provided through a cafeteria plan.

AT


J. Extend Treatment of Alternative Minimum Tax Net
Operating Loss Deductions

Present Law

Under present law, generally a taxpayer may carryback a net operation loss (“NOL”) two
years and may carryover a NOL twenty years, and is allowed to deduct the NOL in the carryback
or carryover year. In computing the alternative minimum tax, a NOL deduction generally cannot
reduce a taxpayer’s alternative minimum taxable income (“AMTI”) by more than 90 percent of
the AMTI (determined without regard to the NOL deduction).

The Job Creation and Worker Assistance Act of 2002 allows an NOL deduction
attributable to NOL carrybacks arising in taxable years beginning in 2001 and 2002, as well as
NOL carryovers to these taxable years, to offset 100 percent of the taxpayer’s AMTI.

Description of Proposal

The proposal allows NOL carrybacks arising in taxable years beginning in 2003, 2004,
and 2005, as well as carryovers to these taxable years, to offset 100 percent of the taxpayer’s
AMTI.

Effective date The proposal applies to NOL carryovers to taxable years beginning in
2003, 2004, and 2005, and NOL carrybacks from these taxable years.

Analysis
Policy issues

Generally, the net operating loss deduction allows taxpayers to average a profitable year
with a loss year. Under the regular tax, losses are allowed to offset taxable income entirely. The
90-percent limitation on the use of NOL deductions on computing the alternative minimum tax
prevents losses on one year from offsetting completely income arising in another taxable year.
Thus, a minimum tax may be imposed notwithstanding that the taxpayer had no net income
taking into account all items of income and deductions from both years.

Complexity issues

Under the proposal, the number of business taxpayers subject to the alternative minimum
tax will be reduced because NOL deductions can reduce the alternative minimum taxable income
to zero.

Prior Action

An identical proposal was included in the President’s fiscal year 2004 budget proposal.

400


and (3) the application of the age discrimination rules.””* These rules are discussed below.
Other issues have been raised in connection with cash balance plans, including the proper
method for applying the accrual rules.””°

There is little guidance under present law with respect to many of the issues raised by
cash balance conversions. In 1999, the IRS imposed a moratorium on determination letters for
cash balance conversions pending clarification of applicable legal requirements.”"° Under the
moratorium, all determination letter requests regarding cash balance plans are sent to the
National Office for review; however, the National Office is not currently acting on these plans.””

Benefit accrual requirements”

In general

Several of the requirements that apply to qualified retirement plans relate to a
participant’s accrued benefit. For example, the vesting requirements apply with respect to a
participant’s accrued benefit. In addition, as discussed below, a plan amendment may not have
the effect of reducing a participant’s accrued benefit. In the case of a defined benefit pension
plan, a participant’s accrued benefit is generally the accrued benefit determined under the plan,
expressed in the form of an annuity commencing at normal retirement age.”

The accrued benefit to which a participant is entitled under a defined benefit pension plan
must be determined under a method (referred as the plan’s accrual method) that satisfies one of
three accrual rules. These rules relate to the pattern in which a participant’s normal retirement
benefit (i.c., the benefit payable at normal retirement age under the plan’s benefit formula)
accrues over the participant’s years of service, so that benefit accruals are not “back-loaded”
(ie., delayed until years of service close to attainment of normal retirement age).

294 Code sec, 411(b)(1)(G) and (H); ERISA sec. 204(b)(1)(G) and (H); Age
Discrimination in Employment Act (“ADEA”), 29 U.S.C. 623(i).

295 Code sec. 411(b); ERISA sec. 204(b).

296 Announcement 2003-1, 2003-2 LR.B. 281.

297 Ta.

288 Code sec. 411(b); ERISA sec. 204(b).

299 Code sec. 411(a)(7). Ifa plan does not provide an accrued benefit in the form of an
annuity commencing at normal retirement age, the accrued benefit is an annuity commencing at

normal retirement age that is the actuarial equivalent of the accrued benefit determined under the
plan. Treas. Reg. sec. 1.411(a)-7(a)(1)(ii).

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Prior Action

This proposal is similar to recommendations contained in Joint Committee on Taxation,
Review of the Present Law Tax and Immigration Treatment of Relinquishment of Citizenship and
Termination of Long-Term Residency, (JCS-2-03), February 2003. S. 1149, the “Energy Tax
Incentives Act of 2003,” and H.R. 2896, the “American Jobs Creation Act of 2003,” also
contained similar proposals. In contrast, the proposals in S. 1637, the “Jumpstart our Business
Strength Act,” and the Senate amendment to H.R. 2, the “Jobs and Growth Tax Relief
Reconciliation Act of 2003,” generally subject certain U.S. citizens who relinquish their U.S.
citizenship and certain long-term residents who terminate their U.S. residence to tax on the net
unrealized gain in their property as if such property were sold for fair market value on the day
before the expatriation or residency termination (the so called “mark-to-market” proposal).

299


net capital gain is reduced by the amount of gain that the individual treats as investment income
for purposes of determining the investment interest limitation under section 163(d).

The term “28-percent rate gain” means the amount of net gain attributable to long-term
capital gains and losses from the sale or exchange of collectibles (as defined in section 408(m)
without regard to paragraph (3) thereof), the amount of gain from the sale of small business stock
(described below) which is included in gross income, the net short-term capital loss for the
taxable year, and any long-term capital loss carryover to the taxable year.

“Unrecaptured section 1250 gain” means any long-term capital gain from the sale or
exchange of section 1250 property (i-c., depreciable real estate) held more than one year to the
extent of the gain that would have been treated as ordinary income if section 1250 applied to all
depreciation, reduced by the net loss (if any) attributable to the items taken into account in
computing 28-percent rate gain. The amount of unrecaptured section 1250 gain (before the
reduction for the net loss) attributable to the disposition of property to which section 1231
applies may not exceed the net section 1231 gain for the year.

The unrecaptured section 1250 gain is taxed at a maximum rate of 25 percent, and the 28-
percent rate gain is taxed at a maximum rate of 28 percent. Any amount of unrecaptured section
1250 gain or 28-percent rate gain otherwise taxed at a 10- or 15-percent rate is taxed at that rate.

Small business stock

Under present law, individuals may exclude 50 percent (60 percent for certain
empowerment zone businesses) of the gain from the sale of certain small business stock acquired
at original issue and held for at least five years.*5 Seven percent of the excluded gain is a
minimum tax preference. The amount of gain eligible for the exclusion by an individual with
respect to any corporation is the greater of (1) ten times the taxpayer's basis in the stock or (2)
$10 million. In order to qualify as a small business, when the stock is issued, the gross assets of
the corporation may not exceed $50 million.

During substantially all the taxpayer’s holding period, 80 percent or more of the
corporation’s assets (by value) must be used in the active conduct of one or more qualified trades
or businesses. Assets that are held to meet reasonable working capital needs of the corporation,
or are held for investment and are reasonably expected to be used within two years to finance
future research and experimentation, are treated as used in the active conduct of a trade or
business.

A qualified trade or business is any trade or business other than (1) a trade or business
involving the performance of services in the fields of health, law, engineering, architecture,
accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage
services, or other trades or businesses based upon the reputation or skill of one or more of its
employees; (2) banking, insurance, financing, leasing, investing, or similar business; (3) farming
businesses, including raising or harvesting timber; (4) mining businesses, and (5) any business of
operating a hotel, motel, or restaurant.

285 Sec, 1202.

207


C. Repeal of Section 132 of the Revenue Act of 1978

Present Law

General tax treatment of nonqualified deferred compensation

The determination of when amounts deferred under a nonqualified deferred compensation
arrangement are includible in the gross income of the individual earning the compensation
depends on the facts and circumstances of the arrangement. A variety of tax principles and Code
provisions may be relevant in making this determination, including the doctrine of constructive
receipt, the economic benefit doctrine, the provisions of section 83 relating generally to transfers
of property in connection with the performance of services, and provisions relating specifically
to nonexempt employee trusts (sec. 402(b)) and nonqualified annuities (sec. 403(c)).

In general, the time for inclusion of nonqualified deferred compensation depends on
whether the arrangement is unfunded or funded. If the arrangement is unfunded, then the
compensation is generally includible in income when it is actually or constructively received. If
the arrangement is funded, then income is includible for the year in which the individual’s rights
are transferable or not subject to a substantial risk of forfeiture.

In general, an arrangement is considered funded if there has been a transfer of property
under section 83. Under that section, a transfer of property occurs when a person acquires a
beneficial ownership interest in such property. The term “property” is defined very broadly for
purposes of section 33.539 Property includes real and personal property other than money or an
unfunded and unsecured promise to pay money in the future. Property also includes a beneficial
interest in assets (including money) that are transferred or set aside from claims of the creditors
of the transferor, for example, in a trust or escrow account. Accordingly, if, in connection with
the performance of services, vested contributions are made to a trust on an individual’s behalf
and the trust assets may be used solely to provide future payments to the individual, the payment
of the contributions to the trust constitutes a transfer of property to the individual that is taxable
under section 83. On the other hand, deferred amounts are generally not includible in income in
situations where nonqualified deferred compensation is payable from general corporate funds
that are subject to the claims of general creditors, as such amounts are treated as unfunded and
unsecured promises to pay money or property in the future.

As discussed above, if the arrangement is unfunded, then the compensation is generally
includible in income when it is actually or constructively received under section 451. Income is
constructively received when it is credited to an individual’s account, set apart, or otherwise
made available so that it can be drawn on at any time. Income is not constructively received if
the taxpayer’s control of its receipt is subject to substantial limitations or restrictions. A
requirement to relinquish a valuable right in order to make withdrawals is generally treated as a
substantial limitation or restriction.

539 Treas, Reg. sec. 1.83-3(e). This definition in part reflects previous IRS rulings on
nonqualified deferred compensation.

333


Application of accrual rules to cash balance plans

Cash balance plans may be categorized based on when the benefits attributable to interest
credits accrue. Under one type of plan, referred to as a “front-loaded interest credit plan,” future
interest credits to an employee’s hypothetical account balance are not conditioned upon future
service. Under a front-loaded plan, the benefits attributable to future interest credits with respect
to a hypothetical allocation accrue at the same time that the benefits attributable to the
hypothetical allocation accrue. As a result, if an employee terminates employment and defers
distribution to a later date, interest credits will continue to be credited to that employee’s
hypothetical account.

A second type of cash balance plan (referred to as a “back-loaded” plan) conditions
future interest credits upon future service. In the case of a back-loaded plan, benefits attributable
to interest credits do not accrue until the interest credits are credited to the employee’s account.
The IRS has indicated that, because back-loaded interest credit plans typically will not satisfy
any of the accrual rules, any future IRS guidance will address only frontloaded interest credit
plans.

Protection of accrued benefits; “wearaway” under cash balance plans

In general

The Code generally prohibits an employer from amending a plan’s benefit formula to
reduce benefits that have already accrued (the “anticutback rule”). 3° For this purpose, an
amendment is treated as reducing accrued benefits if it has the effect of eliminating or reducing
an early, retirement benefit or a retirement-type subsidy or of eliminating an optional form of
benefit.

The anticutback rule applies in the context of cash balance plan conversions. Because of
this rule, after conversion to a cash balance formula, a plan must provide employees with the
normal and early retirement benefit that he or she had accrued before the conversion.*

However, the plan may determine benefits for years following the conversion in a variety of
ways, while still satisfying the anticutback rule. Common plan designs are discussed below.

Wearaway (or “greater of” approach)

Upon a conversion to a cash balance plan, participants are given an opening account
balance. The pay and interest credits provided under the plan are then added to this opening
account balance. The opening account balance may be determined in a variety of ways and is

300 Code sec. 411(d)(6); ERISA sec. 204(g). The provisions do not, however, protect
benefits that have not yet accrued but would have in the future if the plan’s benefit formula had
not changed.

301 Code sec. 411(d)(6)(B); ERISA sec. 204(g)(2).

3 Certain other plan features, such as early retirement subsidies, must also be protected.

214


$75 ($150 in the case of a joint return) in 2007 through 2009, and $100 ($200 in the case of a
joint return) in 2010 and thereafter."

2. Permit tax-free withdrawals from individual retirement arrangements for charitable
contributions

Present Law

In general

If an amount withdrawn from a traditional individual retirement arrangement (“IRA”) or
a Roth IRA is donated to a charitable organization, the rules relating to the tax treatment of
withdrawals from IRAs apply, and the charitable contribution is subject to the normally
applicable limitations on deductibility of such contributions.

Charitable contributions

In computing taxable income, an individual taxpayer who itemizes deductions generally
is allowed to deduct the amount of cash and up to the fair market value of property contributed to
an organization described in section 170(c), including charities and Federal, State, and local
governmental entities. The deduction also is allowed for purposes of calculating alternative
minimum taxable income.

The amount of the deduction allowable for a taxable year with respect to a charitable
contribution of property may be reduced depending on the type of property contributed, the type
of charitable organization to which the property is contributed, and the income of the taxpayer.'!”

A payment to a charity (regardless of whether it is termed a “contribution”) in exchange
for which the donor receives an economic benefit is not deductible, except to the extent that the
donor can demonstrate that the payment exceeds the fair market value of the benefit received
from the charity. To facilitate distinguishing charitable contributions from purchases of goods or
services from charities, present law provides that no charitable contribution deduction is allowed
for a separate contribution of $250 or more unless the donor obtains a contemporaneous written
acknowledgement of the contribution from the charity indicating whether the charity provided
any good or service (and an estimate of the value of any such good or service) to the taxpayer in
consideration for the contribution.'!® In addition, present law requires that any charity that

16 The Economic Recovery Tax Act of 1981 added to the law a temporary provision that
permitted individual taxpayers who did not itemize income tax deductions to claim a deduction
from gross income for a specified percentage of their charitable contributions. The maximum
deduction was $25 for 1982 and 1983, $75 for 1984, 50 percent of the amount of the contribution
for 1985, and 100 percent of the amount of the contribution for 1986. The nonitemizer deduction
terminated after 1986.

"7 Secs. 170(b) and (e).
NB Sec, 170(£)(8).

76


D. Allow Tax-Exempt Financing for Private Highway Projects
and Rail-Truck Transfer Facilities

Present Law

Interest on bonds issued by States or local governments to finance activities of those
governmental units is excluded from tax (sec. 103). In addition, interest on certain bonds
("private activity bonds") issued by States or local governments acting as conduits to provide
financing for private businesses or individuals is excluded from income if the purpose of the
borrowing is specifically approved in the Internal Revenue Code (sec. 141). Examples of
approved private activities for which States or local governments may provide tax-exempt
financing include transportation facilities (airports, ports, mass commuting facilities, and certain
high-speed intercity rail facilities); public works facilities such as water, sewer, and solid waste
disposal; and certain social welfare programs such as low-income rental housing, student loans,
and mortgage loans to certain first-time homebuyers. High-speed intercity rail facilities eligible
for tax-exempt financing include land, rail, and stations (but not rolling stock) for fixed
guideway rail transportation of passengers and their baggage using vehicles that are reasonably
expected to operate at speeds in excess of 150 miles per hour between scheduled stops.

Description of Proposal

Two new categories of exempt facility bonds would be authorized to finance highway
facilities and surface freight transfer facilities. Issuance of the bonds would not be subject to the
general private activity bond volume cap, but rather would be subject to a separate volume
limitation of $15 billion in the aggregate. The Secretary of Transportation would allocate the
$15 billion of authority among eligible projects.

Highway facilities eligible for financing under the program would consist of any surface
transportation project eligible for Federal assistance under title 23 of the United States Code, or
any project for an international bridge or tunnel for which an international entity authorized
under Federal or State law is responsible. Surface freight transfer facilities would consist of
facilities for the transfer of freight from truck to rail or rail to truck, including any temporary
storage facilities directly related to those transfers. Examples of eligible surface freight transfer
facilities would include cranes, loading docks and computer-controlled equipment that are
integral to such freight transfers. Examples of non-qualifying facilities would include lodging,
retail, industrial or manufacturing facilities.

Analysis

Surface freight transfer facilities

Present law provides that private activity bonds may be issued for dock facilities and
airport facilities. Dock and airport facilities eligible for private activity bonds include cranes and
equipment integral to the loading and unloading of ships and planes and enabling the transfer of
that cargo to other modes of transport. The proposal generally would treat rail and truck cargo
exchanges comparably to ship to truck or rail exchanges.

352


Prior Action

Several legislative proposals have included this proposal.‘

44 See, e.g., Joint Committee on Taxation, Description of the “Highway Reauthorization
and Excise Tax Simplification Act of 2004” (JCX-5-04), January 29, 2004; House Ways and
Means Committee Report of H.R. 2896, American Jobs Creation Act of 2003, (H. Rep. 108-393,
November 21, 2003); Senate Finance Committee Report of S. 1637, Jumpstart our Business
Strength (JOBS) Act, (S. Rep. 108-192, November 7, 2003).

302


4. Reform excise tax based on investment income of private foundations
Present Law

Under section 4940(a) of the Code, private foundations that are recognized as exempt
from Federal income tax under section 501(a) of the Code are subject to a two-percent excise tax
on their net investment income. Private foundations that are not exempt from tax, such as certain
charitable trusts, also are subject to an excise tax, under section 4940(b).

Net investment income generally includes interest, dividends, rents, royalties, and capital
gain net income, and is reduced by expenses incurred to earn this income. The two-percent rate
of tax is reduced to one-percent in any year in which a foundation exceeds the average historical
level of its charitable distributions. Specifically, the excise tax rate is reduced if the foundation’s
qualifying distributions (generally, amounts paid to accomplish exempt purposes)!” equals or
exceeds the sum of (1) the amount of the foundation’s assets for the taxable year multiplied by
the average percentage of the foundation’s qualifying distributions over the five taxable years
immediately preceding the taxable year in question, and (2) one percent of the net investment
income of the foundation for the taxable year.'*° In addition, the foundation cannot have been
subject to tax in any of the five preceding years for failure to meet minimum qualifying
distribution requirements.’

The tax on taxable private foundations under section 4940(b) is equal to the excess of the
sum of the excise tax that would have been imposed under section 4940(a) if the foundation was
tax exempt and the amount of the unrelated business income tax that would have been imposed if
the foundation were tax exempt, over the income tax imposed on the foundation under subtitle A
of the Code. Exempt operating foundations are exempt from the section 4940 tax.'?

Nonoperating private foundations are required to make a minimum amount of qualifying
distributions each year to avoid tax under section 4942. The minimum amount of qualifying

29 Sec, 4942(g).
139 Sec, 4940(e).
31 Sec, 4942,

132 Sec. 4940(d)(1). Exempt operating foundations generally include organizations such
as museums or libraries that devote their assets to operating charitable programs but have
difficulty meeting the “public support” tests necessary not to be classified as a private
foundation. To be an exempt operating foundation, an organization must: (1) be an operating
foundation (as defined in section 4942(j)(3)); (2) be publicly supported for at least 10 taxable
years; (3) have a governing body no more than 25 percent of whom are disqualified persons and
that is broadly representative of the general public; and (4) have no officers who are disqualified
persons. Sec. 4940(d)(2).

86


B. Health Care Provisions
1. Refundable tax credit for the purchase of health insurance
Present Law

Present law contains a number of provisions dealing with the Federal tax treatment of
health expenses and health insurance coverage. The tax treatment of health insurance expenses
depends on whether a taxpayer is covered under a health plan paid for by an employer, whether
an individual has self-employment income, or whether an individual itemizes deductions and has
medical expenses that exceed a certain threshold.

In general, employer contributions to an accident or health plan are excludable from an
employee’s gross income (and wages for employment tax purposes).” This exclusion generally
applies to coverage provided to employees (including former employees) and their spouses,
dependents, and survivors. Benefits paid under employer-provided accident or health plans are
also generally excludable from income to the extent they are reimbursements for medical care.
If certain requirements are satisfied, employer-provided accident or health coverage offered
under a cafeteria plan is also excludable from an employee’s gross income and wages.

Present law provides for two general employer-provided arrangements that can be used to
pay for or reimburse medical expenses of employees on a tax-favored basis: flexible spending
arrangements (“FSAs”) and health reimbursement arrangements (“HRAs”). While these
arrangements provide similar tax benefits (i.¢., the amounts paid under the arrangements for
medical care are excludable from gross income and wages for employment tax purposes), they
are subject to different rules. A main distinguishing feature between the two arrangements is that
while FSAs are generally part of a cafeteria plan and contributions to FSAs are made on a salary
reduction basis, HRAs cannot be part of a cafeteria plan and contributions cannot be made on a
salary-reduction basis. 6

The exclusion for employer-provided health coverage does not apply to self-employed
individuals. However, under present law, self-employed individuals (i.¢., sole proprietors or

8 Secs, 106, 3121(a)(2), and 3306(b)(2).

64 Sec. 105. In the case of a self-insured medical reimbursement arrangement, the
exclusion applies to highly compensated employees only if certain nondiscrimination rules are
satisfied. Sec. 105(h). Medical care is defined as under section 213(d) and generally includes
amounts paid for qualified long-term care insurance and services.

§5 Sees. 125, 3121(a)(5)(G), and 3306(b)(5)(G). Long-term care insurance and services
may not be provided through a cafeteria plan.

Notice 2002-45, 2002-28 LR.B. 93 (July 15, 2002); Rev. Rul. 2002-41, 2002-28 LR.B.
75 (July 15, 2002).

41


gain or loss will be recognized on the transfer of the qualified fund and the transferee will take
the transferor’s basis in the fund.'’> The transferee is required to obtain a new ruling amount
from the IRS or accept a discretionary determination by the IRS.!76

Nonqualified nuclear decommissioning funds

Federal and State regulators may require utilities to set aside funds for nuclear
decommissioning costs in excess of the amount allowed as a deductible contribution to a
qualified fund. In addition, taxpayers may have set aside funds prior to the effective date of the
qualified fund rules.'”” The treatment of amounts set aside for decommissioning costs prior to
1984 varies. Some taxpayers may have received no tax benefit while others may have deducted
such amounts or excluded such amounts from income. Since 1984, taxpayers have been required
to include in gross income customer charges for decommissioning costs (sec. 88), and a
deduction has not been allowed for amounts set aside to pay for decommissioning costs except
through the use of a qualified fund. Income earned in a nonqualified fund is taxable to the fund’s
owner as it is earned.

Description of Proposal

Repeal of cost of service requirement

The proposal repeals the cost of service requirement for deductible contributions to a
nuclear decommissioning fund. Thus, all taxpayers, including unregulated taxpayers, would be
allowed a deduction for amounts contributed to a qualified fund.

Exception to ruling amount for certain decommissioning costs

The proposal also permits taxpayers to make contributions to a qualified fund in excess of
the maximum annual contribution amount (IRS ruling amount) up to an amount that equals the
present value of the amount required to fund the nuclear powerplant’s pre-1984
decommissioning costs to which the qualified fund relates. Any amount transferred to the
qualified fund that has not previously been deducted or excluded from gross income is allowed
as a deduction over the remaining useful life of the nuclear powerplant. If a qualified fund that
has received amounts under this rule is transferred to another person, that person will be entitled
to the deduction at the same time and in the same manner as the transferor. Accordingly, if the
transferor was not subject to tax and thus unable to use the deduction, then the transferee will
similarly not be able to utilize the deduction. Amounts contributed (and the earnings on such
amounts) under these rules would not be taken into account in determining the ruling amount for
the qualified fund.

175 Treas. Reg. sec. 1.468A-6.
1%6 Treas, Reg. sec. 1.468A-6(f).

‘77 These funds are generally referred to as “nonqualified funds.”

127


L. Extend Provisions Permitting Disclosure of Return
Information Relating to Terrorism

Present Law

In general

Section 6103 provides that returns and return information may not be disclosed by the
IRS, other Federal employees, State employees, and certain others having access to the
information except as provided in the Internal Revenue Code. Section 6103 contains a number
of exceptions to this general rule of nondisclosure that authorize disclosure in specifically
identified circumstances (including nontax criminal investigations) when certain conditions are
satisfied. One of those exceptions is for the disclosure of return and return information regarding
terrorist activity.

Among the disclosures permitted under the Code is disclosure of returns and return
information for purposes of investigating terrorist incidents, threats, or activities, and for
analyzing intelligence concerning terrorist incidents, threats, or activities. The term “terrorist
incident, threat, or activity” is statutorily defined to mean an incident, threat, or activity
involving an act of domestic terrorism or international terrorism, as both of those terms are
defined in the USA PATRIOT Act.

In general, returns and taxpayer return information must be obtained pursuant to an ex
parte court order. Return information, other than taxpayer return information, generally is
available upon a written request meeting specific requirements. No disclosures may be made
under this provision after December 31, 2003.

Disclosure of returns and return information - by ex parte court order

Ex parte court orders sought by Federal law enforcement and Federal intelligence
agencies

The Code permits, pursuant to an ex parte court order, the disclosure of returns and return
information (including taxpayer return information) to certain officers and employees of a
Federal law enforcement agency or Federal intelligence agency. These officers and employees
are required to be personally and directly engaged in any investigation of, response to, or
analysis of intelligence and counterintelligence information concerning any terrorist incident,
threat, or activity. These officers and employees are permitted to use this information solely for
their use in the investigation, response, or analysis, and in any judicial, administrative, or grand
jury proceeding, pertaining to any such terrorist incident, threat, or activity.

The Attomey General, Deputy Attorney General, Associate Attorney General, an
Assistant Attorney General, or a United States attorney, may authorize the application for the ex
parte court order to be submitted to a Federal district court judge or magistrate. The Federal
district court judge or magistrate would grant the order if based on the facts submitted he or she

1 18 U.S.C. 2331.

402


percent. The percentage of household owner-occupiers among households headed by an
individual 35 to 44 years old was 67.9 percent. The percentage of household owner-occupiers
among households headed by an individual 65 years old or older was 80.4 percent." By
targeting the credit based on annual income, the proposal may provide benefit to two distinct
types of families. The proposal provides benefit both to those families whose income, year-in,
year-out falls below 80 percent of area median and who, consequently, may otherwise always
find down payment and monthly mortgage servicing requirements a hurdle to homeownership.
The proposal also will provide a benefit to families whose income growth will permit them to
own a home without assistance as the family’s income grows through time. For such families
the proposal may only accelerate their ultimate status as a homeowner.

Some observers may find some unfairness in the proposal’s definition of qualifying
family. Under the proposal, the Smith family, whose income is less than 80 percent of the area
median income, and the Jones family, whose income is above 80 percent of the area median
income, can bid on the same property. If the Smith family offered $95,000 for the property and
the Jones family offered $100,000, under the proposal, the Smith’s offer can dominate the
Jones’s offer on an after-tax basis to the seller. The Smith and Jones families can have very
similar incomes. A modest raise may have pushed the Jones family above the qualifying income
threshold and thereby denied the Jones family the opportunity to acquire the home or it may
require the Jones family to offer even more if they hope to acquire the home.

Some opponents of the proposal question the necessity of providing additional benefits to
homeownership. They note that homeownership rates are above 67 percent'® and
homeownership receives preferential treatment under the present income tax as mortgage
interest, home equity interest, and property tax payments are deductible expenses and that for
many taxpayers any capital gain on the income from the sale of a principal residence is excluded
from income. In addition, they note that, under present law, States may issue qualified mortgage
bonds to lower the mortgage costs of middle and lower-middle income families who seek to
acquire a home. That is, the qualified mortgage bond program generally targets the financial
needs of the same population. Proponents of efforts to increase homeownership observe that
homeownership helps support strong, vital communities and participatory democracy. In
particular, they observe, the quality of life in distressed neighborhoods can be improved by
increasing homeownership. In such neighborhoods the costs of renovation or new construction
may exceed the current market value of housing in such neighborhoods and that a State
allocation mechanism for the proposed credits may be able to direct qualifying investments to
such areas where the social return to homeownership is particularly large.

18 U.S, Department of Commerce, Economics and Statistics Administration, Statistical
Abstract of the United States 2001.

163 ty 2000, of 105.7 million occupied housing units nationwide, 71.3 million were

owner-occupied. U.S. Department of Commerce, Economics and Statistics Administration,
Statistical Abstract of the United States 2001.

111


Analysis

The valuation of charitable contributions of patents and similar intellectual property
recently has become a concern. Although methodologies exist to appraise intellectual property,
the actual value of intellectual property is by its very nature speculative and dependent on a
number of future events, such as, in the gift context, whether the charity makes the appropriate
investments, has the right personnel and equipment, and has the necessary sustained interest fully
to develop the property. Many gifts are of intellectual property for which there is no sales
market, which compounds valuation difficulties because an appraiser cannot rely on what a
reasonable buyer would pay for the property pursuant to arm’s length negotiations. As a result,
the high values often claimed for contributions of intellectual property result in a significant tax
benefit to the donor, but little or no actual benefit to the charity, as many patents or other
properties later turn out to be worthless, or produce far less revenue than projected in valuations
performed by or on behalf of the donor. Because the charitable contribution deduction depends
on the value of the property at the time of the gift, the IRS faces significant obstacles in
challenging intellectual property valuations, which may appear to be reasonable, even though
later events prove otherwise, and which require considerable expertise to evaluate properly.

The President’s proposal, along with recent Congressional proposals, address the
difficulties of valuing intellectual property in the context of charitable giving by eliminating the
reliance on valuations of the donated property. Under the President’s proposal, a taxpayer
generally would receive a deduction of basis at the time of the contribution and have a right to
receive future charitable contribution deductions based on the actual revenue generated by the
property contributed. Similarly, a recent Senate proposal also provides that taxpayers generally
will receive a basis deduction upon contribution, with a right to receive future payments from the
charity based on the charity’s income from the contributed property. Both approaches attempt to
provide a more accurate measure of the value of intellectual property by looking at results
instead of predictions.“'?

Critics of either approach might argue that taxpayers will no longer give intellectual
property to charity because a basis deduction plus the promise of future economic benefits does
not provide enough up-front incentive for taxpayers to review their portfolios of intellectual
property, decide which are most appropriate for gift (rather than for sale, joint-venture, or
abandonment), and find a suitable donee. Such critics might acknowledge that the present law
system needs reform, but would argue that a better approach is to strengthen appraisal standards
and limit the class of charitable donees who would be eligible to receive charitable contributions
of intellectual property (for example, educational and research organizations). Such critics might
also emphasize that a taxpayer’s basis in intellectual property(and thus the upfront charitable
deduction) may be zero or minimal because taxpayers often deduct the costs associated with
developing intellectual property as ordinary and necessary business expenses, or as research and
development expenses.

419 Modifications to reporting rules may be needed to avoid requiring appraisals for
intellectual property when a basis deduction is claimed.

269


multiple rates of tax applying within each category depending upon the taxpayer’s circumstance.
Present law requires a holding period of one year or more for a taxpayer to avail him or herself
of the benefit of the alternative tax rates applicable to capital gain income. The proposal layers
an exclusion for the sale of certain assets on top of the present law alternative rate schedule. The
proposal would create a new three-year holding period requirement. This would require
additional computation, instructions, and a longer form for individuals who recognize gains that
qualify for the exclusion of the proposal and also have other gain income. While relatively few
taxpayers would recognize qualifying gains in any one year, those taxpayers who recognize other
capital gain income will have a more complex form to work through.

By its design, the proposal makes economic decisions more complicated as a taxpayer’s
net rate of return to the sale of property would depend upon the buyer’s identity as well as the
buyer’s purchase offer. In theory, if the proposal were to have the desired incentive effect, the
taxpayer would weigh the offer price of a qualifying conservation organization against
competing offers from other persons by calculating his or her after-tax position. Such
calculations are more complex than comparing the dollar purchase offers of competing buyers.
From the buyer’s side, if the qualifying conservation organization were to attempt to utilize the
proposal to its benefit by offering a lower price to the seller, the organization would have to
make estimates, or consult with the seller, regarding the seller’s tax position for the year of the
sale, This would include researching whether the seller’s effective rate of tax may be less than
7.5 percent. As accurate estimates might be crucial to submitting a winning offer for qualifying
property, the qualifying conservation organization, in principle, would need to have information
about the financial affairs of the seller. Such an offer strategy is a more information intensive
process than typical real estate transactions.

The proposal imposes an additional paperwork and record keeping burden on the
qualifying conservation organization and the selling taxpayer. The qualifying conservation
organization must provide certification to the taxpayer selling the property that the sale and
purchase is a qualifying conservation transaction. The selling taxpayer must retain this
certification in order to claim the exclusion. Presumably, a separate reporting requirement would
be established for the buyer and or seller to notify the IRS of a qualifying sale. As the holding
period of potentially qualifying property is satisfied by reference to the taxpayer’s family, rather
than solely by reference to the taxpayer’s ownership of the property, in some cases
documentation from other persons also would be required.

The proposal also imposes additional complexity and record keeping burdens on the
qualifying conservation organization because of the potential penalties that may be imposed for
subsequent transfers or uses of the property that do not satisfy the conservation requirements.
The organization likely will be required to retain records that demonstrate compliance with the
proposal’s requirements, and to notify the IRS if any impermissible change in use takes place
with respect to the property. The IRS will have to modify its forms and instructions to provide
for the imposition of the penalties in such cases. The application of modified bargain-sale rules
to qualified conservation sales at a price less than fair market value also increases complexity for
the buyer and seller of the property.

120


An individual may rollover gain from the sale of small business stock held more than six
months if other small business stock is purchased within 60 days.”*°

Description of Proposal

Under the proposal, the 25- and 28-percent capital gain rates are eliminated. Instead, in
the case of collectibles gain, one-half of the gain is treated as short-term capital gain; in the case
of unrecaptured section 1250 gain, one-half is treated as ordinary income. Generally, the
remaining one-half of the gain is taxed at the lower rates applicable to net capital gain.

Under the proposal, the provisions relating to small business stock are repealed and all
gain from the sale of the stock is taxed at the lower rates generally applicable to capital gain.

Below are tables comparing the present-law tax rates for unrecaptured section 1250 gain,
collectibles gain, and small business stock gain with the effective tax rates under the President’s
proposal.

286 Sec. 1045.

208


A taxpayer may exclude from income the value of any subsidy provided by a public
utility for the purchase or installation of an energy conservation measure. An energy
conservation measure means any installation or modification primarily designed to reduce
consumption of electricity or natural gas or to improve the management of energy demand with
respect to a dwelling unit (sec. 136).

There is no present-law personal tax credit for residential solar energy property.

Description of Proposal

The proposal provides a tax credit for the purchase of photovoltaic equipment and solar
water heating equipment for use in a dwelling unit that is used by the taxpayer as a residence.
Equipment would qualify for the credit only ifis used exclusively for purposes other than
heating swimming pools. The credit is equal to 15 percent of qualified investment up to a
cumulative maximum of $2,000 for solar water heating systems and $2,000 for rooftop
photovoltaic systems. This credit is nonrefundable.

Effective date.The credit applies to equipment placed in service after December 31,
2003 and before January 1, 2007 for solar water heating systems and after December 31, 2003
and before January 1, 2009 for photovoltaic systems.

Analysis

See general discussion following the description of the proposed tax credit for combined
heat and power property, below.

Prior Action

Similar proposals were contained in the President's fiscal year 1999-2004 budget
proposals. The conference agreement to HR. 6, “The Energy Policy Act of 2003,” as passed by
the House of Representatives on November 18, 2003 contained a similar provision. Similar
provisions are contained in Division D of H.R. 6, the "Energy Tax Policy Act of 2003," as
passed by the House of Representatives on April 11, 2003, and in Division H of H.R. 6, the
“Energy Tax Incentives Act of 2003” as amended and passed by the Senate on July 31, 2003.

Similar provisions were also contained in Division C of H.R. 4, the “Energy Tax Policy
Act of 2001,” as passed by the House of Representatives on August 2, 2001, and in Division H
of H.R. 4, “The Energy Tax Incentives Act of 2002,” as amended and passed by the Senate on
April 25, 2002.
3. Modify the tax treatment of nuclear decommissioning funds
Present Law

Overview

Special rules dealing with nuclear decommissioning reserve funds were adopted by
Congress in the Deficit Reduction Act of 1984 (“1984 Act”), when tax issues regarding the time

125


the year; or (2) the amount of the plan’s normal cost for the year plus the amount necessary to
amortize certain unfunded liabilities over ten years, but limited to the full funding limitation for
the year.** However, the maximum amount of deductible contributions is generally not less
than the plan’s unfunded current liability.””°

PBGC premiums

Because benefits under a defined benefit pension plan may be funded over a period of
years, plan assets may not be sufficient to provide the benefits owed under the plan to employees
and their beneficiaries if the plan terminates before all benefits are paid. The PBGC generally
insures the benefits owed under defined benefit pension plans (up to certain limits) in the event
the plan is terminated with insufficient assets. Employers pay premiums to the PBGC for this
insurance coverage.

PBGC premiums include a flat-rate premium and, in the case of an underfunded plan, a
variable rate premium based on the amount of unfunded vested benefits.*°° In determining the
amount of unfunded vested benefits, the interest rate used is 85 percent of the annual yield on
30-year Treasury securities for the month preceding the month in which the plan year begins.

Under the Job Creation and Worker Assistance Act of 2002, for plan years beginning
after December 31, 2001, and before January 1, 2004, the interest rate used in determining the
amount of unfunded vested benefits for PBGC variable rate premium purposes is increased to
100 percent of the annual yield on 30-year Treasury securities for the month preceding the month
in which the plan year begins.

Lump-sum distributions

Accrued benefits under a defined benefit pension plan generally must be paid in the form
of an annuity for the life of the participant unless the participant consents to a distribution in
another form. Defined benefit pension plans generally provide that a participant may choose
among other forms of benefit offered under the plan, such as a lump-sum distribution. These
optional forms of benefit generally must be actuarially equivalent to the life annuity benefit
payable to the participant.

A defined benefit pension plan must specify the actuarial assumptions that will be used in
determining optional forms of benefit under the plan in a manner that precludes employer
discretion in the assumptions to be used. For example, a plan may specify that a variable interest

334 Code sec. 404(a)(1).

335 Seo, 404(a)(1)(D). In the case of a plan that terminates during the year, the maximum
deductible amount is generally not less than the amount needed to make the plan assets sufficient
to fund benefit liabilities as defined for purposes of the PBGC termination insurance program
(sometimes referred to as “termination liability”).

336 BRISA sec. 4006.

231


defined benefit pension plan system by clarifying the status of cash balance plans, and removing
the effective ceiling on interest credits in cash balance plans due to the way lump-sum benefits
are calculated. Specific issues arise with respect to each part of the proposal. In addition, the
proposal raises broader issues relating to the defined benefit pension plan system and retirement
income security.

Retirement income security and cash balance plans

Helping to ensure that individuals have retirement income security is the major objective
of the U.S. private pension system. The system is a voluntary system, relying heavily on tax
incentives in order to encourage employers to establish qualified retirement plans for their
employees. Although qualified plans are subject to a variety of legal requirements, employers
generally may choose whether or not to adopt a qualified plan, the type of plan to adopt, the level
of benefits to be provided, and many other plan features.

Over time, there has been a decline in defined benefit pension plan coverage compared to
coverage under defined contribution plans. This has caused some to be concerned about a
possible decline in retirement income security, and has focused attention on both defined
contribution plans and defined benefit pension plans. Issues of retirement income security with
respect to both types of plans have been the subject of recent Congressional hearings.’ 6

Traditional defined benefit pension plans are viewed by many as providing greater
retirement income security than defined contribution plans. This is primarily because such plans
provide a specific promised benefit. Employers bear the risk of investment loss; if plan
contributions plus earnings are insufficient to provide promised benefits, the employer is

316 The Subcommittee on Select Revenue Measures of the House Committee on Ways
and Means held a hearing on challenges facing pension plan funding on April 30, 2003; see Joint
Committee on Taxation, Present Law and Background Relating to the Funding Rules for
Employer-Sponsored Defined Benefit Plans and the Financial Position of the Pension Benefit
Guaranty Corporation (“PBGC”) (JCX-39-03), April 29, 2003; the Senate Committee on
Finance held a hearing on issues relating to the funding of defined benefit plans on March 11,
2003; see Joint Committee on Taxation, Present Law and Background Relating to Employer-
Sponsored Defined Benefit Plans and the Financial Position of the Pension Benefit Guaranty
Corporation (“PBGC”) (JCX-16-03), March 10, 2003; the Subcommittee on Oversight of the
House Committee on Ways and Means held a hearing on retirement security and defined benefit
pension plans on June 20, 2002; see Joint Committee on Taxation, Present Law and Background
Relating to Employer-Sponsored Defined Benefit Plans (J CX-71-02), June 18, 2002; the Senate
Committee on Finance held a hearing on issues related to retirement security on February 27,
2002; see Joint Committee on Taxation, Present Law and Background Relating to Employer-
Sponsored Defined Contribution Plans and Other Retirement Arrangements and Proposals
Regarding Defined Contribution Plans (JCX-11-02), February 26, 2002; and the House
Committee on Ways and Means held a hearing on Issues Related to Retirement Security and
Defined Contribution Plans on February 26, 2002; see Joint Committee on Taxation, Present
Law and Background Relating to Employer-Sponsored Defined Contribution Plans and Other
Retirement Arrangements (JCX-9-02), February 25, 2002.

220


Cooperatives that qualify as tax-exempt farmers’ cooperatives are permitted to exclude
patronage dividends from their taxable income to the extent of all net income, including net
income that is derived from transactions with patrons who are not members of the cooperative,
provided the value of transactions with patrons who are not members of the cooperative does not
exceed the value of transactions with patrons who are members of the cooperative.!"

Taxation of electric cooperatives exempt from subchapter T

In general, the cooperative tax rules of subchapter T apply to any corporation operating
on a cooperative basis (except mutual savings banks, insurance companies, other tax-exempt
organizations, and certain utilities), including tax-exempt farmers’ cooperatives (described in
section 521(b)). However, subchapter T does not apply to an organization that is “engaged in
furnishing electric energy, or providing telephone service, to persons in rural areas.”'” Instead,
electric cooperatives are taxed under rules that were applicable generally to cooperatives prior to
the enactment of subchapter T in 1962. Under these rules, an electric cooperative can exclude
patronage dividends from taxable income to the extent of all net income of the cooperative,
including net income derived from transactions with patrons who are not members of the
cooperative. '

Tax exemption of rural electric cooperatives

Section 501(c)(12) provides an income tax exemption for rural electric cooperatives if at
least 85 percent of the cooperative’s income consists of amounts collected from members for the
sole purpose of meeting losses and expenses of providing service to its members. The IRS takes
the position that rural electric cooperatives also must comply with the fundamental cooperative
principles described above in order to qualify for tax exemption under section 501(c)(12).'*
The 85-percent test is determined without taking into account any income from qualified pole
rentals and cancellation of indebtedness income from the prepayment of a loan under sections
306A, 306B, or 311 of the Rural Electrification Act of 1936 (as in effect on January 1, 1987).
The exclusion for cancellation of indebtedness income applies to such income arising in 1987,
1988, or 1989 on debt that either originated with, or is guaranteed by, the Federal Government.

Rural electric cooperatives generally are subject to the tax on unrelated trade or business
income under section 511.

191 Sec. 521.
12 Sec, 1381(a)(2)(C).
193 See Rev. Rul. 83-135, 1983-2 C.B. 149.

194 Rey. Rul. 72-36, 1972-1 C.B. 151.

149


the cooperative to satisfy the 85-percent member income requirement for tax exemption. The
proposals define these circumstances with a series of rules that are complex and incorporate
several new terms of art from the electric industry that have no precedent in the tax laws (e.g.,
“open access”).

However, the proposal can be expected to reduce complexity with regard to the
provisions concerning nuclear decommissioning transactions and asset exchange or conversion
transactions. These provisions would resolve some ambiguity that exists in present law with
regard to whether gross income from such transactions is non-member income under the 85-
percent test.

Prior Action

The conference agreement to H.R. 6, “The Energy Policy Act of 2003,” as passed by the
House of Representatives on November 18, 2003, H.R. 6 as passed by the House of
Representative on April 11, 2003, and S. 1149, as passed by the Senate on July 31, 2003, each
contain provisions similar to the proposal.

153


Special statutory provisions govern the timing of the deduction for nonqualified deferred
compensation, regardless of whether the arrangement covers employees or nonemployees and
regardless of whether the arrangement is funded or unfunded.” Under these provisions, the
amount of nonqualified deferred compensation that is includible in the income of the individual
performing services is deductible by the service recipient for the taxable year in which the
amount is includible in the individual’s income.

Rulings on nonqualified deferred compensation

In the 1960’s and early 1970’s, various IRS revenue rulings considered the tax treatment
of nonqualified deferred compensation arrangements.**! Under these rulings, a mere promise to
pay, not represented by notes or secured in any way, was not regarded as the receipt of income
for tax purposes. However, if an amount was contributed to an escrow account or trust on the
individual’s behalf, to be paid to the individual in future years with interest, the amount was held
to be includible in income under the economic benefit doctrine. Deferred amounts were not
currently includible in income in situations in which nonqualified deferred compensation was
payable from general corporate funds that were subject to the claims of general creditors and the
plan was not funded by a trust, or any other form of asset segregation to which individuals had
any prior or privileged claim.” Similarly, current income inclusion did not result when the
employer purchased an annuity contract to provide a source of funds for its deferred
compensation liability if the employer was the applicant, owner and beneficiary of the annuity
contract, and the annuity contract was subject to the general creditors of the employer. In
these situations, deferred compensation amounts were held to be includible in income when
actually received or otherwise made available.

Proposed Treasury regulation 1.61-16, published in the Federal Register for February 3,
1978, provided that if a payment of an amount of a taxpayer’s compensation is, at the taxpayer’s
option, deferred to a taxable year later than that in which such amount would have been payable
but for his exercise of such option, the amount shall be treated as received by the taxpayer in
such earlier taxable year. TM*

54 Secs. 404(a)(5), (b) and (d) and sec. 83(h).

541 The seminal ruling dealing with nonqualified deferred compensation is Rev.
Rul. 60-31, 1960-1 C.B. 174.

54 Rey, Rul. 69-650, 1969-2 C.B. 106; Rev. Rul. 69-49, 1969-1 C.B. 138.
54 Rey, Rul. 72-25, 1972-1 C.B. 127. See also, Rev. Rul. 68-99, 1968-1 C.B. 193, in
which the employer’s purchase of an insurance contract on the life of the employee did not result

in an economic benefit to the employee if all rights to any benefits under the contract were solely
the property of the employer and the proceeds of the contract were payable only to the employer.

544 Prop. Treas. Reg. 1.61-16, 43 Fed. Reg. 4638 (1978).

334


CONTENTS

INTRODUCTION ....scscessssessecsessssssesveseesesssssessseneesesacenecnscnseseneensenssnssscscsaseessenssstucaneqncanseneensensnagtags 1

I. MAKING PERMANENT THE TAX CUTS ENACTED IN 2001 AND 2003.........+5

A.
B.

Extend Through 2010 Certain Provisions Relating to Individuals
Permanently Extend Certain Provisions Expiring Under EGTRRA and JGTRRA

TL. TAX INCENTIVES .n.ccsccssssessessseesssssssesessscsecsueanesssnsanensenesneensseeeaseasenssacescsnssvseenassssanensenessenaaes 13

A.

Provisions Related to Savings.
1. Expansion of tax-free savings opportunities......
2. Consolidation of employer-based savings accounts .
3. Individual development accounts .
Health Care Provisions ..........
1. Refundable tax credit for the purchase of health insurance.
2. Provide an above-the-line deduction for certain high deductible insurance
PFEMIUMS.......esssseescssssessccsssneccessnsceecsnneecsssnescessuseccssssvssensssecssnnsscenunsceeennnensonnsccasseseressess
3. Provide an above-the-line deduction for long-term care insurance premiums
4, Provide an additional personal exemption to home caregivers of family members
5, Expand human clinical trials expenses qualifying for the orphan drug tax credit........
6. Clarifications to the refundable credit for health insurance costs of eligible
individuals
Provisions Relating to Charitable Giving
1. Provide a charitable contribution deduction for nonitemizers..
2. Permit tax-free withdrawals from individual retirement arrangements for
Charitable contributions....c..ccccssecceesssessseseeseeseeseesncensseeseereneenneneeaseenereensesseessaseeseneanes 76
3. Expand and increase the enhanced charitable deduction for contributions of food
inventory
4. Reform excise tax based on investment income of private foundation:
5. Modify tax on unrelated business taxable income of charitable remainder trust
6. Modify the basis adjustment to stock of S corporation contributing appreciated
property
7. Repeal $150 million limit for qualified 501(c)(3) bonds
8. Repeal restrictions on the use of qualified 501(c)(3) bonds for residential rental
PIOPELTY ..seesssseecssssesscsssssnsccessnsscessnnerecsssssseesssvecessssssersssnssscassccennneseesnunsecsnnssenssnasesessssess 96
Extend, Increase and Expand the Above-the-Line Deduction for Qualified
Out-of-Pocket Classroom Expenses
Exclude from Income of Individuals the Value o:
Software and Peripherals
Provide a Tax Credit for Developers of Affordable Single-Family Housin
Environment and Conservation Related Provisions ..........:1s
1. Permanently extend expensing of brownfields remediation cost .
2. Exclude 50 percent of gains from the sale of property for conservation purposes



upon written request by the Secretary, a list of investors with respect to each reportable
transaction.

Effective date —The proposal generally is effective after the date of enactment.

5, Penalty for failure to report interests in foreign financial accounts
Present Law

The Secretary of the Treasury must require citizens, residents, or persons doing business
in the United States to keep records and file reports when that individual engages ina
transaction, or maintains an account, with a foreign financial entity.’ In general, individuals
must fulfill this requirement by answering questions regarding foreign accounts or foreign trusts
that are contained in Part III of Schedule B of the IRS Form 1040. Taxpayers who answer “yes”
in response to the question regarding foreign accounts must then file Treasury Department Form
TD F 90-22.1. This form must be filed with the Treasury Department, and not as part of the tax
return that is filed with the IRS.

The Secretary of the Treasury may impose a civil penalty on any person who willfully
violates this reporting requirement. The civil penalty is the amount of the transaction or the
value of the account, up to a maximum of $100,000; the minimum amount of the penalty is
$25,000.2”> In addition, any person who willfully violates this reporting requirement is subject to
acriminal penalty. The criminal penalty is a fine of not more than $250,000 or imprisonment for
not more than five years (or both); if the violation is part of a pattern of illegal activity, the
maximum amount of the fine is increased to $500,000 and the maximum length of imprisonment
is increased to 10 years.°”°

On April 26, 2002, the Secretary of the Treasury submitted to the Congress a report on
these reporting requirements.” This report, which was statutorily required,” studies methods
for improving compliance with these reporting requirements. It makes several administrative
recommendations, but no legislative recommendations. A further report was required to be
submitted by the Secretary of the Treasury to the Congress by October 26, 2002.

374 31 U.S.C. 5314.

35 31 U.S.C. 5321(a)(5).

37 31 U.S.C. 5322.

3774 Report to Congress in Accordance with Sec. 361(b) of the Uniting and
Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct
Terrorism Act of 2001, April 26, 2002.

378 Sec, 361(b) of the USA PATRIOT Act of 2001 (Pub. L. 107-56).

247


the stripped coupons or bond. With respect to retained items (either the detached coupons or
stripped bond), to the extent that the price payable on maturity, or on the due date of the
coupons, exceeds the portion of the taxpayer’s basis allocable to such retained items, the
difference is treated as OID that is required to be included under the general OID periodic
income inclusion rules.**”

Stripped preferred stock

“Stripped preferred stock” is defined as preferred stock in which there has been a
separation in ownership between such stock and any dividend on such stock that has not become
payable.** A taxpayer who purchases stripped preferred stock is required to include in gross
income, as ordinary income, the amounts that would have been includible if the stripped
preferred stock was a bond issued on the purchase date with OID equal to the excess of the
redemption price of the stock over the purchase price.*®” This treatment is extended to any
taxpayer whose basis in the stock is determined by reference to the basis in the hands of the
purchaser. A taxpayer who strips and disposes the future dividends is treated as having
purchased the stripped preferred stock on the date of such disposition for a purchase price equal
to the taxpayer’s adjusted basis in the stripped preferred stock.>

Mineral production payments

Production payments that are carved out of mineral property and disposed generally are
treated as mortgage loans on the property, rather than economic interests in the property.°""
Conversely, production payments that are retained upon the disposition of a mineral property
generally are treated as purchase money mortgage loans, rather than economic interests in the
property.’ Thus, whereas the present-law treatment of stripped bonds and stripped preferred

387 Special rules are provided with respect to stripping transactions involving tax-exempt
obligations that treat OID (computed under the stripping rules) in excess of OID computed on
the basis of the bond’s coupon rate (or higher rate if originally issued at a discount) as income
from a non-tax-exempt debt instrument (sec. 1286(d)).

388 Sec, 305(e)(5).
38 Sec. 305(e)(1).
3 Sec. 305(e)(3).

3°! Sec, 636(a). For this purpose, a “production payment” generally is defined as a right
to a specified in-kind share of the production from mineral in place (if, as, and when produced),
or the cash proceeds from such production. The term also includes any right that is in substance
economically equivalent to a production payment. However, the term includes only economic
interests in mineral in place. In addition, the term includes only rights with an expected
economic life, at the time that the right is created, that is shorter in duration than the economic
life of the underlying mineral property. Treas. Reg. sec. 1.636-3.

3 Sec. 636(b).

251


Analysis

In recent years, charities and their agents have actively solicited donations of used
automobiles. The General Accounting Office recently estimated that approximately 4,300
charities (or 2.7 percent of charities with revenues of $100,000 or more) have vehicle donation
programs.‘* In many cases, the vehicles are not used by the charitable donee for a charitable
purpose, but are sold shortly after the donation. Although some charities use the automobiles to
further their charitable purposes, e.g., to transport employees, volunteers, or charitable
beneficiaries in the course of conducting the organization’s exempt activities, such use is in the
minority.

The General Accounting Office estimated that approximately 0.6 percent of individual
tax returns, or 733,000 returns, contained tax deductions for vehicle donations for the 2000
taxable year."?° Although the General Accounting Office could not verify the accuracy of
taxpayer claims regarding the value of their donated vehicle,*° many are concerned that the
amounts of charitable deductions claimed by taxpayers often substantially exceed the fair market
values of the donated vehicles because taxpayers often use published values for cars that are in
better condition than the donated vehicles.*?! Further, donated automobiles oftentimes are sold
at auction for wholesale or liquidation prices or to salvage yards for scrap prices, so that the
amount of the claimed charitable deduction substantially exceeds the net sales proceeds (gross
sales proceeds less fees, commissions, towing, advertising, program administration, or other
vehicle processing and other transaction costs paid to agents) received by the charity.“

For two-thirds of the 54 specific vehicle donations GAO examined in its report, charities
received five percent or less of the value donors claimed as deductions on their tax returns.? In
some cases, the charity incurred transaction costs that exceeded the vehicle gross sales price, so
that the charity actually may have lost money as a result of the donation and subsequent sale of
the vehicle.***

428 United States General Accounting Office, Report to the Committee on Finance, U.S.
Senate, Vehicle Donations, Benefits to Charities and Donors, but Limited Program Oversight,
GAO-04-73 (November 2003), p. 7.

“9 Id. at 8.

450 Id. at 15.

431 Td. at 19 (“Charities stated that a number of the vehicles donated are sold for scrap,
and some said donor claims about vehicle value might be inflated.”).

42 Td. at 2.
3 Td. at Highlights.

434 Tq. at p. 17 and at Table 4, p. 37.

276


result from the continued operation of the plant. In the case of the special credit rate for co-firing
biomass with coal, establishing the credit for existing facilities that already co-fire would need to
meet the same tests for the credit to be efficient and not merely produce windfall gains. To the
extent that the credit encourages coal burning facilities to begin to co-fire with biomass, the
credit with respect to such co-firing could be efficient to the extent that the positive external
benefits from the co-firing exceed the costs of the credit. Ifit is impractical to separate new co-
firing from existing investments in co-firing, then for the credit to be economically efficient the
external gains from the newly induced co-firing would need to exceed the costs of the credit with
respect to the new co-firing as well as the cost of the credit with respect to any windfall gains to
facilities that would co-fire in the absence of the credit.

Complexity issues

Each of the President’s proposals in the area of energy production and conservation can
be expected to increase the complexity of tax law. Though the effect of each provision, or even
all provisions collectively, on tax law complexity may be small, they would all add to
complexity merely by providing new tax benefits not previously available. Taxpayers
considering using these provisions would need to consider the impact of additional tax factors in
making investment decisions, and taxpayers that actually utilize the provisions will need to
educate themselves as to the rules of the provisions, as well as fill out the necessary forms to
claim the tax benefits. Taxpayers constrained by the AMT or by the nonrefundability of the
credit would face additional complications in determining the value of the various credits to
them, which would further complicate their investment choices.

In general, the production tax credits add less complexity in the aggregate as there are
relatively few taxpayers in a position to claim such benefits. The personal credits, such as those
for solar equipment and hybrid vehicles, add more aggregate complexity as many more taxpayers
will avail themselves of the credit and they could induce millions more to at least consider
purchasing hybrid vehicles or solar equipment as a result of the credit.

7. Extend excise tax exemption (credit) for ethanol
Present Law

Alcohol fuels income tax credit

In general

Ethanol and methanol derived from renewable sources (e.g., biomass) are eligible for an
income tax credit (the “alcohol fuels credit”) equal under present law to 52 cents per gallon
(ethanol) and 60 cents per gallon (methanol). These tax credits are provided to blenders of the
alcohol with other taxable fuels, or to retail sellers of unblended alcohol fuels. Typically, ethanol
is blended with gasoline subject to Highway Trust Fund excise tax to produce “gasohol.” The
52-cents-per-gallon income tax credit rate is scheduled to decline to 51 cents per gallon during
the period 2005 through 2007. The credit is scheduled to expire after December 31, 2007.

143


E. Exclude from Income of Individuals the Value of Employer-Provided
Computers, Software and Peripherals

Present Law

The value of computers, software, or other office equipment provided by an employer for
use in the home of an employee is generally excludable from income as a working condition
fringe benefit to the extent the equipment is used to perform work for the employer (sec. 132).
The value of such equipment is includible in income to the extent the equipment is used for
personal purposes. If such equipment is used for both personal and business purposes, then a
portion of the value may be excluded from income.

In general, employee business expenses are deductible as an itemized deduction, but only
to the extent such expenses and other miscellaneous itemized deductions exceed two percent of
adjusted gross income. Impairment-related work expenses are not subject to this two-percent
floor. Impairment-related work expenses are expenses: (1) of a handicapped individual for
attendant care services at the individual’s place of employment and other expenses in connection
with such place of employment which are necessary for such individual to be able to work; and
(2) that are trade or business expenses (sec. 162). For these purposes, a handicapped individual
means an individual who has a physical or mental disability (including but not limited to
blindness or deafness) which for such individual constitutes or results in a functional limitation
to employment or who has any physical or mental impairment (including, but not limited to, a
sight or hearing impairment) which substantially limits one or more major life activities of such
individual.

Description of Proposal

The proposal provides an exclusion from income for the value of any computers,
software or other office equipment provided to an individual by that individual’s employer. The
exclusion is limited to equipment necessary for the individual to perform work for the employer
at home but is not limited to business use of such equipment. Therefore, the exclusion applies to
all use of such equipment, including use by the employee for personal purposes or to carry on a
trade or business other than working as an employee of the employer. However, in order to
qualify for the exclusion, the employee is required to make substantial use of the equipment to
perform work for the employer.

If the employer provided the employee with the use of the equipment at the end of its
useful life, the proposal also deems the value of such use to be zero for tax purposes.

Effective date The proposal is effective for taxable years beginning after December 31,
2004.

104


B. Permanently Extend the Research and Experimentation (“R&E”) Tax Credit
Present Law
General rule

Section 41 provides for a research tax credit equal to 20 percent of the amount by which a
taxpayer’s qualified research expenses for a taxable year exceed its base amount for that year.
The research tax credit is scheduled to expire and generally will not apply to amounts paid or
incurred after June 30, 2004.

583 The research tax credit initially was enacted in the Economic Recovery Tax Act of
1981 as a credit equal to 25 percent of the excess of qualified research expenses incurred in the
current taxable year over the average of qualified research expenses incurred in the prior three
taxable years. The research tax credit was modified in the Tax Reform Act of 1986, which
(1) extended the credit through December 31, 1988, (2) reduced the credit rate to 20 percent,
(3) tightened the definition of qualified research expenses eligible for the credit, and (4) enacted
the separate university basic research credit.

The Technical and Miscellaneous Revenue Act of 1988 (“1988 Act”) extended the
research tax credit for one additional year, through December 31, 1989. The 1988 Act also
reduced the deduction allowed under section 174 (or any other section) for qualified research
expenses by an amount equal to 50 percent of the research tax credit determined for the year.

The Omnibus Budget Reconciliation Act of 1989 (“1989 Act”) effectively extended the
research credit for nine months (by prorating qualified expenses incurred before January 1,
1991). The 1989 Act also modified the method for calculating a taxpayer’s base amount (i.e., by
substituting the present-law method which uses a fixed-base percentage for the prior-law moving
base which was calculated by reference to the taxpayer’s average research expenses incurred in
the preceding three taxable years). The 1989 Act further reduced the deduction allowed under
section 174 (or any other section) for qualified research expenses by an amount equal to 100
percent of the research tax credit determined for the year.

The Omnibus Budget Reconciliation Act of 1990 extended the research tax credit through
December 31, 1991 (and repealed the special rule to prorate qualified expenses incurred before
January 1, 1991).

The Tax Extension Act of 1991 extended the research tax credit for six months (i.e., for
qualified expenses incurred through June 30, 1992).

The Omnibus Budget Reconciliation Act of 1993 (1993 Act”) extended the research tax
credit for three years--i.e., retroactively from July 1, 1992 through June 30, 1995. The 1993 Act
also provided a special rule for start-up firms, so that the fixed-base ratio of such firms
eventually will be computed by reference to their actual research experience.

359


additional earnings. Increased wages resulting from the WOTC may be viewed as a partial offset
to these high marginal tax rates. In addition, it may be the case that even if the credit has little
effect on observed wages, credit-eligible individuals may have increased earnings due to
increased employment.

The structure of the WOTC (the 40-percent credit rate for the first $6,000 of qualified
wages) appears to lend itself to the potential of employers churning employees who are eligible
for the credit. This could be accomplished by firing employees after they earn $6,000 in wages
and replacing them with other WOTC-eligible employees. If training costs are high relative to
the size of the credit, it may not be in the interest of an employer to churn such employees in
order to maximize the amount of credit claimed. Empirical research in this area has not found an
explicit connection between employee turnover and utilization of WOTC’s predecessor, the
Targeted Jobs Tax Credit (“TJTC”).°

Job creation

The number of jobs created by the WOTC is certainly less than the number of
certifications. To the extent employers substitute WOTC-eligible individuals for other potential
workers, there is no net increase in jobs created. This could be viewed as merely a shift in
employment opportunities from one group to another. However, this substitution of credit-
eligible workers for others may not be socially undesirable. For example, it might be considered
an acceptable trade-off for a targeted group member to displace a secondary earner from a well-
to-do family (e.g., a spouse or student working part-time).

In addition, windfall gains to employers or employees may accrue when the WOTC is
received for workers that the firm would have hired even in the absence of the credit. When
windfall gains are received, no additional employment has been generated by the credit.
Empirical research on the employment gains from the TJTC has indicated that only a small
portion of the TJTC-eligible population found employment because of the program. One study
indicates that net new job creation was between five and 30 percent of the total certifications.
This finding is consistent with some additional employment as a result of the TJTC program, but
with considerable uncertainty as to the exact magnitude.TM!

A necessary condition for the credit to be an effective employment incentive is that firms
incorporate WOTC eligibility into their hiring decisions. This could be done by determining
credit eligibility for each potential employee or by making a concerted effort to hire individuals
from segments of the population likely to include members of targeted groups. Studies
examining this issue through the TJTC found that some employers made such efforts, while
other employers did little to determine eligibility for the TJTC prior to the decision to hire an

620 See, for example, Macro Systems, Inc., Final Report of the Effect of the Targeted
Jobs Tax Credit Program on Employers, U.S. Department of Labor, 1986.

821 Macro Systems, Inc., Impact Study of the Implementation and Use of the Targeted
Jobs Tax Credit: Overview and Summary, U.S. Department of Labor, 1986.

387


contract. Further, tax-exempt entities engaged in leasing transactions have indicated in internal
correspondence that the service contracts are used to avoid Federal income tax issues, and that
they never expect to ever take any other action than pay the buyout option and terminate the
transaction, irrespective that such buyout is above projected fair market value.

Limitation on tax benefits from certain tax-exempt leases —The proposal is intended to
ensure that certain leasing transactions with tax-exempt entities not create a significant mismatch
in the timing of income and deductions. The proposal generally is intended to be limited to
leasing transactions in which the substance of the arrangement is the payment of a fee to the tax-
exempt entity in exchange for the transfer of tax benefits to a taxable entity that can use such
benefits. In these types of leasing arrangements, the arrangement is economically equivalent to
ownership by the tax-exempt entity (lessee), and thus the investment should be taxed as such
(Le., the tax benefits of depreciation and other costs should be removed). In order to accomplish
this result and deter such activity, the proposal adopts an approach that is similar to the rules
addressing passive activity losses for individuals in that, like passive activity losses, recognition
of net losses from the early years are deferred until corresponding net income (if any) is
recognized by the taxpayer in later years (or upon termination of the leasing transaction).
Advocates of the proposal argue that taxable U.S. corporations should not be permitted to take
advantage of the special tax status of tax-exempt entities participating in a lease in order to
generate U.S. tax benefits that can be used to shelter other unrelated income. Advocates of the
proposal also argue that the mechanics of the passive activity loss rules provide an appropriate
model for addressing the timing issues presented by certain leasing transactions with tax-exempt
entities, Further, they argue that by incorporating exceptions for certain leases from the broad
scope of this proposal it is appropriately targeted. Lastly, the proponents highlight that the
leasing transactions are an inefficient mechanism for providing funds and do not afford Congress
any oversight on the use of the subsidy provided.

Critics of the loss deferral proposal argue it is overly broad and could inappropriately
affect leasing transactions with tax-exempt entities that are not primarily engaged in to shelter
taxable income.*®* In addition, it can be argued that an alternative approach for addressing
certain specific income and deduction mismatching problems could be achieved more effectively
by modifying the class lives of property so that they more accurately reflect the economic useful
life of such property, thus minimizing the ability to obtain significant tax benefits through
mismatching of income and deductions.

Critics also may argue that, irrespective of arrangements (e.g., defeasance of lease
obligations) that limit the risk of the parties involved, such arrangements are not legally binding
and, similar to other non-binding business arrangements, should not impact the tax treatment of

456 On the other hand, some may argue that the proposal is not broad enough because it
does not include lease transactions with U.S. corporations that have expiring net operating losses.
In such situations, such corporations may be considered effectively tax-exempt to the same
degree as State and local governments, nonprofit organizations, and foreign governments and
persons. Thus, it could be argued that the proposal does not comprehensively preclude abusive
lease transactions with tax-exempt entities because it does not apply to transactions with such
corporations.

290


Prior Action

Similar proposals were contained in the President’s fiscal year 2003 and 2004 budget
proposals.

381


to an upfront payment equal to three to four percent of the market value of the property. The
lessor’s benefit is more complicated, but is generally equal to 35 percent of the market value of
the leased property reduced by taxable gain on the sale of the property back to the tax-exempt
entity at the end of the lease term. Because the lessor’s tax benefit (and subsequent additional
taxable income) is recognized over a number of years, the tax benefits (and tax costs) must be
discounted (present valued) to accurately compare such benefit to the tax-exempt entity’s benefit
from the transaction.

To the extent that the significant benefits of the leasing transaction are transferred to
taxable entities, corporate taxpayers, and advisors of tax-exempt entities, leasing is an inefficient
way of providing assistance to tax-exempt entities. A more efficient and direct approach to
assisting tax-exempt entities might include direct spending programs. However, this approach
also may incur additional costs that reduce the benefits to the tax-exempt entity (¢.g., additional
costs to effectuate the program). Alternatively, allowing tax-exempt entities to sell tax benefits
(e.g., depreciation) may allow a broader group of tax-exempt entities to benefit. Currently, the
benefits generally are limited to tax-exempt entities with significant assets that satisfy certain
specific characteristics (e.g., railcars, large number of buses, etc.). This results in a
disproportionate portion of the benefits being allocated to a narrow group of tax-exempt
entities.*TM Providing a direct ability to transfer the tax benefits would allow other assets, and
lower value assets, to qualify that are precluded today because any tax benefits are offset by the
significant costs of engaging in these transactions. However, previous proposals that sanctioned
the transfer of tax benefits resulted in significant revenue loss and were quickly repealed (¢.g.,
safe harbor leasing). These proposals also resulted in a sharing of benefits between tax-exempt
entities, taxable entities, and other parties involved in the transaction.

Budget oversight —A second issue is the impact of governmental leasing on the budget
process. In the case of a lease to a governmental agency, leasing can distort the appropriations
process by shifting capital acquisition costs from the agency’s budget to the U.S. Treasury in the
form of reduced tax revenues. Thus, leasing reduces the oversight over spending normally
exercised by the appropriations process by converting direct outlays, which require
appropriations, into tax benefits, which do not.

In addition, leasing by Federal, State, and local agencies can distort the actual level of
financial support provided to a governmental agency. As mentioned above, these transactions
shift costs from agencies’ budgets to the U.S. Treasury, making it difficult to determine how
much Federal assistance is being provided and to whom or for what purposes it is being
provided. For example, a U.S. municipality that leases its subway railcars effectively transfers
the local operating costs of its subway system to all taxpayers without regard to use and without
any consideration by Congress of whether such cost transfer is appropriate. Removing the tax

450 For example, eight cities (Atlanta, Chicago, Los Angeles, New York, Newark,
Philadelphia, San Francisco, and Washington DC) comprise approximately 75 percent of the
lease transactions (by value of assets) reviewed by the Federal Transit Authority since 1988.
Further, four of these eight cities (Atlanta, Chicago, New York, Newark) comprise
approximately 50 percent of the transactions (by value of assets) reviewed,

285


a medical savings account or health savings account are not eligible for the credit. The amount
of the credit available through filing a tax return is reduced by any credit received on an advance
basis. Married taxpayers filing separate returns are eligible for the credit; however, if both
spouses are eligible individuals and the spouses file a separate return, then the spouse of the
taxpayer is not a qualifying family member.

The Secretary of the Treasury is authorized to prescribe such regulations and other
guidance as may be necessary or appropriate to carry out the provision.

Advance payment of refundable health insurance credit; reporting requirements

The credit is payable on an advance basis (i.e., prior to the filing of the taxpayer’s return).
The disclosure of return information of certified individuals to providers of health insurance
information is permitted to the extent necessary to carry out the advance payment mechanism.
The Code does not specify the items of return information that are to be disclosed, nor does it
provide for the disclosure of such information to contractors of the health insurance providers
authorized to receive such information. Advance payment of the credit has been available since
August 1, 2003. To the extent that disclosures to persons not authorized under the statute are
necessary a consent mechanism has been employed. The signature block of the registration form
for the credit states “By signing, I also agree to allow the IRS to share my eligibility status and
payment information with my health plan administrator.” Applicants are required to give such
consent in applying for the credit.

Any person who receives payments during a calendar year for qualified health insurance
and claims a reimbursement for an advance credit amount is required to file an information
return with respect to each individual from whom such payments were received or for whom
such a reimbursement is claimed.

Description of Proposal

The President’s proposal modifies the refundable health tax credit in several ways.
Under the proposal, individuals who elect to receive one-time lump sum payments from the
PBGC and certain alternative PBGC payees are eligible for the credit.

The proposal provides that the Commonwealths of Puerto Rico and the Northern Mariana
Islands, American Samoa, Guam, and the U.S. Virgin islands are deemed to be States for
purposes of the State-based coverage rules.

In addition, the proposal allows disclosure of certain information necessary to carry out
the advance payment program to contractors of providers of health insurance and provides that
providers of health insurance include employers and administrators of health plans.

Additionally, under the proposal, State continuation coverage provided under State law
automatically qualifies as qualified health insurance, as Federally-mandated COBRA
continuation coverage, without having to meet the requirements relating to State-based qualified
coverage.

64


applicable limit by $500 in 2004, $600 in 2005, $700 in 2006, $800 in 2007, $900 in 2008, and
$1,000 in 2009 and thereafter.

An excise tax applies to contributions in excess of the maximum contribution amount for
the HSA. If an employer makes contributions to employees’ HSAs, the employer must make
available comparable contributions on behalf of all employees with comparable coverage during
the same period.

Taxation of distributions

Distributions from an HSA for qualified medical expenses of the individual and his or her
spouse or dependents generally are excludable from gross income. Qualified medical expenses
generally are defined as under section 213(d). Qualified medical expenses do not include
expenses for insurance other than for (1) long-term care insurance, (2) premiums for health
coverage during any period of continuation coverage required by Federal law, (3) premiums for
health care coverage while an individual is receiving unemployment compensation under Federal
or State law, or (4) in the case of an account beneficiary who has attained the age of Medicare
eligibility, health insurance premiums for Medicare, other than premiums for Medigap policies.
Such qualified health insurance premiums include, for example, Medicare Part A and Part B
premiums, Medicare HMO premiums, and the employee share of premiums for employer-
sponsored health insurance including employer-sponsored retiree health insurance.

For purposes of determining the itemized deduction for medical expenses, distributions
from an HSA for qualified medical expenses are not treated as expenses paid for medical care
under section 213. Distributions from an HSA that are not for qualified medical expenses are
includible in gross income. Distributions includible in gross income are also subject to an
additional 10-percent tax unless made after death, disability, or the individual attains the age of
Medicare eligibility (i.¢., age 65).

Other provisions

Present law also provides other tax benefits for medical expenses other than health
insurance. For example, a flexible spending arrangement (“FSA”) is defined under the Code as a
benefit program which provides employees with coverage under which specified incurred
expenses may be reimbursed and the maximum amount of reimbursement which is reasonably
available to a participant for such coverage is less than 500 percent of the value of such
coverage.*® A health FSA is an FSA that provides for reimbursement of medical expenses.
Health FSAs are typically part of a cafeteria plan and may be funded through salary reduction.
Health FSAs are commonly used, for example, to reimburse employees for medical expenses not
covered by insurance, but can not be used for health insurance. There is no special exclusion for
benefits provided under an FSA. Thus, health benefits provided under an FSA are excludable
from income only if they qualify for exclusion under sections 105 or 106.

85 Sec. 106(c).

50


Treasury regulations, a qualified appraisal means an appraisal document that, among other
things, (1) relates to an appraisal that is made not earlier than 60 days prior to the date of
contribution of the appraised property and not later than the due date (including extensions) of
the return on which a deduction is first claimed under section 170;‘”° (2) is prepared, signed, and
dated by a qualified appraiser; (3) includes (a) a description of the property appraised; (b) the fair
market value of such property on the date of contribution and the specific basis for the valuation;
(c) a statement that such appraisal was prepared for income tax purposes, (d) the qualifications of
the qualified appraiser; and (e) the signature and taxpayer identification number (“TIN”) of such
appraiser; and (4) does not involve an appraisal fee that violates certain prescribed rules,”

Appraisal fees paid by an individual to determine the fair market value of donated
property are deductible as miscellaneous expenses subject to the 2 percent of adjusted gross
income limit.“”7

Description of Proposal

The proposal generally allows a charitable deduction for contributions of vehicles only if
the taxpayer obtains a qualified appraisal of the vehicle. The proposal applies to automobiles
and other types of self-propelled motorized vehicles or modes of transportation, including, for
example, boats and motorcycles. The proposal does not affect contributions of inventory
property. The definition of qualified appraisal generally follows the definition contained in
present law, although the appraisal of a donated vehicle must be obtained by the taxpayer by the
time the contribution is made.

Under the proposal, the Secretary may establish an administrative safe harbor in
published guidance. For example, such guidance might provide that a qualified appraisal is
required only for contributions of vehicles that are subject to generally applicable written
substantiation requirements under present law (i.¢., contributions for which deductions in excess
of $250 are taken by the taxpayer), or provide an alternative standard for what constitutes a
qualified appraisal in certain cases.

Effective date—The proposal is effective for taxable years beginning after December 31,
2003.

$5,000). Under P.L. 98-369, a qualified appraisal means an appraisal prepared by a qualified
appraiser that includes, among other things, (1) a description of the property appraised; (2) the
fair market value of such property on the date of contribution and the specific basis for the
valuation; (3) a statement that such appraisal was prepared for income tax purposes; (4) the
qualifications of the qualified appraiser; (5) the signature and TIN of such appraiser; and (6) such
additional information as the Secretary prescribes in such regulations.

425 Th the case of a deduction first claimed or reported on an amended return, the deadline
is the date on which the amended return is filed.

426 Treas, Reg. sec. 1.170A-13(c)(3).

#27 Rey, Rul. 67-461, 1967-2 C.B. 125.

275


purposes becomes less important to the extent that the support test is replaced by a residency
247
test.

Scope of relationship test One might argue that additional simplification would be
achieved by using a broader definition of qualifying child than that which is proposed, namely,
providing that a qualifying child includes any relative of the taxpayer who is within the
applicable age limit and who satisfies the residency requirement. The need to determine whether
achild bears a particular relationship to a taxpayer adds one additional rule that taxpayers must
apply. In addition, such a rule may cause confusion for some taxpayers because it draws an
arbitrary line based on certain familial relationships that taxpayers themselves may not draw.

For example, a taxpayer may care for a minor nephew and cousin as his or her own children in
his or her home. The nephew may be a qualifying child, but the cousin generally could not be,
because “cousin” is not included in the specified relationships. A broader definition of
qualifying child than that proposed, however, would involve a policy change with respect to
some provisions. In particular, a broader definition could significantly expand the class of
persons for which the earned income credit and the child credit could be claimed, which involves
policy implications beyond the scope of establishing a uniform definition to be used for multiple
tax benefits.

Uniform age test To achieve the greatest amount of simplification, a uniform age would
be adopted for purposes of defining a qualifying child. The proposal adopts a uniform age test
for purposes of the dependency exemption, the earned income credit, and head of household
filing status, but retains the different present-law age tests for the child credit and dependent care
credit.

Some argue that the dependent care credit has a different policy objective than the other
provisions for which the definition of qualifying child is relevant and that this different objective
warrants a different age rule. The dependent care credit provides a subsidy for individuals who
incur employment-related expenses for the care of a child or certain other individuals, which
expenses generally cease to be unnecessary many years before the child realizes the age of
majority. In contrast, the other provisions relating to children generally have the objective of
reducing tax liability for taxpayers with children, including teenage children. Because
determining the age of a child generally is not difficult, some argue that a limited exception to
the generally applicable age limit for the dependent care credit does not undermine the objectives
of simplification. The staff of the Joint Committee on Taxation previously rejected a uniform
age for purposes of all of the family-related tax benefits on the ground that a limited exception to
a generally applicable age limit would not undermine the objectives of simplification, and
recommended that the present-law under age 13 rule be retained for the dependent care credit.

Some argue that there does not appear to be a separate policy underlying the present-law
child credit that justifies an age requirement (under age 17 whether or not disabled) that differs

247 The issue remains, however, to the extent that a taxpayer applies the support test
instead of the residency test for the dependency exemption. Under a separate proposal of the
President’s budget proposal, the household maintenance test is eliminated for head of household
filing status.

171


Description of Proposal

The proposal extends the D.C. Zone designation for two years, through December 31,
2005. The capital gain eligible for the zero-percent capital gains is expanded to include gain
attributable to the period from January 1, 2009 through December 31, 2010.

Effective date—The proposal is effective from December 31, 2003.

Analysis

A temporary extension of the D.C. Zone tax incentives will eliminate (for two years) the
uncertainty faced by businesses and employers within the designated area regarding the tax
incentives that would affect any economic decision on future expansion or investment
opportunities. Some argue, however, that either the temporary expiration of the tax incentives or
the permanent extension of the tax incentives would provide reduced uncertainty permanently.

The additional extension also provides additional time to evaluate the effectiveness of the
incentive. On the other hand, some might argue that since the D.C. Zone designation has been in
place since August 1997, a permanent decision could be made based on the experience during
that time period.

The proposal is designed to encourage business investment in the D.C. Zone by
extending for two years the tax incentives that are available to businesses within this area.
According to the Treasury Department, certain portions of the District of Columbia are still
characterized by high levels of poverty, unemployment and other indicators of economic distress.
An extension of the D.C. Zone incentives would encourage the continued economic
redevelopment of these areas.

In the case of tax benefits that are intended to create an incentive for particular taxpayer
behavior, some may argue that a retroactive extension rewards behavior that occurred without
the incentive and, therefore, is unnecessary. Others may respond that taxpayers have relied on
Congressional assurances of retroactive extension or past retroactive extensions to engage in
such behavior.

Prior Action

A similar proposal was included in the President’s fiscal year 2004 budget proposals.

390


Others might argue that an affordable housing shortage is not widespread and that such
issues would be better addressed through efforts to directly assist low-income persons rather than
by imposing restrictions on the property acquired by the charity. Further, because qualified
501(c)(3) bonds are to be used to further the exempt purposes of the charity, there is a limit on
the extent the charity can operate like a commercial enterprise.

As noted above, the interest on qualified 501(c)(3) bonds is exempt from tax, and is not a
preference for purpose of the alternative minimum tax. Unlike some other private activity bonds,
qualified 501(c)(3) bonds are not subject to the State volume limitations and therefore, do not
have to compete with other private activity bond projects for an allocation from the State.
Proponents of the restrictions might argue that the restrictions are not unreasonable given the
preferential status of qualified 501(c)(3) bonds and the fact that such charities could be viewed as
helping alleviate a burden on government to benefit those most in need.

Prior Action

A similar proposal was included in the President’s fiscal year 2004 budget proposal.

99


argue that it should relax the rules for guaranteed debt relative to current law.*” Lastly, the
proposal is not entirely clear as to how the different percentage thresholds for interest on related-
party debt and interest on guaranteed debt apply.

Prior Action

TLR. 2896, the “American Jobs Creation Act of 2003,” contains a similar earnings-
stripping proposal. Generally, H.R. 2896 eliminates the debt-equity threshold and the carryover
of excess limitation; carryovers of disallowed interest are limited to 10 years; the “adjusted
taxable income” percentage threshold is lowered from 50 percent to 25 percent with respect to
related-party debt.

In contrast, the President’s fiscal year 2004 budget proposal contained an earnings
stripping proposal that changed present law by modifying the safe harbor provision, reducing the
adjusted taxable income threshold, adding a new disallowance provision based on a comparison
of domestic to worldwide indebtedness, and limiting carryovers.

Changes to the earnings stripping rules also were discussed in the Treasury study of
May 2002,*? and were included in H.R. 5095, the “American Competitiveness and Corporate
Accountability Act of 2002.” H.R. 5095 proposed several changes to section 163(j) and added a
new interest disallowance rule that disallowed related-party interest to the extent that the US.
subsidiaries of a foreign parent are more highly leveraged than the overall worldwide corporate
group.

S. 1637, the “Jumpstart our Business Strength Act,” and the Senate amendment to H.R. 2,
the “Jobs and Growth Tax Relief Reconciliation Act of 2003, tightened the earnings stripping
rules only for certain inverted companies.

401 § 1475, the “Promote Growth and Jobs in the USA Act of 2003,” would relax the
current law rules with respect to guaranteed debt. Under S. 1475, interest on guaranteed debt
would fall outside the definition of “disqualified interest” in the case of a guarantee by a foreign
person if the taxpayer established to the satisfaction of the Secretary that the taxpayer could have
borrowed substantially the same principal amount from an unrelated person without the
guarantee.

422 See Treasury study, Part VILA.

257


consolidation of saving into a single vehicle for simplification purposes. However, a taxpayer
with sufficient resources may effect such a conversion simply to shift more saving into
tax-favored accounts. For example, a taxpayer could transfer $50,000 from an existing qualified
tuition program into an LSA, and then reinvest a different $50,000 into the qualified tuition
program.

The tax treatment of contributions under qualified retirement plans is essentially the same
as that of traditional IRAs to which deductible contributions are made. However, the limits on
contributions to qualified plans are much higher than the IRA contribution limits, so that
qualified plans provide for a greater accumulation of funds on a tax-favored basis. A policy
rationale for permitting greater accumulation under qualified plans than IRAs is that the tax
benefits for qualified plans encourage employers to provide benefits for a broad group of their
employees. This reduces the need for public assistance and reduces pressure on the social
security system.

Some argue that offering LSAs and RSAs will reduce the incentive for small business
owners to maintain qualified retirement plans for themselves and their employees. A business
owner can generally contribute more to a qualified plan than the contributions that may be made
to LSAs and RSAs, but only if comparable contributions are made by or on behalf of rank-and-
file employees. The business owner must therefore successfully encourage rank-and-file
employees to contribute to the plan or, in many cases, make matching or nonelective
contributions for rank-and-file employees. The opportunity to contribute $5,000 annually to both
an LSA and an RSA for both the business owner and his or her spouse, without regard to
adjusted gross income or contributions for rank-and-file employees, may be a more attractive
alternative to maintaining a qualified retirement plan. Others argue that many employers
(including small employers) offer qualified retirement plans to attract and retain high-quality
employees and will continue to do so. Some raise concerns that, as a substitute for a qualified
retirement plan, an employer could selectively choose to pay additional compensation only to
highly compensated employees in the form of contributions to LSAs and RSAs. This may
undermine the principle of promoting savings for rank-and-file employees.

Thus, some argue that the proposal may reduce qualified retirement plan coverage,
particularly in the case of small businesses. Whether any reduced coverage would result in an
overall reduction of retirement security would depend, in part, on the extent to which individuals
who are not covered by a qualified retirement plan instead contribute to the new savings
vehicles.

Complexity

The proposal has elements that may both increase and decrease tax law complexity. On
one hand, the proposal provides new savings options to individuals, which may increase
complexity to the extent that taxpayers open new LSAs and RSAs without consolidating existing
tax-preferred savings into such accounts. In addition, although the proposal relating to RSAs
generally precludes future contributions to traditional IRAs, the proposal relating to LSAs does
not preclude future contributions to present-law tax-favored arrangements for certain purposes,
such as Coverdell education savings accounts, qualified tuition programs, and health savings

24


the 100-percent excise tax, and the determination of a market rate of return for purposes of
calculating lump-sum distributions.

Prior Action

No prior action.

226


2006, the weighting factor is 2/3 for the lump-sum value determined under the old methodology
and 1/3 for the lump-sum value determined under the new methodology. For distributions in
2007, the weighting factors are reversed.

Limits on benefit accruals and lump-sum distributions under certain plans

Under the proposal, in the case of a defined benefit pension plan sponsored by an
employer with a credit rating below investment grade, accrued benefits under the plan are
required to be frozen if the value of the plan’s assets is less than 50 percent of termination
liability under the plan. That is, no additional benefit accruals are permitted in those
circumstances.**! In addition, the availability of lump-sum distributions under the plan is
required to be suspended, as well as other forms of accelerated benefit payments, including the
purchase of annuities.

Effective date

The proposal is generally effective for plan years beginning in 2004 and thereafter. The
requirement that accrued benefits be frozen and lump-sum distributions suspended in the case of
certain underfunded plans is effective for plan years beginning in 2005 and thereafter.

Analysis
In general

Almost all changes to pension laws require the balancing of competing policy objectives,
including concerns regarding retirement income security, simplification, reduction of
administrative burdens, and fiscal and tax policy. In some cases, a single policy concern may
result in competing issues. For example, concerns regarding retirement income security may
lead to the enactment of stricter rules; however, if the new rules are too severe, plan sponsors
may modify plans or reduce benefits, thereby potentially reducing retirement security.

The funding rules are a comerstone of the defined benefit pension plan system and, over
time, have been a frequent source of discussion and change. Like many of the qualified
retirement plan rules, proposals relating to the funding rules involve balancing competing policy
interests.

Policy issues relating to the funding and deduction rules for defined benefit pension plans

As discussed above, present law imposes minimum funding requirements with respect to
defined benefit pension plans and a limit on the maximum amount of deductible contributions.
In addition, nondeductible contributions are discouraged through the imposition of an excise tax.
Contributions in excess of the amount needed to provide plan benefits are also discouraged
through the restrictions on reversions of plan assets.

341 Service continues to be credited under the plan for purposes of vesting and eligibility
for benefits.

234


IRAs, in the case of a married couple, contributions of up to the dollar limit may be made for
each spouse, if the combined compensation of both spouses is at least equal to the total amount
contributed for both spouses. Contributions to an RSA may be made regardless of the
individual’s age or adjusted gross income. Contributions to an RSA may be made only in cash.
Contributions to an RSA are taken into account for purposes of the Saver’s credit. Earnings on
contributions accumulate on a tax-free basis.

Qualified distributions from RSAs are excluded from gross income. Under the proposal,
qualified distributions are distributions made after age 58 or in the event of death or disability.
Distributions from an RSA that are not qualified distributions are includible in income (to the
extent that the distribution exceeds basis) and subject to a 10-percent additional tax. As under
the present-law rules for Roth IRAs, distributions are deemed to come from basis first.

As under the present-law rules for Roth IRAs, no minimum distribution rules apply to an
RSA during the RSA owner’s lifetime. In addition, married individuals may toll amounts over
from an RSA to a spouse’s RSA.

Under the proposal, existing Roth IRAs are renamed RSAs and are subject to the rules for
RSAs. In addition, existing traditional IRAs may be converted into RSAs . The amount
converted is includible in income (except to the extent it represents a return of nondeductible
contributions). No income limits apply to such conversions. For conversions of traditional IRAs
made before January 1, 2006, the income inclusion may be spread ratably over four years. For
conversions of traditional IRAs made on or after January 1, 2006, the income that results from
the conversion is included for the year of the conversion.

Under the proposal, existing traditional IRAs that are not converted to RSAs may not
accept new contributions, other than rollovers from other traditional IRAs or employer-
sponsored retirement plans. New traditional IRAs may be created to accept rollovers from
employer-sponsored retirement plans or other traditional IRAs, but they cannot accept any other
contributions. An individual may roll an amount over directly from an employer-sponsored
retirement plan to an RSA by including the rollover amount (excluding basis) in income, similar
to a conversion to a Roth IRA under present law.

Amounts converted to an RSA from a traditional IRA or an Employer Retirement
Savings Account (“ERSA”)** are subject to a five-year holding period. If an amount attributable
to such a conversion (other than amounts attributable to a Roth-type account in an ERSA) is
distributed from the RSA before the end of the five-year period starting with the year of the
conversion or, if earlier, the date on which the individual attains age 58, becomes disabled, or
dies, an additional 10-percent tax applies to the entire amount. The five-year period is
determined separately for each conversion distribution. To determine the amount attributable to
a conversion, a distribution is treated as made in the following order: (1) regular RSA
contributions; (2) conversion contributions (on a first-in, first-out basis); and (3) earnings. To
the extent a distribution is treated as made from a conversion contribution, it is treated as made

34 The proposal relating to ERSAs is discussed in Part I].A.2 of this document.

20


sources of complexity and has recommended that such provisions be repealed.’ These
provisions do not apply to eligible expenses under the proposal. While repealing these
provisions for all taxpayers reduces the complexity of the Federal tax laws, effectively repealing
these provisions only for certain taxpayers (such as teachers and other eligible educators) likely
increases complexity.

Some may view the present-law above-the-line deduction and the proposal as increasing
simplification by providing for deductibility of certain expenses without regard to the present-
law restrictions applicable to itemized deductions and the alternative minimum tax. However,
several elements of the proposal and the present-law above-the-line deduction increase
complexity, The proposal and present-law above-the-line deduction may increase recordkeeping
requirements for certain taxpayers. Taxpayers wishing to take advantage of the above-the-line
deduction are required to keep records, even if they were not otherwise required to do so because
their expenses were not deductible as a result of the 2-percent floor for itemized deductions. In
general, enactment of additional above-the-line deductions for specific expenses undermines the
concept of the standard deduction, which exists in part to simplify the tax code by eliminating
the need for many taxpayers to keep track of specific expenses.

The proposal and the present-law above-the-line deduction do not completely eliminate
the need to apply the present-law rules regarding itemized deductions. For example, a teacher
with expenses in excess of the $400 cap under the proposal or with other miscellaneous itemized
deductions may need to compute tax liability under the present-law itemized deduction rules as
well as under the proposal. In addition, the proposal does not cover all classroom expenses, but
only those that meet the particular requirements of the proposal. Expenses that do not meet those
requirements remain subject to the present-law rules. Similarly, some expenses may either be
deductible under the proposal or used for tax benefits under other provisions. For example,
certain teacher education expenses may be deductible under the proposal or used for a Hope or
Lifetime Learning credit. Taxpayers with such expenses need to determine tax liability in more
than one way in order to determine which provisions result in the lowest tax liability. In
addition, overlapping provisions increase the likelihood that some taxpayers inadvertently claim
more than one tax benefit with respect to the same expense.

Prior Action
Similar proposals were contained in the President's fiscal year 2003 and 2004 budget

proposals. A similar provision was contained in the Tax Relief Extension Act of 2003, as passed
by the House of Representatives on November 20, 2003.

159 See Joint Committee on Taxation, Study of the Overall State of the Federal Tax
System and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal
Revenue Code of 1986, Volume Il, 15, 88, 118 (JCS-3-01), April 2001.

103


Improved cargo transfers improve cargo delivery and reduce transportation costs creating
benefits for all consumers. The providers of truck and rail transportation services are private
businesses. Generally, if there are cost-reducing efficiencies that can be achieved, a profit
opportunity is created and private businesses will make investments to achieve these efficiencies.
For example, private railroads invest in facilities and equipment to facilitate the transfer of
freight from truck to rail and back to truck to provide so-called “piggyback” service. Ifthe
necessary investment to achieve a given level of cost reduction is too great for private business to
achieve a reasonable rate of return on investment, the investment usually is not in the public’s
interest as the benefit to the consuming public is insufficient to justify the investment. However,
some observe that current freight handling facilities may promote the consumption of additional
fuels and result in pollution, imposing costs not borne directly by consumers in the price of
delivered goods. A reduction in pollution may justify subsidies to the investment in freight
handling facilities beyond that that would be provided by private business in the absence of such
subsidies.

The ability to finance capital and operating costs with tax-exempt bonds may
substantially reduce the cost of debt finance. To illustrate, assume the interest rate on taxable
debt is 10 percent. If an investor in the 35 percent marginal income tax bracket purchased a
taxable debt instrument, his after tax rate of return would be the 10 percent interest less a tax of
35 percent on the interest received for a net return of 6.5 percent. If as an alternative this investor
could purchase a tax-exempt bond, all other things such as credit worthiness being equal, he
would earn a better after tax return by accepting any tax-exempt yield greater than 6.5 percent.°”
In the market, the yield spread between a tax-exempt bond and comparable taxable bond is
determined by the marginal buyer of the bonds; in today's market, yield spreads are generally
less than 20 percent.°”’ Because the yield spread arises from forgone tax revenue, economists
say that tax-exempt finance creates an implicit subsidy to the issuer. However, with many
investors in different tax brackets, the loss of Federal receipts is greater than the reduction in the

57© More generally, if the investor's marginal tax rate is t and the taxable bond yields r,
the investor is indifferent between a tax-exempt yield, re, and (/-t)r.

577 For example, while not comparable in security, market trading recently has priced
30-year U.S. Treasuries (due in 27 years) to have a yield to maturity of approximately 4.92
percent. Prices for an index of long-term tax-exempt bonds have produced a yield to maturity of
approximately 4.43 percent. See, The Bond Buyer, 347, February 17, 2004, p. 40. Again
ignoring differences in risk or other non-tax characteristics of the securities, the yield spread
implies that an investor with a marginal tax rate of 10 percent would be indifferent between the
Treasury bond and the average high-quality tax-exempt bond. Thus, under present market
conditions, yield spreads on long-term bonds are so narrow that almost all taxpayers investing in
those instruments should prefer tax-exempt bonds. Viewed another way, almost the entire
Federal subsidy to these bonds goes to bondholders (rather than State or local government
issuers, or the private persons repaying the debt in the case of private activity bonds) under these
market conditions.

353


IX. EXPAND PROTECTIONS FOR MEMBERS OF THE ARMED FORCES

Present Law

General time limits for filing tax returns

Individuals generally must file their Federal income tax returns by April 15 of the year
following the close of a taxable year. The Secretary may grant reasonable extensions of time for
filing such returns. Treasury regulations provide an additional automatic two-month extension
(until June 15 for calendar-year individuals) for United States citizens and residents in military or
naval service on duty on April 15 of the following year (the otherwise applicable due date of the
return) outside the United States. No action is necessary to apply for this extension, but
taxpayers must indicate on their returns (when filed) that they are claiming this extension.

Unlike most extensions of time to file, this extension applies to both filing returns and paying the
tax due.

Treasury regulations also provide, upon application on the proper form, an automatic
four-month extension (until August 15 for calendar-year individuals) for any individual timely
filing that form and paying the amount of tax estimated to be due.

In general, individuals must make quarterly estimated tax payments by April 15, June 15,
September 15, and January 15 of the following taxable year. Wage withholding is considered to
be a payment of estimated taxes.

Suspension of time periods

In general, the period of time for performing various acts under the Code, such as filing
tax returns, paying taxes, or filing a claim for credit or refund of tax, is suspended for any
individual serving in the Armed Forces of the United States in an area designated as a "combat
zone" during the period of combatant activities. This suspension of the time period rules also
applies to persons deployed outside the United States away from the individual’s permanent duty
station while participating in an operation designated by the Secretary of Defense as a
contingency operation or that becomes a contingency operation. An individual who becomes a
prisoner of war is considered to continue in active service and is therefore also eligible for these
suspension of time provisions. The suspension of time also applies to an individual serving in
support of such Armed Forces in the combat zone, such as Red Cross personnel, accredited
correspondents, and civilian personnel acting under the direction of the Armed Forces in support
of those Forces. The designation of a combat zone must be made by the President in an
Executive Order. The President must also designate the period of combatant activities in the
combat zone (the starting date and the termination date of combat).

The suspension of time encompasses the period of service in the combat zone during the
period of combatant activities in the zone, as well as (1) any time of continuous qualified

411


mentally incapable of caring for himself or herself,2”* or (3) the spouse of the taxpayer, if the
spouse is physically or mentally incapable of caring for himself or herself. In addition, a
taxpayer identification number for the qualifying individual must be included on the return.

A taxpayer is considered to maintain a household for a period if over one half the cost of
maintaining the household for the period is furnished by the taxpayer (or, if married, the taxpayer
and his or her spouse). Costs of maintaining the household include expenses such as rent,
mortgage interest (but not principal), real estate taxes, insurance on the home, repairs (but not
home improvements), utilities, and food eaten in the home.

A special rule applies in the case of a child who is under age 13 or is physically or
mentally incapable of caring for himself or herself if the custodial parent has waived his or her
dependency exemption to the noncustodial parent.?”> For the dependent care credit, the child is
treated as a qualifying individual with respect to the custodial parent, not the parent entitled to
claim the dependency exemption.

Head of household filing status”

A taxpayer may claim head of household filing status if the taxpayer is unmarried (and
not a surviving spouse) and pays more than one half of the cost of maintaining as his or her home
a household which is the principal place of abode for more than one half of the year of (1) an
unmarried son, daughter, stepson or stepdaughter of the taxpayer or an unmarried descendant of
the taxpayer’s son or daughter, (2) an individual described in (1) who is married, if the taxpayer
may claim a dependency exemption with respect to the individual (or could claim the exemption
if the taxpayer had not waived the exemption to the noncustodial parent), or (3) a relative with
respect to whom the taxpayer may claim a dependency exemption.””” Tf certain other
requirements are satisfied, head of household filing status also may be claimed if the taxpayer is
entitled to a dependency exemption with respect to one of the taxpayer’s parents.

224 Although such an individual must be a dependent of the taxpayer as defined in section
152, it is not required that the taxpayer be entitled to a dependency exemption with respect to the
individual under section 151. Thus, such an individual may be a qualifying individual for
purposes of the dependent care credit, even though the taxpayer is not entitled to a dependency
exemption because the individual does not meet the gross income test.

25 Sec. 21(e)(5).
226 Sec. 2(b).

227 Sec. 2(b)(1)(A)(ii), as qualified by sec. 2(b)(3)(B). An individual for whom the
taxpayer is entitled to claim a dependency exemption by reason of a multiple support agreement
does not qualify the taxpayer for head of household filing status. A separate proposal contained
in the President’s budget proposal repeals the present-law requirement that the taxpayer provide
over one half the cost of maintaining the household.

160


recordkeeping, and reporting with respect to the account established for a designated beneficiary.
The person or persons who make the contributions to the account need not be the same person
who is regarded as the account owner for purposes of administering the account. Under many
qualified tuition programs, the account owner generally has control over the account or contract,
including the ability to change designated beneficiaries and to withdraw funds at any time and
for any purpose. Thus, in practice, qualified tuition accounts or contracts generally involve a
contributor, a designated beneficiary, an account owner (who oftentimes is not the contributor or
the designated beneficiary), and an administrator of the account or contract.**°

Under present law, section 529 does not establish eligibility requirements for designated
beneficiaries. Accordingly, a beneficiary of any age may be named as a designated beneficiary.
Special considerations generally apply to accounts that are funded by amounts subject to
Uniform Gifts to Minors Act (UGMA) or Uniform Transfers to Minors Act (UTMA) laws.

Section 529 does not provide for any quantitative limits on the amount of contributions,
account balances, or prepaid tuition benefits relating to a qualified tuition account, other than to
require that the account provide adequate safeguards to prevent contributions on behalf of a
designated beneficiary in excess of those necessary to provide for the qualified higher education
expenses of the beneficiary.** Many qualified tuition programs impose limits on the maximum
amount of contributions that may be made, or account balances that may accrue, for the benefit
of a designated beneficiary.**”

Under present law, contributions to a qualified tuition account must be made in cash.*88
A qualified tuition program may not permit any contributor to, or designated beneficiary under,
the program to directly or indirectly direct the investment of any contributions (or earnings
thereon),‘*? and must provide separate accounting for each designated beneficiary.” A qualified

485 Section 529 refers to contributors and designated beneficiaries, but does not define or
otherwise refer to the term account owner, which is a commonly used term among qualified
tuition programs.

4 Sec. 529(b)(6).

487 For example, a qualified tuition program might provide that contributions to all
accounts established for the benefit of a particular designated beneficiary may not exceed a
specified limit (e.g., $250,000), or that the maximum account balance for all accounts established
for the benefit of a particular designated beneficiary may not exceed a specified limit. In the
case of prepaid tuition contracts, the limit might be expressed in terms of a maximum number of
semesters.

488 Sec, 529(b)(2).
“89 See, 529(b)(4).
40 Sec, 529(b)(3).

307


section 174.° An executive in a large technology company has identified the research credit as
one of the most significant areas of complexity for his firm. He summarizes the problem as
follows.

Tax incentives such as the R&D tax credit ... typically pose compliance
challenges, because they incorporate tax-only concepts that may be only
tenuously linked to financial accounting principles or to the classifications used
by the company’s operational units. ... [I]s what the company calls “research and
development” the same as the “qualified research” eligible for the R&D tax credit
under LR.C. Section 41? The extent of any deviation in those terms is in large
part the measure of the compliance costs associated with the tax credit.

Prior Action

The President’s fiscal year 2004 and 2003 budget proposals contained an identical
provision.

602 Natwar M. Gandhi, Associate Director Tax Policy and Administration Issues, General
Government Division, U.S. General Accounting Office, “Testimony before the Subcommittee on
Taxation and Internal Revenue Service Oversight,” Committee on Finance, United States Senate,
April 3, 1995.

63 David R. Seltzer, “Federal Income Tax Compliance Costs: A Case Study of Hewlett-
Packard Company,” National Tax Journal, vol. 50, September 1997, pp. 487-493.

373


Children of divorced or legally separated parents

The proposal repeals the present-law provision that allows a custodial parent to release
the claim to a dependency exemption (and, by extension, the child credit) to a noncustodial
parent. The proposal provides a grandfather rule for a child support instrument between parents
that applies to the dependent and that is in effect as of the date of the announcement of proposed
legislation establishing a uniform definition of a qualifying child, and permits a waiver of the
dependency exemption and child credit in such cases.

Other provisions

A child is not considered a qualifying child unless a taxpayer identification number for
the child is provided on the taxpayer’s return. For purposes of the earned income credit, a
qualifying child is required to have a social security number that is valid for employment in the
United States (that is, the child must be a U.S. citizen, permanent resident, or have a certain type
of temporary visa)?

Effect of proposal on particular provisions

Dependency exemption

Under the proposed uniform definition of qualifying child, the proposal eliminates the
support test (other than in the case of a child who provides more than one half of his or her own
support), and replaces it with the residency requirement described above. Further, the present-
law gross income test does not apply to a qualifying child. The rules relating to multiple support
agreements do not apply with respect to qualifying children because the support test does not
apply to them. Special tie-breaking rules (described above) apply if more than one taxpayer
claims a qualifying child as a dependent under the proposal. These tie-breaking rules do not
apply if a child constitutes a qualifying child with respect to multiple taxpayers, but only one
eligible taxpayer actually claims a dependency exemption for the qualifying child.

The proposal permits taxpayers to continue to apply the present-law dependency
exemption rules to claim a dependency exemption for an individual who does not satisfy the
proposed qualifying child definition. This creates the possibility that multiple taxpayers could
claim a dependency exemption for the same individual, one taxpayer using the present-law
support test, and the other using a present-law residency-based test (e.g., if the child resides in
the taxpayer’s home for the full year and otherwise meets the present-law dependency tests). To
address such cases, the proposal provides that if multiple taxpayers claim the same child, the
proposed residency-based tests supersede present law.

As is the case under present law, a child who provides over half of his or her own support
is not considered a dependent of another taxpayer under the proposal.

230A separate proposal of the President’s budget proposal clarifies the requirements
regarding a social security number that constitutes a valid TIN for earned income credit
purposes.

163


example, consider a custodial parent who has waived the dependency exemption under the rules
relating to divorced and separated parents. The taxpayer may erroneously believe that
ineligibility for the dependency exemption and the child tax credit as a result of the waiver
extends to the earned income credit and head of household filing status. Moreover, the support
tests and maintenance of household tests are similar, but not identical. The former test seeks to
determine the amount of support for a particular individual, whereas the latter looks to a
household. The kinds of expenses taken into account under each test are different; a taxpayer
may inadvertently believe that satisfying one test satisfies the other.

The different rules regarding qualifying children have been identified as a source of
complexity for taxpayers for over a decade. For example, in 1989, the American Bar
Association recommended that the dependency exemption be replaced with a residency
requirement and that the rules regarding qualifying children for the earned income credit and
head of household filing status be conformed. The American Bar Association and the American
Institute of Certified Public Accountants continue to advocate a similar proposal. The
Commissioner of Internal Revenue identified filing status definitions, including those relating to
dependents, as major sources of complexity.” Because these provisions affect so many
taxpayers, the Commissioner’s report concludes that “any complexity in the Code around filing
definitions can result in prodigious overall burden.”*! The National Taxpayer Advocate has
proposed applying a residency test to the definition of child dependent as well as the earned
income credit in legislative recommendations for fiscal years 1997, 1998, 1999, 2000, and 2001.
The staff of the Joint Committee on Taxation included proposals regarding a uniform definition
of qualifying child in its simplification study released in April 2001 2” Tn addition to these
various proposals, comments have been provided by certain of these organizations and others in
response to legislative proposals recently introduced in Congress.

Adopting a uniform definition of qualifying child achieves simplification by making it
easier for taxpayers to determine whether they qualify for the various tax benefits relating to
children. Adopting a uniform definition should reduce inadvertent taxpayer errors arising from

error was known was attributable to claiming a child who was not a qualifying child.

Department of the Treasury, Internal Revenue Service, Compliance Estimates for Earned Income
Tax Credit Claimed on 1999 Returns (February 2002), at 13. Although there may be varying
reasons for such failures, one source may be the erroneous belief that the person entitled to the
dependency exemption is also entitled to the earned income credit (i.e., a failure to recognize the
separate residency requirement for earned income credit as compared to the support test for the
dependency exemption).

240 Department of the Treasury, Internal Revenue Service, Annual Report ‘from the
Commissioner of the Internal Revenue Service on Tax Law Complexity (June 5, 2000), at 13.

2a ig.
242 Joint Committee on Taxation, Study of the Overall State of the Federal Tax System

and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal
Revenue Code of 1986, Volume II, 44-66 (JCS-3-01), April 2001.

167


Designated Roth contributions

There are two general types of individual retirement arrangements (“IRAs”) under
present and prior law: traditional IRAs, to which both deductible and nondeductible
contributions may be made, and Roth IRAs. Individuals with adjusted gross income below
certain levels generally may make nondeductible contributions to a Roth IRA. Amounts held in
a Roth IRA that are withdrawn as a qualified distribution are not includible in income, nor
subject to the additional 10-percent tax on early withdrawals. A qualified distribution is a
distribution that (1) is made after the five-taxable year period beginning with the first taxable
year for which the individual made a contribution to a Roth IRA, and (2) is made after attainment
of age 59-¥%4, is made on account of death or disability, or is a qualified special purpose
distribution (i.e., for first-time homebuyer expenses of up to $10,000). A distribution from a
Roth IRA that is not a qualified distribution is includible in income to the extent attributable to
earnings, and is subject to the 10-percent tax on early withdrawals (unless an exception applies).

Beginning in 2006, a section 401(k) plan or a section 403(b) plan is permitted to include
a “qualified Roth contribution program” that permits a participant to elect to have all or a portion
of the participant’s elective deferrals under the plan treated as designated Roth contributions.
Designated Roth contributions are elective deferrals that the participant designates (at such time
and in such manner as the Secretary may prescribe) as not excludable from the participant’s
gross income. The annual dollar limit on a participant’s designated Roth contributions is the
same as the limit on elective deferrals, reduced by the participant’s elective deferrals that the
participant does not designate as designated Roth contributions. Designated Roth contributions
are treated as any other elective deferral for certain purposes, including the nondiscrimination
requirements applicable to section 401(k) plans.

A qualified distribution from a participant’s designated Roth contributions account is not
includible in the participant’s gross income. A qualified distribution is a distribution that is made
after the end of a specified nonexclusion period and that is (1) made on or after the date on which
the participant attains age 59-¥4, (2) made to a beneficiary (or to the estate of the participant) on
or after the death of the participant, or (3) attributable to the participant’s being disabled.

Description of Proposal

In general

Under the proposal, the various present-law employer-sponsored retirement arrangements
under which individual accounts are maintained for employees and employees may make
contributions are consolidated into a single type of arrangement called an employer retirement
savings account (an “ERSA”). An ERSA is available to all employers and is subject to
simplified qualification requirements.

Employer Retirement Savings Accounts
In general
The rules applicable to ERSAs generally follow the present-law tules for section 401(k)

plans with certain modifications. Existing section 401(k) plans and thrift plans are renamed

32


purposes of a uniform definition of qualifying child.2*! Some have criticized proposals to repeal
the custodial waiver, stating that a repeal of the waiver rules would add significantly greater
complexity to divorce proceedings, and would reduce the financial flexibility (and thus increase
the financial burden) of families that are parties to such proceedings.

The proposal repeals the present-law custodial waiver, but retains a grandfather rule for
certain child support instruments in effect on the date proposed legislation is announced. If
waiver rules are considered desirable in the case of divorce or legal separation, appropriate rules
(beyond the proposed grandfather rule) could be developed.

Interaction with present-law rules and taxpayer selectivity

The proposal permits taxpayers who are eligible to claim the same individual as a
qualifying child to choose which taxpayer will claim the dependency exemption with respect to
the qualifying child, so long as only one taxpayer actually claims that qualifying child. Some
argue that this taxpayer selectivity promotes maximum utilization of family-related tax benefits
to minimize the possibility that a tax benefit will not be allocated to a taxpayer who is unable to
use the benefit. Others argue that in addition to increasing complexity, such selectivity promotes
gaming, and should not be permitted even if it results in no taxpayer obtaining the tax benefit.

Prior Action

A similar proposal was included in the President’s fiscal year 2004 budget proposal.

251 Joint Committee on Taxation, Study of the Overall State of the Federal Tax System
and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal
Revenue Code of 1986, Volume II, 56 (JCS-3-01), April 2001. Others have agreed that retention
of the present-law waiver rule arguably is unnecessary, and have argued that if the waiver rule is
retained, a case can be made that waiver should be extended to all taxpayers without regard to
divorce or legal separation. See e.g., Schenk, Deborah H., Old Wine in Old Bottles:
Simplification of Family Status Tax Issues, presented at the NYU/Tax Analysts Government Tax
Policy Workshop, Tax Code Complexity (February 9, 2001), published in Tax Notes, Vol. 91,
No. 9 (May 28, 2001), 1437, 1450.

173


F. Require Qualified Appraisals for Charitable Contributions of Vehicles
Present Law

In general, a deduction is permitted for charitable contributions, subject to certain
limitations that depend on the type of taxpayer, the property contributed, and the donee
organization.*”? In the case of non-cash contributions, the amount of the deduction generally
equals the fair market value of the contributed property on the date of the contribution.

For certain contributions of property, the taxpayer is required to determine the deductible
amount by subtracting any gain from fair market value, generally resulting in a deduction equal
to the taxpayer’s basis. This rule applies to contributions of: (1) property that, at the time of
contribution, would not have resulted in long-term capital gain if the property was sold by the
taxpayer on the contribution date; (2) tangible personal property that is used by the donee in a
manner unrelated to the donee’s exempt (or governmental) purpose; and (3) property to or for the
use of a private foundation (other than a foundation defined in section 170(b)(1)(E)).

Charitable contributions of capital gain property generally are deductible at fair market
value. Capital gain property means any capital asset or property used in the taxpayer’s trade or
business the sale of which at its fair market value, at the time of contribution, would have
resulted in gain that would have been long-term capital gain. Contributions of capital gain
property are subject to different percentage limitations than other contributions of property.

A taxpayer who donates a used automobile to a charitable donee generally deducts the
fair market value (rather than the taxpayer’s basis) of the automobile. A taxpayer who donates a
used automobile generally is permitted to use an established used car pricing guide to determine
the fair market value of the automobile, but only if the guide lists a sales price for an automobile
of the same make, model and year, sold in the same area, and in the same condition as the
donated automobile. Similar rules apply to contributions of other types of vehicles and property,
such as motorized boats.

Charities are required to provide donors with written substantiation of donations of $250
or more. Taxpayers are required to report non-cash contributions totaling $500 or more and the
method used for determining fair market value.

Taxpayers are required to obtain a qualified appraisal for donated property with a value
of $5,000 or more, and to attach the appraisal to the tax return in certain cases.’”* Under

#23 Charitable deductions are provided for income, estate, and gift tax purposes. Secs.
170, 2055, and 2522, respectively.

24 DT, 98-369, sec. 155(a)(1) through (6) (1984) (providing that not later than
December 31, 1984, the Secretary shall prescribe regulations requiring an individual, a closely
held corporation, or a personal service corporation claiming a charitable deduction for property
(other than publicly traded securities) to obtain a qualified appraisal of the property contributed
and attach an appraisal summary to the taxpayer’s return if the claimed value of such property
(plus the claimed value of all similar items of property donated to one or more donees) exceeds

274


The financial aid application is submitted to the Department of Education and is then
given to a contractor for processing. Based on the information given, the contractor calculates an
expected family contribution that determines the amount of aid a student will receive. All
Department of Education financial aid is disbursed directly through schools or various lenders.

The Department of Education requires schools to verify the financial aid information of
30 percent of the applicants. The applicants must furnish a copy of their tax returns. The
applicants are not required to obtain copies of tax returns from the IRS or to produce certified
copies. If the information reflected on the student’s copy of the tax return does not match the
information on the financial aid application, the school requires corrective action to be taken
before a student receives the appropriate aid.

The Office of Inspector General of the Department of Education has reported that,
because many applicants are reporting incorrect information on their financial aid applications,
erroneous overpayments of Federal Pell grants have resulted.

Overpayments of Pell grants and defaulted student loans

For purposes of locating a taxpayer to collect an overpayment of a Federal Pell grant or to
collect payments on a defaulted loan, the Internal Revenue Service may disclose the taxpayer’s
mailing address to the Department of Education.*!' To assist in locating the defaulting taxpayer,
the Department of Education may redisclose the mailing address to the officers, employees and
agents of certain lenders, States, nonprofit agencies, and educational institutions whose duties
relate to the collection of student loans.°”?

Safeguard procedures and recordkeeping

Federal and State agencies that receive returns and return information are required to
maintain a standardized system of permanent records on the use and disclosure of that
information.©’? Maintaining such records is a prerequisite to obtaining and continuing to obtain
returns and return information. Such agencies must also establish procedures satisfactory to the
IRS for safeguarding the information it receives. The IRS must also file annual reports with the
House Committee on Ways and Means, the Senate Committee on Finance, and the J oint
Committee on Taxation regarding procedures and safeguards followed by recipients of return
and return information.”

51 Sec, 6103(m)(4).
612 Td.
513 Sec. 6103(p)(4).

8'4 Sec, 6103(p)(5).

378


Table 16.-Percentage Distribution of Firms Claiming Research Tax Credit
and of Amount of Credit Claimed by Firm Size, 2001

Percent of Firms Percent of
Asset Size ($) Claiming Credit Credit Claimed
0 2.56 0.82
1 to 100,000 16.15 0.22
100,000 to 250,000 4.61 0.15
250,000 to 500,000 3.20 0.34
500,000 to 1 million 7.69 0.54
1 to 10 million 33.66 5.05
10 to 50 million 17.09 7.69
50 million and more 15.05 85.19

Source: JCT calculations from Internal Revenue Service, Statistics of Income data.

Flat or incremental tax credits?

For a tax credit to be effective in increasing a taxpayer’s research expenditures it is not
necessary to provide that credit for all the taxpayer’s research expenditures (i.e., a flat credit).
By limiting the credit to expenditures above a base amount, incremental tax credits attempt to
target the tax incentives where they will have the most effect on taxpayer behavior.

Suppose, for example, a taxpayer is considering two potential research projects: Project A
will generate cash flow with a present value of $105 and Project B will generate cash flow with a
present value of $95. Suppose that the research cost of investing in each of these projects is
$100. Without any tax incentives, the taxpayer will find it profitable to invest in Project A and
will not invest in Project B.

Consider now the situation where a 10-percent flat credit applies to all research
expenditures incurred. In the case of Project A, the credit effectively reduces the cost to $90.
This increases profitability, but does not change behavior with respect to that project, since it
would have been undertaken in any event. However, because the cost of Project B also is
reduced to $90, this previously neglected project (with a present value of $95) would now be
profitable. Thus, the tax credit would affect behavior only with respect to this marginal project.

Incremental credits attempt not to reward projects that would have been undertaken in
any event but to target incentives to marginal projects. To the extent this is possible, incremental
credits have the potential to be far more effective per dollar of revenue cost than flat credits in
inducing taxpayers to increase qualified expenditures. In the example above, if an incremental
credit were properly targeted, the Government could spend the same $20 in credit dollars and
induce the taxpayer to undertake a marginal project so long as its expected cash flow exceeded

368


plan’s current liability must be within a permissible range of the weighted averageTM” of the
interest rates on 30-year Treasury securities for the four-year period ending on the last day before
the plan year begins. The permissible range is generally from 90 percent to 105 percent.’“° The
interest rate used under the plan must be consistent with the assumptions which reflect the
purchase rates which would be used by insurance companies to satisfy the liabilities under the
plan.

The Job Creation and Worker Assistance Act of 202°” amended the permissible range
of the statutory interest rate used in calculating a plan’s current liability for purposes of applying
the additional contribution requirements. Under this provision, the permissible range is from
90 percent to 120 percent for plan years beginning after December 31, 2001, and before
January 1, 2004.

The Secretary of the Treasury is required to prescribe mortality tables and to periodically
review (at least every five years) and update such tables to reflect the actuarial experience of
pension plans and projected trends in such experience.” The Secretary of the Treasury has
required the use of the 1983 Group Annuity Mortality Table.”

Full funding limitation

No contributions are required under the minimum funding rules in excess of the full
funding limitation. In 2004 and thereafter, the full funding limitation is the excess, if any, of
(1) the accrued liability under the plan (including normal cost), over (2) the lesser of (a) the

325 The weighting used for this purpose is 40 percent, 30 percent, 20 percent and 10
percent, starting with the most recent year in the four-year period. Notice 88-73, 1988-2 C.B.
383.

326 If the Secretary of the Treasury determines that the lowest permissible interest rate in
this range is unreasonably high, the Secretary may prescribe a lower rate, but not less than 80
percent of the weighted average of the 30-year Treasury rate.

327 Code sec. 412(b)(5)(B)(iii)(ID; ERISA sec. 302(b)(5)(B)(iii) I). Under
Notice 90-11, 1990-1 C.B. 319, the interest rates in the permissible range are deemed to be
consistent with the assumptions reflecting the purchase rates that would be used by insurance
companies to satisfy the liabilities under the plan.

328 Pub. L. No. 107-147.

329 Code sec. 412(1)(7)(C)(ii); ERISA sec. 302(d)(7)(C) Gi).

330 Rey. Rul. 95-28, 1995-1 C.B. 74. The IRS and the Treasury Department have
announced that they are undertaking a review of the applicable mortality table and have

requested comments on related issues, such as how mortality trends should be reflected.
Notice 2003-62, 2003-38 LR.B. 576; Announcement 2000-7, 2000-1 C.B. 586.

229


G. Environment and Conservation Related Provisions
1, Permanently extend expensing of brownfields remediation cost

Present Law

Code section 162 allows a deduction for ordinary and necessary expenses paid or
incurred in carrying on any trade or business. Treasury regulations provide that the cost of
incidental repairs that neither materially add to the value of property nor appreciably prolong its
life, but keep it in an ordinarily efficient operating condition, may be deducted currently as a
business expense. Section 263(a)(1) limits the scope of section 162 by prohibiting a current
deduction for certain capital expenditures. Treasury regulations define “capital expenditures” as
amounts paid or incurred to materially add to the value, or substantially prolong the useful life,
of property owned by the taxpayer, or to adapt property to a new or different use. Amounts paid
for repairs and maintenance do not constitute capital expenditures. The determination of whether
an expense is deductible or capitalizable is based on the facts and circumstances of each case.

Under Code section 198, taxpayers can elect to treat certain environmental remediation
expenditures that would otherwise be chargeable to capital account as deductible in the year paid
or incurred. The deduction applies for both regular and alternative minimum tax purposes. The
expenditure must be incurred in connection with the abatement or control of hazardous
substances at a qualified contaminated site. In general, any expenditure for the acquisition of
depreciable property used in connection with the abatement or control of hazardous substances at
a qualified contaminated site does not constitute a qualified environmental remediation
expenditure. However, depreciation deductions allowable for such property, which would
otherwise be allocated to the site under the principles set forth in Commissioner v. Idaho Power
Co.'*4 and section 263A, are treated as qualified environmental remediation expenditures.

A “qualified contaminated site” (a so-called “‘brownfield”) generally is any property that
is held for use in a trade or business, for the production of income, or as inventory and is
certified by the appropriate State environmental agency to be an area at or on which there has
been a release (or threat of release) or disposal of a hazardous substance. Both urban and rural
property may qualify. However, sites that are identified on the national priorities list under the
Comprehensive Environmental Response, Compensation, and Liability Act of 1980
(“CERCLA”) cannot qualify as targeted areas. Hazardous substances generally are defined by
reference to sections 101(14) and 102 of 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.

In the case of property to which a qualified environmental remediation expenditure

otherwise would have been capitalized, any deduction allowed under section 198 is treated as a

164 Commissioner v. Idaho Power Co., 418 U.S. 1 (1974) (holding that equipment
depreciation allocable to the taxpayer’s construction of capital facilities must be capitalized
under section 263(a)(1)).

113


C. Repeal Rules Requiring Reduction of Deductions
for Mutual Life Insurance Companies

Present Law

In general, a corporation may not deduct amounts distributed to shareholders with respect
to the corporation’s stock. The Deficit Reduction Act of 1984 added a provision to the rules
governing insurance companies that was intended to remedy the failure of prior law to
distinguish between amounts returned by mutual life insurance companies to policyholders as
customers, and amounts distributed to them as owners of the mutual company.

Under the provision, section 809, a mutual life insurance company is required to reduce
its deduction for policyholder dividends by the company’s differential earnings amount. If the
company’s differential earnings amount exceeds the amount of its deductible policyholder
dividends, the company is required to reduce its deduction for changes in its reserves by the
excess of its differential earnings amount over the amount of its deductible policyholder
dividends. The differential earnings amount is the product of the differential earnings rate and
the average equity base of a mutual life insurance company.

The differential earnings rate is based on the difference between the average earnings rate
of the 50 largest stock life insurance companies and the earnings rate of all mutual life insurance
companies. The mutual earnings rate applied under the provision is the rate for the second
calendar year preceding the calendar year in which the taxable year begins. Under present and
prior law, the differential earnings rate cannot be a negative number.

A company’s equity base equals the sum of: (1) its surplus and capital increased by 50
percent of the amount of any provision for policyholder dividends payable in the following
taxable year; (2) the amount of its nonadmitted financial assets; (3) the excess of its statutory
reserves over its tax reserves; and (4) the amount of any mandatory security valuation reserves,
deficiency reserves, and voluntary reserves. A company’s average equity base is the average of
the company’s equity base at the end of the taxable year and its equity base at the end of the
preceding taxable year.

‘A recomputation or “true-up” in the succeeding year is required if the differential
earnings amount for the taxable year either exceeds, or is less than, the recomputed differential
earnings amount. The recomputed differential earnings amount is calculated taking into account
the average mutual earnings rate for the calendar year (rather than the second preceding calendar
year, as above). The amount of the true-up for any taxable year is added to, or deducted from,
the mutual company’s income for the succeeding taxable year.

Present law provides a temporary zero rate for both the differential earnings rate and
recomputed differential eamings rate (“true-up”) for a life insurance company’s taxable years
beginning in 2001, 2002, or 2003.

Description of Proposal

The proposal repeals the present-law provision requiring a mutual life insurance company
to reduce its deductions by the differential earnings amount (sec. 809).

374


argued, a gross income test could effectively permit the abuse at which the proposal is aimed:
exclusion of investment income by companies that cannot truly be considered insurance
companies. In response, others may argue that there is no need to base the $350,000 test on
premiums or insurance activity, because this is addressed by the proposal’s change to the
definition of insurance company, which requires that more than half of the company’s income be
derived from insurance or annuity contracts. It could also be argued that the potential for
manipulation could be addressed by appropriate modifications to the proposed gross income test,
for example, to exclude losses from the calculation.

Election to be taxed only on taxable investment income

The proposal modifies the requirements for making the election to be taxed only on net
investment income by extending the election to companies with annual premiums of $350,000 or
less. This proposal might be viewed as simplifying the rules regarding the election by
eliminating the minimum premium threshold requirement. Advocates might also argue that the
proposal enhances the fairness of the tax law by treating all small property and casualty
insurance companies (defined as those with premiums that do not exceed $1.2 million) equally
for this purpose. Further, it can be argued that eliminating the $350,000 threshold makes sense
because it is based on premiums, whereas the proposal modifying eligibility for exempt status
would be based on a different measure, gross income (not premiums as under present law). The
exemption and election provisions would no longer mesh seamlessly as under present law, so it
is argued that, for fairness and simplicity of the tax law, the lower threshold for the election
should be eliminated.

Others might argue that the smallest insurance companies do not need the benefit of this
election, because they generally are eligible for tax-exemption under section 501(c)(15).
Further, it could be argued that there is nothing complicated about the present-law requirement
that companies have premiums that fit within a specified range in order to utilize this election.
Also, some might argue that retaining the $350,000 lower threshold for the election makes sense
because it limits the investment income election to only those companies that have a minimum
level of insurance activity. Thus, companies could not make the election if they have only
minimal amounts of insurance activity (even though such amounts comprise more than half of
their overall activity).

The proposal treats stock companies and mutual companies equally for this purpose.
Some might argue that the rationale for limiting eligibility for tax exemption to mutual
companies also applies for purposes of the election to be taxed only on taxable investment
income, and that the proposal is internally inconsistent in this regard. Proponents of this view
might note that one of the stated reasons for eliminating the exemption from income tax for stock
companies, i.c., initial legislative intent which limited the tax benefit to mutual companies,
would also justify limiting the election only to mutual companies. Others might argue that the
primary abuse being addressed by these proposals is the avoidance of tax on investment income,
and that there is no potential for such abuse by a company (whether a stock company or a mutual
company) that elects to pay tax on its investment income. Thus, the election should be available
to both stock and mutual companies.

263


G. Education Proposals
1. Consolidate higher education credits and deductions
Present Law

A taxpayer may deduct up to $4,000 of qualifying higher education expenses. Single
taxpayers whose modified AGI does not exceed $65,000 ($130,000 for married taxpayers filing
joint returns) may deduct up to $4,000 of qualified expenses. Taxpayers with modified AGI
between $65,000 and $80,000 (between $130,000 and $160,000 for married taxpayers filing joint
returns) may deduct up to $2,000 of qualified expenses. This deduction is an above-the-line
deduction, meaning it is available even if the taxpayer does not itemize deductions. This
provision was enacted on a temporary basis in 2001 and expires after 2005.

A taxpayer may claim one or both of the Hope and lifetime learning credits for qualified
tuition and fees for enrollment of the taxpayer, the taxpayer’s spouse, or the taxpayer’s
dependent in a postsecondary degree or certificate program. To be eligible for the Hope credit,
the student must be enrolled on at least a half-time basis. The Hope Credit is equal to 100 percent
of the first $1,000 of qualified expenses and 50 percent of the next $1,000 of qualified expenses,
for a maximum credit of $1,500 per student. The Hope Credit is only available for the first two
years of a student’s postsecondary education.

A taxpayer may claim a nonrefundable lifetime learning credit for all postsecondary
education, including graduate education and programs not leading to a degree or certificate. The
credit is equal to 20 percent of up to $10,000 of qualified tuition and required fees paid during
the taxable year on behalf of the taxpayer, the taxpayer’s spouse, or a dependent of the taxpayer.
There is no limit on the number of years for which the lifetime learning credit may be claimed.
The $10,000 amount is not indexed for inflation.

With respect to the same student, a taxpayer must choose between the lifetime learning
credit, the deduction for higher education expenses, and the Hope credit (if the student is in the
first two years of post-secondary education).

For calendar year 2004, the Hope credit and the lifetime learning credit are phased out
over the modified AGI range of $42,000 to $52,000 ($85,000 to $105,000 for married taxpayers
filing joint returns). The length of the phaseout range is fixed at $10,000 ($20,000 for married
taxpayers filing joint returns) but the beginning of the range is indexed for inflation subject to a
$1,000 rounding convention. In addition, the amount of the allowable Hope credit is indexed for
inflation in future years (subject to a $100 rounding convention). Taxpayers may claim the Hope
credit for more than one qualifying student. In contrast, the lifetime learning credit is applied on
a per-taxpayer, rather than a per-student, basis.

A taxpayer may deduct up to $2,500 of interest on student loans. This deduction is
phased out between $50,000 and $65,000 of modified adjusted gross income (“AGT”) for single
taxpayers($100,000 and $130,000 for married taxpayers filing joint returns). The phase-out
thresholds are indexed for inflation subject to a $5,000 rounding convention. The deduction is
available regardless of whether the taxpayer claims any of the other tax benefits related to
education.

192


D. Permit Private Sector Debt Collection Companies to Collect Tax Debts

Present Law

In fiscal years 1996 and 1997, the Congress earmarked $13 million for IRS to test the use
of private debt collection companies. There were several constraints on this pilot project. First,
because both IRS and OMB considered the collection of taxes to be an inherently governmental
function, only government employees were permitted to collect the taxes. The private debt
collection companies were utilized to assist the IRS in locating and contacting taxpayers,
reminding them of their outstanding tax liability, and suggesting payment options. If the
taxpayer agreed at that point to make a payment, the taxpayer was transferred from the private
debt collection company to the IRS. Second, the private debt collection companies were paid a
flat fee for services rendered; the amount that was ultimately collected by the IRS was not taken
into account in the payment mechanism.

The pilot program was discontinued because of disappointing results. GAO reported*“*

that IRS collected $3.1 million attributable to the private debt collection company efforts;
expenses were also $3.1 million. In addition, there were lost opportunity costs of $17 million to
the IRS because collection personnel were diverted from their usual collection responsibilities to
work on the pilot.

The IRS has issued an extensive Request for Information concerning its possible use of
private debt collection companies.”

In general, Federal agencies are permitted to enter into contracts with private debt
collection companies for collection services to recover indebtedness owed to the United
States.>°° That provision does not apply to the collection of debts under the Internal Revenue
Code.*' It is unclear whether additional statutory authority is necessary to authorize the IRS to
utilize private debt collection companies.

Description of Proposal

The proposal permits the IRS to use private debt collection companies to locate and
contact taxpayers owing outstanding tax liabilities and to arrange payment of those taxes by the
taxpayers. Several steps are involved. First, the private debt collection company contacts the
taxpayer by letter.>°” If the taxpayer’s last known address is incorrect, the private debt collection

54 GAO/GGD-97-129R Issues Affecting IRS’ Collection Pilot (July 18, 1997).

549 TIRNO-03-H-0001 (February 14, 2003), at www.procurement.irs.treas.gov. The
basic request for information is 104 pages, and there are 16 additional attachments.

550 31 U.S.C. 3718.
5%! 31 U.S.C. 3718(f).

552 Several portions of the proposal require that the IRS disclose confidential taxpayer
information to the private debt collection company. Section 6103(n) permits disclosure for “the

338


The proposal provides that reporting requirements appropriate to ensure compliance
would be promulgated by the Treasury Department.

No inference is intended to be drawn from the proposal as to whether existing companies
claiming to be insurance companies eligible for tax-exempt status, or eligible to elect to be taxed
only on taxable investment income, are insurance companies for Federal tax purposes under
present law.

Effective date

The proposal is effective for taxable years beginning after the date of enactment.

Analysis

Tax-exempt insurance companies

The proposal is directed to abuses of the provision permitting small property and casualty
insurers to be tax-exempt that have arisen since the provision was revised in 1986. At that time,
the rules generally applicable to insurance companies were updated and streamlined, including a
modification extending eligibility for tax-exempt status from mutual companies to mutual and
stock property and casualty insurance companies. In conjunction with these changes, the
threshold for the provision was modified so that the amount of premiums, rather than the sum of
gross investment income and premiums, determined eligibility for tax-exempt status under the
provision. Subsequent to these changes, abuses in the area of tax-exempt insurance companies
have been publicized. Media attention has focused on the inappropriate use of tax-exempt
insurance companies to shelter investment income.

Advocates of reforming the rules for tax-exempt companies assert that use of these
organizations as vehicles for sheltering income was never contemplated by Congress. The
proliferation of these organizations as a means to avoid tax on income, sometimes on large
investment portfolios, is inconsistent with the original narrow scope of the provision, which has
been in the tax law for decades. They argue that it is necessary to limit the availability of tax-
exempt status under the provision so that it cannot be abused as a tax shelter.“°” As a corollary,
they argue that conforming the definition of an insurance company under the property and
casualty insurance company rules to the life insurance company rules would serve to improve
compliance and facilitate enforcement.

406 See David Cay Johnston, Insurance Loophole Helps Rich, N.Y. Times, April 1, 2003;
David Cay Johnston, Tiny Insurers Face Scrutiny as Tax Shields, N.Y. Times, April 4, 2003, at
C1; Janet Novack, Are You a Chump?, Forbes, Mar. 5, 2001.

407 Several recent bills include a similar provision that applies a gross receipts test and
requires that premiums received for the taxable year be greater than 50 percent of gross receipts
in order for a property and casualty insurance company to be eligible for tax-exempt status. See
sections 493 and 494 of S. 1637, the "Jumpstart our Business Strength (JOBS) Act, S. Rep No.
108-192, 214-217; and sections 3028 and 3029 of H.R. 2896, the "American Jobs Creation Act
of 2003," H.R. Rep No. 108-393, 214-218.

261


B. Limit Related-Party Interest Deductions
Present Law

AUS. corporation with a foreign parent may reduce the U.S. tax on its U.S.-source
income through the payment of deductible amounts such as interest, rents, royalties, and
management service fees to the foreign parent or other foreign affiliates that are not subject to
U.S. tax on the receipt of such payments. Although foreign corporations generally are subject to
a gross-basis U.S. tax at a flat 30-percent rate on the receipt of such payments, this may be
reduced or eliminated under an applicable income tax treaty. Consequently, U.S. corporations
may use certain treaties to facilitate earnings stripping transactions without having their
deductions offset by U.S. withholding taxes.

Generally, present law limits the ability of U.S. corporations*” to reduce the U.S. tax on

their U.S.-source income through earnings stripping transactions. Section 163(j) generally
disallows a deduction for so called “disqualified interest” paid or accrued by a corporation in a
taxable year, if two threshold tests are satisfied: the payor’s debt-to-equity ratio exceeds 1.5 to 1
(the so-called “safe harbor”); and the payor’s net interest expense exceeds 50 percent of its
“adjusted taxable income” (generally taxable income computed without regard to deductions for
net interest expense, net operating losses, and depreciation, amortization, and depletion).
Disqualified interest includes interest paid or accrued to (1) related parties when no Federal
income tax is imposed with respect to such interest or (2) unrelated parties in certain instances in
which a related party guarantees the debt (“guaranteed debt”).

Interest amounts disallowed under these rules can be carried forward indefinitely. In
addition, any excess limitation (i.e., the excess, if any, of 50 percent of the adjusted taxable
income of the payor over the payor’s net interest expense) can be carried forward three years.

Description of Proposal

The proposal eliminates from present law the safe harbor and the carryforward of excess
limitation. In addition, the proposal reduces the present-law threshold of 50 percent of adjusted
taxable income to 25 percent with respect to interest on related-party debt. With respect to
interest on guaranteed debt, the present-law threshold of 50 percent of adjusted taxable income is
retained. The carryforward of disallowed interest is limited to 10 years.

Effective date.The proposal is effective on the date of first committee action.

Analysis

Recent inversion transactions led some to question the efficacy of the present-law
earnings stripping rules.” In some cases, it appeared that the earnings stripping benefit

36 Although section 163(j) most commonly applies to U.S. corporations, it can apply to
foreign corporations.

397 See, e.g., Department of the Treasury, General Explanations of the Administration's
Fiscal Year 2004 Revenue Proposals, February 2003, 104 (“Under current law, opportunities are

255


A response to such criticism is that a “strengthened appraisal” regime does not go far
enough to address the underlying problem. Even under tighter appraisal rules, the appraisal still
would determine the amount of the deduction and both donors and appraisers, however well-
intentioned, would have the same incentives as exist under present law to overstate the worth of
the property. Given the inherent difficulties of valuing intellectual property (and reviewing such
valuations), some would argue that it is not realistic to expect that improved valuation standards
substantially would improve the process. In addition, one reason advanced for strengthened
appraisal rules as an alternative to the proposal is the need to retain a significant incentive for
intellectual property donations. However, even assuming that a strengthened appraisal regime
could work as intended, for example, by ensuring that relevant factors always are taken into
account (such as the stage of development of the property, future efforts and investments by the
donee, and the capabilities of the donee, among others), such a regime would not provide the
desired incentive because many properties that presently receive high valuations would receive
significantly lower valuations. Thus, it may be argued that reform of the valuation process and
retention of a significant up-front financial benefit for properties with questionable income
potential are mutually exclusive objectives.

In addition, a “strengthened appraisal” approach does nothing to equalize the respective
positions of the taxpayer and the IRS for purposes of administering the tax laws regarding
charitable donations of property with highly subjective values. Under the strengthened appraisal
approach, the IRS remains at a substantial disadvantage because it cannot review an appraisal of
the property until it conducts an examination, which generally results in a costly appraisal
expense to determine a value of highly subjective property as of a prior date. Proponents of the
strengthened appraisal regime might respond that taxpayers could pay a fee for a review
appraisal by the IRS prior to the gift; however, even assuming that the IRS could efficiently and
accurately review appraisals (or perform their own appraisals) prior to gifts of intellectual
property, the value of the property contributed would remain highly speculative and significant
disputes between the taxpayer and the IRS could undermine any incentive effect. In short, some
argue that any deduction for intellectual property based on an appraised fair market value is
inadministrable (both in terms of efficiency and proper measurement of income) because the
values of intellectual property are too speculative.

Some also argue that a fair market value deduction permits taxpayers a double-benefit
because taxpayers already have received tax benefits in the form of business expense and
research and development deductions, which accounts for taxpayers’ low basis in intellectual
property, and possibly a research tax credit. Others argue that this double benefit exists for
charitable contributions of appreciated property generally and that the proposal unfairly treats
intellectual property relative to other types of property by jeopardizing the double benefit.

Many proponents of a basis deduction coupled with the potential for future economic
benefits (the “future benefits approach”) argue that eliminating the reliance on valuations of
difficult-to-value property takes away the ability and incentive of taxpayers to, intentionally or
otherwise, inflate the value of contributed intellectual property. Congress has determined in
other areas where valuation is especially problematic -- charitable contributions of property
created by the personal efforts of the taxpayer and charitable contributions to certain private
foundations -- that a basis deduction generally is the correct result. By providing more than a
basis deduction, a future benefits approach provides an incentive to donate intellectual property.

270


employees bear under a cash balance plan is more like the risk they bear under a defined
contribution plan. In the case of a traditional defined benefit plan, the plan formula promises a
benefit, payable at normal retirement age. The employer bears the risk that plan assets will not
be sufficient to provide the promised benefits and generally must make up investment losses.
Rather than providing a specified benefit, a cash balance plan specifies interest credits. The
employer bears the risk that plan assets will underperform compared to the interest credits
provided under the plan.

The concern that cash balance plan participants face risk similar to the risk under defined
contribution plans is enhanced to the extent that the hypothetical account balance in a cash
balance plan is subject to investment losses and well as investment gains. While many cash
balance plans are designed to protect against loss in value, others argue that it is permissible to
tie interest credits to hypothetical investments that may incur losses. Some argue that such
declines are inconsistent with the basic concept of a defined benefit pension plan, i.e., a plan that
provides a specified benefit to participants, in contrast to a defined contribution plan under which
participants bear the risk of loss. They argue that cash balance plan designs under which
participants bear the risk of investment loss (even if only on hypothetical investments) should not
be permitted.

Some argue that to the extent proposals relating to cash balance plans are motivated by
concerns about retirement income security that other proposals to address such concerns should
also be considered. For example, some argue that addressing issues with respect to funding of
traditional defined benefit pension plans would help make such plans more attractive to
employers on an on-going basis. Some also argue that it may be appropriate to consider whether
changes to the rules relating to defined contribution plans should be considered to enable such
plans to provide greater retirement income security.

Conversions to cash balance plans; wearaway

The proposal is intended to ensure fairness for older workers in conversions of traditional
defined benefit pension plans to cash balance plans. It provides rules relating to the benefits
accrued by participants in defined benefit pension plans which are converted to cash balance
plans. The proposal provides greater protection for longer-service participants than is currently
required under the present-law rules prohibiting cut backs in accrued benefits.

By requiring that the benefits earned by a participant for the first five years following a
conversion must be at least as valuable as the benefits the participant would have earned under
the traditional plan had the conversion not occurred, participants in the plan who are close to
retirement age are better protected against disadvantages of converting to a cash balance plan.
Further, by prohibiting wearaway in a conversion to a cash balance plan with respect to the
benefits of such participants, possible adverse effects on older and longer-service participants
will be reduced.

On the other hand, some argue that the proposal does not go far enough in ensuring that
older and longer service employees will not be disadvantaged. Some argue that all plan
participants, or at least participants who have attained a certain age or number of years of
service, should automatically be given the greater of benefits under the old plan formula or under

223


July 31, 2003, each contain a similar provision with respect to hybrid vehicles and fuel cell
vehicles. H.R. 6 as passed by the House of Representative on April 11, 2003, contains a similar
provision with respect to fuel cell vehicles, but not hybrid vehicles. In addition, each bill would
extend present-law sections 179A and 30 (S. 1149 also modifies the section 30 credit).

Division C of H.R. 4, the “Energy Tax Policy Act of 2001,” as passed by the House of
Representatives on August 2, 2001, would have extended section 179A, would have extended
and modified section 30, and would have provided new credits for the purchase of hybrid
vehicles and fuel cell motor vehicles. Division H of H.R. 4, the “Energy Tax Incentives Act of
2002,” as amended by the Senate on April 25, 2002, would have extended section 179A, would
have extended and modified section 30, and would have provided new credits for the purchase of
hybrid vehicles and fuel cell motor vehicles.

5, Provide a tax credit for energy produced from landfill gas
Present Law”

Certain fuels produced from “non-conventional sources” and sold to unrelated parties are
eligible for an income tax credit equal to $3 (generally adjusted for inflation) per barrel or BTU
oil barrel equivalent (section 29). For the year 2002,'*! the inflation adjusted value of the credit
was $6.35 per barrel of oil or barrel equivalent (e.g., $1.12 per thousand cubic feet of natural
gas'®*), Qualified fuels must be produced within the United States.

Qualified fuels include:

(1) oil produced from shale and tar sands;

'80 Section 29 was enacted (originally as Code section 44D) in the Crude Oil Windfall
Profit Tax of 1980, effective for fuels produced and sold after December 31, 1979 and before
January 1, 2001, from facilities placed in service after December 31, 1979 and before January 1,
1990, The Technical and Miscellaneous Revenue act of 1988 extended the placed in service date
by one year. The Omnibus Budget Reconciliation Act of 1990 extended the placed in service
date through 1992 and provided for credit for qualifying fuels through 2002. The Energy Policy
Act of 1992 provided that facilities that produce gas from biomass or synthetic fuels from coal
would be deemed to be placed in service before 1993 if they were placed in service before 1997
pursuant to a binding contract in effect prior to 1996. The Small Business Job Protection Act of
1996 extended the binding contract and placed in service dates for facilities producing synthetic
fuel from coal and gas from biomass.

‘8! Under present law the indexed amount of credit applicable to production during a
calendar year is not known until after the close of the calendar year. The Secretary generally
publishes the indexed value of the credit for a calendar year in April of the subsequent year.
Hence, the value of the credit for 2003 may be expected to be published in April 2004.

'82 Conversion made assuming 1,027 Btu per cubic foot of natural gas, the conversion

factor reported for dry gas in production by the Energy Information Administration, U.S.
Department of Energy, Monthly Energy Review, February 2001.

134


phase-outs reduces the uncertainty as to whether a taxpayer is eligible for the credit or exclusion,
and simplifies preparation of tax returns for those who adopt children. Additionally, for
taxpayers beyond the phase-out range (no credit or exclusion allowed) or in the phase-out range
(credit or exclusion limited), the repeal of the phase-outs creates, or increases, a financial
incentive to adopt children. Opponents of repeal may argue that it is appropriate to restrict the
benefits of the credit or exclusion such that the highest income taxpayers, who can afford to
adopt without additional assistance, do not receive a tax reduction as a result of adopting
children.”

Prior Action

A similar proposal was included in the President’s fiscal year 2004 budget proposal.

252 For a complete discussion of policy issues with regard to the elimination of phase-
outs, see Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and
Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue
Code of 1986, Volume II, 79-91 (JCS-3-01), April 2001. This study includes recommendations
to repeal many phase-outs, including the phaseout relating to the adoption credit and exclusion.

175


Others argue that it is not necessary to have the leasing of property and the ownership of
property treated alike for tax purposes because a “true lease" is different from outright
ownership. However, if the leasing arrangement has factors that indicate it is economically
equivalent to ownership by the lessee then the investments should be similarly taxed. Otherwise
the tax system has influenced the investment decision between leasing property and owning
property.

Privatization.—A fifth issue has been raised by some who contend that private parties can
provide public services more economically than can governments. It is argued that leasing is a
mechanism for promoting the “privatization” of public services and should be encouraged. The
greater expertise of private providers, as well as their ability to bypass negotiations with public
labor unions, Federal and State mandates, facility design or other criteria specified by public
agencies, and delays in obtaining financing through public budgeting processes (e.g., debt
ceilings and balanced budget requirements) are among the sources of the advantages cited for
privatization. However, critics argue that the tax rules should not be used to supersede laws and
procedures that the public itself, through its representatives in Congress and other governmental
agencies, has imposed and can amend directly upon a full consideration and public debate of
their merits. In addition, others highlight that many of the leasing transactions have not altered
the party responsible for providing the services, or anything else, but, rather, have only altered
who is considered the tax owner of the property. Critics also highlight that if there are economic
advantages to privatizing certain governmental services, such advantages are separate, and occur
apart from, any tax incentives.

Policy issues pertaining to leases with certain tax-exempt entities

As mentioned above, the relative importance of these policy issues varies according to
whether the lessee is a Federal agency, a State or local governmental agency, a nonprofit
organization, or a foreign government or person. The following discussion addresses the relative
importance of these issues to each of these types of entities.

Federal government.—The main issues involved in leasing by Federal government
agencies appear to be the distortion of the appropriations process, the inefficiency of tax-
motivated leases, and the public’s perception of the integrity of the Federal tax system. Leasing
by a Federal agency distorts the appropriations process by shifting capital acquisition costs from
the agency’s budget to the U.S. Treasury in the form of reduced tax revenues. Thus, it reduces
the control over spending normally exercised by the appropriations process by converting direct
outlays, which require appropriations, into tax benefits, which do not. Leasing also shifts the
disbursement of funds from the agency’s procurement account to a possibly less scrutinized part
of the agency’s budget, such as an operations and maintenance account. When a Federal agency
leases property, the cost of the property tends to be obscured in the agency’s budget because the
cost is reflected in the budget as ongoing rental payments rather than a more conspicuous
authorization or annual outlay in the procurement section of the budget. In addition, leasing is
inefficient and likely raises the total government cost of acquiring property. Finally, the sale of
tax benefits by a Federal government agency may contribute to a public perception of inequity in
the Federal income tax system.

287


Prior Action

An identical proposal was included in the President’s fiscal year 2004 budget proposal.

337


Table 14.-Comparison of Individual Tax Liability With and Without
Extension of Exemption Amounts, 2005"!

Without Proposal
Extension (With
Extension)

Adjusted gross income $100,000 $100,000
Less standard deduction” 9,900 9,900
Less personal exemptions (4 @ $3,150) 12,600 12,600
Taxable income 77,500 77,500
Regular tax 12,738 12,738
AMT exemption amount 45,000 58,000
AMTI less exemption amount 55,000 42,000
Tentative minimum tax 14,300 10,920
Alternative minimum tax 1,562 0
Child tax credit 2,000 2,000
Net tax 12,300 10,738
Net tax reduction 1,562

Prior Action

A substantially similar proposal was included in the President’s fiscal year 2004 budget

proposal.

581 The example assumes all extensions recommended by the President’s proposal,

except that the AMT exemption amount is assumed not extended in the first column of the table.

582 This example assumes the taxpayers claim the standard deduction and have no
itemized deductions (other than taxes and miscellaneous itemized deductions). Taxpayers

subject to the AMT may elect to itemize deductions even though the total amount of the itemized
deductions for purposes of the regular tax is less than the standard deduction. Taxpayers may

not use the standard deduction for the regular tax and use itemized deductions for the AMT.

358



fundamental need than, or at least an equal need to, long-term care insurance and that it is not
appropriate to provide more favorable rules for long-term care insurance. Proponents of the
proposal argue that the President’s fiscal year 2005 budget proposal contains other provisions, in
particular, a tax credit for the purchase of health insurance and an above-the-line deduction for
high deductible health insurance premiums, that address the need for health insurance. In
addition, some argue that an additional incentive to purchase long-term care insurance is
appropriate to encourage individuals to purchase the insurance when they are younger.
Premiums for long-term care insurance typically have a level payment feature; that is, part of the
premium is allocated to the cost of current coverage and part to future coverage. Some argue
that additional tax benefits will encourage individuals to purchase such coverage at a young
enough age so that premiums are more affordable.

Many agree that it is important to impose standards on long-term care insurance policies
to ensure that products deliver quality to consumers. While the proposal provides that the
Secretary is authorized to require qualified long-term care insurance policies to meet consumer
protection standards for quality coverage, it does not mandate standards. Some argue that
standards should be mandatory and that should be should specifically enumerated in the law.
Lack of specific standards provides uncertainty in determining whether a specific product
qualifies for the deduction. Others argue that it is important to provide the Secretary flexibility
in imposing such requirements.

From a tax policy perspective, it could be questioned whether providing an additional
incentive for the purchase of long-term care insurance serves the tax policy goal of accurate
income measurement. Implementing the social policy of encouraging the financing of long-term
care needs through subsidies provided in the tax system arguably is inefficient. Some criticize
the proposal as providing a targeted subsidy for one type of insurance product for which there
has been a weak market, rather than directly addressing the social policy issue of growing long-
term care needs. On the other hand, some point out that Congress has already provided subsidies
to long-term care insurance through the tax law to encourage people to provide for long-term
care needs, and that this proposal is consistent with the policy already expressed by Congress.

Complexity issues

The proposal may contribute to complexity in the tax system by providing different sets
of rules for long-term care insurance and health insurance. If the tax rules for long-term care
insurance are more favorable than for health insurance, there may be pressure to provide health
insurance under a long-term care policy. Thus, many of the definitional issues that arose prior to
the enactment of the present-law rules may again arise. The proposal also adds complexity in
that it would increase the number of savings incentives in the tax law, each with different
requirements.

A new tax deduction will increase complexity in IRS forms and instructions, by requiring

anew line on the Form 1040 and additional information in instructions regarding the deduction.
The new deduction may also require IRS programming modifications.

56


home offered by a developer who has not received an allocation of the proposed tax credits), in
which case the entire economic benefit of the tax credits will accrue to the developer/seller
claiming the credits under the proposal. Generally, the more responsive purchasers are to
changes in the market price, the greater will be the proportion of the economic incidence of a tax
benefit that accrues to the seller. The more responsive sellers are to changes in the market price,
the greater will be the proportion of the economic incidence of a tax benefit that accrues to the
purchaser.'® For example, if there are relatively few properties of a comparable type and it is
difficult to obtain land or building permits to build more such properties, the more likely it will
be that qualifying homebuyers bid against one another for a property. By bidding up the sales
price of the property, more of the economic benefit of the tax credit accrues to the seller. On the
other hand, if there are relatively few qualified buyers, but there are several potential developers
who have credit allocations and can easily supply housing for sale, the developers may compete
against each other to sell to a qualifying buyer by lowering the price they charge to such buyers.
By lowering the price of the property under competitive pressure, more of the economic benefit
of the tax credit accrues to the buyer.

Because of the diversity in market conditions of different local housing markets, it is not
possible to predict whether buyers or sellers are likely to be the primary economic beneficiary of
the proposed tax credit. The proposal requires that the credit may only be claimed for sales that
occur within one year of the property being certified for occupancy. The time limit may exert
pressure on developers to reduce the price of the property in order to sell it before the one-year
period expires. On the other hand, the limit on the number of properties on which the credit may
be claimed may impose a supply constraint. Potential qualifying buyers can bid against one
another, keeping the sales price higher than it otherwise might be. Even if the economic
beneficiary were to be the developer, the developer may only claim the credit ifa family with an
income of less than 80 percent of the area median income is the purchaser. Therefore, even if
such a family did not receive a substantial price discount, if the developer sold to such a family,
rather than a non-qualifying family, the goal of increasing home ownership by families with
incomes less than 80 percent of the area median income may have been advanced.

The proposal defines qualifying buyers by reference to their annual income at the time of
purchase. As noted above, a lower proportion of families with incomes less than area median
income are homeowners than are families with incomes above the area median income. It is also
the case that families headed by individuals 30 years old or younger are more likely to have
incomes less than the area median income than are families headed by individuals over 30 years
of age. This arises because most individuals’ earning power increases with experience and job
tenure. As the family’s earners age, the family is more able to accumulate funds for a down
payment and have sufficient monthly income to qualify for a mortgage on a home. Data on
homeownership by age are consistent with this scenario. In 2000, the percentage of household
owner-occupiers among households headed by an individual less than 35 years old was 40.8

161 Economists measure the responsiveness to demand and supply to price changes by
reference to the “price elasticity of demand” and the “price elasticity of supply.” The greater the
price elasticity of demand relative to the price elasticity of supply, the greater the economic
incidence falls to the benefit of purchasers. The greater the price elasticity of supply relative to
the price elasticity of demand, the greater the economic incidence falls to the benefit of the seller.

110


Table 3.-Individual Charitable Donations, 1984-2001

(Billions of Dollars)

Total Individual Donations

Year Estimated to Have Been Individual Itemized Charitable
Received by Charitable Donations Claimed on Tax
Organizations’ Returns?

1984 56.46 42.12
1985 57.39 47.96
1986 67.09 53.82
1987 64.53 49.62
1988 69.98 50.95
1989 79.45 55.46
1990 81.04 57.24
1991 84.27 60.58
1992 87.70 63.84
1993 92.00 68.35
1994 92.52 70.54
1995 95.36 74.99
1996 107.56 86.16
1997 124.20 95.82
1998 138.35 109.24
1999 155.24 125.80
2000 175.10 140.68
2001 182.47 139.24
2002 183.73 136.84"

' Giving USA 2003. Data do not include donations from trusts. Tabulations prepared by the staff of the Joint Committee

on Taxation.

2 Individual itemized deductions taken from Internal Revenue Statistics of Income data. Tabulations prepared by the staff

of the Joint Committee on Taxation.

3 Preliminary, advance estimate from Internal Revenue Service Statistics of Income data..

Complexity issues

The proposal adds complexity to the tax law. The proposal would affect over 50 million
individual tax returns. Taxpayers who take the standard deduction and make charitable
contributions would have to keep additional records (e.g., canceled checks, a receipt from the
donee organization, or other reliable written records) in order to substantiate that a contribution
was made to a qualified charitable organization. In addition, the proposal, like any other “non-
itemizer” deduction, would undermine the purpose of the standard deduction, which exists in
part to relieve taxpayers with small deductions from the burdens of itemization and
substantiation. One motivation behind the substantial increase in the standard deduction in the
Tax Reform Act of 1986 was that “[t]axpayers who will use the standard deduction rather than

74



beneficiary. The proposal modifies the income tax treatment of a change in a designated
beneficiary to provide that a change of designated beneficiary to a new eligible designated
beneficiary who is not a member of the family of the old beneficiary is not treated as a
distribution for income tax purposes.°*

The proposal provides that upon the death of a designated beneficiary, the account is
treated as distributed to the estate of the designated beneficiary, thereby triggering potential
income tax, additional tax or excise tax, and estate tax consequences, unless a new eligible
designated beneficiary is named in a timely manner.

Custodial arrangement for benefit of a designated beneficiary

The proposal requires that a qualified tuition account be a custodial arrangement
maintained for the benefit of a designated beneficiary. Under the proposal, no person other than
the designated beneficiary may possess a beneficial interest in the account.

Under the proposal, there is a single individual (the custodian) that the administrator may
look to for account decisions and reporting. The custodian is the only person who may change
the designated beneficiary, make investment decisions, direct that a distribution be made (for
qualified higher education expenses or otherwise), or terminate the account or contract. The
custodian may not change the designated beneficiary to the custodian, the custodian’s spouse, or
to an employee or creditor of the custodian. Distributions may be made only to the person who
is the designated beneficiary at the time of the distribution, except that a custodian may receive a
distribution in the limited case where the designated beneficiary dies or becomes incapacitated
and the designated beneficiary has no spouse, siblings, or descendants.

Imposition of excise tax on nonqualifying distributions

The proposal retains the present-law income tax treatment of distributions from a
qualified tuition account that are used for qualified higher education expenses. Such
distributions are not subject to income tax, regardless of the distributee’s identity. The proposal
modifies present law with respect to distributions that are used other than for qualified higher
education expenses. Distributions used for purposes other than qualified higher education
expenses are subject to income tax on the earnings portion of the distribution. Further, the
income portion of the first $50,000 in cumulative nonqualified distributions to a designated
beneficiary is subject to a 10-percent additional tax (unless the distribution is made on account of
death or disability of the beneficiary or receipt of a scholarship by the beneficiary). Nonqualified
distributions in excess of $50,000 but less than or equal to $150,000 (computed on a cumulative
basis for each designated beneficiary, including for this purpose the entire amount of the
distribution, not just earnings) are subject to a new excise tax imposed at the rate of 35 percent.
Nonqualified distributions in excess of $150,000 (computed on a cumulative basis for each
designated beneficiary, including for this purpose the entire amount of the distribution, not just

58 This change is proposed in order to be consistent with the objective of imposing no
taxes on a change of designated beneficiary so long as the new beneficiary is an eligible
designated beneficiary and the funds are not used for nonqualified purposes.

311


retirement plan covers a broad group of employees. Certain of these rules are discussed in more
detail, below.

Qualified retirement plans are broadly classified into two categories, defined benefit
pension plans and defined contribution plans, based on the nature of the benefits provided.
Under a defined benefit plan, benefits are determined under a plan formula, generally based on
compensation and years of service. Benefits under defined contribution plans are based solely
on the contributions (and earnings thereon) allocated to separate accounts maintained for each
plan participant.

In addition to qualified section 401(k) plans, present law provides for other types of
employer-sponsored plans to which pretax employee elective contributions can be made. Many
of these arrangements are not qualified retirement plans, but receive the same tax-favored
treatment as qualified retirement plans. The rules applicable to each type of arrangement vary.
These arrangements include SIMPLE section 401(k) plans, tax-sheltered annuity plans
(“section 403(b) plans”),“° governmental eligible deferred compensation plans (“section 457
plans”),*! SIMPLE IRAs,” and salary-reduction simplified employee pensions (“SARSEPs”).°

Limits on contributions to qualified defined contribution plans

The annual additions under a defined contribution plan with respect to each plan
participant cannot exceed the lesser of (1) 100 percent of the participant’s compensation or (2) a
dollar amount, indexed for inflation ($41,000 for 2004). Annual additions are the sum of
employer contributions,”* employee contributions, and forfeitures with respect to an individual
under all defined contribution plans of the same employer.

Nondiscrimination requirements applicable to qualified retirement plans

The nondiscrimination requirements are designed to ensure that qualified retirement plans
benefit an employer's rank-and-file employees as well as highly compensated employees.*°

* Sec. 403(b).

4! Sec, 457.

® Sec. 408(p).

® Sec. 408(k).

44 Elective deferrals are treated as employer contributions for this purpose.

45 For purposes of the nondiscrimination requirements, an employee is treated as highly
compensated if the employee (1) was a five-percent owner of the employer at any time during
the year or the preceding year, or (2) either (a) had compensation for the preceding year in excess
of $90,000 (for 2004) or (b) at the election of the employer had compensation for the preceding
year in excess of $90,000 (for 2004) and was in the top 20 percent of employees by
compensation for such year (sec. 414(q)). A nonhighly compensated employee is an employee
other than a highly compensated employee.

26


company searches for the correct address. The private debt collection company is not permitted
to contact either individuals or employers to locate a taxpayer. Second, the private debt
collection company telephones the taxpayer to request full payment.>> If the taxpayer cannot
pay in full immediately, the private debt collection company offers the taxpayer an installment
agreement providing for full payment of the taxes over three years.°** If the taxpayer is unable to
pay the outstanding tax liability in full over a three-year period, the private debt collection
company obtains financial information from the taxpayer and will provide this information to the
IRS for further processing and action by the IRS.

The proposal specifies several procedural conditions under which the proposal would
operate. First, provisions of the Fair Debt Collection Act would apply to the private debt
collection company.°°* Second, taxpayer protections that are statutorily applicable to the IRS
would also be made statutorily applicable to the private sector debt collection companies.”*°
Third, the private sector debt collection companies would be required to inform taxpayers of the
availability of assistance from the Taxpayer Advocate. Fourth, the private sector debt collection
companies would not be permitted to subcontract any activities involving taxpayer contact or
quality monitoring.

The proposal creates a revolving fund from the amounts collected by the private debt
collection companies. The private debt collection companies would be paid out of this fund.

Effective date—The proposal is effective after the date of enactment.

providing of other services ... for purposes of tax administration.” Accordingly, no amendment
to 6103 appears to be necessary to implement the proposal.

553 The proposal does not explicitly state that the private debt collection company would
be permitted to accept payment; under the earlier pilot program, the private debt collection
company was not permitted to accept payment directly. Payments were required to be processed
by IRS employees.

554 Although the proposal does not explicitly say so, presumably taxpayers could choose
an installment agreement of less than three years.

555 This is present law.

556 In some instances, statutory amendments may be required to accomplish this goal. It
may be conceptually difficult to apply some of these taxpayer protection provisions to private
sector debt collection companies or to their employees. For example, section 1203 of the IRS
Restructuring Act contains detailed rules requiring the termination of IRS employees for
specified misconduct; the proposal does not specify how those termination rules would apply in
this context (including whether they would apply to the private sector debt collection company
itself (by, for example, mandating termination of the contract) or to the individual employee of
the private sector debt collection company that violated these tules, or to both).

339


Analysis

The proposal is intended to produce a better result than present law for trusts that have
only small or inadvertent amounts of unrelated business taxable income. The present-law rule
that any amount of unrelated business taxable income results in loss of tax-exemption for the
year discourages trusts from making investments that might generate insignificant (or
inadvertent) unrelated business taxable income. A loss of exemption could be particularly
punitive in a year in which a trust sells, for example, the assets that originally funded the trust
and does not distribute the proceeds. The proposal avoids this result by requiring a trust to pay
the amount of the unrelated business taxable income as an excise tax but does not require the
trust to pay tax on all of its other income for the year. In addition, the proposal is helpful to
trusts that receive unrelated business taxable income as a result of a change in the status of the
entity in which trust assets are invested. However, the proposal also may enable trusts to choose
to make certain investments that have small amounts of unrelated business income that some
argue are and should be discouraged by present law. For example, investments in rental property
may generate a small amount of unrelated business taxable income from fees for services
provided to tenants. Such investments may be unattractive for charitable remainder trusts under
present law because the unrelated income causes the trust to lose exemption. Under the
proposal, however, a rental property owner might have an incentive to contribute the rental
property to a charitable remainder trust (of which the owner was beneficiary) to shelter the rental
income from tax (to the extent the rental income exceeds the unitrust amount or annuity
payment). Some argue that charitable remainder trusts should not be encouraged to make such
investments.

The proposal also is intended to be a more effective deterrent than present law to prevent
charitable remainder trusts from investing in assets that generate large amounts of unrelated
business taxable income. Although present law requires that a charitable remainder trust become
a taxable trust for a year in which the trust has unrelated business taxable income, a charitable
remainder trust nevertheless may invest in assets that produce significant unrelated business
income but pay tax only on the trust’s undistributed income. This is because, as a taxable trust,
the trust may take a deduction for distributions of income that are taxable to the beneficiaries.
(To the extent the trust pays tax, trust assets are depleted to the detriment of the charitable
beneficiary.) Thus, proponents argue that the proposal better deters trusts from making
investments that generate significant unrelated business taxable income because the 100 percent
excise tax would be prohibitive. On the other hand, some question whether such a deterrent is
the right policy in cases where a trustee determines that investment in assets that produce
unrelated business taxable income will increase the (after tax) rate of return to the trust (and thus
inure to the benefit of the charitable remainderman).

The proposal provides that unrelated business income is treated as ordinary income to the
trust and taxes are paid from corpus. Thus, the proposal treats the trust beneficiary the same as
under present law, that is, distributions of the unrelated business income are taxed as ordinary
income to the beneficiary. As a result, the proposed rule in effect taxes the unrelated business
income twice, once as an excise tax (at a 100-percent rate), and again when distributed. (Double
taxation presently exists to the extent that the trust’s income from all sources exceeds the amount
distributed to the beneficiary during a year in which the trust is not exempt from income tax.)
Proponents of the proposal would argue that double taxation is not a concern because the excise

92


In general, the position holder is liable for payment of tax with respect to taxable
removals from the terminal rack and bulk transfers not received at an approved terminal or
refinery.°’! The refiner is liable for payment of tax with respect to certain taxable removals from
the refinery."

Description of Proposal

The proposal requires that for a bulk transfer of a taxable fuel to be exempt from tax, any
pipeline or vessel operator that is a party to the bulk transfer be registered with the Secretary.
Transfer to an unregistered party will subject the transfer to tax. In addition, vessel and barge
operators transporting taxable fuel would also be required to display proof of registration in a
manner prescribed by the IRS. New penalties would be imposed for failure to comply with
registration and display proof of registration requirements. The penalty for failure to register
would be $1,000 per day and the penalty for failure to display proof of registration would be
$500 per day.

Effective date—The proposal would apply to bulk transfers (in the case of limits on the
exemption) and failures (in the case of new penalties) occurring after October 31, 2004.

Analysis

The proposal limits the exemption for bulk transfers of untaxed fuel to transfers by
registered bulk carriers. Proponents of the proposal argue that the opportunities for unregistered
bulk carriers to divert the fuel to retailers or end users before the tax is paid will be curtailed
under the proposal. They assert that refiners who under present law transfer fuel to unregistered
parties as part of an exempt bulk transfer will no longer be willing to do so because of the
potential to be liable for tax on the thousands of gallons of fuel that might be involved in a bulk
transfer. In addition, requiring the registration and reporting by bulk carriers will enable the IRS
to better track bulk transfers of fuel and detect evasion.

The proposal is unclear as to who bears the burden of tax upon transfer to an unregistered
party. Some may argue to the extent the proposal would impose tax on the refiner, such
imposition of tax is not an appropriate way to curb abuse by unregistered bulk carriers. If the
purchaser rather than the refiner contracts with the bulk carrier, some might argue the refiner has
no control over whether the chosen carrier is registered, and therefore, the refiner should not bear
the risk of being subject to tax. Proponents of the proposal, however, argue that such risk is
appropriate, noting that the requirement for the bulk carrier to display proof of registration
should provide sufficient notice to the refiner as to whether such a person is registered and
therefore entitled to carry tax-free fuel.

Opponents may argue further that a substantial monetary penalty on the unregistered
party for carrying untaxed fuel is more appropriate than imposing tax on the fuel. Opponents

57. Treas. Reg, sec. 48.4081-2; Treas. Reg. sec. 48.4081-3(d) & (e).

5? Treas, Reg. sec. 48.4081-3(b).

348


marriage decision were distorted, it would be difficult to measure the cost to society of delayed
or accelerated marriages or alternative family structures.'?

Some analysts have suggested that the marriage penalty may alter taxpayers’ decisions to
work. As explained above, a marriage penalty exists when the sum of the tax liabilities of two
unmarried individuals filing their own tax returns (either single or head of household returns) is
less than their tax liability under a joint return (if the two individuals were to marry). This is the
result of a tax system with increasing marginal tax rates. The marriage penalty not only means
the total tax liability of the two formerly single taxpayers is higher after marriage than before
marriage, but it also generally may result in one or both of the formerly single taxpayers being in
a higher marginal tax rate bracket. That is, the additional tax on an additional dollar of income
of each taxpayer is greater after marriage than it was when they were both single. Economists
argue that changes in marginal tax rates may affect taxpayers' decisions to work. Higher
marginal tax rates may discourage household saving and labor supply by the newly married
household. For example, suppose a woman currently in the 25-percent tax bracket marries a man
who currently is unemployed. If they had remained single and the man became employed, the
first $7,950 of his earnings would be tax-free.'* However, because he marries a woman in the
25-percent income tax bracket, if he becomes employed he would have a tax liability of 25 cents
on his first dollar of earnings, leaving a net of 75 cents for his labor.'> Filing a joint return may
distort the man's decision regarding whether to enter the work force. If he chooses not to work,
society loses the benefit of his labor. Some have suggested that the labor supply decision of the
lower earner or “secondary earner” in married households may be quite sensitive to the
household's marginal tax rate,’

The possible disincentive effects of a higher marginal tax rate on the secondary worker
arise in the case of couples who experience a marriage bonus as well. In the specific example
above, the couple consisted of one person in the labor force and one person not in the labor force.

13 Marriage bonuses may similarly distort taxpayer behavior.

14 Asa single taxpayer, the man could claim the standard deduction of $4,850 and one
personal exemption of $3,100 for 2004, effectively exempting the first $7,950 of his earnings.
This example ignores payroll taxes.

15 This example assumes that as a result of the marriage the combined income is still
high enough to place the couple in the 25-percent bracket with respect to the rate schedule for
married taxpayers filing jointly. It is possible that if the woman were just into the 25-percent
bracket as a single filer the combined income of the couple would place them in the 15-percent
bracket for married couples. In this case the marginal tax rate with respect to the income tax for
the man would have increased from 0 to 15 percent, while that of the woman would have fallen
from 25 percent to 15 percent.

16 See Charles L. Ballard, John B. Shoven, and John Whalley, “General Equilibrium
Computations of the Marginal Welfare Costs of Taxes in the United States,” American Economic
Review, 75, March 1985, for a review of econometric studies on labor supply of so-called
primary and secondary earners. CBO, For Better or Worse, at 10-12, also reviews this literature.


itemize their deductions will be freed from much of the record keeping, paperwork, and
computations that were required under prior law.?"*

The structure of the proposal also adds complexity. The floor and ceiling may be
confusing to taxpayers. The proposal would require two additional lines on the individual
income tax return forms and modification to the form instructions. The deduction is available
only for contributions that exceed a certain level, so taxpayers must maintain records even
though the deduction might not be available at year’s end. The proposal might result in an
increase in disputes with the IRS for taxpayers who are unable to substantiate a claimed
deduction. Additional regulatory guidance would not be necessary to implement the proposal

On the other hand, the proposal could simplify the law for a limited number of taxpayers
who currently itemize but would choose to claim the standard deduction under the proposal.
Taxpayers who currently itemize, but have total itemized deductions that exceed the standard
deduction by less than $250'!> would receive more tax benefit if they claimed the standard
deduction, provided they have charitable contributions at least equal to the amount by which
their total deductions exceed the standard deduction. By switching to the standard deduction,
such taxpayers would no longer have to itemize deductions (other than the nonitemizer charitable
deduction). However, any potential itemizers who choose to take the standard deduction as a
result of these calculations would still need to keep records of potential itemized deductions in
order to make the calculation, and thus simplification benefits are diminished.

Prior Action

The President’s fiscal year 2004 and 2003 budget proposals contained a similar
provision. The President’s fiscal year 2001 and 2002 budget proposals also contained proposals
that would have provided a charitable nonitemizer deduction for a percentage of a taxpayer’s
charitable contributions up to certain limits.

The “CARE Act of 2003,” S. 476, as passed by the Senate on April 9, 2003, contains a
similar proposal. H.R. 7, “The Charitable Giving Act of 2003,” as passed by the House of
Representatives on September 17, 2003 includes a similar proposal. Both proposals would
expire after two years, whereas the President’s proposal would make the deduction permanent.

H.R. 7, the “Community Solutions Act of 2001,” as passed by the House of
Representatives on July 19, 2001, included a charitable nonitemizer deduction that provides a
deduction for the lesser of (1) the amount allowable to itemizers as a charitable deduction for
cash contributions and (2) an applicable amount. The applicable amount is $25 ($50 in the case
ofa joint return) in 2002 and 2003, $50 ($100 in the case of a joint return) in 2004 through 2006,

114 Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986
(JCS-10-87), May 4, 1987, 11.

15 ‘This dollar amount is $500 in the case of a joint return. Under the proposal both the
$250 and $500 amounts would be indexed in years after 2005.

75


owner attains age 59-Y%. H.R. 7, the “Charitable Giving Act of 2003,” as passed by the House of
Representatives on September 17, 2003, includes a similar provision, except the H.R. 7 provision
applies to distributions made directly to a charitable organization or to a split-interest entity only
on or after the date the IRA owner reaches age 70-¥2 and the exclusion does not apply to
distributions from SIMPLE IRAs or simplified employee pensions (“SEPs”).

3. Expand and increase the enhanced charitable deduction for contributions of food
inventory

Present Law

Under present law, a taxpayer’s deduction for charitable contributions of inventory
generally is limited to the taxpayer’s basis (typically, cost) in the inventory. However, for
certain contributions of inventory, C corporations may claim an enhanced deduction equal to the
lesser of (1) the taxpayer’s basis in the contributed property plus one-half of the property’s
appreciated value (i.c., basis plus one-half of fair market value in excess of basis) or (2) two
times basis.'”

To be eligible for the enhanced deduction, the contributed property generally must be
inventory of the taxpayer, contributed to a charitable organization described in section 501(c)
(other than a private nonoperating foundation), and the donee must (1) use the property
consistent with the donee’s exempt purpose solely for the care of the ill, the needy, or infants,
(2) not transfer the property in exchange for money, other property, or services, and (3) provide
the taxpayer a written statement that the donee’s use of the property will be consistent with such
requirements. In the case of contributed property subject to the Federal Food, Drug, and
Cosmetic Act, the property must satisfy the applicable requirements of such Act on the date of
transfer and for 180 days prior to the transfer.

To claim the enhanced deduction, the taxpayer must establish that the fair market value
of the donated item exceeds basis. The valuation of food inventory has been the subject of
ongoing disputes between taxpayers and the IRS. In one case, the Tax Court held that the value
of surplus bread inventory donated to charity was the full retail price of the bread rather than half
the retail price, as the IRS asserted.'**

Description of Proposal

Under the proposal, the enhanced deduction for donations of food inventory is increased
to the lesser of (1) fair market value, or (2) two times the taxpayer’s basis in the contributed
inventory. In addition, any taxpayer engaged in a trade or business, whether or not a C
corporation, is eligible to claim an enhanced deduction for donations of food inventory. The
deduction for donations by S corporations and noncorporate taxpayers is limited to 10 percent of
the net income from the associated trade or business. The proposal provides a special rule that
would permit certain taxpayers with a zero or low basis in the food donation (e.g., taxpayers that

13 Sec. 170(e)(3).

124 Lucky Stores Inc. v. Commissioner, 105 T.C. 420 (1995).

81


Calculating lump-sum distributions

The proposal is intended to eliminate situations in which the amount of a minimum lump-
sum distribution required from a cash balance plan is greater than a participant’s hypothetical
account balance because the plan’s interest crediting rate is higher than the statutory interest rate.
The proposal departs from the analysis set out in IRS Notice 96-8 and followed by several
Federal courts that have considered this issue.

Proponents argue that the cases are based on IRS rulings that pre-date the prevalence of
cash balance plans and that apply rules that are inappropriate in a cash balance context. Further,
they argue that, as a result of the present-law rules, employers have reduced the amount of
interest credits under cash balance plans, thus reducing benefits for participants. The proposal
avoids this result and thus, it is argued, will benefit plan participants by encouraging employers
to use a higher rate of return that the statutorily-prescribed rate.

In order for the proposal to apply, the plan must not use interest credits in excess of a
market rate of return, and the Secretary is to provide safe harbors as to what is a market rate.
This aspect of the proposal raises issues as to how to determine a market rate of return. Recent
discussions over what constitutes an appropriate replacement for the interest rate on 30-year
Treasury obligations for purposes related to defined benefit pension plans reflects the degree of
complexity which may be involved in prescribing such safe harbors. The effects of the proposal
on plan benefits, and the ease with which the proposal can be implemented by employers,
understood by employees, and administered by the IRS will depend in large part on the ability to
determine measures of market rates of returns. Some argue that because so much depends on
what is a market rate of return under the proposal, it would be more appropriate to provide
statutory guidance on this issue, rather than leave the issue for the Secretary to resolve.

Complexity

As a result of its study of Enron Corporation, performed at the direction of the Senate
Committee on Finance, the staff of the Joint Committee on Taxation (“Joint Committee staff’)
found that the lack of guidance with respect to cash balance plan conversions and cash balance
plans generally creates uncertainty for employers and employees. The Joint Committee staff
recommended that clear rules for such plans should be adopted in the near future.*'*

The budget proposals help to reduce uncertainty with respect to cash balance plans by
addressing certain issues that frequently arise with respect to cash balance plans. However, the
proposals do not address all issues with respect to such plans. In addition, certain aspects of the
proposals need further clarification, or may add some additional complexities. For example,
additional clarification is needed with respect to types of transition approaches in conversions
which do not violate age discrimination or other qualification rules, allowing participants to
choose between a traditional defined benefit formula and cash balance formula in order to avoid

318 Joint Committee on Taxation, Report of Investigation of Enron Corporation and
Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations
(JCS-3-03), February 2003, at 487.

225


Prior Action

No prior action.

342


Potential abuses addressed by the proposal
Establishing eligibility requirements for designated beneficiaries

The proposal attempts to address potential abuses of qualified tuition accounts that might
result from taxpayers establishing multiple accounts for multiple beneficiaries, and taking
advantage of the section 529 income tax and transfer tax rules without ever using the money for
qualified higher education expenses. The proposal establishes the under age 35 requirement for
designated beneficiaries to promote the use of the funds for education purposes while the
beneficiary is relatively young. Some might view this age as too young, given the changing
economy and the need for many workers older than age 35 to obtain education to “retool” for
changing circumstances. Age 35 is more generous than Coverdell limits (age 30), however, but
not so generous as to encourage the use of these accounts for retirement savings. Also, the
proposal permits taxpayers to redesignate new beneficiaries, without income tax or transfer tax
consequences, so long as the new beneficiary is under age 35. This could result in a qualified
tuition account being established and maintained for many generations without income tax or
transfer tax liability being imposed, because the funds have not been distributed and used for
purposes other than to pay qualified higher education expenses. Accordingly, some might argue
that the under age 35 rule is too liberal, and that a maximum duration (for example, 50 years)
should be established, at which time the account must be used for education expenses or
distributed to the then-designated beneficiary, with the imposition of all appropriate income tax
and transfer tax at that time.

Excise tax on amounts used other than for qualified higher education expenses

The proposal attempts to discourage substantial multi-generational accumulations of
qualified tuition account assets by imposing new excise taxes on distributions that are ultimately
used other than for qualified higher education expenses. The proposed excise tax is imposed
only if an actual or deemed distribution (for example, upon the failure to appoint a new eligible
designated beneficiary upon the former beneficiary’s death or attaining age 35) occurs and the
distributed amounts are not used for qualified higher education expenses. In such cases, excise
taxes on the entire amount of a distribution that exceeds certain cumulative thresholds, including
on both the principal and earnings components, would be imposed. Such excise taxes are
intended to serve as deterrents to using the funds other than for qualified higher education
expenses. However, the excise taxes are not imposed unless an actual or deemed distribution
occurs, and thus would not be imposed so long as the funds are maintained in a qualified tuition
account that continues to be held for the benefit of an eligible designated beneficiary. The
proposal does not impose a specific deadline by which time the funds must be used for education
expenses or become subject to income, excise, and transfer taxes.

Some may argue that this proposal does not go far enough to deter (or in fact may create
an opportunity to achieve) substantial multi-generational accumulations of qualified tuition
account assets, and that a better approach would be to impose caps on the amounts that can be
contributed to such accounts, or on the length of time that such assets can be held. Enforcing
such caps, however, would impose significant administrative burdens on administrators,
taxpayers, and the IRS. Others may argue that the present-law requirement that the account or
contract provide adequate safeguards to prevent contributions on behalf of a designated

316


beginning in 2011 and thereafter, the size of the basic standard deduction for joint filers is less
than twice the basic standard deduction for single individuals,’ as determined prior to EGTRRA.

Marriage penalty relief in the 15-percent rate bracket for married couples filing joint
returns

The size of the 15-percent regular income tax rate bracket for married taxpayers filing
joint retums is twice the width of the 15-percent regular income tax rate bracket for single
returns for taxable years beginning in 2003 and 2004. For taxable years beginning in 2005-2007,
the size of the 15-percent regular income tax rate bracket for married taxpayers filing a joint
return reverts to levels less than twice the width of the 15- “percent regular income tax rate bracket
for single returns, but which gradually increase under the provisions of EGTRRA until they are
again twice the width of the 15-percent regular income tax rate bracket for single returns for
taxable years beginning in 2008-2010. For taxable years beginning in 2011 and thereafter, the
size of the 15-percent regular income tax rate bracket for married taxpayers filing joint return, is
less than twice the width of the 15-percent regular income tax rate bracket for single returns. °

Child credit

The child credit is $1,000 for taxable years beginning in 2003 and 2004. The child credit
is reduced to $700 for taxable years beginning in 2005-2008 and to $800 for taxable years
beginning in 2009. The child credit becomes $1,000 for taxable years beginning in 2010 and
drops to $500 for taxable years beginning in 2011 and thereafter.®

Description of Proposal

The proposal eliminates the scheduled reductions for taxable years beginning before 2009
in the (1) 10-percent rate bracket, (2) basic standard deduction for married taxpayers filing
jointly, (3) fifteen-percent rate bracket for married taxpayers filing jointly, and (4) child credit.’

4 A separate proposal in the budget eliminates the sunset provision that causes this
reduction in tax benefits for taxable years beginning after 2010.

> A separate proposal in the budget eliminates the sunset provision that causes this
reduction in tax benefits for taxable years beginning after 2010.

© A separate proposal in the budget eliminates the sunset provision that causes this
reduction in tax benefits for taxable years beginning after 2010.

7 A separate proposal in the budget eliminates the scheduled sunset of these provisions
for taxable years beginning after December 31, 2010.


beneficiary in excess of those necessary to provide for the qualified higher education expenses of
the beneficiary, combined with the maximum contribution or account balance limits established
by many of the various qualified tuition programs, adequately address any concerns that such
accounts might be used to improperly accumulate assets for purposes other than providing for
qualified higher education expenses of the designated beneficiary. Others may counter that
program-imposed limits oftentimes are applied on a per-State basis, and further, that the ability
of an individual to establish accounts for an unlimited number of designated beneficiaries means
there are no effective limits under present law.

Prior Action

No prior action.

317


Policy issues

Families with incomes less than the median income family are less often homeowners
than are families with incomes above the median income. While many factors determine a
family’s decision to rent rather than own their own home, the price of a home creates two
important financial factors that, at least temporarily, persuade families with incomes less than the
median income to choose to rent rather than buy. First, the greater the price of a home, the
greater the required down payment, and families generally must accumulate funds for the down
payment. Second, the greater the price of a home, the greater the monthly mortgage payment,
and both lenders and prudent buyers generally limit monthly housing expenses by reference to a
percentage of current income. In summary, lower housing prices will make it easier for families
with incomes less than the median income to accumulate funds for a down payment and to
qualify for a mortgage based upon their current income.

The local housing market, supply and demand, determine the price of available homes.
An important factor in determining the market price is the cost of developing new properties or
renovating old properties. A developer’s expenses in the provision of housing can be thought of
as consisting of two components: (1) the cost of the land; and (2) the cost of construction. The
proposal will provide a developer a credit against his income tax liability related to qualified
construction expenses for housing sold to a qualified homebuyer whose family income is 80
percent or less of area median income (70 percent or less for families comprised of one, two, or
three individuals). Ina sale to a qualifying homebuyer, the credit has the effect of subsidizing
construction costs. As a consequence, the developer may be able to offer housing for sale to a
qualifying homebuyer at a lower price than the developer’s costs, or the local housing market,
might warrant. The tax credit may enable the developer to earn an after-tax rate of return
comparable or greater to that the developer will have earned had the same housing been sold to a
non-qualifying homebuyer or comparable or greater to that the developer will have earned had
the developer built other housing to be sold to a non-qualifying homebuyer in the same local
housing market.

The statutory incidence of the proposal provides that the taxpayer developing the
qualifying property claims the tax benefit. However, in a market economy the economic
incidence can differ from the statutory incidence. All of the benefit can accrue to a buyer of the
property in the form of reduction in purchase price (compared to an otherwise comparable home
offered by a developer who has not received an allocation of the proposed tax credits) equal to
the full present value of the tax credits! the developer/seller may claim under the proposal.
Alternatively, there may be no change in purchase price (compared to an otherwise comparable

160 The proposal will determine the present value of the tax credits as provided under
present-law Code section 42 (the low-income housing credit). The present value calculation
prescribed in subsection 42(b) was based on a marginal income tax rate applicable to the highest
income taxpayers of 28 percent. Subsequent changes in the marginal income tax rate structure,
including changes enacted as part of the Economic Growth and Tax Relief Reconciliation Act of
2001, have established marginal income tax rates other than 28 percent to be applicable to the
highest income taxpayers. Thus, the present value calculation of the proposal may not reflect the
actual present value to the taxpayer.

109


E. Increase Continuous Levy for Certain Federal Payments

Present Law

If any person is liable for any internal revenue tax and does not pay it within 10 days after
notice and demand*” by the IRS, the IRS may then collect the tax by levy upon all property and
rights to property belonging to the person,° unless there is an explicit statutory restriction on
doing so. A levy is the seizure of the person’s property or rights to property. Property that is not
cash is sold pursuant to statutory requirements. 61

A continuous levy is applicable to specified Federal payments. This includes any
Federal payment for which eligibility is not based on the income and/or assets of a payee. Thus,
a Federal payment to a vendor of goods or services to the government is subject to continuous
levy. This continuous levy attaches up to 15 percent of any specified payment due the taxpayer.

Description of Proposal

The proposal permits a levy of up to 100 percent of a Federal payment to a vendor of
goods or services to the government.

Effective date—The proposal is effective on the date of enactment.

Analysis

The proposal could provide for more rapid collection of amounts due the IRS by
permitting levy on up to the entire Federal payment to vendors of goods or services to the
government.” On the other hand, the proposal might also discourage vendors who owe
amounts to the IRS from selling goods and services to the Federal government, which could deny
the government access to essential goods and services. In addition, the proposal could, with
respect to some taxpayers, lead to a reduction in total payments of amounts owed to the IRS, in
that a levy of 100 percent on a sizeable payment for goods and services to a contactor nearly all
of whose business is with the Federal government could lead to the bankruptcy of that Federal
contractor, thereby terminating the possibility of further payments to the IRS.

559 Notice and demand is the notice given to a person liable for tax stating that the tax
has been assessed and demanding that payment be made. The notice and demand must be
mailed to the person’s last known address or left at the person’s dwelling or usual place of
business (Code sec. 6303).

56 Code sec. 6331.

5°! Code secs. 6335-6343.

5® Code sec. 6331(h).

563 See Some DOD Contractors Abuse the Federal Tax System with Little Consequence,
GAO-04-95, February 2004.

341


Congressional assurances of retroactive extension or past retroactive extensions to engage in
such behavior.

Prior Action

A similar proposal was included in the President’s fiscal year 2004 budget proposals.

392


Description of Proposal

The proposal provides an exclusion from gross income for otherwise taxable IRA
withdrawals from a traditional or a Roth IRA for distributions to a qualified charitable
organization. The exclusion does not apply to indirect gifts to a charity through a split interest
entity, such as a charitable remainder trust, a pooled income fund, or a charitable gift annuity.
The exclusion is available for distributions made on or after the date the IRA owner attains
age 65 and applies only to the extent the individual does not receive any benefit in exchange for
the transfer. Amounts transferred directly from the IRA to the qualified charitable organization
are treated as a distribution for purposes of the minimum distribution rules applicable to IRAs.
Amounts transferred from the IRA to the qualified organization that would not be taxable if
transferred directly to the individual, such as a qualified distribution from a Roth IRA or the
return of nondeductible contributions from a traditional IRA, are subject to the present law
charitable contribution deduction rules.

Effective date—The proposal is effective for distributions after December 31, 2003.
Analysis

Policy issues

In general, the proposal is intended to enable IRA owners to give a portion of their IRA
assets to charity without being subject to the charitable contribution percentage limitations or the
overall limitation on itemized deductions. Present law requires an IRA owner to take the IRA
distribution into income, give the money to a qualified charity, and then claim a deduction for the
gift. However, the deduction is subject to the percentage limitations of section 170 and to the
overall limit on itemized deductions. The proposal will avoid these limitations and therefore
might encourage additional charitable giving by increasing the tax benefit of the donation for
those who would not be able to fully deduct the donation by reason of the present-law
limitations. However, some argue that the proposal merely avoids present-law limitations on
charitable contributions that will be made in any event and will not encourage additional giving.

Further, some question the appropriateness of limiting the tax benefits of the provision to
IRA owners. That is, if the limits on charitable deductions are determined to be undesirable,
they should be removed for all taxpayers, not only those that are able to make charitable
contributions through an IRA. In addition, the proposal will alter present law and give IRA
owners a tax benefit for charitable contributions even if they do not itemize deductions. For
example, under present law, a taxpayer who takes the standard deduction cannot claim a
charitable contribution deduction; however, under the proposal, a taxpayer can both claim the
standard deduction and benefit from the exclusion. It might be beneficial for taxpayers who
itemize their deductions but have a significant amount of charitable deductions to make their
charitable contributions through the IRA and then claim the standard deduction.

In addition, some argue that the proposal inappropriately will encourage IRA owners to
use retirement monies for nonretirement purposes (by making such use easier and providing
greater tax benefits in some cases). To the extent that the proposal will spur additional gifts by
circumventing the percentage limitations, IRA owners may spend more of their retirement

79


under two alternatives (each computes the EIC for qualifying children, but not the EIC for
taxpayers without qualifying children) to yield the lowest tax cost or the highest tax benefit for
the parties.

The proposal’s adoption of different rules for unmarried parents than for other taxpayers
who reside with a qualifying child in the same residence creates complexity, and places
unmarried parents at a disadvantage when compared with other types of extended family
situations (e.g., a mother and grandmother sharing the same principal place of abode witha
qualifying child).

Elimination of disqualified investment income test

Under present law, a taxpayer who otherwise is eligible for the earned income credit
(including the maximum credit amount) loses the entire credit if he or she has investment income
that exceeds the investment income limit. For example, under present law, a taxpayer with
$2,650 of investment income in 2004 who is eligible for the maximum credit of $4,300, would
lose the entire credit if he or she had an additional dollar of investment income. Eliminating the
disqualified investment income test eliminates the cliff effect that can deny an EIC to a taxpayer
merely because he or she has an additional dollar of investment income. However, the cliff
effect could be addressed by implementing a phaseout rule so that the credit is reduced as
investment income exceeds certain amounts. Adopting a phaseout rule for disqualified
investment income would also increase complexity. Eliminating the investment income test also
could result in some wealthy taxpayers with relatively modest earned income amounts receiving
an earned income credit, for example, if they have net operating losses that offset their
investment income and other types of income, such that their adjusted gross income is within the
EIC phaseout ranges. To prevent wealthy taxpayers from being eligible for the earned income
credit, the investment income ceiling could be increased, rather than eliminated.

TIN requirements

The proposal permits a taxpayer to claim the EIC for taxpayers without a qualifying child
(maximum credit of $390 for 2004) if the taxpayer has a qualifying child who does not have a
valid TIN. The proposal has the effect of reducing the amount of the lost tax benefit associated
with failing to satisfy the TIN requirement for a qualifying child. Some may argue that this is
equitable because it treats a taxpayer with a qualifying child who lacks a valid TIN in the same
manner as a taxpayer who does not have a qualifying child. Others may argue that in some cases
the proposal reduces the incentive for a taxpayer to obtain a valid TIN for a qualifying child.

Prior Action

No prior action.

186


Analysis

Complexity issues

One purpose of the proposal may be a simplification purpose, that is, to reduce record
keeping for employees to whom an employer provides office equipment. The proposal
eliminates the need to keep track of personal versus business use of covered equipment.

However, the proposal gives rise to new tax law complexity because it would add a new
factual determination (“substantial” business use) as a criterion for the tax benefit it provides.
The proposal does not specify what constitutes “substantial” business use for these purposes.
Because any standard for making this determination involves a factual inquiry, the proposal
increases the complexity of tax administration by increasing the likelihood of factual disputes
and litigation.

Policy issues

Under normal income tax principles, if an employer pays an employee cash, the cash is
taxable as income to the employee regardless of whether the employee uses the cash to purchase
a computer and software for personal use or whether the employee purchases other consumer
goods for personal consumption. Thus, under normal income tax principles, when an employer
provides any item of value to an employee, the value of the good or service provided to the
employee should be included in the taxable income of the employee, because the provision of the
good or service is a form of compensation. The proposal excludes the value of computer
hardware and software provided to certain employees for personal use from the taxable income
of the employees.

If certain forms of compensation are not taxed to the employee, the employer is
indifferent (the employer’s outlay is deductible as compensation regardless of whether in cash or
in kind), but the employee will find the untaxed forms of compensation more valuable. For
example, if a taxpayer in the 15-percent income tax bracket sought to purchase a $1,000
computer system, the taxpayer would have to earn $1,176 in income in order to have the $1,000
after-tax income sufficient to purchase the computer system. If the employer can provide the
computer system to the employee and the value of the system is excluded from the employee’s
taxable income, it is equivalent to the employee receiving a 15-percent discount on the price of
the computer system. Alternatively, it is equivalent to the employee having received an
additional $176 in compensation. More generally, for a taxpayer whose marginal income tax
rate is t, if the employer can provide the computer system to the employee and the value of the
system is excluded from the employee’s taxable income, it is equivalent to the employee
receiving a t-percent discount on the price of the computer system or, alternatively, it is
equivalent to the employee having received an additional 1/(1-t) percentage increase in
compensation. Generally, if the price of a good declines, consumers purchase more of the good.
In this context, this could result in employees seeking more compensation in the form of untaxed
computer goods and services and less in the form of taxable compensation.

Exempting certain forms of compensation from taxable income also has the potential
create economic inefficiencies. Because certain employees do not bear the full cost of computer

105


or 5.0 percent in each year from 1991 through 1995 and was 5.0 percent in 1999.' The median
payout rates for foundations with assets between $10 million and $50 million declined annually
from 5.4 percent in 1990 to 5.1 percent in 1995 and 1999. Similarly, the median payout rates for
foundations with assets between $100,000 and $1 million declined from 6.7 percent in 1990 to
5.5 percent in 1995 and 5.4 percent in 1999.'*? Critics of the present-law excise tax structure
argue that these data suggest that the excise tax structure is not encouraging any noticeable
increase in payout rates.

The proposal reduces complexity for private foundations by replacing the two-tier tax on
net investment income with a one-tier tax. Under the proposal, private foundations do not have
to allocate resources to figuring which tier of the tax would be applicable or to planning the
optimum payout rate. The proposal also would make compliance easier for private foundations,
as they would not have to compute a five-year average of charitable distributions on the
information return they file each year.

Prior Action

The President’s fiscal year 2003 and 2004 budget proposals included a similar proposal.

The President’s fiscal year 2001 budget proposal included a similar proposal, but would
have reduced the rate of tax to 1.25 percent.

HR. 7, the “Community Solutions Act of 2001,” as passed by the House of
Representatives on July 19, 2001, included a similar proposal.

HR. 7, the “Charitable Giving Act of 2003,” as passed by the House of Representatives
on September 17, 2003, included a similar proposal.

5. Modify tax on unrelated business taxable income of charitable remainder trusts
Present Law

A charitable remainder annuity trust is a trust that is required to pay, at least annually, a
fixed dollar amount of at least five percent of the initial value of the trust to a noncharity for the
life of an individual or for a period of 20 years or less, with the remainder passing to charity. A
charitable remainder unitrust is a trust that generally is required to pay, at least annually, a fixed
percentage of at least five percent of the fair market value of the trust’s assets determined at least
annually to a noncharity for the life of an individual or for a period 20 years or less, with the
remainder passing to charity.'*

142 See Figure I in Paul Arnsberger, “Private Foundations and Charitable Trusts, 1995,”
Internal Revenue Service, Statistics of Income Bulletin, 18, Winter 1998-1999 at 73; Figure I in
Ludlum, “Domestic Private Foundations and Charitable Trusts, 1999” at 148.

3g.

"4 Sec. 664(d).

90


D. Reduce Computational Complexity of Refundable Child Tax Credit

Present Law

An individual may claim a tax credit for each qualifying child under the age of 17. The
amount of the credit per child is $1,000 in 2004, $700 in 2005, 2006, 2007, and 2008, $800 in
2009, and $1,000 in 2010. A child who is not a citizen, national, or resident of the United States
may not be a qualifying child.

The credit is phased out for individuals with income over certain threshold amounts.
Specifically, the otherwise allowable child tax credit is reduced by $50 for each $1,000 (or
fraction thereof) of adjusted gross income over $75,000 for single individuals or heads of
households, $110,000 for married individuals filing joint returns, and $55,000 for married
individuals filing separate returns.

The credit is allowable against the regular tax and the alternative minimum tax. To the
extent the child credit exceeds the taxpayer’s tax liability, the taxpayer is eligible for a
refundable credit (the additional child tax credit) equal to 10 percent of earned income in excess
of $10,750 (the “earned income” formula). The percentage is increased to 15 percent for
calendar years beginning after 2004. The threshold dollar amount is indexed for inflation.

Families with three or more children may determine the additional child tax credit using
the “alternative formula,” if this results in a larger credit than determined under the earned
income formula. Under the alternative formula, the additional child tax credit equals the amount
by which the taxpayer's social security taxes exceed the taxpayer's earned income credit (“EIC”).

Earned income is defined as the sum of wages, salaries, tips, and other taxable employee
compensation plus net self-employment earnings. Unlike the EIC, which also includes the
preceding items in its definition of earned income, the additional child tax credit is based only on
earned income to the extent it is included in computing taxable income. For example, some
ministers’ parsonage allowances are considered self-employment income, and thus are
considered earned income for purposes of computing the EITC, but the allowances are excluded
from gross income for individual income tax purposes, and thus are not considered earned
income for purposes of the additional child tax credit since the income is not included in taxable
income.

Residents of U.S. possessions (e.g., Puerto Rico) are generally not eligible for the
refundable child credit, because the earned income formula is based on earned income to the
extent the earned income is included in taxable income. Because residents of possessions are not
subject to the U.S. income tax on income earned outside the US., they are not generally eligible
for the refundable child credit. However, the alternative child credit formula for taxpayers with
three or more children is based on social security taxes, and thus residents of possessions with
three or more children are eligible for the refundable child credit if they pay social security taxes,
as do Puerto Ricans on Puerto Rican or U.S. sourced earnings.

178


E. Simplify EIC Eligibility Requirements Regarding Filing Status, Presence
of Children, Investment Income and Work and Immigrant Status

Present Law

Overview

Low and moderate-income workers may be eligible for the refundable earned income
credit (EIC). Eligibility for the EIC is based on eamed income, adjusted gross income,
investment income, filing status, and immigration and work status in the United States. The
amount of the EIC is based on the presence and number of qualifying children in the worker’s
family, as well as on adjusted gross income and earned income.

The earned income credit generally equals a specified percentage of wages up to a
maximum dollar amount. The maximum amount applies over a certain income range and then
diminishes to zero over a specified phaseout range. For taxpayers with earned income (or
adjusted gross income (AGI), if greater) in excess of the beginning of the phaseout range, the
maximum EIC amount 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. For taxpayers with
earned income (or AGI, if greater) in excess of the end of the phaseout range, no credit is
allowed.

An individual is not eligible for the EIC if the aggregate amount of disqualified income
of the taxpayer for the taxable year exceeds $2,650 (for 2004). This threshold is indexed.
Disqualified income is the sum of: (1) interest (taxable and tax exempt); (2) dividends; (3) net
rent and royalty income (if greater than zero); (4) capital gains net income; and (5) net passive
income (if greater than zero) that is not self-employment income.

The EIC is a refundable credit, meaning that if the amount of the credit exceeds the
taxpayer’s Federal income tax liability, the excess is payable to the taxpayer as a direct transfer
payment. Under an advance payment system, eligible taxpayers may elect to receive the credit
in their paychecks, rather than waiting to claim a refund on their tax return filed by April 15 of
the following year.

Filing status

An unmarried individual may claim the EIC if he or she files as a single filer or as a head
of household. Married individuals generally may not claim the EIC unless they file jointly. An
exception to the joint return filing requirement applies to certain spouses who are separated.
Under this exception, a married taxpayer who is separated from his or her spouse for the last six
months of the taxable year shall not be considered as married (and, accordingly, may file a return
as head of household and claim the EIC), provided that the taxpayer maintains a household that
constitutes the principal place of abode for a dependent child (including a son, stepson, daughter,
stepdaughter, adopted child, or a foster child) for over half the taxable year,*° and pays over half
the cost of maintaining the household in which he or she resides with the child during the year.

256 A foster child must reside with the taxpayer for the entire taxable year.

181


As an alternative to the two-ADL test described above, an individual is considered to
have long-term care needs if he or she were certified by a licensed physician as, for at least 180
consecutive days: (1) requiring substantial supervision to be protected from threats to health and
safety due to severe cognitive impairment and (2) being unable to perform at least one ADL or to
engage in age appropriate activities as determined under regulations prescribed by the Secretary
of the Treasury in consultation with the Secretary of Health and Human Services.

The taxpayer is required to provide a correct taxpayer identification number for the
individual with long-term care needs, as well as a correct physician identification number (e.g.,
the Unique Physician Identification Number that is currently required for Medicare billing) for
the certifying physician. Failure to provide correct taxpayer and physician identification
numbers is subject to the mathematical error rule. Under that rule, the IRS may summarily
assess additional tax due without sending the individual a notice of deficiency and giving the
taxpayer an opportunity to petition the Tax Court. Further, the taxpayer could be required to
provide other proof of the existence of long-term care needs in such form and manner, and at
such times, as the Secretary requires.

Effective date—The proposal is effective for taxable years beginning after December 31,
2004.

Analysis
Complexity issues

The addition of a new personal! exemption with special criteria adds complexity to the tax
law.

The proposal adds new criteria for the additional personal exemption, relating to whether
an individual has long-term care needs. The tests, related to activities of daily living and
requiring physician certification, resemble present-law tests of whether long-term care insurance
premiums may be deductible or excludible. However, the extension of these tests to the rules
relating to the personal exemption adds more factual determinations and certification
requirements, resulting in increased complexity.

The proposal also adds a maintenance of household requirement to a personal exemption
provision that is not a requirement under the present-law dependency exemption in many cases.
For some taxpayers, this may require recordkeeping in addition to that required under present
law.

Policy issues

The proposal is intended to provide a benefit to individuals who maintain a household
that includes certain family members with long-term care needs. Proponents argue that allowing
an additional personal exemption in this case better reflects the individual’s ability to pay taxes,
because of the likelihood that family members with long-term care needs may have increased
expenses associated with those needs. The proposal is intended to recognize both the formal and
informal costs of providing long-term care in the home.

58


Individuals who purchase their own qualified long-term care insurance may claim an
itemized deduction for the premiums, but only to the extent that eligible qualified long-term care
insurance premiums, together with the individual’s medical expenses exceed 7.5 percent of
adjusted gross income.®° The amount of qualified long-term care insurance premiums that may
be taken into account in determining the amount allowed as an itemized deduction is limited as
follows (for 2004): $260 in the case of an individual 40 years old or less; $490 in the case of an
individual who is more than 40 but not more than 50; $980 in the case of an individual who is
more than 50 but not more than 60; $2,600 in the case of an individual who is more than 60 but
not more than 70; and $3,250 in the case of an individual who is more than 70. These dollar
limits are indexed for inflation.

Self-employed individuals may deduct qualified long-term care insurance premiums for
the individual and his or her spouse and dependents.” The deduction applies to qualified long-
term care insurance premiums, subject to the same dollar limits that apply for purposes of the
itemized deduction, described above.

Employees can exclude from income 100 percent of qualified long-term care insurance
paid for by the employee’s employer. There is no dollar limit on this exclusion. Unlike health
insurance, long-term care insurance cannot be provided under a cafeteria plan.

Payments made under a qualified long-term care insurance contract are excludable from
gross income, subject to a dollar limitation that applies in the case of contracts that provide for
payment on a per diem or similar basis.

In order for a long-term care insurance contract to be a qualified long-term care insurance
contract: (1) the only insurance protection provided under the contract can be coverage for
qualified long-term care services; (2) the contract must not pay or reimburse expenses
reimbursable under Medicare or application of a deductible or coinsurance amount; (3) the
contract must be guaranteed renewable; (4) the contract generally cannot provide for a cash
surrender value or other money that can be paid, assigned, or pledged as a loan or borrowed; (5)
all refunds of premiums, and all policyholder dividends or similar amounts, under the contract
are to be applied as a reduction in future premiums or to increase future benefits; and (6) the
contract must meet certain consumer protection standards.** Contracts that provide for per diem
or similar payments are subject to additional requirements.

The consumer protection provisions applicable to qualified long-term care insurance
contracts require that: (1) such contracts meet certain provisions under the model long-term care
insurance act and regulations promulgated by the National Association of Insurance
Commissioners (NAIC); (2) the issuer of the contract discloses that the contract is intended to be

% Sec. 213(d).

87 The deduction for long-term care insurance expenses of self-employed individuals 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.

88 Sec, 7702B.

54


adjusted gross income between $95,000 and $110,000 and for joint filers with adjusted gross
income between $150,000 and $160,000. The adjusted gross income phase-out range for
married taxpayers filing a separate return is $0 to $10,000. Contributions to a Roth IRA may be
made even after the account owner has attained age 70-.

Taxpayers with modified adjusted gross income of $100,000 or less generally may
convert a traditional IRA into a Roth IRA. The amount converted is includible in income as if a
withdrawal had been made, except that the 10-percent early withdrawal tax does not apply.
Married taxpayers who file separate returns cannot convert a traditional IRA into a Roth IRA.

Amounts held in a Roth IRA that are withdrawn as a qualified distribution are not
includible in income, or subject to the additional 10-percent tax on early withdrawals. A
qualified distribution is a distribution that (1) is made after the five-taxable year period beginning
with the first taxable year for which the individual made a contribution to a Roth IRA, and (2) is
made after attainment of age 59-%, on account of death or disability, or is made for first-time
homebuyer expenses of up to $10,000.

Distributions from a Roth IRA that are not qualified distributions are includible in
income to the extent attributable to earnings. To determine the amount includible in income, a
distribution that is not a qualified distirbution is treated as made in the following order:

(1) regular Roth IRA contributions; (2) conversion contributions (on a first-in, first-out basis);
and (3) earnings. To the extent a distribution is treated as made from a conversion contribution,
it is treated as made first from the portion, if any, of the conversion contribution that was
required to be included in income as a result of the conversion. The amount includible in income
is also subject to the 10-percent early withdrawal tax unless an exception applies. The same
exceptions to the early withdrawal tax that apply to traditional IRAs apply to Roth IRAs.

Roth IRAs are not subject to the minimum distribution rules during the IRA owner’s
lifetime. Roth IRAs are subject to the post-death minimum distribution rules that apply to
traditional IRAs.

Saver’s credit

Present law provides a temporary nonrefundable tax credit for eligible taxpayers for
qualified retirement savings contributions.”° The maximum annual contribution eligible for the
credit is $2,000. The credit rate depends on the adjusted gross income (“AGI”) of the taxpayer.
Taxpayers filing joint returns with AGI of $50,000 or less, head of household returns of $37,500
or less, and single returns of $25,000 or less are eligible for the credit. The AGI limits applicable
to single taxpayers apply to married taxpayers filing separate returns. The credit is in addition to
any deduction or exclusion that would otherwise apply with respect to the contribution. The
credit offsets minimum tax liability as well as regular tax liability. The credit is available to
individuals who are 18 or over, other than individuals who are full-time students or claimed as a
dependent on another taxpayer’s return. The credit is available with respect to contributions to

26 Sec, 25B. The Saver’s credit does not apply to taxable year’s beginning after
January 31, 2006.

16


from sucha plan. The proposal also requires the freezing of benefit accruals and the suspension
of lump-sum distributions in the case of certain underfunded defined benefit pension plans.**°

Interest rates used in determining current liability and lump sums

For plan years beginning in 2004 and 2005, the interest rate used to determine a plan’s
current liability must be within a permissible range (from 90 percent to 100 percent) of the
weighted average of the yields on high-quality long-term corporate bonds. The average is
determined for the 48 months ending with the month preceding the first day of the plan year.

Beginning in 2008, a plan’s current liability is determined using a series of interest rates
drawn from a yield curve of high-quality zero-coupon bonds with various maturities. The
maturities used to determine a plan’s current liability are selected to match the amounts and
timing of benefit payments expected to be made from the plan. The yield curve is to be issued
monthly by the Secretary of the Treasury and is to be based on the 90-day average of interest
rates for high-quality corporate bonds.

For plan years beginning in 2006 and 2007, a plan’s current liability is determined as the
weighted average of two values: (1) the value of the plan’s current liability determined using the
methodology applicable for plan years beginning in 2004 and 2005 (the “old” methodology); and
(2) the value of the plan’s current liability determined using the methodology applicable for 2008
and thereafter (the “new” methodology). For plan years beginning in 2006, the weighting factor
is 2/3 for the current liability value determined under the old methodology and 1/3 for the current
liability value determined under the new methodology. For plan years beginning in 2007, the
weighting factors are reversed.

For plan years beginning in 2004 and 2005, the proposal does not change the law relating
to the determination of minimum and maximum lump sums from defined benefit pension plans
(e.g., minimum lump-sum values are determined using the rate of interest on 30-year Treasury
securities). Beginning in 2008, the proposal provides that minimum and maximum lump-sum
values are to be calculated using rates drawn from the zero-coupon corporate bond yield curve.
Thus, the interest rate that applies depends on how many years in the future a participant’s
annuity payment will be made. Typically, a higher interest rate applies for payments made
further out in the future.

For distributions in 2006 and 2007, lump-sum values are determined as the weighted
average of two values: (1) the value of the lump sum determined using the methodology under
present law (the “old” methodology); and (2) the value of the lump sum determined using the
methodology applicable for 2008 and thereafter (the “new” methodology). For distributions in

30 In addition to these proposals, the President's fiscal year 2005 budget includes a
proposal to provide better information about the financial status of pension plans to plan
participants, retirees, and investors. See, "Safeguarding Workers’ Retirement and Health
Benefits Security," Office of Management and Budget, Budget of the United States Government,
Fiscal Year 2005 (H. Doc. 108-146, Vol. I), pp. 229-230, and Appendix (H. Doc. 108-146,

Vol. II), pp. 716-717.

233


protections to purchasers, and that any credit for the purchase of coverage in the individual
market should only be adopted if accompanied by modest reforms.

The proposal addresses some of the present-law differences in tax treatment between
employer-subsidized health insurance and insurance purchased by individuals. Critics of the
proposal argue that providing a credit for the purchase of health insurance undermines the
current employment-based health insurance system by encouraging healthier individuals who can
obtain less expensive coverage in the individual market to leave the employee pool, thus
increasing the cost of insurance for the employees remaining in the pool. Further, some argue
that the existence of the tax credit could cause some employers to not offer health benefits for
their employees. This could cause the insurance market to tum into a predominantly individual
market, which could result in an increase in the cost of health coverage for some individuals.

Others argue that the design of the credit will not cause employees to leave employers’
plans, as the credit is targeted to low-income individuals who are less likely to have employer-
provided health insurance. Additionally, the subsidy rate is phased out as income increases and
there is a cap on the premium eligible for the subsidy.

Because of the limit on the number of children per family eligible for the credit, families
with more than two children will receive a smaller benefit under the proposal. For example, a
married couple with two children could be eligible for a credit up to $3,000, while a single parent
with three children could be eligible for a maximum credit of only $2,000.

Some argue that the objective of the proposal to increase health insurance would be better
served under a direct spending program, especially because the credit is refundable and does not
require that the individual pay tax. Those opponents to the credit argue that expanding public
programs would be a better alternative because such expansion would make health insurance
coverage more affordable and accessible. On the other hand, a spending program may provide
less individual choice of health insurance options.

Advanced payment mechanism

The advanced payment feature of the credit raises numerous issues. The main argument
in favor of providing the credit on an advanced basis is that many of the intended recipients
would not be able to purchase insurance without the advanced credit. Because advancing the
credit merely changes the timing of payment and does not reduce the cost of insurance (except
for the time value of money), this argument is best understood not as making the insurance
affordable, as is often stated, but rather in making it available to those who would not otherwise
be able to arrange the financing to pay for the insurance in advance of receiving the credit.
Given the target population of the credit, it might reasonably be argued that for many potential
users of the credit, other financing mechanisms, such as credit cards, loans from relatives or
friends, personal savings, etc., would not be available, or would not be used even if available,
and the best way to encourage individuals to buy insurance would be to provide the credit in
advance, at the time of purchase of the insurance.

Some argue that the mechanism for delivering the credit on an advanced basis is not
effective. For example, basing eligibility on the prior year’s income raises issues. Using prior

45


Taxpayers are required to obtain a qualified appraisal for donated property with a value
of $5,000 or more, and to attach the appraisal to the tax return in certain cases."'® Under
Treasury regulations, a qualified appraisal means an appraisal document that, among other
things, (1) relates to an appraisal that is made not earlier than 60 days prior to the date of
contribution of the appraised property and not later than the due date (including extensions) of
the return on which a deduction is first claimed under section 170;"!” (2) is prepared, signed, and
dated by a qualified appraiser; (3) includes (a) a description of the property appraised; (b) the fair
market value of such property on the date of contribution and the specific basis for the valuation;
(c) a statement that such appraisal was prepared for income tax purposes; (d) the qualifications of
the qualified appraiser; and (e) the signature and taxpayer identification number (“TIN”) of such
appraiser; and (4) does not involve an appraisal fee that violates certain prescribed rules.‘!®

Description of Proposal

The proposal provides that if a taxpayer contributes a patent or other intellectual property
(other than certain copyrights or inventory) to a charitable organization, the taxpayer’s initial
charitable deduction is limited to the lesser of the taxpayer’s basis in the donated property or the
fair market value of the property. In addition, the taxpayer is permitted to deduct, as a charitable
deduction, certain additional amounts in subsequent taxable years based on the amount of the
royalties or other revenue actually received by the charitable donee from the donated property.
For this purpose, “other revenue” includes sales proceeds and net income derived by the donee
that properly is allocable to the intellectual property itself (as opposed to the activity in which the
intellectual property is used). The amount of the additional charitable deduction is calculated as
a sliding-scale percentage of revenues actually received by the charitable donee from the donated
property during the taxable year of the charitable donee.

Table 11, below, summarizes the amount of charitable deduction the taxpayer may claim
in the year of contribution and each year thereafter.

416 pL, 98-369, sec. 155(a)(1) through (6) (1984) (providing that not later than
December 31, 1984, the Secretary shall prescribe regulations requiring an individual, a closely
held corporation, or a personal service corporation claiming a charitable deduction for property
(other than publicly traded securities) to obtain a qualified appraisal of the property contributed
and attach an appraisal summary to the taxpayer’s return if the claimed value of such property
(plus the claimed value of all similar items of property donated to one or more donees) exceeds
$5,000). Under P.L. 98-369, a qualified appraisal means an appraisal prepared by a qualified
appraiser that includes, among other things, (1) a description of the property appraised; (2) the
fair market value of such property on the date of contribution and the specific basis for the
valuation; (3) a statement that such appraisal was prepared for income tax purposes; (4) the
qualifications of the qualified appraiser; (5) the signature and TIN of such appraiser; and (6) such
additional information as the Secretary prescribes in such regulations.

417 Th the case of a deduction first claimed or reported on an amended return, the deadline
is the date on which the amended return is filed.

418 Treas, Reg. sec. 1.170A-13(c)(3).

267


Also, the nature of the proposed custodial arrangement does not fully align the proposed
transfer tax treatment of section 529 plans with otherwise applicable transfer tax principles.
Although the proposal curtails the custodian’s rights to account assets generally to provide that
the assets must be used for the benefit of a designated beneficiary, the designated beneficiary
does not become the owner of the account’s assets under generally applicable transfer tax
principles. Under the proposal, the designated beneficiary does not have the right to withdraw
funds for education purposes or for other uses, terminate the account, make investment decisions,
or change beneficiaries. Absent such or similar rights, the designated beneficiary would not be
viewed as receiving a completed gift of a present interest under generally applicable transfer tax
principles. Rather, the custodian’s rights to make investment decisions, terminate the account,
direct that distributions be made for education or otherwise, and change beneficiaries, might
resemble the bundle of rights that a person holding a special power of appointment over the
account’s assets might possess, or arguably as treating the custodian as the owner of the
account’s assets for transfer tax purposes. '3 Perhaps the most important right that the custodian
possesses under the proposal, for transfer tax purposes, is that of changing the designated
beneficiary to any person who is under age 35 (except for prohibitions against naming the
custodian and certain persons with specified relationships to the custodian as a designated
beneficiary). As long as the custodian may change the designated beneficiary, there is no
assurance that the account benefits will be used for the benefit of a specific designated
beneficiary.*"* On the other hand, the proposal eliminates one of the most significant
incongruities in present-law section 529 that treats the designated beneficiary as the donee even
though the arrangement generally allows the account owner to withdraw the funds at any time
and for any purpose.

It is unclear how the proposal would apply to accounts established pursuant to the
Uniform Gifts to Minors Act (UGMA) or the Uniform Transfers to Minors Act (UTMA).
Further, it is unclear how the proposed custodian rules would be interpreted for purposes of (or
whether such rules would be consistent with) various state laws, including, for example, laws
regarding fiduciary duties or accounting for assets subject to custodial arrangements established
under such laws.

The proposal generally does not impose the new custodial requirements on existing
qualified tuition accounts, unless an existing savings account elects to be covered by the new
rules, or additional prepaid benefits are purchased with respect to existing accounts.

513 Under the proposal, however, the custodian generally is prohibited from using the
account’s assets for the benefit of the custodian.

514 The proposal takes steps to increase the likelihood that the funds will be used for the
benefit of a designated beneficiary, but by permitting designated beneficiary changes to virtually
any person under age 35, does not ensure that any specific beneficiary will be the beneficiary of
the account’s assets.

315


December 31, 2003. In general, HSAs provide tax-favored treatment for current medical
expenses as well as the ability to save on a tax-favored basis for future medical expenses.

Eligible individuals

Eligible individuals for HSAs are individuals who are covered by a high deductible
health plan and no other health plan that is not a high deductible health plan and which provides
coverage for any benefit which is covered under the high deductible health plan. Individuals
entitled to benefits under Medicare are not eligible to make contributions to an HSA. Eligible
individuals do not include individuals who may be claimed as a dependent on another person’s
tax return. An individual with other coverage in addition to a high deductible health plan is still
eligible for an HSA if such other coverage is certain permitted insurance or permitted coverage.*®

A high deductible health plan is a health plan that has a deductible that is at least $1,000
for self-only coverage or $2,000 for family coverage and that has an out-of-pocket expense limit
that is no more than $5,000 in the case of self-only coverage and $10,000 in the case of family
coverage.** A plan is not a high deductible health plan if substantially all of the coverage is for
permitted coverage or coverage that may be provided by permitted insurance, as described
above. A plan does not fail to be a high deductible health plan by reason of failing to have a
deductible for preventive care.

Tax treatment of and limits on contributions

Contributions to an HSA by or on behalf of an eligible individual are deductible (within
limits) in determining adjusted gross income (i.e., “above-the-line”) of the individual. In
addition, employer contributions to HSAs (including salary reduction contributions made
through a cafeteria plan) are excludable from gross income and wages for employment tax
purposes, The maximum aggregate annual contribution that can be made to an HSA is the lesser
of (1) 100 percent of the annual deductible under the high deductible health plan, or (2) the
maximum deductible permitted under an Archer MSA high deductible health plan under present
law, as adjusted for inflation. For 2004, the amount of the maximum deductible under an Archer
MSA high deductible health plan is $2,600 in the case of self-only coverage and $5,150 in the
case of family coverage. The annual contribution limits are increased for individuals who have
attained age 55 by the end of the taxable year. In the case of policyholders and covered spouses
who are age 55 or older, the HSA annual contribution limit is greater than the otherwise

83 Permitted insurance is: (1) insurance if substantially all of the coverage provided under
such insurance relates to (a) liabilities incurred under worker’s compensation law, (b) tort
liabilities, (c) liabilities relating to ownership or use of property (e.g., auto insurance), or (d) such
other similar liabilities as the Secretary may prescribe by regulations; (2) insurance for a
specified disease or illness; and (3) insurance that provides a fixed payment for hospitalization.
Permitted coverage is coverage (whether provided through insurance or otherwise) for accidents,
disability, dental care, vision care, or long-term care.

84 The limits are indexed for inflation.

49


XI. OTHER PROVISIONS MODIFYING THE INTERNAL REVENUE CODE

A. Extension of the Rate of Rum Excise Tax Cover Over
to Puerto Rico and Virgin Islands

Present Law

A $13.50 per proof gallon®* excise tax is imposed on distilled spirits produced in or
imported (or brought) into the United States.*” The excise tax does not apply to distilled spirits
that are exported from the United States, including exports to U.S. possessions (e.g., Puerto Rico
and the Virgin Islands).°°

The Code provides for cover over (payment) to Puerto Rico and the Virgin Islands of the
excise tax imposed on rum imported (or brought) into the United States, without regard to the
country of origin. The amount of the cover over is limited under Code section 7652(f) to
$10.50 per proof gallon ($13.25 per proof gallon during the period July 1, 1999 through
December 31, 2003).°7

Tax amounts attributable to shipments to the United States of rum produced in Puerto
Rico are covered over to Puerto Rico. Tax amounts attributable to shipments to the United
States of rum produced in the Virgin Islands are covered over to the Virgin Islands. Tax
amounts attributable to shipments to the United States of rum produced in neither Puerto Rico
nor the Virgin Islands are divided and covered over to the two possessions under a formula.°?
Amounts covered over to Puerto Rico and the Virgin Islands are deposited into the treasuries of
the two possessions for use as those possessions determine.“ All of the amounts covered over
are subject to the limitation.

658 A proof gallon is a liquid gallon consisting of 50 percent alcohol. See sec.
5002(a)(10) and (11).

659 Sec, 5001(a)(1).

6 Secs. 5062(b), 7653(b) and (c).

61 Secs, 7652(a)(3), (b)(3), and (e)(1). One percent of the amount of excise tax collected
from imports into the United States of articles produced in the Virgin Islands is retained by the
United States under section 7652(b)(3).

682 The amount covered over is limited to the amount of excise tax imposed under
section 5001(a)(1), if lower than the limits stated above. Sec. 7652(f)(2).

3 Sec, 7652(e)(2).

64 Secs. 7652(a)(3), (b)(3), and (e)(1).

417


Ig «6,

definition of an “insurance company” based on the company’s “primary and predominant
business activity."

When enacting the statutory definition of an insurance company in 1984, Congress stated,
“{b]y requiring [that] more than half rather than the ‘primary and predominant business activity’
be insurance activity, the bill adopts a stricter and more precise standard for a company to be
taxed as a life insurance company than does the general regulatory definition of an insurance
company applicable for both life and nonlife insurance companies... Whether more than half
of the business activity is related to the issuing of insurance or annuity contracts will depend on
the facts and circumstances and factors to be considered will include the relative distribution of
the number of employees assigned to, the amount of space allocated to, and the net income
derived from, the various business activities."“°°

Thus, though its name, charter powers, and subjection to State insurance laws are significant in
determining the business which a company is authorized and intends to carry on, it is the
character of the business actually done in the taxable year which determines whether a company
is taxable as an insurance company under the Internal Revenue Code." Treas. Reg. section
1.801-3(a)(1).

404 Court cases involving a determination of whether a company is an insurance company
for Federal tax purposes have examined all of the business and other activities of the company.
In considering whether a company is an insurance company for such purposes, courts have
considered, among other factors, the amount and source of income received by the company
from its different activities. See Bowers v. Lawyers Mortgage Co., 285 U.S. 182 (1932); United
States v. Home Title Insurance Co., 285 U.S. 191 (1932). See also Inter-American Life
Insurance Co. v. Comm’r, 56 T.C. 497, aff'd per curiam, 469 F.2d 697 (9th Cir. 1972), in which
the court concluded that the company was not an insurance company: "The. . . financial data
clearly indicates that petitioner’s primary and predominant source of income was from its
investments and not from issuing insurance contracts or reinsuring risks underwritten by
insurance companies. During each of the years in issue, petitioner’s investment income far
exceeded its premiums and the amounts of earned premiums were de minimis during those years.
It is equally as clear that petitioner’s primary and predominant efforts were not expended in
issuing insurance contracts or in reinsurance. Of the relatively few policies directly written by
petitioner, nearly all were issued to [family members of the owners]. Also, Investment Life, in
which [family members] each owned a substantial stock interest, was the source of nearly all of
the policies reinsured by petitioner. These facts, coupled with the fact that petitioner did not
maintain an active sales staff soliciting or selling insurance policies . . . , indicate a lack of
concentrated effort on petitioner’s behalf toward its chartered purpose of engaging in the
insurance business. . . . For the above reasons, we hold that during the years in issue, petitioner
was not ‘an insurance company... engaged in the business of issuing life insurance’ and hence,
that petitioner was not a life insurance company within the meaning of section 801." 56 T.C.
497, 507-508.

405 FER. Rep. 98-432, part 2, at 1402-1403 (1984); S. Prt. No. 98-169, vol. I, at 525-526
(1984); see also H.R. Rep. No. 98-861 at 1043-1044 (1985) (Conference Report).

259


the form of a guaranteed annuity or a fixed percentage of the annual value of the property.'?! For
such interests, a charitable deduction is allowed to the extent of the present value of the interest
designated for a charitable organization.

IRA rules

Within limits, individuals may make deductible and nondeductible contributions to a
traditional IRA. Amounts in a traditional IRA are includible in income when withdrawn (except
to the extent the withdrawal represents a return of nondeductible contributions). Individuals also
may make nondeductible contributions to a Roth IRA. Qualified withdrawals from a Roth IRA
are excludable from gross income. Withdrawals from a Roth IRA that are not qualified
withdrawals are includible in gross income to the extent attributable to earnings. Includible
amounts withdrawn from a traditional IRA or a Roth IRA before attainment of age 59-4 are
subject to an additional 10-percent early withdrawal tax, unless an exception applies.

If an individual has made nondeductible contributions to a traditional IRA, a portion of
each distribution from an IRA is nontaxable, until the total amount of nondeductible
contributions has been received. In general, the amount of a distribution that is nontaxable is
determined by multiplying the amount of the distribution by the ratio of the remaining
nondeductible contributions to the account balance. In making the calculation, all traditional
IRAs of an individual are treated as a single IRA, all distributions during any taxable year are
treated as a single distribution, and the value of the contract, income on the contract, and
investment in the contract are computed as of the close of the calendar year.

In the case of a distribution from a Roth IRA that is not a qualified distribution, in
determining the portion of the distribution attributable to earnings, contributions and
distributions are deemed to be distributed in the following order: (1) regular Roth IRA
contributions; (2) taxable conversion contributions;'”” (3) nontaxable conversion contributions;
and (4) earnings. In determining the amount of taxable distributions from a Roth IRA, all Roth
IRA distributions in the same taxable year are treated as a single distribution, all regular Roth
IRA contributions for a year are treated as a single contribution, and all conversion contributions
during the year are treated as a single contribution.

Traditional IRAs are subject to minimum distribution rules, under which distributions
from the IRA must generally begin by the April 1 of the calendar year following the year in
which the IRA owner attains age 70-

Traditional and Roth IRAs are subject to post-death minimum distribution rules that
require that distributions upon the death of the IRA owner must begin by a certain time.

21 Sec, 170(f)(2).

122 Conversion contributions refer to conversions of amounts in a traditional IRA to a
Roth IRA.

78


K. Extend the Statute of Limitations for Reportable Transactions
Where a Taxpayer Fails to Disclose on Return as Required

Present Law

In general, the Code requires that taxes be assessed within three years after the date a
return is filed.*” If there has been a substantial omission of items of gross income that total
more than 25 percent of the amount of gross income shown on the return, the period during
which an assessment must be made is extended to six years.*”' If an assessment is not made
within the required time periods, the tax generally cannot be assessed or collected at any future
time. Tax may be assessed at any time if the taxpayer files a false or fraudulent return with the
intent to evade tax or if the taxpayer does not file a tax return at all.”

Description of Proposal

The proposal extends the statute of limitations with respect to a reportable transaction*”>
if a taxpayer fails to include on any return or statement for any taxable year any information with
respect to a reportable transaction which is required to be included (under section 6011) with
such return or statement. The statute of limitations with respect to any understatement of tax
arising from the reportable transaction will not expire before the date which is one year after the
earlier of (1) the date on which the taxpayer furnishes the information so required, or (2) the date
that a material advisor (as defined in 6111) satisfies the list maintenance requirements (as
defined by section 6112) with respect to a request by the Secretary.

Effective date The proposal is effective for taxable years with respect to which the
period for assessing a deficiency has not expired on the date of enactment.

Analysis

See the general discussion in section V.A. above following the description of the
proposals to combat tax avoidance transactions.

4 Sec, 6501(a). For this purpose, a return that is filed before the date on which it is due
is considered to be filed on the required due date (sec. 6501(b)(1)).

*" Sec, 6501(e).
4 Sec. 6501(c).

43 ‘The term “reportable transaction” has the same meaning as described in a previous
proposal regarding the penalty for failure to disclose reportable transactions.

301


Treatment of changes of designated beneficiaries

Under present-law section 529, a change of designated beneficiary to a beneficiary who is
in a generation lower than the former beneficiary constitutes a taxable gift, even though the new
designated beneficiary would, under otherwise applicable transfer tax principles, be regarded as
not receiving a completed gift. Further, present-law section 529 does not identify which party is
responsible for payment of the transfer tax when it is imposed in such instances. Also, under
present-law section 529, there is no express requirement that the multiple annual present interest
exclusion is available only if there is a present intent to allow the designated beneficiary to
receive the benefits of the qualified tuition program.

Present law also has different change-of-beneficiary rules for income tax and transfer tax
purposes. A change of beneficiary to a person who is not a member of the same family as the
old beneficiary is treated as a distribution for income tax purposes, regardless of whether the new
beneficiary is in a lower generation than the former beneficiary. Under present law, a change of
beneficiary to a person who is in a lower generation than the former beneficiary is treated as a
transfer for transfer tax purposes, regardless of whether the new beneficiary is of the same family
as the former beneficiary.

The proposal eliminates these disparities and provides that a change of beneficiary will
not be treated as a distribution or transfer, respectively, for income tax or transfer tax purposes,
provided that the new beneficiary has not reached age 35, regardless of the respective
generations of the beneficiaries or whether they are members of the same family.

Because the proposal expands the class of permissible successor designated beneficiaries
without the imposition of any income or transfer taxes, individuals interested in establishing a
qualified tuition account as a means to fund qualified higher education expenses for their
children, relatives, or others, might view these changes as being a liberalization and
simplification of existing law.

Custodial arrangement requirement

A significant aspect of the proposal is the change that requires that qualified tuition
savings accounts and prepaid tuition contracts established under qualified tuition programs
constitute custodial arrangements maintained for the benefit of designated beneficiaries. This
aspect of the proposal is a significant change from the terms and conditions of many existing
qualified tuition programs, which generally permit account owners to have the flexibility to
terminate the accounts or otherwise withdraw funds for any purpose, subject only to the tax
penalties associated with using the funds other than for qualified higher education expenses.
Individuals interested in establishing qualified tuition accounts as a means to fund higher
education expenses for their children, relatives, or others, may view these changes as being
overly restrictive, and might choose instead to use alternative means to fund for higher education
expenses,

Rather, the proposal treats the account owner as a custodian for the benefit of a designated
beneficiary, and a mere change in custodian would have no tax consequences under the proposal.

314


additional investment can be attributed to the credit. However, all $1.1 million in investments
will be eligible for the 10-percent credit, at a budgetary cost of $110,000 (10 percent of 1.1
million). Thus, only $100,000 in additional investment would be undertaken, at a budgetary cost
of $110,000. Because there is a large aggregate amount of investment undertaken without
general investment credits, introducing a general credit would subsidize much activity that would
have taken place anyway.

Targeted credits like the above proposals, on the other hand, are likely to be more cost
effective, from a budget perspective, in achieving the objective of increased investment, if only
for the reason that a government would likely not consider their use if there were already
extensive investment in a given area. Thus, not much investment that would take place anyhow
is subsidized, because there presumably is not much of such investment taking place. The
presumption behind these targeted tax credits is that there is not sufficient investment in the
targeted areas because the alternative and more emissions-producing investments are less costly
to the investor. Hence, a tax credit would be necessary to reduce costs and encourage investment
in the favored activity.

A final limitation on the efficiency of the proposed credits is their restricted availability.
The proposed tax credits come with several limitations beyond their stipulated dollar limitation.
Specifically, they are nonrefundable and cannot be used to offset tax liability determined under
the AMT.'® The credit for solar equipment has a cap on the dollar amount of the credit, and thus
after the cap is reached the marginal cost of further investment becomes equal to the market price
again, which is presumed to be inefficient. The impact of these limitations is to make the credit
less valuable to those without sufficient tax liability to claim the full credit, for those subject to
the AMT, or those who have reached any cap on the credit. Given the arguments outlined above
as to the rationale for targeted tax credits, it is not economically efficient to limit their
availability based on the tax status of a possible user of the credit. It can be argued that, if such
social benefits exist and are best achieved through the tax system, the credit should be both
refundable and available to AMT taxpayers. Some would argue that making the credits
refundable may introduce compliance problems that would exceed the benefits from encouraging
the targeted activities for the populations lacking sufficient tax liability to make use of the credit.
With respect to the AMT, the rationale for the limitation is to protect the objective of the AMT,
which is to insure that all taxpayers pay a minimum (determined by the AMT) amount of tax.
Two differing policy goals thus come in conflict in this instance. Similarly, caps on the aggregate
amount of a credit that a taxpayer may claim are presumably designed to limit the credit's use out
of some sense of fairness, but again, this conflicts with the goal of pollution reduction.

A justification for targeted tax credits that has been offered with respect to some pollution
abatement activities, such as home improvements that would produce energy savings
(installation of energy saving light bulbs or attic insulation, for example), is that the investment
is economically sound at unsubsidized prices, but that homeowners or business owners are
unaware of the high returns to the investments. The argument for targeted tax credits in this

183 The AMT treatment of the proposed personal credits for residential solar and hybrid
vehicles is unclear. The proposals do not state that the credits would be allowed to offset AMT
liability.

140


Table 7.-2000 Model Year City Fuel Economy

Vehicle Inertia Passenger
Weight Class Automobile Light Truck

(pounds) (miles per gallon) | (miles per gallon)
1,500 43.7 37.6
1,750 43.7 37.6
2,000 38.3 33.7
2,250 34.1 30.6
2,500 30.7 28.0
2,750 27.9 25.9
3,000 25.6 24.1
3,500 22.0 21.3
4,000 19.3 19.0
4,500 17.2 17.3
5,000 15.5 15.8
5,500 14.1 14.6
6,000 12.9 13.6
6,500 11.9 12.8
7,000 11.1 12.0
8,500 1L1 12.0

Effective dateThe proposal is effective for vehicles purchased after December 31, 2003.

Analysis

See the general discussion following the description of the proposed tax credit for
combined heat and power property, below.

Prior Action
The President’s fiscal year 2003 and 2004 budget proposals contained a similar proposal
to the current proposal (identical except for effective dates). The President’s fiscal year 1999,
2000, 2001, and 2002 budget proposals proposed creating a credit for electric and hybrid
vehicles.

The conference agreement to H.R. 6, “The Energy Policy Act of 2003,” as passed by the
House of Representatives on November 18, 2003, and S. 1149, as passed by the Senate on

133


Effective date—The proposal is effective on the date of enactment.

Analysis

In general

The policy merits of permanently extending the provisions of EGTRRA and JGTRRA
that sunset depend on considerations specific to each provision. In general, however, advocates
of eliminating the sunset provisions may argue that it was never anticipated that the sunset
actually would be allowed to take effect, and that eliminating them promptly would promote
stability and rationality in the tax law. In this view, if the sunsets were eliminated, other rules of
EGTRRA and JGTRRA that phase in or phase out provisions over the immediately preceding
years would be made more rational. On the other hand, others may argue that certain provisions
of EGTRRA and JGTRRA would not have been enacted at all, or would not have been phased in
or phased out in the same manner, if the sunset provisions had not been included in EGTRRA
and JGTRRA, respectively.

Complexity issues

The present-law sunset provisions of EGTRRA and JGTRRA arguably contribute to
complexity by requiring taxpayers to contend with (at least) two different possible states of the
law in planning their affairs. For example, under the sunset provision of EGTRRA, an individual
planning his or her estate will face very different tax regimes depending on whether the
individual dies in 2010 (estate tax repealed) or 2011 (estate tax not repealed). This “cliff effect”
requires taxpayers to plan an estate in such a way as to be prepared for both contingencies,
thereby creating a great deal of complexity. On the other hand, some may argue that this kind of
uncertainty is always present to some degree -- with or without a sunset provision, taxpayers
always face some risk that the Congress will change a provision of law relevant to the planning
of their affairs. Others may acknowledge this fact, but nevertheless argue that the sunset
provision creates an unusual degree of uncertainty and complexity as to the areas covered by the
Act, because they consider it unlikely that the sunset will actually go into effect. In this view,
the sunset provision of EGTRRA leaves taxpayers with less guidance as to the future state of the
law than is usually available, making it difficult to arrange their affairs. In addition to the
complexity created by the need to plan for the sunset, uncertainty about the timing and details of
how the sunset might be eliminated arguably creates further complexity.

Even if it is assumed that the sunset provisions will take effect, it is not clear how the
sunsets would apply to certain provisions. It would be relatively simple to apply the EGTRRA
sunset to some provisions, such as the individual rate reductions. With respect to other
provisions, however, further guidance would be needed as to the effect of the sunset. For
example, if the Code will be applied after 2010 as if the Act had never been enacted, then one
possible interpretation of the pension provisions is that contributions made while EGTRRA was
in effect will no longer be valid, possibly resulting in the disqualification of plans. While this
result was likely not intended, without further guidance taxpayers may be unsure as to the effect
of the sunset.

11


taxpayer, at the time the vehicle is being donated.**® This is intended to have the effect of
reducing the number and extent of overvaluations of vehicles that are being donated to charities.
However, some might argue that the Treasury proposal does not go far enough to address the
overvaluation problem associated with donated vehicles, pointing out the administrative
difficulties the IRS faces in examining and enforcing charitable deductions with respect to in
kind property in general, and claiming that it will only be a matter of time before an appraisal
industry emerges to provide qualified appraisals to maximize the value to be claimed by
automobile donors. Others might also argue that even if the valuation of vehicles is improved,
auction sales of vehicles generally will continue and would still result in sales prices significantly
lower than appraised prices.

Other possible alternatives to address the overvaluation problem include limiting the
charitable deduction for a vehicle donation to the actual selling price (gross sales price could be
used for this purpose) derived from the sale of the donated vehicle. Limiting the charitable
deduction to the price at which the donated vehicle was sold would provide an easily
determinable measure of value for purposes of the charitable deduction. In order for a selling
price proposal to be administrable, however, it likely would have to defer the claiming of a
charitable deduction until the charity reports the sales price to the donor, which could be in a
taxable year after the contribution had been made.” A selling price deduction rule would
impose some administrative burdens on the charitable donees, and the donor would not have the
certainty of knowing how much the contribution deduction is worth at the time he or she makes
the contribution, which could decrease the incentive to make contributions of automobiles and
other vehicles. Critics of a “selling price” rule also may argue that it is unfair for donors to have
to tie their deduction amount to the selling price, especially in those cases where the vehicle is
sold at auction, because the price at which the charity sells the donated vehicle is beyond the
control of the donor and may not approximate fair market value. Others may counter that the
“selling price” rule is an appropriate proxy for fair market value, and that such a rule would
provide an incentive for a donor to attempt to determine both the value of the vehicle and the
methods used by the donee to maximize net proceeds it derives from vehicle sales fundraisers.
To the extent that charities do not use the vehicles in their exempt purposes, do not rely on
vehicle donation programs as a significant source of revenue, and consistently sell donated
vehicles at wholesale or scrap auction prices, some would argue that a “selling price” rule that
discourages large numbers of automobile donations is a worthy goal. In addition, under a
“gelling price” rule, an exception could be made for vehicle donations if the charity uses the
vehicle in its exempt programs.

438 ‘The proposal provides an exception from the appraisal requirement for inventory
property contributed by a taxpayer. In such cases, the taxpayer generally is in a reasonable
position to know the condition and fair market value of the donated property, and imposing a
separate appraisal requirement arguably would add unnecessary transaction costs to such
donations.

439 variation of this alternative might be to permit the donor to take a charitable
deduction for either the selling price as reported by the charity to the donor, or a legally
enforceable option price that a dealer in used cars is willing to pay the donor for the specific
vehicle.

278


Government, further risk is imposed on the investor. These information costs and other risks
serve to increase the credit rate and hence the costs to the Federal Government for a given level
of support to the zone academies. For these reasons, and the fact that tax credit bonds will be
less liquid than Treasury Securities, the bonds would bear a credit rate that is equal to a measure
of the yield on outstanding corporate bonds.

The direct payment of interest by the Federal Government on behalf of States or
localities, which was discussed above as being economically the equivalent of the credit
proposal, would involve less complexity in administering the income tax, as the interest could
simply be reported as any other taxable interest. Additionally, the tax credit approach implies
that non- taxable entities would only be able to invest in the bonds to assist school investment
through repurchase agreements or by acquiring rights to repayment of principal if a tax credit
bond is stripped. In the case of a direct payment of interest, by contrast, tax-exempt
organizations would be able to enjoy such benefits.

Prior Action

Similar proposals were included in the President’s fiscal year 2003 and 2004 budget
proposals.

396


(2) gas produced from geopressured brine, Devonian shale, coal seams, tight
formations (“tight sands”), or biomass; and

(3) liquid, gaseous, or solid synthetic fuels produced from coal (including lignite).
Landfill gas qualifies for the section 29 production credit as gas produced from biomass.

In general, the credit is available only with respect to fuels produced from wells drilled or
facilities placed in service after December 31, 1979, and before January 1, 1993. An exception
extends the January 1, 1993 expiration date for facilities producing gas from biomass and
synthetic fuel from coal if the facility producing the fuel is placed in service before July 1, 1998,
pursuant to a binding contract entered into before January 1, 1997.

The credit may be claimed for qualified fuels produced and sold before January 1, 2003
(in the case of non-conventional sources subject to the January 1, 1993 expiration date) or
January 1, 2008 (in the case of biomass gas and synthetic fuel facilities eligible for the extension
period).

Description of Proposal

The proposal extends the section 29 production credit for landfill gas if the gas is
produced from a facility placed in service after December 31, 2003 and before January 1, 2012,
and is sold (or used to make electricity) before January 1, 2012. In the case of any landfill, the
proposal provides that the term “facility” includes the wells, pipes, and related components used
to collect landfill methane and that production of gas attributable to wells, pipes, and related
components placed in service after December 31, 2003 is treated as produced from the portion of
the facility placed in service after that date. Thus, a landfill that opened to receive municipal
solid waste prior to January 1, 2004, may have portions of the landfill placed in service after
December 31, 2003, for purposes of claiming the section 29 credit.

In the case of gas produced at landfills subject to the Environmental Protection Agency’s
1996 New Source Performance Standards/Emissions Guidelines, the taxpayer is permitted a
credit equal to two-thirds of the otherwise allowable credit (1) beginning with gas produced on
and after January 1, 2008 in the case of a landfill on which any portion of a facility for producing
gas at that landfill was placed in service before July 1, 1998, or (2) beginning with gas produced
on and after January 1, 2004 in all other cases.

Effective date—The proposal is effective on the date of enactment.

Analysis

See the general discussion following the description of the proposed tax credit for
combined heat and power property, below.

Prior Action

The President’s fiscal year 2003 and 2004 budgets proposed a similar proposal to the
current proposal (identical except for certain placed in service dates and fuel production dates).

135


proposal is narrowly targeted. For example, because the proposal is limited to insurance
purchased in the individual market, an individual participating in a group high-deductible plan
could not qualify for the deduction even if the employee pays 100 percent of the cost of
coverage.

While the proposal provides that the deduction is not allowed for individuals covered by
employer plans, it is unclear what specifically constitutes an employer plan. For example, an
employee could have a high deductible health plan purchased in the individual market, a portion
of the cost of which is paid by the employer. It is unclear whether such plan would qualify for
the deduction.

Complexity issues

Conditioning the deduction on making a contribution to an HSA adds complexity to the
proposal compared to providing a deduction without such a requirement. In addition, the
requirement is easily satisfied, raising questions as to whether the additional complexity serves
any policy function. For example, an individual could contribute as little as $1 to an HSA and be
eligible for the deduction.

By providing additional options to individuals, the proposal may increase transactional
complexity because individuals will have to determine which option is best for them.
Individuals eligible for the proposed refundable tax credit for health insurance will have to
determine which option is best for them because such individuals are not eligible for both the
credit and the deduction. Employees will also have to determine whether it is better to remain in
employer plans or to purchase a policy in the individual market.

In order for the IRS to administer the deduction, additional reporting would need to be
required. To determine if individuals are eligible for the deduction, policyholders would have to
be notified whether their health insurance plan qualifies. Providers of high deductible health
plans would need to provide information regarding the type of health insurance plan, such as the
policy premium and deductible and that the policy meets the requirements for the deduction.

Creating a new tax deduction will necessitate a new line on the Form 1040 and additional
information in instructions regarding the deduction. The new deduction may also require IRS
programming modifications.

Prior Action

No prior action.
3. Provide an above-the-line deduction for long-term care insurance premiums

Present Law

Under present law, the Federal income tax treatment of qualified long-term care
insurance expenses is similar to the treatment of health insurance expenses. As is the case with
health insurance expenses, the Federal income tax treatment of qualified long-term care
insurance expenses depends on the individual’s circumstances.

53


A.
B.
Cc.
D. Permanently Extend and Expand Disclosure of Tax Return Information for
Administration of Student Loans ......ccsssssessssssseesessesssessesessesseessenesnecneseesneneeanenesenseneereny 377
E. Extend and Modify the Work Opportunity Tax Credit and Welfare-to-Work Tax
Credit... eeeesssessesesstssssesseessessseesteeneceeeneeneees
F, Extend District of Columbia Enterprise Zone
G. Extend District of Columbia Homebuyer Tax Credit
H. Extend Authority to Issue Qualified Zone Academy Bonds
I. Extend Deduction for Corporate Donations of Computer Tec!
J. Extend Treatment of Alternative Minimum Tax Net Operating Loss Deductions.
K. Permanently Extend IRS User Fees
L. Extend Provisions Permitting Disclosure of Return Information Relating to
Terrorism :
M. Extend the Authority to Issue Liberty Zone Bonds - 406
N. Extend Excise Tax on Coal at Current Rates........ 409
IX. EXPAND PROTECTIONS FOR MEMBERS OF THE ARMED FORCES .......esueesstee 411
X. RESPOND TO FOREIGN SALES CORPORATION / EXTRATERRITORIAL INCOME
DECISIONS wuicessesssssesscssssscsscsscasecsscsessecusensenecucsucsscsussnssvcsssenesncesecueaussnssnsnnceneaeneeseansensansersansseseess 414
XI. OTHER PROVISIONS MODIFYING THE INTERNAL REVENUE CODE... 417

A. Extension of the Rate of Rum Excise Tax Cover Over to Puerto Rico and Virgin
Islands
B. Merge Treasury Inspector General for Tax Administration and Treasury Inspector
General into New Inspector General for Treasury

iv


H. Extend Authority to Issue Qualified Zone Academy Bonds

Present Law

Tax-exempt bonds

Interest on State and local governmental bonds generally is excluded from gross income
for Federal income tax purposes if the proceeds of the bonds are used to finance direct activities
of these governmental units or if the bonds are repaid with revenues of the governmental units.
Activities that can be financed with these tax-exempt bonds include the financing of public
schools (sec. 103). An issuer must file with the IRS certain information about the bonds issued
by them in order for that bond issue to be tax-exempt (sec. 149(e)). Generally, this information
return is required to be filed no later the 15"" day of the second month after the close of the
calendar quarter in which the bonds were issued.

Qualified zone academy bonds

As an alternative to traditional tax-exempt bonds, States and local governments were
given the authority to issue “qualified zone academy bonds” (“QZABs”) (sec. 1397E). A total of
$400 million of qualified zone academy bonds was authorized to be issued annually in calendar
years 1998 through 2003. The $400 million aggregate bond cap was allocated each year to the
States according to their respective populations of individuals below the poverty line. Each
State, in turn, allocated the credit authority to qualified zone academies within such State.

Financial institutions that hold qualified zone academy bonds are entitled to a
nonrefundable tax credit in an amount equal to a credit rate multiplied by the face amount of the
bond. A taxpayer holding a qualified zone academy bond on the credit allowance date is entitled
to acredit. The credit is includable in gross income (as if it were a taxable interest payment on
the bond), and may be claimed against regular income tax and AMT liability.

The Treasury Department set the credit rate at a rate estimated to allow issuance of
qualified zone academy bonds without discount and without interest cost to the issuer. The
maximum term of the bond was determined by the Treasury Department, so that the present
value of the obligation to repay the bond was 50 percent of the face value of the bond.

“Qualified zone academy bonds” are defined as any bond issued by a State or local
government, provided that (1) at least 95 percent of the proceeds are used for the purpose of
renovating, providing equipment to, developing course materials for use at, or training teachers
and other school personnel in a “qualified zone academy” and (2) private entities have promised
to contribute to the qualified zone academy certain equipment, technical assistance or training,
employee services, or other property or services with a value equal to at least 10 percent of the
bond proceeds.

A school is a “qualified zone academy” if (1) the school is a public school that provides
education and training below the college level, (2) the school operates a special academic
program in cooperation with businesses to enhance the academic curriculum and increase
graduation and employment rates, and (3) either (a) the school is located in an empowerment

393


from that under the other family related tax benefits. The legislative history of the child credit
indicates that it is intended to provide tax relief for families with children, which arguably is
similar to the policy of the dependency exemption.”“* Adopting a uniform age requirement that
would increase the child credit to children under 19, for example, would promote simplification,
but would expand the number of children who would qualify for the child credit. The proposal
retains the present-law under age 17 test for the child credit.

Waivers in cases of divorced or legally separated parents

The treatment of children of divorced or separated parents raises significant policy issues.
For a number of years the Code has permitted divorced or separated parents to negotiate
dependency exemptions between themselves, through a waiver of the dependency exemption by
the custodial parent to the noncustodial parent, provided that together they provide over one half
of the child’s support and satisfy certain other requirements.” Many have come to view the
present-law waiver rules as a bargaining chip in divorce and separation negotiations. Perhaps
most important, it is oftentimes argued that the parent with the means to provide child support is
much more willing to make child support payments if he or she obtains a tax benefit for doing
so.

Recommendations regarding the present-law custodial waiver have ranged from repeal of
the present-law provision, with no grandfather rule for existing child support instruments, to
retention of a waiver rule that is amended to address significant differences in treatment of
children of divorced or separated parents resulting from State court determinations. The
explanation to a recent proposal made by the IRS Taxpayer Advocate stated that courts in 35
States have held that they have authority to allocate the dependency exemption between spouses
who are before them in a divorce or custody case. The IRS Taxpayer Advocate made a specific
recommendation that the present-law waiver rule be amended to clarify that a custodial parent
must voluntarily sign a written release of the dependency exemption to the noncustodial parent,
and to provide that the dependency exemption cannot be allocated (or enforced against a
custodial parent involuntarily) by State domestic relations courts.”

The staff of the Joint Committee on Taxation concluded that the present-law custodial
waiver rule primarily is designed to avoid difficult determinations under the support test, and that
such waivers would not be necessary if the support test is replaced by a residency test for

248 4 variety of proposals to provide further simplification by eliminating or reducing
overlapping benefits relating to children have been proposed, including proposals that would
combine the dependency exemption and the child credit. Some proposals would also combine
these provisions with the earned income credit. Such proposals would provide additional
simplification, but also raise additional policy issues.

249 In 1997, the ability to negotiate tax benefits in these circumstances was extended to
the child credit, which generally is available with respect to a child under age 17 if the taxpayer
is entitled to the dependency exemption with respect to such child.

250 National Taxpayer Advocate FY 2001 Annual Report to Congress, at 105 (2002).

172


offering credit toward a bachelor’s degree, an associate’s degree, a graduate-level or professional
degree, or another recognized post-secondary credential. Certain proprietary institutions and
post-secondary vocational institutions also are eligible institutions. The remaining four
provisions define a qualifying higher education institution by reference to section
170(b)(1)(A)Gi), which includes an organization which normally maintains a regular faculty and
curriculum and normally has a regularly enrolled body of pupils or students in attendance at the
place where its educational activities are regularly carried on.

Certain provisions also have variations on these basic definitions. For example, the
above-the-line deduction for student loan expenses generally uses the definition from the Higher
Education Act, but also includes institutions conducting an internship or residency program
leading to a degree or certificate awarded by an institution of higher education, a hospital, or a
health care facility which offers postgraduate training?”

With respect to qualifying education expenses, there is various treatment of the following
components of education expenses: (1) tuition; (2) required fees; (3) books, supplies, and
equipment; (4) room and board; and (5) special needs services. The treatment of these expenses
under each of the tax benefits for educational expenses is shown in Table 8.

accounts; (4) exclusion from income for distributions from qualified tuition plan; (5) exclusion
from income for interest on savings bonds; (6) above-the-line deduction for interest on education
loans; and (7) the temporary above-the-line deduction for higher education expenses.

277 Sec, 221(e)(2).

196


Conversions to cash balance plans; wearaway

Under the proposal, for the first five years following the conversion of a traditional
defined benefit pension plan to a cash balance plan, the benefits earned by any participant in the
cash balance plan who was a participant in the traditional plan must be at least as valuable as the
benefits the participant would have earned under the traditional plan had the conversion not
occurred. Additionally, wearaway of normal and early retirement benefits in connection with a
conversion to a cash balance plan is prohibited.

Failure to follow these requirements will not result in disqualification of the plan.
However, a 100-percent excise payable by the plan sponsor will be imposed on any difference
between required benefits and the benefits actually provided under a plan which has been
converted to a cash balance formula. The amount of the excise tax cannot exceed the plan’s
surplus assets at the time of the conversion or the plan sponsor’s taxable income, whichever is
greater. The excise tax does not apply if participants are given a choice between the traditional
defined benefit pension plan formula and the cash balance formula or if current participants are
“grandfathered,” i.e., permitted to continue to earn benefits under the traditional formula rather
than the cash balance formula.

Age discrimination

Under the proposal, a cash balance plan satisfies age discrimination requirements if it
provides pay credits for older participants that are not less than the pay credits for younger
participants (in the same manner as under a defined contribution plan). Additionally, certain
transition approaches used in conversions, such as preserving the value of early retirement
subsidies, do not violate the age discrimination or other qualification rules. The proposal
provides similar rules for other types of hybrid plans and for conversions from traditional defined
benefit pension plans to other types of hybrid plans.

Calculating lump-sum distributions

The proposal permits the value of a lump-sum distribution to be determined as the
amount of a participant’s hypothetical account balance under a cash balance plan as long as the
plan does not provide interest credits in excess of a market rate of return. The Secretary of the
Treasury is authorized to provide safe harbors for market rates of return and to prescribe
appropriate conditions regarding the calculation of plan distributions.

Effective date

The proposal is effective prospectively. No inference is intended as to the status of cash
balance plans or cash balance conversions under present law.

Analysis
In general

In addressing certain legal issues relating to cash balance plans, the proposal has three
stated objectives: to ensure fairness for older workers in cash balance conversions, to protect the

219


Description of Proposal
Detailed description of proposal
In general

The proposal establishes a uniform definition of qualifying child for purposes of the
dependency exemption, the child credit, the earned income credit, the dependent care credit, and
head of household filing status. A taxpayer could continue to claim an individual who does not
meet the proposed uniform definition of qualifying child as a dependent if the present-law
dependency requirements are satisfied. The proposal does not modify other parameters of each
tax benefit (e.g., the earned income requirements of the earned income credit) or the rules for
determining whether individuals other than children qualify for each tax benefit.”

Under the proposed uniform definition, in general, a child is a qualifying child of a
taxpayer if the child satisfies each of three tests: (1) the child has the same principal place of
abode in the United States as the taxpayer for more than one half the taxable year; (2) the child
has a specified relationship to the taxpayer; and (3) the child has not yet attained a specified age.
A tie-breaking rule applies if more than one taxpayer claims a child as a qualifying child.

Under the proposal, the present-law support and gross income tests do not apply to a
child who meets the requirements of the uniform definition of qualifying child.

The proposal eliminates the household maintenance test with respect to the dependent
care credit.

Residency test

Under the proposed residency test, a child must have the same principal place of abode in
the United States as the taxpayer for more than one half the taxable year. As under present-law
tules, temporary absences due to special circumstances, including absences due to illness,
education, business, vacation, or military service, would not be treated as absences. Military
personnel on extended active duty outside the United States would be considered to be residing
in the United States.

Relationship test

In order to be a qualifying child under the proposal, the child must be the taxpayer’s son,
daughter, stepson, stepdaughter, brother, sister, stepbrother, stepsister, or a descendant of any
such individual. A foster child who is placed with the taxpayer by an authorized placement
agency is treated as the taxpayer’s child. If the child is the taxpayer’s sibling or stepsibling or a
descendant of any such individual, the taxpayer must care for the child as if the child were his or
her own child.

228 Separate proposals of the President’s budget proposal, however, modify certain of the
tules relating to the child credit, the earned income credit, and the head of household filing
status.

161


standard deduction, if it is in their financial interest to itemize. Thus, for most taxpayers who
choose the standard deduction under present law, the standard deduction more than compensates
the donor for the income he or she has forgone even when they have made substantial charitable
contributions.

The proposal is intended to provide an incentive to donate cash to charities. Proponents
of the proposal would argue that taxpayers who take the standard deduction would have an
incentive not present in current law to make a charitable contribution because some or all of the
contribution would be deductible. Some argue, however, that the standard deduction already
takes into account a taxpayer’s charitable contributions and that the nonitemizer deduction would
not lead to much, if any, additional giving. On the other hand, taxpayers who take the standard
deduction and do not currently make charitable contributions might respond to the incentive
presented by a nonitemizer charitable deduction, and begin to give to charity. In addition, some
argue that the proposal would encourage taxpayers who currently take the standard deduction
and make charitable contributions to increase their level of giving. At a minimum, some argue
that the standard deduction does not adequately recognize a taxpayer’s charitable contributions
and that all taxpayers should be given a separate deduction to acknowledge their charitable
giving. Others argue that the provision would be difficult to administer effectively, and
therefore, could invite widespread taxpayer fraud. This could occur, for example, if taxpayers
believe that IRS would not make the effort to verify small contributions.

As with any tax deduction, the charitable deduction is worth more the higher the
taxpayer’s marginal tax rate. Thus, higher rather than lower income taxpayers generally have a
greater incentive to make charitable contributions because the price of giving is less for those
with a higher income.'® Indeed, under present law, lower income taxpayers are less likely than
higher income taxpayers to itemize deductions and, in such event, have no direct tax incentive to
make charitable contributions because a nonitemizing taxpayer pays the full price of the gift.'°°
Thus, the proposal would provide nonitemizers with a direct tax incentive to make charitable
contributions by reducing the tax price of giving. However, the proposal requires that aggregate
cash contributions exceed a specified floor amount and caps the nonitemizer deduction at an

'05 ‘The price of giving is determined as one minus the taxpayer’s marginal tax rate. For
example, for a taxpayer who itemizes deductions and is in the 28-percent tax bracket, a $100
cash gift to charity reduces the taxpayer’s taxable income by $100, and thereby reduces tax
liability by $28. As a consequence, the $100 cash gift to charity reduces the taxpayer’s after-tax
income by only $72. Economists would say that the price of giving $100 cash to charity is $72
for this taxpayer.

106 A taxpayer always has a tax incentive to give to the extent that charitable
contributions plus other qualifying deductions exceed the standard deduction amount. In
general, however, a nonitemizing taxpayer has no tax incentive under present law to make a
charitable contribution because the taxpayer will receive the standard deduction whether or not
the taxpayer makes a charitable contribution. Nevertheless, some would argue that a
nonitemizing taxpayer that makes a charitable contribution receives a tax benefit because the
standard deduction is not intended as a windfall but as a substitute for itemization for taxpayers
with comparatively low amounts of qualifying deductions.

70


accounts. On the other hand, the proposal may decrease complexity by permitting consolidation
of tax-favored savings accounts.

Additionally, with respect to future saving, in one respect choices are made easier by the
elimination of the need to decide whether to make deductible or nondeductible IRA contributions
for those taxpayers eligible to contribute to both. However, employer-sponsored qualified
retirement plans generally receive the same tax treatment as traditional IRAs to which deductible
contributions are made (i.e., contributions are not taxable, but distributions are). Therefore, the
increased availability of Roth-type savings vehicles, in terms of eligibility to make contributions
and higher contribution limits, is likely to mean that many more taxpayers will face a choice of
how to balance their savings between deductible and nondeductible savings vehicles.
Notwithstanding, the ability to make contributions to LSAs and RSAs without limitations based
on age or income level, the uniform tax treatment of all contributions to LSAs and RSAs, and the
lack of restrictions on LSA withdrawals, are likely to decrease complexity.

Prior Action

The President’s fiscal year 2004 budget proposals included a similar proposal; among the
differences are that in the fiscal year 2004 proposal, the annual dollar limit on contributions to
RSAs or to LSAs was $7,500.

2. Consolidation of employer-based savings accounts

Present Law

In general

A plan of deferred compensation that meets the qualification standards of the Code (a
qualified retirement plan) is accorded special tax treatment under present law. Employees do not
include contributions in gross income until amounts are distributed, even though the arrangement
is funded and benefits are nonforfeitable. In the case of a taxable employer, the employer is
entitled to a current deduction (within limits) for contributions even though the contributions are
not currently included in an employee's income. Contributions to a qualified plan (and earnings
thereon) are held in a tax-exempt trust.

Qualified retirement plans may permit both employees and employers to make
contributions to the plan. Under a qualified cash or deferred arrangement (i.e., a section 401(k)
plan), employees may elect to make pretax contributions to a plan. Such contributions are
referred to as elective deferrals. Employees may also make after-tax contributions to a qualified
retirement plan. Employer contributions consist of two types: nonelective contributions and
matching contributions. Nonelective contributions are employer contributions that are made
without regard to whether the employee makes pretax or after-tax contributions. Matching
contributions are employer contributions that are made only if the employee makes
contributions.

Present law imposes a number of requirements on qualified retirement plans that must be
satisfied in order for the plan to be qualified and for the favorable tax treatment to apply. These
requirements include nondiscrimination rules that are intended to ensure that a qualified

25


C. Provisions Relating to Charitable Giving
1. Provide a charitable contribution deduction for nonitemizers
Present Law

In computing taxable income, a taxpayer who itemizes deductions generally is allowed to
deduct the amount of cash and the fair market value of property contributed to an organization
described in section 170(c) of the Code, including charities and Federal, State, and local
governmental entities. The deduction also is allowed for purposes of calculating alternative
minimum taxable income.

The amount of the deduction allowable for a taxable year with respect to a charitable
contribution of property may be reduced depending on the type of property contributed, the type
of charitable organization to which the property is contributed, and the income of the taxpayer.!°

A taxpayer who takes the standard deduction (i.e., who does not itemize deductions) may
not take a separate deduction for charitable contributions.

A payment to a charity (regardless of whether it is termed a “contribution”) in exchange
for which the donor receives an economic benefit is not deductible, except to the extent that the
donor can demonstrate that the payment exceeds the fair market value of the benefit received
from the charity. To facilitate distinguishing charitable contributions from purchases of goods or
services from charities, present law provides that no charitable contribution deduction is allowed
for a separate contribution of $250 or more unless the donor obtains a contemporaneous written
acknowledgement of the contribution from the charity indicating whether the charity provided
any good or service (and an estimate of the value of any such good or service) to the taxpayer in
consideration for the contribution.’ In addition, present law requires that any charity that
receives a contribution exceeding $75 made partly as a gift and partly as consideration for goods
or services furnished by the charity (a “quid pro quo” contribution) is required to inform the
contributor in writing of an estimate of the value of the goods or services furnished by the charity
and that only the portion exceeding the value of the goods or services is deductible as a
charitable contribution.’

Under present law, total deductible contributions of an individual taxpayer to public
charities, private operating foundations, and certain types of private nonoperating foundations
may not exceed 50 percent of the taxpayer’s contribution base, which is the taxpayer’s adjusted
gross income for a taxable year (disregarding any net operating loss carryback). To the extent a
taxpayer has not exceeded the 50-percent limitation, (1) contributions of capital gain property to
public charities generally may be deducted up to 30 percent of the taxpayer’s contribution base;

102 Secs. 170(b) and (e).
13 Sec. 170(£)(8).

104 Sec, 6115.

68


Small producer credit

In addition to the general alcohol fuels credit, small producers of ethanol are entitled to a
10-cents-per-gallon income tax credit for up to a maximum of 15 million gallons. Eligible small
producers are defined as persons whose production capacity does not exceed 30 million gallons.
This credit is scheduled to expire after December 31, 2007.

Excise tax reduction

Registered ethanol blenders may forgo the full income tax credit and instead pay reduced
rates of excise tax on gasoline that they purchase for blending with ethanol. Most of the benefit
of the alcohol fuels credit is claimed through the excise tax system.

The reduced excise tax rates apply only when gasoline is being purchased for the
production of “gasohol.” Gasohol is defined as a gasoline/ethanol blend that contains 5.7 percent
ethanol, 7.7 percent ethanol, or 10 percent ethanol. The Federal excise tax on gasoline is 18.4
cents per gallon. For the calendar year 2003, the following reduced rates apply to gasohol:!*

5.7 percent ethanol 15.436 cents per gallon
7.7 percent ethanol 14.396 cents per gallon
10.0 percent ethanol 13.200 cents per gallon

Description of Proposal

The President’s budget proposal extends the present-law income tax credits and excise
tax reduced rates for ethanol fuels, ethanol-blended fuels, methanol fuels, and methanol-blended
fuels, for an additional three years, through December 31, 2010.

Effective date—The proposal is effective on the date of enactment.
Analysis

Policy issues

The present-law tax credit for the production of ethanol is 52 cents per gallon of pure
ethanol produced. Ethanol’s price averages approximately $1.40 per gallon in the United States.
The present-law tax subsidy is 38 percent of the market price. Proponents of such subsidies for
ethanol state that the present-law tax credit helps advance several policy goals. As a motor fuel,
ethanol displaces petroleum in the market place. To the extent that the petroleum displaced is

'85 ‘These special rates will terminate on September 30, 2007 (sec. 4081(c)(8)). In
addition, the basic fuel tax rate will drop to 4.3 cents per gallon beginning on October 1, 2005.

144


insurance of the taxpayer and qualifying family members for each eligible coverage month
beginning in the taxable year. The credit is available only with respect to amounts paid by the
taxpayer.

Qualifying family members are the taxpayer’s spouse and any dependent of the taxpayer
with respect to whom the taxpayer is entitled to claim a dependency exemption. Any individual
who has other specified coverage is not a qualifying family member.

Persons eligible for the credit

Eligibility for the credit is determined on a monthly basis. In general, an eligible
coverage month is any month if, as of the first day of the month, the taxpayer (1) is an eligible
individual, (2) is covered by qualified health insurance, (3) does not have other specified
coverage, and (4) is not imprisoned under Federal, State, or local authority. In the case of a joint
return, the eligibility requirements are met if at least one spouse satisfies the requirements. An
eligible month must begin after November 4, 2002.7

An eligible individual is an individual who is (1) an eligible TAA recipient, (2) an
eligible alternative TAA recipient, and (3) an eligible PBGC pension recipient.

An individual is an eligible TAA recipient during any month if the individual (1) is
receiving for any day of such month a trade adjustment allowance” or who would be eligible to
receive such an allowance but for the requirement that the individual exhaust unemployment
benefits before being eligible to receive an allowance and (2) with respect to such allowance, is
covered under a certification issued under subchapter A or D of chapter 2 of title II of the Trade
Act of 1974. An individual is treated as an eligible TAA recipient during the first month that
such individual would otherwise cease to be an eligible TAA recipient.

An individual is an eligible alternative TAA recipient during any month if the individual
(1) is a worker described in section 246(a)(3)(B) of the Trade Act of 1974 who is participating in
the program established under section 246(a)(1) of such Act, and (2) is receiving a benefit for
such month under section 246(a)(2) of such Act. An individual is treated as an eligible
alternative TAA recipient during the first month that such individual would otherwise cease to be
an eligible TAA recipient.

An individual is a PBGC pension recipient for any month if he or she (1) is age 55 or
over as of the first day of the month, and (2) is receiving a benefit any portion of which is paid
by the Pension Benefit Guaranty Corporation (the “PBGC”). The IRS has interpreted the
definition of PBGC pension recipient to also include certain alternative recipients and recipients
who have received certain lump-sum payments on or after August 6, 2002.

% This date is 90 days after the date of enactment of the Trade Act of 2002, which was
August 6, 2002.

> Part I of subchapter B, or subchapter D, of chapter 2 of title II of the Trade Act of
1974.

61


B. Initiate IRS Cost Saving Measures
1. Allow the Financial Management Service to retain transaction fees from levied amounts

Present Law

To facilitate the collection of tax, the IRS can generally levy upon all property and rights
to property of a taxpayer (sec. 6331). With respect to specified types of recurring payments, the
IRS may impose a continuous levy of up to 15 percent of each payment, which generally
continues in effect until the liability is paid (sec. 6331(h)). Continuous levies imposed by the
IRS on specified Federal payments are administered by the Financial Management Service
(FMS) of the Department of the Treasury. FMS is generally responsible for making most non-
defense related Federal payments. FMS is required to charge the IRS for the costs of developing
and operating this continuous levy program. The IRS pays these FMS charges out of its
appropriations.

Description of Proposal

The proposal allows FMS to retain a portion of the levied funds as payment of these FMS
fees. The amount credited to the taxpayer’s account would not, however, be reduced by this fee.

Effective date.The provision is effective on the date of enactment.

Analysis

Proponents believe that altering the bookkeeping structure of these costs will provide for
cost savings to the government.

Prior Action

An identical proposal was contained in the “Taxpayer Protection and IRS Accountability
Act of 2003,” as passed by the House of Representatives on June 19, 2003. An identical
proposal was contained in the “Tax Administration Good Government Act of 2004,” as passed
by the Senate Committee on Finance on February 2, 2004.

2. Extend the due date for electronically filed tax returns
Present Law

In general, individuals must file their income tax returns and pay the full amount owed by
April 15 (sec. 6072(a)). This deadline applies regardless of the method the taxpayer may choose
to submit the tax return to the IRS. The Secretary may grant reasonable extensions of time for
filing returns, but in general the time for paying tax may not be extended (sec. 6081(a)). Failure
to file or pay on a timely basis may subject the taxpayer to interest and penalties.

330


State program, may make contributions to an account that is established for the purpose of
meeting qualified higher education expenses of the designated beneficiary of the account.
Contributions to a qualified tuition program must be made in cash, and the program must have
adequate safeguards to prevent contributions in excess of amounts necessary to provide for the
beneficiary’s qualified higher education expenses. Contributions to a qualified tuition program
generally are treated as a completed gift eligible for the gift tax annual exclusion.

Distributions from a qualified tuition program are not includible in the distributce’s gross
income to the extent that the total distribution does not exceed the qualified education expenses
incurred by the beneficiary during the year the distribution is made. Ifa distribution from a
qualified tuition program exceeds the qualified education expenses incurred by the beneficiary
during the year of the distribution, the portion of the excess that is treated as earnings generally is
subject to income tax and an additional 10-percent tax. Amounts in a qualified tuition program
may be rolled over to another qualified tuition program for the same beneficiary or for a member
of the family of that beneficiary.

Health savings accounts

Effective for taxable years beginning after December 31, 2003, a health savings account
(“HSA”) is a trust or custodial account used to accumulate funds on a tax-preferred basis to pay
for qualified medical expenses.’ Within limits, contributions to an HSA made by or on behalf
of an eligible individual are deductible by the individual. Contributions to an HSA are
excludable from income and employment taxes if made by the individual’s employer. Earnings
on amounts in HSAs are not taxable. Distributions from an HSA for qualified medical expenses
are not includible in gross income. Distributions from an HSA that are not used for qualified
medical expenses are includible in gross income and are subject to an additional tax of 10
percent, unless the distribution is made after death, disability, or the individual attains the age of
Medicare eligibility (i-e., age 65).

Eligible individuals for HSAs are individuals who are covered by a high deductible
health plan and no other health plan that is not a high deductible health plan. A high deductible
health plan is a health plan that has a deductible that is at least $1,000 for self-only coverage or
$2,000 for family coverage (indexed for inflation) and that has an out-of-pocket expense limit
that is no more than $5,000 in the case of self-only coverage and $10,000 in the case of family
coverage.

The maximum aggregate annual contribution that can be made to an HSA is the lesser of
(1) 100 percent of the annual deductible under the high deductible health plan, or (2) the
maximum deductible permitted under an Archer MSA high deductible health plan under present
law, as adjusted for inflation. For 2004, the amount of the maximum deductible under an Archer
MSA high deductible health plan is $2,600 in the case of self-only coverage and $5,150 in the
case of family coverage. The annual contribution limits are increased for individuals who have
attained age 55 by the end of the taxable year. In the case of policyholders and covered spouses
who are age 55 or older, the HSA annual contribution limit is greater than the otherwise

31 Sec. 223.

18


individual.®”? In these latter cases, the TJTC provided a cash benefit to the firm, without
affecting the decision to hire a particular worker.

Retroactive effective date

In the case of tax benefits that are intended to create an incentive for particular taxpayer
behavior, some may argue that a retroactive extension rewards behavior that occurred without
the incentive and, therefore, is unnecessary. Others may respond that taxpayers have relied on
Congressional assurances of retroactive extension or past retroactive extensions to engage in
such behavior.

Prior Action
Separate proposals to extend the two credits without combining them were included in

the President’s fiscal year 2002 and 2003 budget proposals.* A similar proposal was included
in the President’s fiscal year 2004 budget proposals.

622 For example, see U.S. General Accounting Office, Targeted Jobs Tax Credit:
Employer Actions to Recruit, Hire, and Retain Eligible Workers Vary (GAO-HRD 91-33),
February 1991.

®3 Dub. L. No. 107-147, “The Job Creation and Worker Assistance Act of 2002,”
extended the credit for two years.

388


compensated employees from receiving a disproportionate amount of the tax subsidy provided
with respect to employer-sponsored retirement plans.

The rules governing employer-sponsored retirement plans, particularly the
nondiscrimination rules, are generally regarded as complex. Some have argued that this
complexity deters employers from establishing qualified retirement plans or causes employers to
terminate such plans. Others assert that the complexity of the rules governing employer-
sponsored retirement plans is a necessary byproduct of attempts to ensure that retirement benefits
are delivered to more than just the most highly compensated employees of an employer and to
provide employers, particularly large employers, with the flexibility needed to recognize
differences in the way that employers do business and differences in workforces.

Analysis of ERSA proposal

General nondiscrimination test

The special nondiscrimination rules for 401(k) plans are designed to ensure that
nonhighly compensated employees, as well as highly compensated employees, actually receive
benefits under the plan. The nondiscrimination rules give employers an incentive to make the
plan attractive to lower- and middle-income employees (¢.g., by providing a match or qualified
nonelective contributions) and to undertake efforts to enroll such employees, because the greater
the participation by such employees, the more highly compensated employees can contribute to
the plan.

Some argue that the present-law nondiscrimination rules are unnecessarily complex and
discourage employers from maintaining retirement plans. By reducing the complexity associated
with ADP and ACP testing and reducing the related compliance costs associated with a plan, the
proposal arguably makes employers more likely to offer retirement plans, thus increasing
coverage and participation. Others argue that the present-law section 401(k) safe harbor already
provides a simplified method of satisfying the nondiscrimination requirements without the need
to run the ADP and ACP tests. Some also point out that the proposal allows a greater differential
in the contribution rates for highly and nonhighly compensated employees under an ERSA than
the present-law rules for section 401(k) plans. They argue that this weakens the
nondiscrimination rules by enabling employers to provide greater contributions to highly paid
employees than under present law without a corresponding increase in contributions for rank-
and-file employees. They also argue that the proposal reduces the incentive for employers to
encourage nonhighly compensated employees to participate in the plan, which could result in
lower contributions for rank-and-file employees. On the other hand, others believe that allowing
contributions to favor highly paid employees more than under present law is appropriate in order
to encourage employers to maintain plans that benefit rank-and-file employees.

ERSA safe harbor

The present-law safe harbors for elective deferrals and matching contributions were
designed to achieve the same objectives as the special nondiscrimination tests for these amounts,
but in a simplified manner. The alternative of a nonelective contribution of three percent ensures
a minimum benefit for all employees covered by the plan, while the alternative of matching

35


Relationship or member of household test

Relationship test—The relationship test is satisfied if an individual is the taxpayer’s
(1) son or daughter or a descendant of either (¢.g., grandchild or great-grandchild); (2) stepson or
stepdaughter; (3) brother or sister (including half brother, half sister, stepbrother, or stepsister);
(4) parent, grandparent, or other direct ancestor (but not foster parent); (5) stepfather or
stepmother; (6) brother or sister of the taxpayer’s father or mother; (7) son or daughter of the
taxpayer’s brother or sister; or (8) the taxpayer’s father-in-law, mother-in-law, son-in-law,
daughter-in-law, brother-in-law, or sister-in-law.

An adopted child (or a child who is a member of the taxpayer’s household and who has
been placed with the taxpayer for adoption) is treated as a child of the taxpayer. A foster child is
treated as a child of the taxpayer if the foster child is a member of the taxpayer’s household for
the entire taxable year.

Member of household test.—If the relationship test is not satisfied, then the individual may
be considered the dependent of the taxpayer if the individual is a member of the taxpayer’s
household for the entire year. Thus, a taxpayer may be eligible to claim a dependency exemption
with respect to an unrelated child who lives with the taxpayer for the entire year.

For the member of household test to be satisfied, the taxpayer must both maintain the
household and occupy the household with the individual.” A taxpayer or other individual does
not fail to be considered a member of a household because of “temporary” absences due to
special circumstances, including absences due to illness, education, business, vacation, and
military service.” Similarly, an individual does not fail to be considered a member of the
taxpayer’s household due to a custody agreement under which the individual is absent for less
than six months.” Indefinite absences that last for more than the taxable year may be
considered “temporary.” For example, the IRS has ruled that an elderly woman who was
indefinitely confined to a nursing home was temporarily absent from a taxpayer’s household.
Under the facts of the ruling, the woman had been an occupant of the household before being
confined to a nursing home, the confinement had extended for several years, and it was possible
that the woman would die before becoming well enough to return to the taxpayer’s household.

the child’s principal place of abode is the taxpayer’s home and (2) the taxpayer is a citizen or
national of the United States. Sec. 152(b)(3).

200 This restriction does not apply if the return was filed solely to obtain a refund and no
tax liability would exist for either spouse if they filed separate returns. Rev. Rul. 54-567, 1954-2
CB. 108.

201 Treas. Reg. sec. 1.152-1(b).

202 Td.

203. Tq.

155


Description of Proposal
In general

The proposal imposes a penalty for any person who fails to include with any return or
statement any required information with respect to a reportable transaction.

Penalty rate

Under the proposal, a taxpayer failing to disclose a reportable transaction will be subject
to a penalty in the following amounts: (1) for corporate taxpayers with respect to listed
transactions, $200,000 and five percent of any underpayment resulting from the listed
transaction; (2) for corporate taxpayers with respect to other reportable transactions, $50,000;
(3) for partnerships, S corporations, and trusts, $200,000 with respect to listed transactions and
$50,000 with respect to other reportable transactions; (4) for individual taxpayers with respect to
listed transactions, $100,000 and five percent of any underpayment resulting from the listed
transaction; and (5) for individual taxpayers with respect to other reportable transactions,
$10,000.

A public entity that is required to pay a penalty for failing to disclose a listed transaction
(or is subject to an understatement penalty attributable to a non-disclosed listed transaction) must
disclose the imposition of the penalty in reports to the Securities and Exchange Commission for
such period as the Secretary shall specify.

Effective date
The proposal generally is effective after the date of enactment.
2. Disclosure of reportable transactions by material advisors

Present Law

Registration of tax shelter arrangements

An organizer of a tax shelter is required to register the shelter with the Secretary not later
than the day on which the shelter is first offered for sale.*** A “tax shelter” means any
investment with respect to which the tax shelter ratio** for any investor as of the close of any of
the first five years ending after the investment is offered for sale may be greater than two to one
and which is: (1) required to be registered under Federal or State securities laws, (2) sold
pursuant to an exemption from registration requiring the filing of a notice with a Federal or State

354 Sec. 6111(a).

355 The tax shelter ratio is, with respect to any year, the ratio that the aggregate amount of
the deductions and 350 percent of the credits, which are represented to be potentially allowable
to any investor, bears to the investment base (money plus basis of assets contributed) as of the
close of the tax year.

242


a qualified policy; and (3) the issuer offers the policyholder a nonforfeiture provision meeting
certain requirements.

Description of Proposal

The proposal provides an above-the-line deduction for a percentage of qualified long-
term care insurance premiums up to the dollar limitations that apply under the present-law
itemized deduction. The deduction is available to an individual covered under an employer-
sponsored health plan if the employee pays at least 50 percent of the cost of the coverage. The
Secretary is authorized to require qualified long-term care insurance policies to meet consumer
protection standards for quality coverage, for example, to reflect changes in the NAIC model
standards.

The deductible percentage of qualified long-term care insurance premiums is 25 percent
in 2005, 35 percent in 2006, 65 percent in 2007, and 100 percent in 2008 and thereafter.

Effective date.—The proposal is effective for taxable years beginning on or after
January 1, 2005.

Analysis
Policy issues

The present-law favorable tax treatment of qualified long-term care insurance contracts
was adopted to provide an incentive for individuals to take financial responsibility for their long-
term care needs.®” In addition, the present-law rules serve to provide certainty with respect to the
tax treatment of qualified long-term care insurance contracts. Prior to the adoption of the
present-law rules, which generally are effective beginning in 1997, the tax treatment of qualified
long-term care insurance was unclear. There were no specific rules with respect to such
insurance, rather, the tax treatment depended on the applicability of the rules relating to medical
expenses and accident or health insurance, which involved a case by case determination. Thus,
the present-law rules contribute to simplification of the tax laws by reducing uncertainty.

The proposal provides additional tax incentives for the purchase of qualified long-term
care insurance. Like the present-law rules, such additional tax incentives are designed to
encourage individuals to provide for their long-term care needs. The proposal raises both tax
policy and health policy issues.

From a health policy perspective, one issue is whether it is appropriate to provide more
favorable tax treatment for the purchase of long-term care insurance than for the purchase of
health insurance. If this proposal were adopted, persons would be able to deduct long-term care
insurance premiums above-the-line, whereas individuals who purchase their own health
insurance (and who are not self-employed) could only deduct health insurance premiums under
the itemized deduction for medical expenses. Some argue that health insurance is a more

89 Joint Committee on Taxation, General Explanation of Tax Legislation Enacted in the
104" Congress (JCS-12-6), December 18, 1996, at 336.

55


transaction are not sustained, or (2) the fees are contingent on the intended tax consequences
from the transaction being sustained.*”?

The fourth category of reportable transactions relates to any transaction resulting in a
taxpayer claiming a loss (under section 165) of at least (1) $10 million in any single year or $20
million in any combination of years by a corporate taxpayer or a partnership with only corporate
partners; (2) $2 million in any single year or $4 million in any combination of years by all other
partnerships, S corporations, trusts, and individuals; or (3) $50,000 in any single year for
individuals or trusts if the loss arises with respect to foreign currency translation losses.*”°

The fifth category of reportable transactions refers to any transaction done by certain
taxpayers in which the tax treatment of the transaction differs (or is expected to differ) by more
than $10 million from its treatment for book purposes (using generally accepted accounting
principles) in any year.**!

The final category of reportable transactions is any transaction that results in a tax credit
exceeding $250,000 (including a foreign tax credit) if the taxpayer holds the underlying asset for
less than 45 days.*°?

Under present law, there is no specific penalty for failing to disclose a reportable
transaction. However, such a failure may jeopardize a taxpayer’s ability to claim that any
income tax understatement attributable to such undisclosed transaction is due to reasonable
cause, and that the taxpayer acted in good faith.***

349 Treas. Reg. sec. 1.6011-4(b)(4).

350 Treas. Reg. sec. 1.6011-4(b)(5). Rev. Proc. 2003-24, 2003-11 LR.B. 599, exempts
certain types of losses from this reportable transaction category.

351 Treas, Reg. sec. 1.6011-4(b)(6). The significant book-tax category applies only to
taxpayers that are reporting companies under the Securities Exchange Act of 1934 or business
entities that have $250 million or more in gross assets. Rev. Proc. 2003-25, 2003-11 LR.B. 601,
exempts certain types of transactions from this reportable transaction category.

352 Treas. Reg. sec. 1.6011-4(b)(7).

353 Section 6664(c) provides that a taxpayer can avoid the imposition of a section 6662
accuracy-related penalty in cases where the taxpayer can demonstrate that there was reasonable
cause for the underpayment and that the taxpayer acted in good faith. However, Treas. Reg. sec.
1.6664-4(d) provides that the failure to disclose a reportable transaction that results in a tax
understatement is a “‘strong indication” that the taxpayer did not act in good faith with respect to
the transaction.

241


first from the portion, if any, of the conversion contribution that was required to be included in
income as a result of the conversion.

Lifetime Savings Accounts

Under the proposal, an individual may make nondeductible contributions to an LSA of y
to $5,000 annually, regardless of the individual’s age, compensation, or adjusted gross income.>
Additionally, individuals other than the LSA owner may make contributions to an LSA. The
contribution limit applies to all LSAs in an individual’s name, rather than to the individuals
making the contributions. Thus, contributors may make annual contributions of up to $5,000
each to the LSAs of other individuals but total contributions to the LSAs of any one individual
may not exceed $5,000 per year. Contributions to LSAs may be made only in cash.
Contributions to an LSA are not taken into account for purposes of the Saver’s credit. Earnings
on contributions accumulate on a tax-free basis.

All distributions from an individual’s LSA are excludable from income, regardless of the
individual’s age or the use of the distribution. As under the present-law rules for Roth IRAs, no
minimum distribution rules apply to an LSA during the LSA owner’s lifetime. In addition,
married individuals may roll amounts over from an LSA to a spouse’s LSA.

Control over an LSA in a minor’s name is to be exercised exclusively for the benefit of
the minor by the minor’s parent or legal guardian acting in that capacity until the minor reaches
the age of majority (determined under applicable state law).

Taxpayers may convert balances in Coverdell education savings accounts and qualified
tuition programs to LSA balances. All conversions must be made before January 1, 2006, and
are subject to certain limitations. An amount may be rolled over to an individual’s LSA only if
the individual was the beneficiary of the Coverdell education savings account or qualified tuition
program as of December 31, 2003. The amount that can be rolled over to an LSA from a
Coverdell education savings account is limited to the sum of: (1) the amount in the Coverdell
education savings account as of December 31, 2003; and (2) any contributions to and earnings on
the account for 2004. The amount that can be rolled over to an LSA from a qualified tuition
program is limited to the sum of: (1) the lesser of $50,000 or amount in the qualified tuition
program as of December 31, 2003; and (2) any contributions to and earnings on the qualified
tuition program for 2004. The total amount rolled over to an individual’s LSAs that is
attributable to 2004 contributions for the individual to Coverdell education savings accounts and
qualified tuition programs cannot exceed $5,000 (plus any earnings on such contributions).

Under the proposal, qualified tuition programs continue to exist as separate arrangements,
but may be offered in the form of an LSA. For example, State agencies that administer qualified
tuition programs may offer LSAs with the same investment options that are available under the
qualified tuition program. The annual limit on LSA contributions apply to such an LSA, but the

35 Total contributions to an LSA for a year may not exceed $5,000, regardless of whether
any distributions are taken from the LSA during the year. The contribution limit is indexed for
inflation.

21


recovered, While gas can be used directly as a fuel, in practice, much landfill gas is burned on,
or near, site to make electricity. The value of the proposed credit for landfill gas can be
compared to the credit for electricity produced from wind and closed-loop biomass facilities. As
noted above, efficiency is enhanced if the value of the credit does not exceed the positive
externality that the alternative source of electricity produces. From this logic, if the value of the
credit per kilowatt-hour of electricity produced exceeds that of a properly set (ie. efficiency
maximizing) credit provided to electricity produced from wind or closed-loop biomass,
efficiency can only be enhanced if the positive externalities from generating electricity from
landfill gas exceed the positive externalities from generating electricity from wind or closed-loop
biomass. The value of the present-law section 29 credit expressed in terms of credit dollars per
kilowatt-hour of electricity produced from landfill gas depends upon the efficiency of the
combustion facility that burns the gas to make electricity. In 2000, if the combustion facility was
20 percent efficient, the value of the section 29 credit for landfill gas when converted to
electricity was 1.8 cents per kilowatt-hour. For a combustion facility that was 30 percent
efficient, the value of the section 29 credit for landfill gas when converted to electricity was 1.2
cents per kilowatt-hour.'®* In 2000, the value of the section 45 production credit for wind and
closed-loop biomass facilities was 1.7 cents per kilowatt-hour.

With respect to the expansion of the biomass materials eligible for the credit, the basic
issues are the same as those outlined above for any tax benefit for energy conservation or
pollution abatement. To justify the credit on economic grounds, the positive externalities from
the burning of biomass for the production of electricity must outweigh the costs of the tax
subsidy. With respect to the waste materials that are proposed to be made eligible for the credit,
one positive externality is similar to that of wind power production, namely the reduction in
electricity production from the more environmentally damaging coal. Another consideration
with the waste products is whether their current disposal is harmful to the environment. Ifso, an
additional positive externality may exist from discouraging such disposal. If the disposal is
harmful to the environment and is a partial justification for the credit, then ideally the credit
amount should vary for each biomass waste product if their present disposal varies in its harm to
the environment. A single credit rate would be justified if the negative externalities are of a
similar magnitude, or if administrative considerations would make multiple credit rates
problematic.

With respect to the special lower credits for non-closed-loop biomass facilities that are
already placed in service and for biomass co-fired with coal, additional justifications for the
credits need to be offered. In general, establishing a credit for existing economic activity is
inefficient--if the activity already takes place without the credit then establishing the credit only
produces a windfall gain for the producers. Establishing the credit for the existing activity would
only be efficient if the existing plants would otherwise choose to shut down if the credit were not
established, and the cost of the credit was less than the value of the positive external benefits that

184 Th 2000, the section 29 credit was $6.14 per barrel of oil equivalent. A barrel of oil
has a heat value of 5.8 million British thermal units (Btu). One kilowatt-hour of electricity has a
heat value of 3,142 Btu. If a gas combustion facility is 20 percent efficient, it requires five Btu
of gas to produce one Btu of electricity. The Department of Energy reports that landfill gas
facilities that produce electricity generally are less than 30 percent efficient.

142


to charities.!°5 Critics of the present-law two-tier excise tax have criticized the efficiency of the
excise tax as an incentive to increase payout rates. First, critics note, the reduction in excise tax
depends only upon an increase in the foundation’s rate of distributions to charities, not on the
size of the increase in the rate of distributions. Thus, a large increase in distributions is rewarded
by the same reduction in excise tax rate as is a small increase in distributions. There is no extra
incentive to make a substantial increase in distributions rather than a quite modest increase in
distributions.

In addition, critics assert that, under a number of circumstances, the present-law two-tier
excise tax can create a disincentive for foundations to increase charitable distributions
substantially.'°° In order to take advantage of the one-percent excise tax rate, a private
foundation must increase its rate of charitable distributions in the current year above that which
prevailed in the preceding five years. Whether the present-law two-tier excise tax creates an
incentive or disincentive to increased payout rates depends, in part, on whether the foundation
currently is subject to the one-percent tax rate or the two-percent tax rate. Because modest
increases in payout rates qualify a foundation for the one-percent tax rate, some analysts suggest
that a foundation may be able to manage its distributions actively so that the foundation qualifies
for the one-percent tax rate without substantially increasing its payout rate,'37 For a foundation
subject to the one-percent rate in the current year, an increased payout in any year becomes part
of the computation to determine eligibility for the one-percent rate in future years. Thus, under
the present-law formula, the foundation can trigger the two-percent excise tax rate by increasing
the payout amount in a particular year because increased payouts make it more difficult for the
foundation to qualify for the one-percent rate in subsequent years, and it increases the possibility
that the foundation will become subject to the two-percent tax rate. Consequently, over time, the
one-percent rate provides a disincentive for increasing charitable distributions.

On the other hand, for a foundation currently subject to the one-percent excise tax rate
and also making charitable distributions at a rate above the minimum required amount, the
present-law two-tier excise tax can create a disincentive for foundations to reduce their payout
rate. A reduction in payout rate in the future would reduce the foundation’s five-year moving

135 In general, foundations that make only the minimum amount of charitable
distributions and seek to minimize total payouts have no incentive to decrease their rate of excise
tax because such a decrease would result in an increase in the required minimum amount of
charitable distributions, thus making no difference to the total payout of the private foundation.

136 See C. Eugene Steuerle and Martin A. Sullivan, “Toward More Simple and Effective
Giving: Reforming the Tax Rules for Charitable Contributions and Charitable Organizations,”
American Journal of Tax Policy, 12, Fall 1995, 399-447.

137 For example, if over a 10-year period the foundation increased its payout rate from

the minimum 5.00 percent to 5.01 percent, to 5.02 percent, up to 5.10 percent, the foundation
generally would qualify for the one-percent excise tax rate throughout the 10-year period.

88


VI. TAX ADMINISTRATION PROVISIONS AND UNEMPLOYMENT INSURANCE
A. IRS Restructuring and Reform Act of 1998
1. Modify section 1203 of the IRS Restructuring and Reform Act of 1998

Present Law

Section 1203 of the IRS Restructuring and Reform Act of 1998 requires the IRS to
terminate an employee for certain proven violations committed by the employee in connection
with the performance of official duties. The violations include: (1) willful failure to obtain the
required approval signatures on documents authorizing the seizure of a taxpayer’s home,
personal belongings, or business assets; (2) providing a false statement under oath material to a
matter involving a taxpayer; (3) with respect to a taxpayer, taxpayer representative, or other IRS
employee, the violation of any right under the U.S. Constitution, or any civil right established
under titles VI or VII of the Civil Rights Act of 1964, title IX of the Educational Amendments of
1972, the Age Discrimination in Employment Act of 1967, the Age Discrimination Act of 1975,
sections 501 or 504 of the Rehabilitation Act of 1973 and title I of the Americans with
Disabilities Act of 1990; (4) falsifying or destroying documents to conceal mistakes made by any
employee with respect to a matter involving a taxpayer or a taxpayer representative; (5) assault
or battery on a taxpayer or other IRS employee, but only if there is a criminal conviction or a
final judgment by a court in a civil case, with respect to the assault or battery; (6) violations of
the Internal Revenue Code, Treasury Regulations, or policies of the IRS (including the Internal
Revenue Manual) for the purpose of retaliating or harassing a taxpayer or other IRS employee;
(7) willful misuse of section 6103 for the purpose of concealing data from a Congressional
inquiry; (8) willful failure to file any tax return required under the Code on or before the due date
(including extensions) unless failure is due to reasonable cause; (9) willful understatement of
Federal tax liability, unless such understatement is due to reasonable cause; and (10) threatening
to audit a taxpayer for the purpose of extracting personal gain or benefit.

Section 1203 also provides non-delegable authority to the Commissioner to determine
that mitigating factors exist, that, in the Commissioner’s sole discretion, mitigate against
terminating the employee. The Commissioner, in his sole discretion, may establish a procedure
to determine whether an individual should be referred for such a determination by the
Commissioner.

Description of Proposal

The proposal removes the following from the list of violations requiring termination:
(1) the late filing of refund returns, and (2) employee versus employee acts. The proposal also
adds unauthorized inspection of returns and return information to the list of violations.
Additionally, the proposal requires the Commissioner to establish guidelines outlining specific
penalties, up to and including termination, for specific types of wrongful conduct covered by
section 1203 of the IRS Restructuring and Reform Act of 1998. The Commissioner retains the
non-delegable authority to determine whether mitigating factors support a personnel action other
than that specified in the guidelines for a covered violation.

Effective date—The proposal is effective on the date of enactment.

318


exempt entity” includes Federal, State and local governmental units, charities, and, foreign
entities or persons.“

In determining the length of the lease term for purposes of the 125-percent calculation,
several special rules apply. In addition to the stated term of the lease, the lease term includes
options to renew the lease or other periods of time during which the lessee could be obligated to
make rent payments or assume a risk of loss related to the leased property.

Tax-exempt use property does not include property that is used by a taxpayer to provide a
service to a tax-exempt entity. So long as the relationship between the parties is a bona fide
service contract, the taxpayer will be allowed to depreciate the property used in satisfying the
contract under normal MACRS rules, rather than the rules applicable to tax-exempt use
property.““* In addition, property is not treated as tax-exempt use property merely by reason of a
short-term lease. In general, a short-term lease means any lease the term of which is less than
three years and less than the greater of one year or 30 percent of the property’s class life.45
Also, tax-exempt use property generally does not include any qualified technological equipment
if the lease to the tax-exempt entity has a lease term of five years or less.“ The term “qualified
technological equipment” is defined as computers and related peripheral equipment, high
technology telephone station equipment installed on a customer’s premises, and high technology
medical equipment.” Finally, tax-exempt use property does not include computer software
because it is intangible property.

Description of Proposal
Overview

The Administration's proposal modifies the recovery period of certain property leased to
a tax-exempt entity, alters the definition of lease term for all property leased to a tax-exempt

43 Sec, 168(h)(2).

44 Sec, 7701(e) provides that a service contract will not be respected, and instead will be
treated as a lease of property, if such contract is properly treated as a lease taking into account all
relevant factors. The relevant factors include, among others, the service recipient controls the
property, the service recipient is in physical possession of the property, the service provider does
not bear significant risk of diminished receipts or increased costs if there is nonperformance, the
property is not used to concurrently provide services to other entities, and the contract price does
not substantially exceed the rental value of the property.

448 Sec, 168(h)(1)(C).

446 Sec, 168(h)(3). However, the exception does not apply if part or all of the qualified
technological equipment is financed by a tax-exempt obligation, is sold by the tax-exempt entity
(or related party) and leased back to the tax-exempt entity (or related party), or the tax-exempt
entity is the United States or any agency or instrumentality of the United States.

47 Sec. 168(i)(2).

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amongst themselves in certain instances increases flexibility for taxpayers, the existence of
choice may increase planning and compliance complexity for such taxpayers.

Policy issues

In general

The primary objective of the proposal is to simplify the tax law pertaining to child-related
tax benefits. The proposal raises several important policy issues, however, that are separate from
its simplification goals. The most significant of these policy concerns generally involve
questions of which taxpayer should be entitled to the relevant child-related tax benefits, the
expansion or shifting of tax benefits as a result of the changes to present law made by the
proposal, and the treatment of children of divorced or separated parents.

Expansion or shifting of tax benefits under the proposal

Residency and support tests.—The selection of residency or support as a determinant of
who is entitled to certain child-related tax benefits raises policy issues separate from complexity.
Many argue that child-related tax benefits should inure to those individuals who bear the greatest
economic and other burdens associated with raising the child. That is, at least in part, the
rationale for present-law rules that allocate dependency exemptions and certain other tax benefits
to taxpayers who provide over one half of the individual’s support or cost of maintaining the
household. There is, however, no uniform definition of “support” within the tax law (Le., the
support test used for the dependency exemption and the child credit differs from the household
maintenance test used for other purposes). Some believe that residency is a reasonable proxy for
support because the cost of providing a residence is oftentimes the largest component of a child’s
support. Some have argued that a residency test is less open to abuse than a support test, because
it generally is easier to determine when the residency test is satisfied.

Adopting a residency test for all five family-related tax benefits changes the beneficiary
of certain tax benefits in certain cases. Replacing the support test with the residency test may
result in the child credit or dependency exemption shifting from the provider of support (under
present law) to the taxpayer who satisfies the residency test (under the proposal).“° For
example, a child who lives with his or her father, but who is provided more than one half of his
or her support by the mother who lives elsewhere, no longer entitles the mother to a child credit
or the dependency exemption with respect to that child.

The treatment of means-tested government benefits has policy implications under present
law. Present law generally treats such benefits as provided by the government, not by the
taxpayer, for purposes of determining support and the cost of maintaining a household. Some,
including the IRS Taxpayer Advocate, argue that such government benefits should be
disregarded for these purposes, so that a taxpayer who receives public benefits is not penalized
simply because he or she receives such benefits. The treatment of public benefits for these

246 In certain cases, the proposal may expand the child credit and dependent care
benefits, such as in those cases involving no taxpayer who satisfies the support test.

170


partners in a partnership)” are entitled to deduct 100 percent of the amount paid for health
insurance for themselves and their spouse and dependents for income tax purposes.

Under present law, individuals who itemize deductions may deduct amounts paid during
the taxable year (to the extent not reimbursed by insurance or otherwise) for medical care of the
taxpayer, the taxpayer’s spouse, and dependents, to the extent that the total of such expenses
exceeds 7.5 percent of the taxpayer’s adjusted gross income.”

Self-employed individuals and individuals employed by small employers maintaining a
high-deductible health plan can accumulate funds in an Archer medical savings account
(“MSA”) on a tax-preferred basis to pay for medical expenses.”

Under the Consolidated Omnibus Budget Reconciliation Act of 1985 (“COBRA”),
qualified beneficiaries are eligible to purchase continuation coverage under an employer-
sponsored plan upon the occurrence of certain events that would otherwise result in loss of
coverage, such as termination of employment. The employer may charge up to 102 percent of
the average cost of the employer’s health plan for continuation coverage. Depending on the
circumstances, former employees and their dependents can elect to continue COBRA coverage
for up to 18 to 36 months.

Under the Trade Adjustment Assistance Reform Act of 2002,” eligible individuals can
receive a refundable tax credit for the cost of qualified health coverage. The credit is equal to 65
percent of the amount paid by certain individuals receiving a trade readjustment allowance, or
who would be eligible to receive such an allowance but for the fact that they had not exhausted
their regular unemployment benefits, or by certain individuals who are receiving pension
benefits from the Pension Benefit Guaranty Corporation. The credit is payable on an advance
basis.

The Medicare Prescription Drug, Improvement, and Modemization Act of 2003” added
provisions for health savings accounts (HSAs), effective for taxable years beginning after

67 Self-employed individuals include more than two-percent shareholders of S
corporations who are treated as partners for purposes of fringe benefit rules pursuant to section
1372.

8 Sec. 162(1). The deduction does not apply for self-employment tax (SECA) purposes.

© Sec. 213. The adjusted gross income percentage is 10 percent for purposes of the
alternative minimum tax. Sec. 56(b)(1)(B).

7 After 2003, no new contributions can be made to Archer MSAs except by or on behalf
of individuals who previously had Archer MSA contributions and employees who are employed
by a participating employer.

7 Pub. L. No. 107-210, sec. 201(a), 202 and 203 (2002).

® Pub. L. No. 108-173.

42


likely would argue that a government program would be less effective in identifying the needy
and overseeing delivery of the food than would the proposal.'?°

More specifically, critics argue that the definition of fair market value under the proposal
is too generous because it may permit taxpayers to claim as fair market value the full retail price
of food that was no longer fresh when donated. If so, taxpayers might be better off contributing
the food to charity than by selling the food in the ordinary course of their business. For example,
assume a taxpayer whose income is taxed at the highest corporate income tax rate of 35 percent
has purchased an avocado for $0.75. The taxpayer previously could have sold the avocado for
$1.35, but now could only sell the avocado for $0.30. If the taxpayer sold the avocado for $0.30,
the taxpayer would incur a loss of $0.45 ($0.75 basis minus $0.30 sales revenue) on the sale.
Because the loss on the sale of the avocado reduces the taxpayer’s taxable income, the taxpayer’s
tax liability would decline by approximately $0.16 ($0.45 multiplied by 35 percent), so the net
loss from the sale in terms of after-tax income would be $0.29. If, alternatively, the taxpayer had
donated the avocado to the local food bank, and under the proposal were allowed to claim a
deduction for the previous fair market value of $1.35, the taxpayer’s taxable income would be
reduced by $1.35 resulting in a reduction in tax liability of approximately $0.47 ($1.35
multiplied by 35 percent). However, the taxpayer originally purchased the avocado for $0.75
and, as the avocado is donated, this expense cannot be deducted as a cost of goods sold. By
donating the avocado, the taxpayer’s net loss on the avocado is $0.28 (the $0.47 in income tax
reduction minus the cost of acquiring the avocado, $0.75). Under the proposal, the taxpayer
loses less on the avocado by donating the avocado to charity than by selling the avocado.

This possible outcome is a result of permitting a deduction for a value that the taxpayer
may not be able to achieve in the market. Whether sold or donated, the taxpayer incurred a cost
to acquire the good. When a good is donated, it creates “revenue” for the taxpayer by reducing
his or her taxes otherwise due. When the value deducted exceeds the revenue potential of an
actual sale, the tax saving from the charitable deduction can exceed the sales revenue from a sale.
While such an outcome is possible, in practice it may not be the norm. In part because the
proposal limits the enhanced deduction to the lesser of the measure of fair market value or twice
the taxpayer’s basis, it can only be more profitable to donate food than to sell food if the
taxpayer would otherwise be selling the food to be donated at a loss. In general, it depends upon
the amount by which the deduction claimed exceeds the taxpayer's basis in the food relative to
the extent of the loss the taxpayer would incur from a sale,'*6

25 See generally Louis Alan Talley, “Charitable Contributions of Food Inventory:
Proposals for Change Under the ‘Community Solutions Act of 2001,’” Congressional Research
Service Report for Congress (August 23, 2001).

126 Th general, it is never more profitable to donate food, than to sell food unless the
taxpayer is permitted to deduct a value other than the current fair market value of the food. To
see this:

¢ let Y denote the taxpayer’s pre-tax income from all other business activity;

e let B denote the taxpayer’s acquisition cost (basis) of the item to be donated;

83


stock respects the separation of interest or dividend rights from the underlying bond or stock
(while recharacterizing the tax consequences of such transactions), the present-law treatment of
carved-out or retained mineral production payments recharacterizes the separation transaction
itself as a secured borrowing (rather than respecting the separation of production payments from
mineral property and treating such payments as economic interests in the property).

Description of Proposal

The proposal treats an income separation transaction as a secured borrowing, rather than
as a separation of ownership, such that the tax treatment of the transaction clearly reflects
income. The proposal does not define the term “income separation transaction.”

Effective date.The proposal generally is effective after the date of enactment.

Analysis of the Proposals Designed to Combat Abusive Tax. Avoidance Transactions

Policy issues

Individuals and corporations are increasingly using sophisticated transactions to avoid or
evade Federal income tax. Such a phenomenon poses a serious threat to the efficacy of the tax
system because of both the potential revenue loss and the potential threat to the integrity of the
self-assessment system.

On March 21, 2002, the Senate Committee on Finance heard testimony from Treasury
Department and IRS officials that only 272 transactions by 99 different taxpayers were disclosed
under the present law for the 2001 tax-filing season. In connection with the hearing, the
Treasury Department announced a new initiative (“Treasury shelter initiative”) that is designed
to provide the government with the tools necessary to respond to abusive tax avoidance
transactions.°” The President’s budget proposals to combat abusive tax avoidance transactions
generally are similar to the proposals that were contained in the Treasury shelter initiative.

The proposals emphasize combating abusive transactions by requiring increased
disclosure of such transactions by all parties involved. Clearly, greater disclosure is necessary if
the IRS is expected to respond to these transactions in a timely and meaningful manner.
However, there is some concern regarding whether increased disclosure, in and of itself, will be
sufficient to deter taxpayers from engaging in tax avoidance transactions. A motivated
corporation can manipulate the technical provisions of the law to achieve significant unintended
benefits. Such a taxpayer often obtains tax opinion letters from sophisticated tax advisors, and
uses exceedingly complicated structures and a myriad of entities to obfuscate the essential
elements of the transaction. These factors, coupled with a taxpayer’s assertion of attomey-client
privilege to impede the IRS’s ability to understand and analyze the transaction, cast doubt on any
proposal the effectiveness of which depends heavily on increased disclosure.

33 See generally, “The Treasury Department’s Enforcement Proposals for Abusive Tax
Avoidance Transactions,” (March 20, 2002).

252


Analysis
Policy issues
Late filing of refund returns

The proposal has the effect of treating IRS employees more like individuals employed by
any other employer, with respect to late filing of refund returns. Late filing generally is not
grounds for termination by most employers. In addition, late filing of refund claims is generally
not subject to penalty under the Code.>!° Proponents of the proposal relating to late filings may
argue that late filings of refund claims is not the type of serious conduct for which the severe
penalties imposed by the IRS Restructuring and Reform Act should apply. Others may argue
that IRS employees, as the enforcers of the country’s tax laws, should be held to a higher
standard and be required to timely file all income tax returns.

Employee vs. employee allegation

Advocates of removing employee versus employee allegations from the list of grounds
for IRS employee termination may argue that allegations of willful conduct by IRS employees
against other IRS employees can be addressed by existing administrative and statutory
procedures. Other means, such as the Whistleblower Protection Act, negotiated grievance
processes, and civil rights laws, exist to address employee complaints and appeals. Moreover, it
is argued that under present-law rules, parallel investigative and adjudicative functions for
addressing employee complaints and appeals are confusing to employees and burdensome for the
IRS.

Proponents also believe that it is appropriate to remove employee versus employee
allegations from the list of section 1203 violations because, unlike other section 1203 violations,
such allegations do not violate taxpayer protections. On the other hand, opponents may point out
that Congress believed it appropriate to include such allegations in the statutory list of grounds
for IRS employee termination. They may argue that including employee versus employee
allegations in the section 1203 violation list benefits tax administration. Another issue to
consider is the extent to which the inclusion of employee versus employee allegations on the list
of section 1203 violations deters inappropriate behavior (by reducing the likelihood of real
employee versus employee actions) or increases inappropriate behavior (by increasing the
inappropriate use of allegations of inappropriate behavior against other employees for purposes
of intimidation, harassment, or retribution).

Unauthorized inspection of returns

Advocates of the proposal argue that unauthorized inspection of tax returns and return
information is a serious act of misconduct that should be included in the list of violations subject
to termination, as unauthorized inspection is as serious as the other taxpayer rights protections
covered by section 1203. Code section 7213A already makes the unauthorized inspection of

515 The refund claim must be filed prior to the expiration of the applicable statute of
limitations for the taxpayer to receive the refund.

319


entity, and establishes rules to limit deductions associated with leases to tax-exempt entities
unless such lease satisfies specified criteria.

Modify the recovery period of certain property leased to a tax-exempt entity

The proposal modifies the recovery period for qualified technological equipment and
computer software leased to a tax-exempt entity“*® to be the longer of the property’s assigned
class life or 125 percent of the lease term. The proposal does not apply to short-term leases as
defined under present law section 168(h)(1)(C) and section 168(h)(3).

Modify definition of lease term

In determining the length of the lease term for purposes of the 125-percent calculation,
the proposal requires that the lease term include all service contracts and other similar
arrangements following a lease of property to a tax-exempt party. This requirement applies to all
leases of property to a tax-exempt entity.

Limit deductions for leases of property to tax-exempt parties

The proposal also provides that if a taxpayer leases property to a tax-exempt entity, the
taxpayer may not claim deductions from each lease transaction in excess of the taxpayer’s gross
income from the lease for that taxable year. This limit applies to deductions or losses related to a
lease to a tax-exempt party and the leased property. Any disallowed deductions are carried
forward and treated as deductions related to the lease in the next taxable year subject to the same
limitations. A taxpayer is permitted to deduct previously disallowed deductions and losses when
the taxpayer completely disposes of its interest in the property.

A lease of property to a tax-exempt party is not subject to the deduction limitations
described in the preceding paragraph if the lease satisfies all of the following five requirements.

(1) Property is not financed with tax-exempt bonds

The leased property is not financed with tax-exempt bonds. For example, a lease of
rolling stock to a municipality would be subject to the proposal if the proceeds of the
municipality’s general obligation bond were used to finance the acquisition of the rolling stock
(in whole or part).

(2) Tax-exempt entity does not monetize its lease obligation

The tax-exempt party does not enter into an arrangement to monetize its lease
obligations, including any purchase option, in an amount that exceeds 20 percent of the
taxpayer’s cost of the leased property. Arrangements to monetize lease obligations include a
defeasance arrangement, a loan by the tax-exempt party (or an affiliate) to the taxpayer (or an
affiliate), a deposit agreement, a letter of credit collateralized with cash or cash equivalents, a

448 The proposal defines a tax-exempt entity as under present law. Thus, it includes
Federal, State, local, and foreign governmental units, charities, foreign entities or persons.

282


B. Repeal Phase-Out for Adoption Provisions
Present Law
Tax credit

A maximum nonrefundable credit of $10,000 per eligible child is allowed for qualified
adoption expenses paid or incurred by the taxpayer. An eligible child is an individual (1) who
has not attained age 18 or (2) who is physically or mentally incapable of caring for him or
herself.

Qualified adoption expenses are reasonable and necessary adoption fees, court costs,
attorneys’ fees, and other expenses that are directly related to the legal adoption of an eligible
child. All reasonable and necessary expenses required by a State as a condition of adoption are
qualified adoption expenses. Generally, a taxpayer is not eligible for the adoption credit in the
year that qualified adoption expenses are paid or incurred by the taxpayer, but rather, in the next
taxable year. An exception is provided for qualified adoption expenses paid or incurred in the
year the adoption becomes final.

In the case of a special needs child, the adoption expenses taken into account are
increased by the excess, if any, of $10,000 over actual qualified adoption expenses otherwise
taken into account for that special needs child. A special needs child is an eligible child who
also meets other requirements. Specifically, a special needs child must be a citizen or resident of
the United States which the State has determined: (1) cannot or should not be returned to the
home of the birth parents, and (2) has a specific factor or condition because of which the child
cannot be placed with adoptive parents without adoption assistance.

Exclusion from income

Present law provides a maximum $10,000 exclusion from the gross income of an
employee for qualified adoption expenses (as defined above) paid by the employer. The $10,000
limit is a per-child limit, not an annual limitation. In the case of a special needs adoption, the
amount of adoption expenses taken into account in determining the exclusion for employer-
provided adoption assistance is increased by the excess, if any, of $10,000 over the amount of
the aggregate adoption expenses otherwise taken into account for that special needs child.

Description of Proposal

The proposal repeals the income phase-outs of the adoption credit and the exclusion for
qualified adoption expenses.

Effective date—The proposal is effective for taxable years beginning after December 31,
2004.

Analysis

Repeal of the phase-outs of the adoption credit and of the exclusion of adoption
assistance simplifies the tax system for those claiming the credit or exclusion. Removing the

174


The proposal treats small business stock capital gain rates the same as other stock capital
gain rates. The effective rates for gain from the sale of small business stock are currently similar
to the rates for other stock, taking into account the exclusion, treatment as 28-percent rate gain,
and the alternative minimum tax preference. The repeal of the small business stock provisions
would simplify administration of the tax law, in part, because the Internal Revenue Service may
not readily know whether the corporation is a qualified small business when the tax benefits are
claimed on the return of an individual shareholder.

Prior Action

No prior action.

210


A 20-percent research tax credit also applies to the excess of (1) 100 percent of corporate
cash expenses (including grants or contributions) paid for basic research conducted by
universities (and certain nonprofit scientific research organizations) over (2) the sum of (a) the
greater of two minimum basic research floors plus (b) an amount reflecting any decrease in
nonresearch giving to universities by the corporation as compared to such giving during a fixed-
base period, as adjusted for inflation. This separate credit computation is commonly referred to
as the university basic research credit (see sec. 41(e)).

Computation of allowable credit

Except for certain university basic research payments made by corporations, the research
tax credit applies only to the extent that the taxpayer’s qualified research expenses for the current
taxable year exceed its base amount. The base amount for the current year generally is computed
by multiplying the taxpayer’s fixed-base percentage by the average amount of the taxpayer’s
gross receipts for the four preceding years. If a taxpayer both incurred qualified research
expenses and had gross receipts during each of at least three years from 1984 through 1988, then
its fixed-base percentage is the ratio that its total qualified research expenses for the 1984-1988
period bears to its total gross receipts for that period (subject to a maximum fixed-base

Although the research tax credit expired during the period J uly 1, 1995, through June 30,
1996, the Small Business Job Protection Act of 1996 (“1996 Act”) extended the credit for the
period July 1, 1996, through May 31, 1997 (with a special 11-month extension for taxpayers that
elect to be subject to the alternative incremental research credit regime). In addition, the 1996
Act expanded the definition of start-up firms under section 41(c)(3)(B)(i), enacted a special rule
for certain research consortia payments under section 41(b)(3)(C), and provided that taxpayers
may elect an alternative research credit regime (under which the taxpayer is assigned a three-
tiered fixed-base percentage that is lower than the fixed-base percentage otherwise applicable
and the credit rate likewise is reduced) for the taxpayer’s first taxable year beginning after
June 30, 1996, and before July 1, 1997.

The Taxpayer Relief Act of 1997 (“1997 Act”) extended the research credit for 13
months--i.e., generally for the period June 1, 1997, through June 30, 1998. The 1997 Act also
provided that taxpayers are permitted to elect the alternative incremental research credit regime
for any taxable year beginning after June 30, 1996 (and such election will apply to that taxable
year and all subsequent taxable years unless revoked with the consent of the Secretary of the
Treasury). The Tax and Trade Relief Extension Act of 1998 extended the research credit for 12
months, i.e., through June 30, 1999.

The Ticket To Work and Work Incentive Improvement Act of 1999 extended the
research credit for five years, through June 30, 2004, increased the rates of credit under the
alternative incremental research credit regime, and expanded the definition of research to include
research undertaken in Puerto Rico and possessions of the United States.

360


Room and board

With respect to the exclusion for distributions from qualified tuition plans and Coverdell
education savings accounts, the proposal eliminates the two-part test for determining how much
can been received tax-free with respect to such expenses. Under the proposal, distributions from
such plans and accounts for room and board are excluded from income only to the extent that
they do not exceed the allowance (applicable to the student) for room and board included in the
cost of attendance as determined by the education institution for Federal student aid purposes.
The proposal does not affect provisions that do not allow any room and board expenses as
qualifying higher education expenses under present law. 79

Analysis

Taxpayers may be easily confused by the differences between definitions of similar terms
with respect to the various education provisions. Because of the variations in definitions,
taxpayers may inadvertently claim benefits to which they are not entitled or fail to claim benefits
to which they are entitled. The differences in definitions may also complicate record keeping for
taxpayers. The varying definitions also increase administrative burdens for the IRS in trying to
enforce compliance with the various provisions. The present-law rules may also increase
taxpayer frustration with the Federal tax laws because the reasons for the differences in the tax
treatment of certain expenses are unclear.

The staff of the Joint Committee on Taxation (“Joint Committee staff”) has previously
noted the complexities resulting from the differences in definitions of higher education expenses
in the various education tax benefits.”®° In its statutorily mandated simplification study, the Joint
Committee staff recommended that a uniform definition of qualifying education expenses should
be adopted.”*!

The proposal would achieve simplification in some areas with respect to the definition of
qualifying higher education expenses. By providing a uniform definition of “tuition and fees”
for all provisions, six of the 10 education provisions would have the same definition of
qualifying expenses. In addition, some simplification would be achieved by providing a uniform
definition of “books, supplies, and equipment” for those provisions that include such items as
qualifying expenses. However, because the proposal does not provide a uniform definition for
all types of qualifying expenses for all provisions, taxpayers may still be confused as to whether
an expense is a qualified expense under each of the provisions and therefore, as under present
law, may claim benefits for which they are not entitled and fail to claim benefits for which they

2 ‘The proposal also does not affect the two-prong test for room and board expenses
with respect to distributions from Coverdell education accounts for elementary and secondary
school expenses.

280 Joint Committee on Taxation, Study of the Overall State of the Federal Tax System
and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal
Revenue Code of 1986 (JCS-3-01), April 2001, Volume II, at 125.

28 Td. at 126.

200


percent. A credit rate of 3.75 percent applies to the extent that a taxpayer’s current-year research
expenses exceed a base amount computed by using a fixed-base percentage of two percent. An
election to be subject to this alternative incremental credit regime may be made for any taxable
year beginning after June 30, 1996, and such an election applies to that taxable year and all
subsequent years unless revoked with the consent of the Secretary of the Treasury.

Eligible expenses

Qualified research expenses eligible for the research tax credit consist of: (1) in-house
expenses of the taxpayer for wages and supplies attributable to qualified research; (2) certain
time-sharing costs for computer use in qualified research; and (3) 65 percent of amounts paid or
incurred by the taxpayer to certain other persons for qualified research conducted on the
taxpayer’s behalf (so-called contract research expenses).>*

To be eligible for the credit, the research must not only satisfy the requirements of
present-law section 174 (described below) but must be undertaken for the purpose of discovering
information that is technological in nature, the application of which is intended to be useful in
the development of a new or improved business component of the taxpayer, and substantially all
of the activities of which must constitute elements of a process of experimentation for functional
aspects, performance, reliability, or quality of a business component. Research does not qualify
for the credit if substantially all of the activities relate to style, taste, cosmetic, or seasonal design
factors (sec. 41(d)(3)). In addition, research does not qualify for the credit: (1) if conducted
after the beginning of commercial production of the business component; (2) if related to the
adaptation of an existing business component to a particular customer’s requirements; (3) if
related to the duplication of an existing business component from a physical examination of the
component itself or certain other information; or (4) if related to certain efficiency surveys,
management function or technique, market research, market testing, or market development,
routine data collection or routine quality control (sec. 41(d)(4)). Research does not qualify for
the credit if it is conducted outside the United States, Puerto Rico, or any U.S. possession.

Relation to deduction

Under section 174, taxpayers may elect to deduct currently the amount of certain research
or experimental expenditures paid or incurred in connection with a trade or business,
notwithstanding the general rule that business expenses to develop or create an asset that has a

586 Under a special rule enacted as part of the Small Business Job Protection Act of 1996,
75 percent of amounts paid to a research consortium for qualified research is treated as qualified
research expenses eligible for the research credit (rather than 65 percent under the general rule
under section 41(b)(3) governing contract research expenses) if (1) such research consortium is a
tax-exempt organization that is described in section 501(c)(3) (other than a private foundation) or
section 501(c)(6) and is organized and operated primarily to conduct scientific research, and
(2) such qualified research is conducted by the consortium on behalf of the taxpayer and one or
more persons not related to the taxpayer. Sec. 41(b)(3)(C).

362


disorder, valuable time will have been lost and Congress’s original intent in enacting the orphan
drug tax credit will have been partially thwarted.

For those cases where the process of filing an application and receiving designation as a
potential treatment for a rare disease or disorder occurs sufficiently expeditiously to fall entirely
within the taxpayer’s taxable year plus permitted filing extension, the proposal removes the
potential financial benefit from delaying clinical testing. While such an outcome may well
describe most applications, in some cases, particularly for applications filed near the close of a
taxpayer’s taxable year, there may be some uncertainty that designation will be made in a timely
manner. In such a case, the taxpayer is in the same position as present law and may choose to
delay filing the appropriate application until the beginning of his next taxable year.

The FDA is required to approve drugs for human clinical testing. Such approval creates a
unique starting point from which human clinical testing expenses can be measured. An
alternative proposal would be to expand qualifying expenses to include those expenses paid or
incurred after the date on which the taxpayer files an application with FDA for designation of the
drug as a potential treatment for a rare disease or disorder, regardless of whether the designation
is approved during the taxable year in which the application is filed. Such an alternative
proposal would provide more certainty to the taxpayer regarding clinical expenses eligible for
the credit. However, unlike the current proposal, such an alternative may create the additional
taxpayer burden of requiring the taxpayer to file an amended return to claim credit for qualifying
costs related to expenses incurred in a taxable year prior to designation.

The staff of the Joint Committee on Taxation recommended a change similar to the
current proposal as part of its 2001 simplification study.”

Prior Action

A similar proposal was part of the President’s fiscal year 2004 budget proposal.

A similar provision was included in H.R. 1308 as passed by the House of Representatives
in 2003.

6. Clarifications to the refundable credit for health insurance costs of eligible individuals

Present Law

Refundable health insurance credit: in general

Under the Trade Act of 2002,” in the case of taxpayers who are eligible individuals, a
refundable tax credit is provided for 65 percent of the taxpayer’s expenses for qualified health

% Joint Committee on Taxation, Study of the Overall State of the Federal Tax System
and Recommendations for Simplification, Pursuant to Section 8022(3)(b) of the Internal Revenue
Code of 1986, Vol. II (JCS-3-01), April 2001, p. 310.

\ Pub, L. No. 107-210.

60


Table 12.Present Value of Tax Benefit from a Contribution
of Intellectual Property

Year of Payment | Sliding Scale Present Value of
Payment Amount Percentage Tax Benefit Tax Benefit
1 $100 $100 $35.00 $33.30
2 100 90 31.50 28.51
3 100 80 28.00 24.11
4 100 70 24.50 20.07
5 100 60 21.00 16.36
6 100 50 17.50 12.97
7 100 40 14.00 9.87
8 100 30 10.50 7.04
9 100 20 7.00 4.47
10 100 10 3.50 2.13
Thereafter 100 0 0 0
Total present value
of tax benefit $158.83

If desired, much of this disparity could be reduced by reducing the range of the sliding
scale percentages (e.g., 67 percent allowed deduction in years one through five, 33 percent
allowed deduction in years six through 10), or by employing a constant allowance percentage
(e.g., 50 percent for each year of the 10 year period). For example, assuming the same five
percent discount rate and a 35 percent tax rate, a constant deduction allowance percentage of 59
percent would yield approximately the same present value (after-tax) as a 10 year stream of
equivalent payments under the President’s sliding scale proposal.

Under the recent Senate proposals, the disparity between the present value of a payment
received in year one versus year 10 would be limited to the discount factor element, because the
donor would be entitled to receive the same payment percentage in each year throughout the
permitted payment period.

Prior Action

H.R. 2, the “Jobs and Growth Tax Act of 2003,” as passed by the Senate on May 15,
2003, contained a provision that generally provided a basis deduction for charitable contributions
of patents and other intellectual property. This provision was struck in conference.

S. 1637, the “Jumpstart Our Business Strength Act,” as reported by the Senate Committee
on Finance on October 1, 2003, contained a similar provision, except that the future benefits
provided to the donor of intellectual property is in the form of payments by the charitable donee.

273


In addition, to the extent the proposal would subsidize food disposal, companies
producing food may take less care in managing their inventories and might have less incentive to
sell aging food by lowering prices, knowing that doing so might also reduce the value of an
eventual deduction.'?’ Critics also argue that the proposal would in effect provide a deduction
for the value of services, which are not otherwise deductible, because in some cases, services are
built into the fair market value of food.

© let a represent the percentage by which the permitted deduction exceeds the
taxpayer’s basis, that is 0B equals the value of the deduction permitted;

let B equal the current market value as a percentage of the taxpayer’s basis in the
item, that is the revenue that could be attained from sale is BB;

and let t denote the taxpayer’s marginal tax rate.

Further assume that B < 1 <a, that is, at the current market value the taxpayer would be
selling at a loss, but previously the taxpayer could sell at a profit.

The taxpayer’s after-tax income from sale of the item is (Y + BB - B)(1-t).

Under the proposal, the taxpayer’s after-tax income from contribution of the item is
Y —B-t(Y —aB). For the case in which the permitted deduction would exceed twice the
taxpayer’s basis, the taxpayer’s after-tax income from contribution of the item is
Y—-B-t(Y¥ - 2B).

It is more profitable to donate the item than to sell it when the following inequality is
satisfied.

(1) (¥+BB-B)(1-) < Y-B-t(Y -aB).
This inequality reduces to:
(2) BB+ (a-1)) <t.

Whether it is more profitable to donate food than to sell food depends upon the extent to
which the food would be sold at a loss (B) relative to the extent of the loss plus the extent to
which the permitted deduction exceeds the taxpayer’s basis (a-1), compared to the taxpayer’s
marginal tax rate. Because under present law, the marginal tax rate is 0.35, equation (2)
identifies conditions on the extent of loss and the permitted deduction that could create a
situation where a charitable contribution produces a smaller loss than would a market sale, such
as the example in the text. In the case where the taxpayer’s deduction would be limited to twice
basis, it is possible to show that for a marginal tax rate of 35 percent, the current market value of
the item to be donated must be less than 53.8 percent of the taxpayer’s basis in the item, that is, B
<0.538.

127 See Martin A. Sullivan, “Economic Analysis: Can Bush Fight Hunger With a Tax
Break?,” Tax Notes, vol. 94, Feb. 11, 2002, at 671.

84


State and local governments.—The main tax issues involved in State and local
governmental leasing appear to be whether leasing is an appropriate mechanism to provide State
and local government assistance and whether certain leasing transactions provide a double tax
benefit to State and local governments.

Congress already provides targeted assistance to States through the appropriations
process and also provides assistance through the tax system to State and local governments by
means of the exclusion from Federal tax of interest paid on municipal bonds and the itemized
deduction for certain State and local taxes. In addition, Congress has provided direct funding to
States.“°? In these situations, Congress generally either directs the funds to specific activities
(e.g., by direct appropriation) or limits the benefits by imposing rules that require the State and
local governments to follow certain rules (e.g., tax-exempt bond limitations). In contrast, the
benefits provided by leasing transactions are not subject to Congressional review or oversight.

Proponents of leasing claim that it is a mechanism to increase funding to maintain or
provide public services that could not be offered because bond issues have been rejected or limits
on indebtedness have been reached. However, critics argue that the federal tax Code ought not
be used to supersede laws and procedures that the local residents have imposed and can amend
directly upon a full consideration of their merits.

In some instances, State and local governments may be combining the benefits of leasing
with Federal financial assistance by leasing assets that previously have been funded with tax-
exempt obligations and grants by the Federal government. The proceeds of the sale may then be
invested by the State or local government in investments, the interest on which is used to cover
rental payments, meet other current operating expenses, and provide a sinking fund for
repurchasing the property at the end of the lease term. Some have argued that this produces two
financial benefits provided by the Federal government on the same asset, one enjoyed by the
governmental entity (through the Federal financial assistance) and another enjoyed by the tax-
exempt entity and the lessor (the tax benefits of depreciating the property).

Nonprofit organizations.—Leasing by nonprofit organizations generally raises similar tax
policy issues as State and local governmental leasing. Congress currently provides other
assistance to nonprofit organizations through the tax system (c.g., tax-exemption and
deductibility of charitable contributions of property donated to such organizations).

Foreign governments and persons.—As is the case with any other lessee, a foreign person
leasing property from a U.S. lessor may receive an indirect subsidy from the U.S. Treasury. If
the foreign person is taxable by the United States on all the income generated by that property,
the subsidy may be as justifiable as that provided to any other taxable user. However, if only a
small portion of the income is taxable by the United States, or if the foreigner is not subject to
USS. tax because it is a foreign government or a foreign entity not doing business in the United
States, then many of the same issues as those described above are raised. For example,
information provided for leases that have been registered as tax shelters with the IRS highlights

42 See e.g., Pub. L. 108-27, sec. 401, which provided $20 billion in direct funding to
States to provide funding for essential government services, and for Medicaid.

288


returns and return information illegal, with violations punishable by fine, imprisonment, and
discharge from employment. Even though unauthorized inspection is punishable under a
separate law, it is argued that extending section 1203 coverage to unauthorized inspection will
strengthen the IRS’ power to discipline without the penalty being overturned.

On the other hand, opponents of this part of the proposal may point out that most
violations of Code section 7213A are not prosecuted, but employees are subject to discipline
based on administrative determination. The IRS policy has been to propose termination of
employment in cases of unauthorized inspection, but in a number of recent cases, arbitrators and
the Merit Systems Protection Board have overturned the IRS’ determination to terminate
employees for such violations.

Advocates may also argue that adding unauthorized inspection of returns to the list of
section 1203 violations will prevent overturning of the IRS’ determination of the level of
appropriate employee punishment. Some might question whether it is appropriate to use an
internal administrative process to achieve a result that the IRS states that it has been unable to
achieve through judicial or external administrative processes. In addition, adding unauthorized
inspection of returns to the list of section 1203 violations could add to the fear of IRS employees
that they will be subject to unfounded allegations and lose their jobs as a result, which might
deter fair enforcement of the tax laws.

The position taken by the IRS with respect to this part of the proposal can be criticized as
inconsistent with its position on the employee versus employee allegations piece of the proposal.
The IRS argues that employee versus employee allegations should be removed from the list of
section 1203 violations because such allegations can be addressed by existing administrative and
statutory procedures, while at the same time argues that unauthorized inspection of returns
should be added to the list of violations even though it is punishable under a separate law. Some
might view these positions as inconsistent.

While the proposal makes unauthorized inspection (which is a misdemeanor) a section
1203 violation, it does not make unauthorized disclosure (which is a felony under Code section
7213) a section 1203 violation. Arguably, more damage can be done by disclosing sensitive tax
information to a third party than by looking at a return out of curiosity. Thus, the proposal can
be criticized as lacking the proper focus.

Penalty guidelines

Some are concerned that the IRS’ ability to administer the tax laws efficiently is
hampered by a fear among employees that they will be subject to false allegations and possibly
lose their jobs. Proponents of the proposal requiring the IRS to publish detailed guidelines argue
that these guidelines are needed to provide notice to IRS employees of the most likely
punishment that will result from specific violations. They believe that the certainty provided by
specific guidelines would improve IRS employee morale and enhance the fundamental fairness
of the statute.

Others argue that since Congress intended for the section 1203 violations to warrant
termination, it is not appropriate to allow the IRS to determine a lesser level of punishment.

320


The proposal allows an individual to offset the entire regular tax liability and alternative
minimum tax liability by the nonrefundable personal credits.

Effective date—The proposal is effective for taxable years beginning in 2004 and 2005.

Analysis

Allowing the nonrefundable personal credits to offset the regular tax and alternative
minimum tax, and increasing the exemption amounts results in significant simplification.
Substantially fewer taxpayers need to complete the alternative minimum tax form (Form 6251),
and the forms and worksheets relating to the various credits can be simplified.

Congress, in legislation relating to expiring provisions in recent years, has determined
that allowing these credits to fully offset the regular tax and alternative minimum tax does not
undermine the policy of the individual alternative minimum tax and promotes the important
social policies underlying each of the credits.

Congress also has temporarily increased the exemption amount in recent years to limit
the impact of the AMT. For example, the Jobs and Growth Tax Relief Act Reconciliation Act of
2003 increased the AMT exemption amounts for taxable years beginning in 2003 and 2004.

The following examples compare the effect of not extending minimum tax relief with the
effect of the proposal extending minimum tax relief:

Example 1.—Assume in 2004, a married couple has an adjusted gross income of $80,000,
they do not itemize deductions, and they have four dependent children, two of whom are eligible
for the child tax credit and two of whom are eligible for a combined $3,000 HOPE Scholarship
credit, The couple’s net tax liability (without and with an extension) is shown in Table 13.

580 For a recommendation that the repeal of the individual alternative minimum tax will
result in significant tax simplification, see Study of the Overall State of the Federal Tax System
and Recommendations Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986,
Volume II: Recommendations of the Staff of the Joint Committee on Taxation to Simplify the
Federal Tax System, p. 2.

356


their purchase of property can qualify a taxpayer for a lower effective tax rate (a higher after-tax
return) may bid less than they otherwise might knowing that the highest offer may not be
selected by a taxpayer who is informed of the tax benefits of the lower bid. In this sense, the
proposal is equivalent to the Federal government partially subsidizing the purchase of
conservation property selected by the qualifying conservation organization. From the
calculations above, by lowering the effective tax rate, the Federal government would be
effectively contributing as much as 7.5 percent of the purchase price of the property.'”

The extent to which the benefit of the proposed exclusion accrues to the taxpayer selling
the property or to the qualifying conservation organization purchasing the property depends upon
the demand for the property and the extent to which other similar properties also are offered for
sale, If one qualifying conservation organization is bidding against other persons for a property,
in general one might expect that the qualifying conservation organization might be able to derive
a substantial portion of the benefit of the lower effective tax rate. While the persons who are not
qualifying conservation organizations would bid based on what they believe the market value of
the property to be, the qualifying conservation could bid less, and as demonstrated above, the
seller could find it in his or her interest to accept the lower bid of the qualifying conservation
organization. To receive the entire benefit of the lower effective tax rate, the qualifying
conservation organization would have to know the tax position of the seller (see discussion of
complexity below). In practice, such knowledge would not be available to the qualifying
conservation organization and conservative bidding would result in the qualifying conservation
organization deriving less than the full benefit.

On the other hand, if several qualifying conservation organizations bid against each other
on the same property, as they compete with price offers they would transfer most of the benefit
from the exclusion to the taxpayer selling the property.

The incentive effects of the proposal decrease as the capital gains tax rate decreases for
the selling taxpayer, as is the case for many taxpayers as a result of the JGTRRA capital gain rate
reductions.

Complexity issues

In its report,'”! the staff of the Joint Committee on Taxation identified the taxation of
income from capital gains as an area of complexity in the individual income tax. The staff of the
Joint Committee on Taxation has identified nine different categories of capital gain, often with

170 ‘The percentages in the text assume that the taxpayer selling the property has a zero
basis in the property. Thus, the percentages in the text represent an upper bound on the Federal
governments effective share of the purchase price. In the case of property sold by a taxpayer
otherwise in the 10 or 15-percent marginal income tax brackets, the comparable percentages
would be lower.

171 Joint Committee on Taxation, Study of the Overall State of the Federal Tax System

and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal
Revenue Code of 1986, Volume II, 97-108, (JCS-3-01), April 2001.

119


Description of Proposal

Under the Administration’s proposal, the lifetime learning credit is revised to subsume the
deductions for student loan interest and qualified higher education expenses by allowing the
credit on a per-student basis and treating up to $2,500 of interest on student loans as a qualified
expense. The temporary above-the-line deduction for higher education expenses and the
deduction for student loan interest is repealed. The beginning of the phase-out range is raised to
$50,000 of modified AGI($100,000 for joint returns) and a new phase-out rule is added that
would reduce the otherwise allowed credits by 5 percent of the extent to which modified AGI
exceeds the new limits. The phase-out rules for the Hope credit is conformed to those of the
revised lifetime learning credit.

The dollar limits of the revised lifetime learning credit and the Hope credit are indexed
for inflation after 2005 using a $100 rounding convention. The phase-out rules for the Hope
credit and the lifetime learning credit are indexed for inflation after 2005 using a $1,000
rounding convention.

Effective date—The proposal is effective for taxable years beginning after December 31,
2004.

Analysis

By eliminating the deduction for higher education expenses, the proposal provides
simplification for taxpayers who, with respect to the same student, face the choice of claiming
the deduction or either the Hope or lifetime learning credit. Such taxpayers may have had to
make several calculations to see which tax benefit was most advantageous. If the taxpayer may
claim either the Hope or the lifetime learning credit with respect to the same student, the
proposal still requires calculating the benefit for each to see which results in the higher credit.
Such a calculation would be relatively easy in this case, however, given the credit formulas. For
expenses below a certain level, the Hope credit would always yield the higher benefit, and for
expenses above that level, the lifetime learning credit would be greater. IRS guidance could
identify this level of expenses such that taxpayers would not have to calculate each credit
themselves to see which is higher.

275

Subsuming the student loan interest deduction into the lifetime learning credit provides
modest simplification for taxpayers who claim the student loan interest deduction in addition to
claiming the lifetime learning credit or the deduction for higher education expenses. The
simplification results from conforming the phaseout ranges among these provisions, rather than

215 The staff of the Joint Committee on Taxation, in its statutorily mandated
simplification study, recommended consolidating the Hope and lifetime learning credits. The
deduction for higher education expenses did not exist at the time of the Joint Committee study.
See Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and
Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue
Code of 1986 (JCS-3-01), April 2001, volume ii, at 126-130.

193


F. Extend District of Columbia Enterprise Zone
Present Law

The Taxpayer Relief Act of 1997 designated certain economically depressed census tracts
within the District of Columbia as the District of Columbia Enterprise Zone (the “D.C. Zone”),
within which businesses and individual residents are eligible for special tax incentives. The D.C.
Zone designation remains in effect for the period from January 1, 1998, through December 31,
2003.4 In addition to the tax incentives available with respect to a Round I empowerment zone
(including a wage credit), the D.C. Zone also has a zero-percent capital gains rate that applies to
gain from the sale of certain qualified D.C. Zone assets acquired after December 31, 1997, and
held for more than five years.

With respect to the tax-exempt financing incentives, the D.C. Zone generally is treated
like a Round I empowerment zone; therefore, the issuance of such bonds is subject to the
District of Columbia’s annual private activity bond volume limitation. However, the aggregate
face amount of all outstanding qualified enterprise zone facility bonds per qualified D.C. Zone
business may not exceed $15 million.”°

624 The Omnibus Budget Reconciliation Act of 1993 authorized the designation of a total
of nine empowerment zones and 95 enterprise communities to provide tax incentives for
businesses to locate within certain geographic areas designated by the Secretaries of Housing and
Urban Development (“HUD”) and Agriculture. Portions of the District of Columbia were
designated an enterprise community in 1994 and thus became eligible to issue tax-exempt
enterprise zone facility bonds.

The Taxpayer Relief Act of 1997 designated certain economically depressed census tracts
within the District of Columbia as the D.C. Zone. The census tracts that compose the D.C.
Enterprise Zone are (1) all census tracts that presently are part of the D.C. enterprise community
designated under section 1391 (i.e., portions of Anacostia, Mt. Pleasant, Chinatown, and the
easternmost part of the District), and (2) all additional census tracts within the District of
Columbia where the poverty rate is not less than 20 percent. The D.C. Zone designation was
scheduled to expire on December 31, 2002.

The Community Renewal Tax Relief Act of 2000 extended the designation of the D.C.
Zone for one additional year, through December 31, 2003.

625 portions of the District of Columbia were designated as an enterprise community
under section 1391 in 1994. Accordingly, the District of Columbia was entitled to issue
tax-exempt enterprise zone facility bonds.

826 Sec. 1400A(a).

389


H. Energy Provisions
1. Extend and modify the tax credit for producing electricity from certain sources
Present Law’”

An income tax credit is allowed for the production of electricity from either qualified
wind energy, qualified “closed-loop” biomass, or qualified poultry waste facilities (sec. 45). The
amount of the credit is 1.5 cents per kilowatt hour (indexed for inflation) of electricity produced.
The amount of the credit was 1.8 cents per kilowatt hour for 2003. The credit is reduced for
grants, tax-exempt bonds, subsidized energy financing, and other credits.

The credit applies to electricity produced by a wind energy facility placed in service after
December 31, 1993, and before January 1, 2004, to electricity produced by a closed-loop
biomass facility placed in service after December 31, 1992, and before January 1, 2004, and toa
poultry waste facility placed in service after December 31, 1999, and before January 1, 2004.
The credit is allowable for production during the 10-year period after a facility is originally
placed in service. In order to claim the credit, a taxpayer must own the facility and sell the
electricity produced by the facility to an unrelated party. In the case of a poultry waste facility,
the taxpayer may claim the credit as a lessee/operator of a facility owned by a governmental unit.

Closed-loop biomass is plant matter, where the plants are grown for the sole purpose of
being used to generate electricity. It does not include waste materials (including, but not limited
to, scrap wood, manure, and municipal or agricultural waste). The credit also is not available to
taxpayers who use standing timber to produce electricity. Poultry waste means poultry manure
and litter, including wood shavings, straw, rice hulls, and other bedding material for the
disposition of manure.

The credit for electricity produced from wind, closed-loop biomass, or poultry waste isa
component of the general business credit (sec. 38(b)(8)). The credit, when combined with all
other components of the general business credit, generally may not exceed for any taxable year
the excess of the taxpayer’s net income tax over the greater of (1) 25 percent of net regular tax
liability above $25,000, or (2) the tentative minimum tax. For credits arising in taxable years
beginning after December 31, 1997, an unused general business credit generally may be carried
back one year and carried forward 20 years (sec. 39). To coordinate the carryback with the
period of application for this credit, the credit for electricity produced from closed-loop biomass
facilities may not be carried back to a tax year ending before 1993 and the credit for electricity
produced from wind energy may not be carried back to a tax year ending before 1994 (sec. 39).

12 The Energy Policy Act of 1992 created section 45 as a production credit for
electricity produced from wind and closed-loop biomass for production from certain facilities
placed in service before July 1, 1999. The Ticket to Work and Work Incentives Improvement
Act of 1999 added poultry waste as a qualifying energy source, extended the placed in service
date through December 31, 2001, and made certain modifications to the requirements of
qualifying wind facilities. The Job Creation and Worker Assistance Act of 2002 extended the
placed in service date through December 31, 2003.

122


D. Permanently Extend and Expand Disclosure of Tax Return Information
for Administration of Student Loans

Present Law

Income-contingent loan verification program

Present law prohibits the disclosure of returns and retum information, except to the extent
specifically authorized by the Code. An exception is provided for disclosure to the
Department of Education (but not to contractors thereof) of a taxpayer’s filing status, adjusted
gross income and identity information (i.e., name, mailing address, taxpayer identifying number)
to establish an appropriate repayment amount for an applicable student loan. The Department
of Education disclosure authority is scheduled to expire after December 31, 2004.

An exception to the general rule prohibiting disclosure is also provided for the disclosure
of returns and return information to a designee of the taxpayer.” Because the Department of
Education utilizes contractors for the income-contingent loan verification program, the
Department of Education obtains taxpayer information by consent under section 6103(c), rather
than under the specific exception.°8 The Department of Treasury has reported that the Internal
Revenue Service processes approximately 100,000 consents per year for this purpose.5°?

Verifying financial aid applications

The Higher Education Act of 1998 (“Higher Education Act”) authorized the Department
of Education to confirm with the Internal Revenue Service four discrete items of return
information for the purposes of verifying of student aid applications.°'° The Higher Education
Act, however, did not amend the Code to permit disclosure for this purpose. Therefore, the
disclosure provided by the Higher Education Act may not be made unless the taxpayer consents
to the disclosure under section 6103(c).

64 Sec, 6103.

5 Sec. 6103(1)(13).

66 Pub. L. No. 108-89, sec. 201 (2003).
7 Sec. 6103(c).

608 Department of Treasury, Report to the Congress on Scope and Use of Taxpayer
Confidentiality and Disclosure Provisions, Volume I: Study of General Provisions (October
2000) at 91.

608 Department of Treasury, General Explanations of the Administration's Fiscal Year
2004 Revenue Proposals (February 2003), p. 133.

610 Pub. L. No. 105-244, sec. 483 (1998).

377


related person) does not exceed 50 percent of the taxpayer’s basis in the property. Contributions
may be made to private foundations under certain conditions.

Description of Proposal

The proposal extends the enhanced deduction to apply to donations made in taxable years
beginning after December 31, 2003 and to donations made in taxable years beginning before
January 1, 2006.

Effective date—The proposal is effective on the date of enactment.

Analysis

In the absence of the enhanced deduction of present law, if the taxpayer were to dispose
of excess inventory by dumping unneeded computer equipment in a garbage dumpster, the
taxpayer generally could claim the purchase price of the inventory (the taxpayer’s basis in the
property) as an expense against his or her gross income. In the absence of the enhanced
deduction of present law, if the taxpayer were to donate the unneeded computer equipment to a
school or library, the taxpayer generally would be able to claim a charitable deduction equal to
the taxpayer’s basis in the computer equipment (subject to certain limit on charitable
contributions). From the perspective of the taxpayer’s profit motive, the taxpayer would be
indifferent between donating the computer equipment and dumping the computer equipment in a
garbage dumpster. If the taxpayer must incur cost to deliver the computer equipment to the
school or library, the taxpayer would not find it in his or her financial interest to donate the
computer equipment to the school or library. The enhanced deduction for computer equipment
and software is intended to give businesses greater incentive to contribute computer equipment
and software to educational organizations and public libraries.

Proponents argue that present law helps accelerate the nationwide adoption of computer
technology in education and helps avail more individuals internet access through their local
public library. Proponents argue that more time is needed to achieve higher levels of computer
access and that it is appropriate to extend the present-law enhanced deduction to help attain this
outcome. However, some argue that if the intended policy were to promote adoption of
computer technology in education and internet access via public libraries, it would be more
direct and efficient to provide a direct government subsidy instead of making a tax expenditure
through the tax system, which may result in abuse and cannot be monitored under the annual
budgetary process.

The proposal, as does present law, creates certain complexities for the taxpayer and the
Internal Revenue Service. The enhanced deduction is allowed to the donor only for equipment
that the donee does not trade or sell. Generally, once the equipment is in the hands of the donee
it is difficult for the donor to monitor the use of the equipment. Likewise, it is difficult for the
Internal Revenue Service to ascertain whether a claim for an enhanced deduction would be valid.
Also, the proposal, as does present law, predicates the enhanced deduction on an ascertainable

654 Sec. 170(€)(6)(C).

398


Nondiscrimination tests for matching contributions and after-tax employee contributions

Employer matching contributions and after-tax employee contributions are also subject to
a special annual nondiscrimination test, the “ACP test”.* The ACP test compares the actual
contribution percentages (“ACPs”) of the highly compensated employee group and the
nonhighly compensated employee group. The ACP for each group generally is the average of
the contribution percentages separately calculated for the employees in the group who are
eligible to make after-tax employee contributions or who are eligible for an allocation of
matching contributions for all or a portion of the relevant plan year. Each eligible employee’s
contribution percentage generally is the employee’s aggregate after-tax employee contributions
and matching contributions for the year divided by the employee’s compensation for the year.

The plan generally satisfies the ACP test if the ACP of the highly compensated employee
group for the current plan year is either (1) not more than 125 percent of the ACP of the
nonhighly compensated employee group for the prior plan year, or (2) not more than 200 percent
of the ACP of the nonhighly compensated employee group for the prior plan year and not more
than two percentage points greater than the ACP of the nonhighly compensated employee group
for the prior plan year.

A safe harbor section 401(k) plan is deemed to satisfy the ACP test with respect to
matching contributions, provided that (1) matching contributions are not provided with respect to
elective deferrals or after-tax employee contributions in excess of six percent of compensation,
(2) the rate of matching contribution does not increase as the rate of an employee’s elective
deferrals or after-tax contributions increases, and (3) the rate of matching contribution with
respect to any rate of elective deferral or after-tax employee contribution of a highly
compensated employee is no greater than the rate of matching contribution with respect to the
same rate of deferral or contribution of a nonhighly compensated employee.

Tax-sheltered annuities (section 403(b) plans:

Section 403(b) plans are another form of employer-based retirement plan that provide the
same tax benefits as qualified retirement plans. Employers may contribute to such plans on
behalf of their employees, and employees may make elective deferrals. Section 403(b) plans
may be maintained only by (1) tax-exempt charitable organizations, and (2) educational
institutions of State or local governments (including public schools). Some of the rules that
apply to section 403(b) plans are similar to rules applicable to qualified retirement plans.

Contributions to a section 403(b) plan are generally subject to the same contribution
limits applicable to qualified defined contribution plans, including the special limits for elective
deferrals (and catch-up contributions) under a section 401(k) plan. If contributions are made to
both a qualified defined contribution plan and a section 403(b) plan for the same employee, a
single limit applies to the contributions under both plans. Special contribution limits apply to
certain employees under a section 403(b) plan maintained by a church. In addition, additional
elective deferrals are permitted under a plan maintained by an educational organization, hospital,

4 Sec. 401(m).

29


Income contingent loan verification program

Currently the Department of Education uses consents to obtain tax information for
purposes of its income contingent loan verification program, and does not rely on the statutory
authority to receive that information without consent. The IRS processes over 100,000 consents
for this program. Some might argue that since the specific statutory authority is not being used,
it should not be extended.

Verifying financial aid applications

Congress has expressed a concern about the increasing number of requests for the
disclosure of confidential tax information for nontax purposes and the effect of such disclosures
on voluntary taxpayer compliance.°"° Some might argue that consensual disclosure of return
information, in which the taxpayer knowingly consents to the disclosure of his or her return
information (“consents”), is less likely to adversely impact taxpayer compliance than adding a
nonconsensual provision for the disclosure of taxpayer information. Since the Internal Revenue
Service is already processing consents for the Department of Education, some would argue that
the current practice simply could be extended to financial aid applications.*'® On the other hand,
some might argue that because present law does not impose restrictions on redisclosure of return
information obtained by consent, the proposal, which imposes such restrictions, would be
preferable.

Critics might argue that the disclosure of sensitive return information of millions""” of

taxpayers to identify the abuse of a few does not strike the appropriate balance between the need
to know and the right to privacy. On the other hand, some might argue that since this financial
information is already required to be submitted as part of the financial aid form, the infringement
on taxpayer privacy is minimal.

615 § Prt, No. 103-37 at 54 (1993).

616 Ty its study on the disclosure of return information, the Department of Treasury noted:
“The burden of processing this number of consents obviously would be reduced if the consents
were executed and transmitted electronically. Accordingly, the Department of Education has
asked to be included in the TDS program.” Department of Treasury, Report to the Congress on
Scope and Use of Taxpayer Confidentiality and Disclosure Provisions, Volume I: Study of
General Provisions (2000) at 92.

617 The Department of Education seeks access to the return information of approximately
15 million taxpayers each year. The Department of Education receives approximately 10 million
applications for student financial assistance each year. Because roughly half of the applicants
are dependents, income information is needed for both the student and his or her parents. Thus,
verification under this provision could apply to over 15 million taxpayers each year. It is not
clear what percentage of applicants submit fraudulent financial aid applications. Id.

380


Another factor that may deter significant numbers of individuals from availing
themselves of the extended Federal due date is whether States and local governments that impose
income taxes provide parallel extensions of time to file. If they do not, and if the State or local
income tax requires completion of the Federal return first (which many but not all do), taxpayers
in those jurisdictions may not be able to avail themselves of the extended due date for Federal
returns.

Although the proposal may in many instances reduce administrative burdens, having two
different Federal filing deadlines could be considered to increase complexity. It would, for
example, require explaining two filing deadlines, which is likely to be more complex than
explaining one. Another factor that could affect complexity is whether all tax forms (or only
some tax forms) will be eligible for electronic filing by the time the proposal becomes effective.
For the current tax filing season, many (but not all) tax forms are eligible for electronic filing.”
If some forms cannot be filed electronically, taxpayers required to file those forms will be
ineligible for this extension of time to file and pay. This could mean that taxpayers with
especially complicated returns will be ineligible for this extension. If taxpayers are unaware in
advance of their ineligibility to file electronically, ineligible taxpayers (erroneously believing
they were eligible) might delay the filing of their returns until after April 15 intending to take
advantage of this extension of time, then discover they are in fact ineligible and consequently
inadvertently file late returns (owing interest and penalties). Some taxpayers could also find
themselves inadvertently filing late returns if they planned to take advantage of the proposal but
their computers break down after April 15 and they are unable to make them operational prior to
April 30. Similar situations could arise if there are break downs in the transmission process.

Prior Action
A similar proposal was included in the President’s fiscal year 2003 budget proposal. An
identical proposal was included in the President’s fiscal year 2004 budget proposal. A similar

proposal was contained in the “Taxpayer Protection and IRS Accountability Act of 2003,” as
passed by the House of Representatives on June 19, 2003.

538 See IRS Publication 1345A, Filing Season Supplement for Authorized IRS E-File
Providers, pp. 22-3 (December 19, 2003).

332


Il. SIMPLIFY THE TAX LAWS FOR FAMILIES
A. Establish Uniform Definition of a Qualifying Child

Present Law

In general

Present law contains five commonly used provisions that provide benefits to taxpayers
with children: (1) the dependency exemption; (2) the child credit; (3) the earned income credit;
(4) the dependent care credit; and (5) head of household filing status. Each provision has
separate criteria for determining whether the taxpayer qualifies for the applicable tax benefit with
respect to a particular child. The separate criteria include factors such as the relationship (if any)
the child must bear to the taxpayer, the age of the child, and whether the child must live with the
taxpayer. Thus, a taxpayer is required to apply different definitions to the same individual when
determining eligibility for these provisions, and an individual who qualifies a taxpayer for one
provision does not automatically qualify the taxpayer for another provision.

Dependency exemption'”
In general

Taxpayers are entitled to a personal exemption deduction for the taxpayer, his or her
spouse, and each dependent. For 2004, the amount deductible for each personal exemption is
$3,100, The deduction for personal exemptions is phased out for taxpayers with incomes above
certain thresholds.'*

In general, a taxpayer is entitled to a dependency exemption for an individual if the
individual: (1) satisfies a relationship test or is a member of the taxpayer’s household for the
entire taxable year; (2) satisfies a support test; (3) satisfies a gross income test or is a child of the
taxpayer under a certain age; (4) is a citizen or resident of the U.S. or resident of Canada or
Mexico;! and (5) did not file a joint return with his or her spouse for the year." In addition,
the taxpayer identification number of the individual must be included on the taxpayer’s return.

197 Secs, 151 and 152. Under the statutory structure, section 151 provides for the
deduction for personal exemptions with respect to “dependents.” The term “dependent” is
defined in section 152. Most of the requirements regarding dependents are contained in section
152; section 151 contains additional requirements that must be satisfied in order to obtain a
dependency exemption with respect to a dependent (as so defined). In particular, section 151
contains the gross income test, the rules relating to married dependents filing a joint return, and
the requirement for a taxpayer identification number. The other rules discussed here are
contained in section 151.

188 Sec. 151(d)(3).

19 A Jegally adopted child who does not satisfy the residency or citizenship requirement
may nevertheless qualify as a dependent (provided other applicable requirements are met) if (1)

154


Other policy issues related to the research and experimentation credit

Perhaps the greatest criticism of the research and experimentation tax credit among
taxpayers regards its temporary nature. Research projects frequently span years. If a taxpayer
considers an incremental research project, the lack of certainty regarding the availability of
future credits increases the financial risk of the expenditure. A credit of longer duration may
more successfully induce additional research than would a temporary credit, even if the
temporary credit is periodically renewed.

An incremental credit does not provide an incentive for all firms undertaking qualified
research expenditures. Many firms have current-year qualified expenditures below the base
amount. These firms receive no tax credit and have an effective rate of credit of zero. Although
there is no revenue cost associated with firms with qualified expenditures below base, there may
be a distortion in the allocation of resources as a result of these uneven incentives.

Ifa firm has no current tax liability, or if the firm is subject to the alternative minimum
tax (“AMT”) or the general business credit limitation, the research credit must be carried forward
for use against future-year tax liabilities. The inability to use a tax credit immediately reduces its

This makes it empirically difficult to distinguish short-run and long-run effects, particularly as it
may take firms some time to fully appreciate the incentive structure of the revised credit. See,
Bronwyn H. Hall, “R&D Tax Policy During the 1980s: Success or Failure?” in James M. Poterba
(ed.), Tax Policy and the Economy, 7, pp. 1-35 (Cambridge: The MIT Press, 1993). Another
recent study examined the post-1986 growth of research expenditures by 40 U.S.-based
multinationals and found price elasticities between 1.2 and 1.8. However, including an
additional 76 firms, that had initially been excluded because they had been involved in merger
activity, the estimated elasticities fell by half. See, James R. Hines, Jr., “On the Sensitivity of
R&D to Delicate Tax Changes: The Behavior of U.S. Multinationals in the 1980s” in Alberto
Giovannini, R. Glenn Hubbard, and Joel Slemrod (eds.), Studies in International Taxation,
(Chicago: University of Chicago Press 1993). Also see M. Ishaq Nadiri and Theofanis P.
Mamuneas, “R&D Tax Incentives and Manufacturing-Sector R&D Expenditures,” in James M.
Poterba, editor, Borderline Case: International Tax Policy, Corporate Research and
Development, and Investment, (Washington, D.C.: National Academy Press), 1997. While their
study concludes that one dollar of research tax credit produces 95 cents of research, they note
that time series empirical work is clouded by poor measures of the price deflators used to convert
nominal research expenditures to real expenditures.

Other research suggests that many of the elasticity studies may overstate the efficiency of
subsidies to research. Most R&D spending is for wages and the supply of qualified scientists is
small, particularly in the short run. Subsidies may raise the wages of scientists, and hence
research spending, without increasing actual research. See Austan Goolsbee, “Does Government
R&D Policy Mainly Benefit Scientists and Engineers?” American Economic Review, vol. 88,
May, 1998, pp. 298-302.

371


taxpayer generally may file as head of household if: (1) he or she resides with a qualifying child,
or a related dependent, for more than half the taxable year; or (2) he or she claims a parent as a
dependent, regardless of whether the parent resides with the taxpayer. A special rule applies in
the case of unmarried parents who reside together with their son or daughter for more than half
the year. In such cases, only one of the parents may claim head of household filing status with
respect to the son or daughter. If both parents claim head of household filing status with respect
to the son or daughter, only the parent with the higher adjusted gross income could claim the son
or daughter. If the unmarried parents reside together with more than one son or daughter, the
special rule applies (that is, only one of the two parents may claim head of household filing
status).

The proposal also eliminates the household maintenance test for purposes of the
surviving spouse rules. Under the proposal, a taxpayer is considered a surviving spouse if his or
her spouse died during either of the two years immediately preceding the current taxable year,
and the taxpayer resides with his or her dependent child (son, daughter or stepchild) for over half
the taxable year.

The proposal is effective for taxable years beginning after December 31, 2004.

Analysis

The proposal would simplify tax administration by permitting an unmarried taxpayer to
claim a filing status that is more advantageous than single without having to determine whether
the taxpayer provided over half the cost of certain expenses for the qualifying child or other
dependent. Instead, the taxpayer need only show that the qualifying child or other dependent
resided with the taxpayer in the same principal place of abode for more than half the taxable
year. Eliminating the expense test is consistent with other simplification proposals that eliminate
the support test and replace it with the requirement that the child or other dependent satisfy a
residency test with respect to the taxpayer.

Some may argue that the proposal has the effect of eliminating the head of household
filing status and replacing it with a filing status for unmarried taxpayers with a qualifying child
or other dependent who resides with the taxpayer.

The staff of the Joint Committee on Taxation simplification proposal to adopt a uniform
definition of qualifying child recommended that the household maintenance test be retained for
purposes of head of household filing status.> The staff noted that eliminating the test might
decrease complexity, but stated that the test is integral to head of household filing status.

Prior Action

No prior action.

255 Joint Committee on Taxation, Study of the Overall State of the Federal Tax System
and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal
Revenue Code of 1986, Volume Il, 58 (JCS-3-01), April 2001.

177


as all people living together under one roof.) A third concept of equity is that the income tax
should be progressive; that is, as income rises, the tax burden should rise as a percentage of
income.

These three concepts of equity are mutually inconsistent. A tax system can generally
satisfy any two of them, but not all three. The current tax system is progressive: as a taxpayer’s
income rises, the tax burden increases as a percentage of income. It also taxes married couples
with equal income equally. It specifies the married couple as the tax unit so that married couples
with the same income pay the same tax. But the current tax system is not marriage neutral.’ A
system of mandatory separate filing for married couples would sacrifice the principle of equal
taxation of married couples with equal incomes for the principle of marriage neutrality, unless it
were to forgo progressivity.

There is disagreement as to whether equal taxation of couples with equal incomes isa
better principle than marriage neutrality.® Those who hold marriage neutrality to be more
important tend to focus on marriage penalties that may arise under present law and argue that tax
policy discourages marriage and encourages unmarried individuals to cohabit without getting
married, thereby lowering society’s standard of morality. Also, they argue that it is simply unfair
to impose a marriage penalty even if the penalty does not actually deter anyone from marrying.

Those who favor the principle of equal taxation of married couples with equal incomes
argue that as long as most couples pool their income and consume as a unit, two married couples
with $20,000 of income are equally well off regardless of whether their income is divided
$10,000-$10,000 or $15,000-$5,000. Thus, it is argued, those two married couples should pay
the same tax, as they do under present law. By contrast, a marriage-neutral system with
progressive rates would involve a larger combined tax on the married couple with the unequal
income division.

8 Even when the bracket breakpoints and the standard deduction amounts for unmarried
taxpayers (and for married taxpayers filing separate returns) are half of those for married couples
filing a joint return, the tax system would not be marriage neutral. Many married couples would
still have marriage bonuses. As described below, the joint return in such a system would allow
married couples to pay twice the tax of a single taxpayer having one-half the couple’s taxable
income. With progressive rates, this income splitting may result in reduced tax liabilities for
some couples filing joint returns. For example, consider a married couple in which one spouse
has $60,000 of income and the other has none. By filing a joint return, the couple pays the same
tax as a pair of unmarried individuals each with $30,000 of income. With progressive taxation,
the tax liability on $30,000 would be less than half of the tax liability on $60,000. Thus the
married couple has a marriage bonus: the joint return results in a smaller tax liability than the
combined tax liability of the spouses if they were not married.

9 This discussion assumes that the dilemma cannot be resolved by moving to a
proportional tax (i.e., a single rate on all income for all taxpayers) system. A proportional system
would automatically produce marriage neutrality and equal taxation of couples with equal
incomes.


be self-supporting: “In effect, the annual advances from the Treasury are being used to pay back
interest to the Treasury, while the debt has been growing as if with compound interest.” 50

Miners and survivors qualify for benefits from the Fund only if the miner’s mine
employment terminated before 1970 or no mine operator is liable for the payment of benefits.
Some might argue that since the Federal Government has essentially made a loan to itself with a
transfer between funds, the interest component should be forgiven. Because the class of
beneficiaries is dwindling and revenues currently cover benefits and administrative costs, coal
tax revenues could eventually pay off the bonds if extended at their current rates.

Based on historical trends, it appears that the trust fund will not be able to pay off its debt
by December 31, 2013. Therefore, it could be argued that it is appropriate to continue the tax on
coal at the increased rates beyond that expiration date until the debt is repaid, rather than require
that the General Fund provide even larger advances to the trust fund. On the other hand, since
the tax is not scheduled to be reduced until December 31, 2013, it could be argued that this
proposal to further extend the rates is premature.

Prior Action

No prior action.

650 Id.

410


percentage of 16 percent). All other taxpayers (so-called start-up firms) are assigned a fixed-
base percentage of three percent.*®

In computing the credit, a taxpayer’s base amount may not be less than 50 percent of its
current-year qualified research expenses.

To prevent artificial increases in research expenditures by shifting expenditures among
commonly controlled or otherwise related entities, a special aggregation rule provides that all
members of the same controlled group of corporations are treated as a single taxpayer (sec.
41(£(1)). Under regulations prescribed by the Secretary, special rules apply for computing the
credit when a major portion of a trade or business (or unit thereof) changes hands, under which
qualified research expenses and gross receipts for periods prior to the change of ownership of a
trade or business are treated as transferred with the trade or business that gave rise to those
expenses and receipts for purposes of recomputing a taxpayer’s fixed-base percentage (sec.

41(f)(3)).
Alternative incremental research credit regime

Taxpayers are allowed to elect an alternative incremental research credit regime.”® Ifa
taxpayer elects to be subject to this alternative regime, the taxpayer is assigned a three-tiered
fixed-base percentage (that is lower than the fixed-base percentage otherwise applicable under
present law) and the credit rate likewise is reduced. Under the alternative incremental credit
regime, a credit rate of 2.65 percent applies to the extent that a taxpayer’s current-year research
expenses exceed a base amount computed by using a fixed-base percentage of one percent (i.e.,
the base amount equals one percent of the taxpayer’s average gross receipts for the four
preceding years) but do not exceed a base amount computed by using a fixed-base percentage of
1.5 percent. A credit rate of 3.2 percent applies to the extent that a taxpayer’s current-year
research expenses exceed a base amount computed by using a fixed-base percentage of 1.5
percent but do not exceed a base amount computed by using a fixed-base percentage of two

584 The Small Business Job Protection Act of 1996 expanded the definition of start-up
firms under section 41(c)(3)(B)(i) to include any firm if the first taxable year in which such firm
had both gross receipts and qualified research expenses began after 1983.

A special rule (enacted in 1993) is designed to gradually recompute a start-up firm’s
fixed-base percentage based on its actual research experience. Under this special rule, a start-up
firm will be assigned a fixed-base percentage of three percent for each of its first five taxable
years after 1993 in which it incurs qualified research expenses. In the event that the research
credit is extended beyond the scheduled expiration date, a start-up firm’s fixed-base percentage
for its sixth through tenth taxable years after 1993 in which it incurs qualified research expenses
will be a phased-in ratio based on its actual research experience. For all subsequent taxable
years, the taxpayer’s fixed-base percentage will be its actual ratio of qualified research expenses
to gross receipts for any five years selected by the taxpayer from its fifth through tenth taxable
years after 1993 (sec. 41(c)(3)(B)).

585 Sec, 41(c)(4).

361


H. Allow Employers of Household Employees to Report and Pay Combined Federal
and State Unemployment Insurance Taxes on the Form 1040

Present Law

Individuals with household employees are subject to Federal unemployment taxes
(FUTA) on wages paid to such employees if total wages paid to all such employees equals at
least $1,000 in any calendar quarter of the current or immediately proceeding taxable year.
Household employees may include babysitters, cleaning persons and housekeepers.

Individuals with household employees may also be subject to State unemployment taxes
that are required to be reported and paid quarterly to the State by the household employer. A
credit against FUTA taxes is generally available for State unemployment taxes paid by the
employer.

FUTA taxes on household employees are reported and paid on Schedule H for the Form
1040 of the household employer.

Description of Proposal

The proposal provides for household employers to report and pay State unemployment
taxes for household employees on the household employer’s Schedule H of Form 1040 rather
than quarterly to the States. Therefore household employers would report and pay FICA, FUTA
and income tax withheld for their household employees on Schedule H of Form 1040.

The present law requirement that household employers file employee wage and tax
statements (Form W-2) and transmittal of wage and tax statements (Form W-3) is not affected by
this proposal.

Effective date The proposal is effective for taxable years beginning after December 31,
2004.

Analysis

The proposal eases compliance burdens on employers of household employees by
consolidating the reporting and payment of State and Federal unemployment taxes on the
employer’s Form 1040. This proposal replaces the State quarterly reporting and tax payments of
unemployment insurance taxes.

The proposal eliminates the ability of the States to individually set an income threshold
for employment coverage, a ceiling on covered wages and experience ratings for household
employers. Instead these levels would be set at uniform levels by the Federal government. This
may reduce the State unemployment costs for some household employers but increase such costs
for others.

The proposal does not alter the present law ability of the States to set unemployment
benefit eligibility and benefit levels. States may adjust such levels to reflect the uniform levels

204


energy source for the simultaneous or sequential generation of (1) electricity or mechanical shaft
power (or both) and (2) steam or other forms of useful thermal energy (including heating and
cooling applications). A qualified CHP system is required to produce at least 20 percent of its
total useful energy in the form of thermal energy and at least 20 percent of its total useful energy
in the form of electrical or mechanical power (or a combination thereof) and would also be
required to satisfy an energy-efficiency standard. For CHP systems with an electrical capacity in
excess of 50 megawatts (or a mechanical energy capacity in excess of 67,000 horsepower), the
total energy efficiency of the system would have to exceed 70 percent. For smaller systems, the
total energy efficiency would have to exceed 60 percent. For this purpose, total energy efficiency
is calculated as the sum of the useful electrical, thermal, and mechanical power produced by the
system at normal operating rates, measured on a Btu basis, divided by the lower heating value of
the primary fuel source for the system. The eligibility of qualified CHP property is verified under
regulations prescribed by the Secretary of the Treasury.

Qualified CHP assets that are assigned cost recovery periods of less than 15 years are
eligible for the credit, but only if the taxpayer elects to treat such property as having a 22-year
class life. Thus, for such property, regular tax depreciation allowances are calculated using a 15-
year recovery period and the 150 percent declining balance method.

The credit is treated as an energy credit under the investment credit component of the
section 38 general business credit, and is subject to the tules and limitations governing that
credit. Taxpayers using the credit for CHP equipment would not be entitled to any other tax
credit for the same equipment.

Effective date—The credit would apply to equipment placed in service after December
31, 2003 and before January 1, 2009.

Analysis

See General discussion immediately below.
Prior Action

A similar proposal was contained in the President's fiscal year 2000, 2003 and 2004
budget proposals. The conference agreement to H.R. 6, “The Energy Policy Act of 2003,” as
passed by the House of Representatives on November 18, 2003 contained a similar provision.
Similar provisions are contained in Division D of H.R. 6, the "Energy Tax Policy Act of 2003,"
as passed by the House of Representatives on April 11, 2003, and in Division H of H.R. 6, the
“Energy Tax Incentives Act of 2003” as amended and passed by the Senate on July 31, 2003.

Similar provisions were also contained in Division C of HR. 4, the “Energy Tax Policy
Act of 2001,” as passed by the House of Representatives on August 2, 2001, and in Division H
of HR. 4, “The Energy Tax Incentives Act of 2002,” as amended and passed by the Senate on
April 25, 2002.

137


Tax Administration. The role of the existing Treasury IG was redefined to exclude responsibility
for the IRS. The Treasury IG for Tax Administration is under the supervision of the Secretary of
Treasury, with certain additional reporting to the IRS Oversight Board (the “Board”) and the
Congress.

The Treasury Office of Inspector General (“Treasury IG”) was established in 1988 and is
charged with conducting independent audits, investigations and review to help the Department of
Treasury accomplish its mission, improve its programs and operations, promote economy,
efficiency and effectiveness, and prevent and detect fraud and abuse.

Treasury IG for Tax Administration

The Treasury IG for Tax Administration is selected by the President, with the advice and
consent of the Senate. The Treasury IG for Tax Administration can be removed from office by
the President. The President must communicate the reasons for such removal to both Houses of
Congress.

The Treasury IG for Tax Administration must be selected without regard to political
affiliation and solely on the basis of integrity and demonstrated ability in accounting, auditing,
financial analysis, law, management analysis, public administration, or investigations. The
Treasury IG for Tax Administration may not be employed by the IRS within the two years
preceding and the five years following his or her appointment.

Duties and responsibilities of Treasury IG for Tax Administration

The Treasury IG for Tax Administration is charged with conducting audits,
investigations, and evaluations of IRS programs and operations (including the Board) to promote
the economic, efficient and effective administration of the nation’s tax laws and to detect and
deter fraud and abuse in IRS programs and operations. In this regard, the Treasury IG for Tax
Administration specifically is directed to evaluate the adequacy and security of IRS technology
on an ongoing basis. The Treasury IG for Tax Administration is charged with investigating
allegations of criminal misconduct as well as administrative misconduct. The Act provides,
however, that the responsibility for (1) protecting IRS employees and (2) investigating the
backgrounds of prospective IRS employees shall not be transferred to the Treasury IG for Tax
Administration, but shall remain with the IRS.

In addition, the Act directs the Treasury IG for Tax Administration to implement a
program periodically to audit at least one percent of all determinations (identified through a
random selection process) where the IRS has asserted either section 6103 (directly or in
connection with the Freedom of Information Act or the Privacy Act) or law enforcement
considerations (i.e., executive privilege) as a rationale for refusing to disclose requested
information. The Treasury IG for Tax Administration is directed to report any findings of
improper assertion of section 6103 or law enforcement considerations to the Board.

Authority of Treasury IG for Tax Administration

The Treasury IG for Tax Administration reports to and is under the general supervision of
the Secretary of Treasury. Under the Act, the Secretary cannot prevent or prohibit the Treasury

420


$80. Unfortunately, it is nearly impossible as a practical matter to determine which particular
projects would be undertaken without a credit and to provide credits only to other projects. In
practice, almost all incremental credit proposals rely on some measure of the taxpayer’s previous
experience as a proxy for a taxpayer’s total qualified expenditures in the absence of a credit.
This is referred to as the credit’s base amount. Tax credits are provided only for amounts above
this base amount.

Since a taxpayer’s calculated base amount is only an approximation of what would have
been spent in the absence of a credit, in practice, the credit may be less effective per dollar of
revenue cost than it otherwise might be in increasing expenditures. If the calculated base amount
is too low, the credit is awarded to projects that would have been undertaken even in the absence
of acredit, If, on the other hand, the calculated base amount is too high, then there is no
incentive for projects that actually are on the margin.

Nevertheless, the incentive effects of incremental credits per dollar of revenue loss can be
many times larger than those of a flat credit. However, in comparing a flat credit to an
incremental credit, there are other factors that also deserve consideration. A flat credit generally
has lower administrative and compliance costs than does an incremental credit. Probably more
important, however, is the potential misallocation of resources and unfair competition that could
result as firms with qualified expenditures determined to be above their base amount receive
credit dollars, while other firms with qualified expenditures considered below their base amount
receive no credit.

The responsiveness of research expenditures to tax incentives

Like any other commodity, the amount of research expenditures that a firm wishes to
incur generally is expected to respond positively to a reduction in the price paid by the firm.
Economists often refer to this responsiveness in terms of price elasticity, which is measured as
the ratio of the percentage change in quantity to a percentage change in price. For example, if
demand for a product increases by five percent as a result of a 10-percent decline in price paid by
the purchaser, that commodity is said to have a price elasticity of demand of 0.5.5°° One way of
reducing the price paid by a buyer for a commodity is to grant a tax credit upon purchase. A tax
credit of 10 percent (if it is refundable or immediately usable by the taxpayer against current tax
liability) is equivalent to a 10-percent price reduction. If the commodity granted a 10-percent tax
credit has an elasticity of 0.5, the amount consumed will increase by five percent. Thus, if a flat
research tax credit were provided at a 10-percent rate, and research expenditures had a Price
elasticity of 0.5, the credit would increase aggregate research spending by five percent.”””

59 For simplicity, this analysis assumes that the product in question can be supplied at
the same cost despite any increase in demand (i.e., the supply is perfectly elastic). This
assumption may not be valid, particularly over short periods of time, and particularly when the
commodity--such as research scientists and engineers--is in short supply.

597 It is important to note that not all research expenditures need be subject to a price
reduction to have this effect. Only the expenditures that would not have been undertaken

369


the transaction.*’ Critics may argue further that the abusive characteristics of the targeted
leasing transactions are not merely a function of the presence of a tax-exempt accommodating
party but, rather, are related to the absence of economic substance in the transaction and should
be challenged on such basis. Lastly, critics may argue the transactions are no less efficient than
other forms of Federal assistance.

Prior Action

Proposals to limit deductions associated with tax-exempt leasing and include all service
contracts in the lease term were included in S. 1637, the “Jumpstart Our Business Strength
(JOBS) Act,” as passed by the Senate Committee on Finance on November 7, 2003. In addition,
a proposal to limit deductions associated with tax-exempt leasing was included in the President’s
fiscal year 2000 budget proposal. A proposal to include all service contracts in the lease term
was included in the President’s fiscal year 2001 budget proposal.

457 However, it should be noted, Treas. Reg. sec. 1.148-1(c)(2) states that if an issuer of
tax-exempt bonds voluntarily sets up a sinking fund that it reasonably expects to use to pay debt
service on the bonds, the amounts deposited in the sinking fund will be subject to the arbitrage
tules.

291


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imported, the production of ethanol improves the United States’ energy security. In addition, by
displacing imported petroleum, the production of ethanol may reduce the US. trade deficit.
Moreover, ethanol is an oxygenate in motor fuels that is environmentally friendly, reducing
urban smog.

Proponents also note that production of ethanol for motor fuel creates an important
source of demand for corn. Corn used to produce ethanol comprises approximately seven
percent of domestic corn production. In the absence of the tax subsidy, demand for com would
fall. This would reduce corn and soybean prices and, thereby, farm incomes. With falling farm
prices, jobs in farming and related industries, such as farm equipment manufacturing, would be
lost.

Opponents of the tax credit for ethanol observe that ethanol’s impact in the domestic
motor fuels market is modest. Ethanol production totaled approximately 2.13 billion gallons in
2002. By comparison, the United States, on net, imported approximately 462 million gallons of
petroleum and petroleum products per day in 2001. Total motor gasoline produced and imported
into the United States in 2001 totaled approximately 134 billion gallons. Opponents note that in
the market for motor fuels, ethanol displaces high cost petroleum first. Imported petroleum is
not necessarily the high cost petroleum to a refiner. Consequently, ethanol may displace
domestic petroleum and claims of an improved trade balance and energy independence may be
overstated.

Opponents argue that to the extent the tax subsidy increases the market price for corn,
consumers at large are hurt as higher com prices increase the price of milk, beef, pork, and
poultry. They claim that the effects on the price of corn and soybeans are likely to be smaller in
the long run than in the short run. They note that these grains are traded in the world market and
in the absence of the subsidy the corn might be exported, thereby sustaining farm incomes and
jobs in farming and related industries. In 2001, the United States exported approximately 20
percent of com produced and approximately 35 percent of soybean production.'*° Opponents
also note increased regulatory preference for ethanol as an oxygenate to meet air quality
standards. They observe that such air quality regulations should produce increased demand for
ethanol in the market and question whether further subsidy at current levels is warranted if other
forces are creating an increase in demand.

Complexity issues

As described above, the benefit of the alcohol fuels income tax credit may be claimed
through reduced excise tax paid on alcohol blended with gasoline. While claiming the benefit
through the excise tax system provides a timing advantage, it adds complexity to the excise tax
system. Gasoline excise taxes are imposed upon removal of the gasoline from a registered
terminal facility. Registered owners of record inside the terminal are liable for the gasoline
excise tax and include it in the price charged to persons removing the fuel from the terminal.
Ethanol blenders typically are wholesale distributors who remove the gasoline and pay the tax-
inclusive price to their supplier. If the ethanol blenders are registered with the Internal Revenue

186 United States Department of Agriculture, Agriculture Statistics (2002).

145


securities agency, or (3) a substantial investment (greater than $250,000 and at least five
investors).

Other promoted arrangements are treated as tax shelters for purposes of the registration
requirement if: (1) a significant purpose of the arrangement is the avoidance or evasion of
Federal income tax by a corporate participant; (2) the arrangement is offered under conditions of
confidentiality; and (3) the promoter may receive fees in excess of $100,000 in the aggregate.>>’

A transaction has a “significant purpose of avoiding or evading Federal income tax” if the
transaction: (1) is the same as or substantially similar to a “listed transaction,” or (2) is
structured to produce tax benefits that constitute an important part of the intended results of the
arrangement and the promoter reasonably expects to present the arrangement to more than one
taxpayer.>°? Certain exceptions are provided with respect to the second category of
transactions.

An arrangement is offered under conditions of confidentiality if: (1) an offeree has an
understanding or agreement to limit the disclosure of the transaction or any significant tax
features of the transaction; or (2) the promoter claims, knows, or has reason to know that a party
other than the potential participant claims that the transaction (or any aspect of it) is proprietary
to the promoter or any party other than the offeree, or is otherwise protected from disclosure or
use.

Failure to register tax shelter

The penalty for failing to timely register a tax shelter (or for filing false or incomplete
information with respect to the tax shelter registration) generally is the greater of one percent of
the aggregate amount invested in the shelter or $500.7 However, if the tax shelter involves an
arrangement offered to a corporation under conditions of confidentiality, the penalty is the

38 Sec. 6111(c).

357 Sec. 6111(d).

358 Treas, Reg. sec. 301.6111-2(b)(2).

3) Treas. Reg. sec. 301.6111-2(b)(3).

3 Treas. Reg. sec. 301.6111-2(b)(4).

361 The regulations provide that the determination of whether an arrangement is offered
under conditions of confidentiality is based on all the facts and circumstances. If an offeree’s
disclosure of the tax treatment or tax structure of the transaction is limited in any way by an
express or implied understanding or agreement with (or for the benefit of) any tax shelter

promoter, an offer is considered made under conditions of confidentiality, whether or not such
understanding or agreement is legally binding. Treas. Reg. sec. 301.6111-2(c)(1).

38 Sec. 6707.

243


or activities. The information is to be used by such officers and employees solely for such
response or investigation.

The Code permits the redisclosure by a Federal law enforcement agency to officers and
employees of State and local law enforcement personally and directly engaged in the response to
or investigation of the terrorist incident, threat, or activity. The State or local law enforcement
agency must be part of an investigative or response team with the Federal law enforcement
agency for these disclosures to be made.

Disclosure upon request from the Departments of Justice or Treasury for intelligence
analysis of terrorist activity

Upon written request satisfying certain requirements discussed below, the IRS is to
disclose return information (other than taxpayer return information) to officers and employees
of the Department of Justice, Department of Treasury, and other Federal intelligence agencies,
who are personally and directly engaged in the collection or analysis of intelligence and
counterintelligence or investigation concerning terrorist incidents, threats, or activities. Use of
the information is limited to use by such officers and employees in such investigation, collection,
or analysis.

The written request is to set forth the specific reasons why the information to be disclosed
is relevant to a terrorist incident, threat, or activity. The request is to be made by an individual
who is: (1) an officer or employee of the Department of Justice or the Department of Treasury,
(2) appointed by the President with the advice and consent of the Senate, and (3) responsible for
the collection, and analysis of intelligence and counterintelligence information concerning
terrorist incidents, threats, or activities. The Director of the United States Secret Service also is
an authorized requester under the Act.

Description of Proposal

The proposal extends the disclosure authority relating to terrorist activities. Under the
proposal, no disclosures can be made after December 31, 2004.

Effective date.—The proposal is effective for disclosures on or after the date of enactment.

Analysis

The proposal adds complexity to the Code in that its temporary nature introduces a
degree of uncertainty on the extent of the disclosure of return information relating to terrorist
activities, i.e., whether the provision will be the subject of further extensions.

The additional extension provides additional time to evaluate the effectiveness of the
provision and whether any modifications need to be implemented to enhance the provision. On
the other hand, some might argue that since the provision has been in place for several years, a

2 A taxpayer’s identity is treated as not having been supplied by the taxpayer or his
representative.

404


IG for Tax Administration from initiating, carrying out, or completing any audit or investigation
or from issuing any subpoena during the course of any audit or investigation.

Under the Act, the Treasury IG for Tax Administration must provide to the Board all
reports regarding IRS matters on a timely basis and conduct audits or investigations requested by
the Board. The Treasury IG for Tax Administration also must, in a timely manner, conduct such
audits or investigations and provide such reports as may be requested by the Commissioner. In
addition, the Act provides that the Commissioner or the Board may request the Treasury IG for
Tax Administration to conduct an audit or investigation relating to the IRS. If the Treasury IG
for Tax Administration determines not to conduct an audit or investigation requested by the
Commissioner or the Board, the Treasury IG for Tax Administration shall timely provide the
requesting party with a written explanation of its determination. In this regard, it is intended that
the Treasury IG for Tax Administration shall make all reasonable efforts to be responsive to the
requests of the Commissioner and the Board.

Resources

To ensure that the Treasury IG for Tax Administration had sufficient resources to carry
out his or her duties and responsibilities under the Act, approximately 900 FTEs from the IRS
Office of the Chief Inspector were transferred to the Treasury IG for Tax Administration. Such
FTEs included all of the FTEs performing investigative functions in the Office of the Chief
Inspector Internal Security and Integrity Investigations and Activities.

The Commissioner retained approximately 300 FTEs from the IRS Office of the Chief
Inspector to staff an audit function (including support staff) for internal IRS management
purposes. Like other IRS functions, however, this audit function is subject to oversight and
review by the Treasury IG for Tax Administration.

Access to taxpayer returns and return information

Taxpayer returns and return information are available for inspection by the Treasury IG
for Tax Administration pursuant to section 6103(h)(1). Thus, the Treasury IG for Tax
Administration has the same access to taxpayer returns and return information as does the Chief
Inspector under prior law.

Treasury IG

The Treasury IG for Tax Administration operates independently of the Treasury IG. The
Secretary of Treasury was directed to establish procedures pursuant to which the Treasury IG for
Tax Administration and the Treasury IG shall coordinate audits and investigations in cases
involving overlapping jurisdiction. The Treasury IG generally does not have access to taxpayer
returns and return information under section 6103 (unless carrying out responsibilities related to
tax administration).

The Treasury IG has responsibility for providing an opinion on the Department of
Treasury’s consolidated financial statement as required under the Chief Financial Officer Act.
The Treasury IG for Tax Administration is responsible for rendering an opinion on the IRS

421


earnings) are subject to an excise tax imposed at the rate of 50 percent. The excise tax is
required to be withheld by the program administrator.

Changes in trust contribution rules

The proposal modifies the rules applicable to trusts making contributions to qualified
tuition accounts, to clarify the tax treatment with respect to such arrangements. The proposal
contemplates that a trust could establish a qualified tuition savings account or a prepaid tuition
contract in limited circumstances, provided that the trust is the only person authorized to make
contributions to the account. This assumes that, because of the trustee’s fiduciary obligations,
the trustee would also serve as custodian. Special rules would be required to address the tax
treatment of contributions made by the trust to the account or contract, and the recovery of
contributions and earnings by the trust from the account or contract.

Changes in reporting requirements

The proposal provides that reporting requirements applicable to qualified tuition accounts
would be modified. For example, new reporting requirements would be established to facilitate
the administration of excise tax withholding by administrators. Such requirements might include
certifications provided by designated beneficiaries to administrators of qualified tuition
programs, so that administrators may withhold appropriate amounts of excise taxes with respect
to distributions used other than for qualified higher education expenses.

Grant of regulatory authority to Treasury

The proposal grants the Secretary of the Treasury broad regulatory authority to ensure
that qualified tuition accounts are used in a manner consistent with Congressional intent.

Effective dates

The proposal generally is effective for qualified tuition accounts (including savings
accounts and prepaid tuition contracts) established after the date of enactment of the proposal,
including prepaid tuition contracts if additional prepaid tuition benefits are purchased on or after
the date of enactment of the proposal. The proposal does not apply to prepaid tuition contracts
that are fully funded as of the date of enactment, or to prepaid tuition contracts for which
additional contributions are required to be made under the terms of the program if such
contribution amounts relate to prepaid tuition benefits purchased before the date of enactment.
The proposal does not apply to qualified tuition savings accounts that are in existence on the date
of enactment unless an election is made to be covered by the new rules. No additional
contributions to savings accounts in existence on the date of enactment of the proposal would be
permitted without such election.”

509 In cases where an existing account or contract is subject to the new rules, the entire
account or contract is subject to the new rules, not just that portion of the account or contract that
relates to contributions made, or prepaid benefits acquired, after the date of enactment.

312


zone or enterprise community designated under the Code, or (b) it is reasonably expected that at
least 35 percent of the students at the school will be eligible for free or reduced-cost lunches
under the school lunch program established under the National School Lunch Act.

Description of Proposal

The proposal authorizes issuance of up to $400 million of qualified zone academy bonds
annually in calendar years 2004 and 2005. For qualified zone academy bonds issued after the
date of enactment, the proposal requires issuers to report issuance to the IRS in a manner similar
to the information returns required for tax-exempt bonds.

Effective date The provision is effective generally for obligations issued after the date of
enactment.

Analysis
Complexity issues

A temporary extension provides some stability in the qualified zone academy bonds
program. Certainty that the program would continue at least temporarily, without further
interruption or modification, arguably would facilitate financial planning by taxpayers during
that period. The uncertainty that results from expiring provisions may adversely affect the
administration of and perhaps the level of participation in such provisions. For example, a
taxpayer may not be willing to devote the time and effort necessary to satisfy the complex
requirements of a provision that expires shortly. Similarly, the Internal Revenue Service must
make difficult decisions about the allocation of its limited resources between permanent and
expiring tax provisions.

Some argue that a permanent or long-term extension is necessary to encourage optimal
participation among potential QZAB issuers. Others respond that the permanent repeal of
expiring provisions such as the QZAB rules that are inherently complex would provide the same
level of certainty for tax planning purposes as a long-term or permanent extension, and would
further reduce the overall level of complexity in the Code. A related argument is that programs
such as qualified zone academy bonds would be more efficient if administered as direct
expenditure programs rather than as a part of the tax law.

The proposal’s reporting requirements may assist in the monitoring of the use of these
bonds. On the other hand, it will add to complexity in that it imposes a requirement not
previously applied to qualified zone academy bonds. In addition, the proposal increases the
paperwork burden on issuers in that forms must be completed and filed with the IRS.

Policy issues

The proposal to extend qualified zone academy bonds would subsidize a portion of the
costs of new investment in public school infrastructure and, in certain qualified areas, equipment
and teacher training. By subsidizing such costs, it is possible that additional investment will take
place relative to investment that would take place in the absence of the subsidy. If no additional
investment takes place than would otherwise, the subsidy would merely represent a transfer of

394


Treatment of income from load loss transactions

Tax-exempt rural electric cooperatives

The proposal provides that income received or accrued by a tax-exempt tural electric
cooperative from a “load loss transaction” is treated under 501(c)(12) as income collected from
members for the sole purpose of meeting losses and expenses of providing service to its
members. Therefore, income from load loss transactions is treated as member income in
determining whether a rural electric cooperative satisfies the 85-percent test for tax exemption
under section 501(c)(12). The proposal also provides that income from load loss transactions
does not cause a tax-exempt electric cooperative to fail to be treated for Federal income tax
purposes as a mutual or cooperative company under the fundamental cooperative principles
described above.

The term “load loss transaction” generally is defined as any wholesale or retail sale of
electric energy (other than to a member of the cooperative) to the extent that the aggregate
amount of such sales during a ten-year period beginning with the “start-up year” does not exceed
the reduction in the amount of sales of electric energy during such period by the cooperative to
members. The “start-up year” is defined as the first year that the cooperative offers
nondiscriminatory open access or, if later and at the election of the cooperative, the calendar year
that includes the date of enactment of the proposal.

The proposal also excludes income received or accrued by rural electric cooperatives
from load loss transactions from the tax on unrelated trade or business income.

Taxable electric cooperatives

The proposal provides that the receipt or accrual of income from load loss transactions by
taxable electric cooperatives is treated as income from patrons who are members of the
cooperative. Thus, income from a load loss transaction is excludible from the taxable income of
a taxable electric cooperative if the cooperative distributes such income pursuant to a pre-
existing contract to distribute the income to a patron who is not a member of the cooperative.
The proposal also provides that income from load loss transactions does not cause a taxable
electric cooperative to fail to be treated for Federal income tax purposes as a mutual or
cooperative company under the fundamental cooperative principles described above.

Effective date

The proposal is effective for taxable years beginning after the date of enactment.
Analysis
Policy issues

Proponents of the proposal argue that the present-law rules for tural electric cooperatives
should be modified to allow cooperatives to carry out their statutory purpose in a restructured
competitive electric energy market environment without adversely impacting their tax-exempt
status. Accordingly, the proposal relaxes the 85-percent member income test for rural electric

151


installment agreement to achieve the same effect: a reduction in the total amount of tax they will
have to pay.

The proposal does not specify how it interacts with the provision of present law that
requires the IRS to enter into an installment agreement with taxpayers who meet specified
criteria? Although it might be possible to apply this automatic installment agreement provision
to partial payment installment agreements, the more appropriate policy result might be to restrict
automatic installment agreements to those where the liability is to be paid in full. The proposal
also does not specify how it interacts with the related proposal permitting termination of
installment agreements if the taxpayer fails to file tax returns or make required deposits. The
more appropriate policy result might be to terminate a partial payment installment agreement in
the same circumstances under which any other installment agreement is terminated.

Complexity issues

Permitting partial payment installment agreements may lead to an increase in the overall
number of installment agreements. It could be argued that this increases complexity in tax
administration because of increased record-keeping on the part of both taxpayers and the IRS.
Further record-keeping would also be required with respect to the balance of taxes due but not
included in the partial payment installment agreement and with respect to any defaults by the
taxpayer. On the other hand, it could be argued that that provision causes no increase in
complexity because administrative mechanisms are already in place for the collection of tax
liability both under an installment agreement and without such an agreement. Further, if partial
payment installment agreements result in a reduction in other types of collection actions, the net
result could be an improvement in the efficiency of tax collection.

Prior Action

An identical proposal was included in the President’s fiscal year 2003 and 2004 budget
proposals. A substantially similar proposal was contained in the “Taxpayer Protection and IRS
Accountability Act of 2003,” as passed by the House of Representatives on June 19, 2003. A
substantially similar proposal was contained in the “Tax Administration Good Government Act
of 2004,” as passed by the Senate Committee on Finance on February 2, 2004.

4. Termination of installment agreements
Present Law

The Code authorizes the IRS to enter into written agreements with any taxpayer under
which the taxpayer is allowed to pay taxes owed, as well as interest and penalties, in installment
payments, if the IRS determines that doing so will facilitate collection of the amounts owed (sec.
6159). An installment agreement does not reduce the amount of taxes, interest, or penalties
owed. Generally, during the period installment payments are being made, other IRS enforcement
actions (such as levies or seizures) with respect to the taxes included in that agreement are held
in abeyance.

53 Sec, 6159(c).

325


credit remains $1,200 (40 percent of the first $3,000 of qualified first-year wages). For the
welfare-to-work/long-term family assistance recipients, the maximum credit equals $4,000 per
employee (40 percent of $10,000 of wages).

Second year wages.—In the case of long-term family assistance recipients the maximum
credit is $5,000 (50 percent of the first $10,000 of qualified second-year wages).

Minimum employment period

No credit is allowed for qualified wages paid to employees who work less than 120 hours
in the first year of employment.

Coordination of the work opportunity tax credit and the welfare-to-work tax credit

Coordination is no longer be necessary once the two credits are combined

Effective date.—The proposal is effective for wages paid or incurred to a qualified
individual who begins work for an employer after December 31, 2003 and before January 1,
2006.

Analysis
Complexity issues

Extension of the provision for two years provides some continuity and simplifies tax
planning during that period for taxpayers and practitioners. Some may argue that a permanent
extension will have a greater stabilizing effect on the tax law. They point out that temporary
expirations, like the current one, not only complicate tax planning but also deter some taxpayers
from participating in the program. Others who are skeptical of the efficacy of the WOTC
program may argue that not extending the credit could eliminate a windfall benefit to certain
taxpayers and permanently reduce complexity in the Code.

Overview of policy issues

The WOTC is intended to increase the employment and earnings of targeted group
members. The credit is made available to employers as an incentive to hire members of the
targeted groups. To the extent the value of the credit is passed on from employers to employees,
the wages of target group employees will be higher than they would be in the absence of the
credit.

The rationale for the WOTC is that employers will not hire certain individuals without a
subsidy, because either the individuals are stigmatized (e.g., convicted felons) or the current

68 For individuals with productivity to employers lower than the minimum wage, the
credit may result in these individuals being hired and paid the minimum wage. For these cases, it
would be clear that the credit resulted in the worker receiving a higher wage than would have
been received in the absence of the credit (e.g., zero).

385


Policies eligible for the credit have to meet certain requirements, including coverage for
high medical expenses.” Qualifying health insurance can be purchased through the non-group
insurance market, private purchasing groups, State-sponsored insurance purchase pools, and
State high-risk pools.

At the option of States, after December 31, 2005, the credit can be used by certain
individuals not otherwise eligible for public health insurance programs to buy into privately
contracted State-sponsored purchasing groups (such as Medicaid or SCHIP purchasing pools for
private insurance or State government employee programs for States in which Medicaid or
SCHIP does not contract with private plans). States can provide additional contributions to
individuals who purchase insurance through such purchasing groups. The maximum State
contribution is $2,000 per adult (for up to two adults) for individuals with incomes up to 133
percent of the poverty level. The maximum State contribution is phased-down ratably, reaching
$500 per adult at 200 percent of the poverty level. Individuals with income above 200 percent of
the poverty level are not eligible for a State contribution. States are not allowed to offer any
other explicit or implicit cross subsidies.

Effective date. The credit is effective for taxable years beginning after December 31,
2004. The advanced payment option is available beginning July 1, 2006.

Analysis
Policy issues

In general

The proposal is intended to provide an incentive to uninsured individuals to purchase
health insurance by providing assistance in paying premiums. Proponents of the proposal argue
that the proposal will enable low-income individuals to purchase health insurance, thereby
reducing the number of uninsured individuals.

Opponents of the credit argue that it is not sufficient to make insurance affordable for
many individuals and thus would not be utilized by many uninsured. For example, the credit
may not improve the opportunity for coverage in the individual market for the elderly and
individuals with chronic health problems if coverage is too expensive, even with the credit. In
addition, opponents of the credit question whether the amount of the credit will be sufficient to
allow many low-income individuals, regardless of age or health status, to purchase adequate
health insurance coverage. They argue that the credit is too low to allow individuals to purchase
a policy other than a very minimal policy, and that those most likely to benefit from the credit
will be insurers. Proponents counter that the credit level is sufficient, and that individuals who
purchase insurance as a result of the credit will be better off than they would be without
insurance.

Some opponents are also concerned about the focus of the credit on insurance purchased
in the individual market. They believe the individual market does not presently offer sufficient

® The proposal does not include details regarding the requirements policies must satisfy.

44


confidentiality restrictions).° Recently finalized regulations under section 6112 provide rules
regarding the list maintenance requirements.

The final regulations provide that, for this purpose, a potentially abusive tax shelter is any
transaction that (1) is required to be registered under section 6111, (2) is a listed transaction (as
defined under the new final regulations under section 6011), or (3) a potential material advisor
(at the time the transaction is entered into or an interest is acquired) knows or reasonably expects
will become a reportable transaction (as defined under the new final regulations under section
6011).

The regulations define an organizer or seller of a potentially abusive tax shelter as any
person who is a material advisor with respect to that transaction.*® A “material advisor” is
defined as any person who (1) directly or indirectly receives, or is expected to receive, a
minimum fee of (a) $250,000 for a transaction that is a potentially abusive tax shelter if all
participants are corporations, or (b) $50,000 for any other transaction that is a potentially abusive
tax shelter, and (2) makes or provides a statement to any person regarding the potential tax
consequences of the transaction. A material advisor also includes any person that is required
to register the transaction under section 6111.

The Secretary is required to prescribe regulations which provide that, in cases in which 2
or more persons are required to maintain the same list, only one person would be required to
maintain the list.*°*

Penalties for failing to maintain investor lists

Under section 6708, the penalty for failing to maintain the list required under section
6112 is $50 for each name omitted from the list (with a maximum penalty of $100,000 per year).

Description of Proposal

Investor lists

Each person required to file an information return with respect to a reportable
transaction*” is required to maintain a list that (1) identifies each person with respect to whom

38 Sec. 6112.

3 Treas. Reg. sec. 301.6112-1.

365 Treas, Reg. sec. 301.6112-1(b).

366 Treas. Reg. sec. 301.6112-1(c)(1).

367 Treas, Reg. sec. 301.6112-1(c)(1) and (2).

388 Sec. 6112(c)(2).

245


I. Simplify Taxation of Capital Gains of Individuals

Present Law

In general

In general, gain or loss reflected in the value of an asset is not recognized for income tax
purposes until a taxpayer disposes of the asset. On the sale or exchange of a capital asset, any
gain generally is included in income. Any net capital gain of an individual is taxed at maximum
rates lower than the rates applicable to ordinary income. Net capital gain is the excess of the net
long-term capital gain for the taxable year over the net short-term capital loss for the year. Gain
or loss is treated as long-term if the asset is held for more than one year.

Capital losses generally are deductible in full against capital gains. In addition,
individual taxpayers may deduct capital losses against up to $3,000 of ordinary income in each
year. Any remaining unused capital losses may be carried forward indefinitely to another
taxable year.

A capital asset generally means any property except (1) inventory, stock in trade, or
property held primarily for sale to customers in the ordinary course of the taxpayer’s trade or
business, (2) depreciable or real property used in the taxpayer’s trade or business, (3) specified
literary or artistic property, (4) business accounts or notes receivable, (5) certain U.S.
publications, (6) certain commodity derivative financial instruments, (7) hedging transactions,
and (8) business supplies. In addition, the net gain from the disposition of certain property used
in the taxpayer’s trade or business is treated as long-term capital gain. Gain from the disposition
of depreciable personal property is not treated as capital gain to the extent of all previous
depreciation allowances. Gain from the disposition of depreciable real property is generally not
treated as capital gain to the extent of the depreciation allowances in excess of the allowances
that would have been available under the straight-line method of depreciation.

Under present law, for taxable years beginning before January 1, 2009, the maximum rate
of tax on the adjusted net capital gain of an individual is 15 percent. In addition, any adjusted
net capital gain which otherwise would have been taxed at a 10- or 15-percent rate is taxed at a
five-percent rate (zero for taxable years beginning in 2008). These rates apply for purposes of
both the regular tax and the alternative minimum tax.

The “adjusted net capital gain” of an individual is the net capital gain reduced (but not
below zero) by the sum of the 28-percent rate gain and the unrecaptured section 1250 gain. The

284 For taxable years beginning after December 31, 2008, the rates on the adjusted net
capital gain are 20-percent and 10-percent, respectively. Any gain from the sale or exchange of
property held more than five years that would otherwise be taxed at the 10-percent rate is taxed
at an 8-percent rate. Any gain from the sale or exchange of property held more than five years
and the holding period for which began after December 31, 2000, which would otherwise be
taxed at a 20-percent rate is taxed at an 18-percent rate. Another provision of the President’s
proposal makes the present-law lower rates permanent.

206


the new plan formula. Others argue that any such additional requirement would cause employer
qualified retirement plan costs to increase, and could cause employers to reduce benefits further
or terminate existing plans. They argue that the proposal provides an appropriate balance
between concerns about older workers and the need to provide flexibility to employers in order
to maintain the voluntary pension system.

Some argue that the 100-percent excise tax on any difference between required benefits
and the benefits actually provided under a plan which has been converted to a cash balance
formula is sufficient to encourage compliance with the proposal. However, others argue that
limiting the amount of the excise tax to the plan’s surplus assets at the time of the conversion or
the plan sponsor’s taxable income, whichever is greater, will allow plan sponsors to manipulate
the timing of a conversion so that the requirements of the proposal can be avoided without
imposition of the excise tax. They argue that absent the potential for plan disqualification, the
efficacy of the proposal is diminished, or even eliminated.

Some argue that the proposal provides appropriate flexibility to employers and additional
safeguards for employees, by allowing employers to avoid the excise tax by grandfathering
participants under the old formula or giving employees a choice between the old and new
formula. On the other hand, some point out that giving employees options increases complexity
for plan participants, and that many participants may not adequately understand the differences
between the new plan formula and the old plan formula. These concerns may be addressed, at
least to some extent, by requiring that participants receive sufficient information to make an
informed decision. As mentioned above, others would go further, and require that at least some
employees be automatically given the greater of the two formulas. This would avoid the need
for elections, and the possibility that an employee may unwittingly choose an option that is
clearly worse than the old plan formula. On the other hand, some view such a requirement as
unduly restricting employers options in plan design.

Age discrimination

By providing that cash balance plans satisfy the age discrimination rules if the plan
provides pay credits for older participants that are not less than the pay credits for younger
participants, the proposal provides certainty in this regard. Some have argued that if such
certainty is not provided, employers will be disinclined to offer defined benefit pension plans,
including cash balance plans, to their employees. By reducing uncertainty as to how cash
balance plans can meet age discrimination requirements, some would argue that employers will
be more likely to sponsor (or continue to sponsor) defined benefit pension plans, including cash
balance plans. Some, however, argue that pay credits for younger participants in cash balance
plans are inherently discriminatory and for this, and other reasons, cash balance plans should not
be encouraged. These issues are discussed more fully above in the discussion of present law,
under the heading “Age discrimination.”

The proposal lacks specificity with respect to certain transition strategies and other types
of hybrid plans. Additional issues may arise depending on the specifics of such proposals.

224


Analysis

Analysis of complexity and policy issues for acceleration proposals

Some may argue that this proposal to eliminate the pre-2009 reductions raises only
macroeconomic issues. That is, the proposal only raises issues regarding the budgetary effects of
maintaining higher levels for the provisions rather than temporarily reducing them as scheduled,
because the underlying microeconomic policy choices (¢.g., reducing the marriage penalty) have
already been made. However, it can also be argued that the current Congress and President, or a
future Congress and President, could rescind these provisions before they go into effect, and thus
these policies are not truly current policy until their respective effective dates. In this view, since
the actual future implementation of these policies is not guaranteed, making the policies effective
immediately raises policy issues specific to the individual proposals, and not just macroeconomic
issues with respect to the timing of a proposal. These policy issues are briefly discussed below.
Macroeconomic issues arise with any tax changes that significantly alter the budget surplus or
deficit, and in general are not discussed here.

Ten percent regular income tax rate and reduction of other regular income tax rates

Altering the tax bracket sizes and rate structure raises the general issue of the
progressivity of the income tax structure, or the degree to which the average tax rate rises with
income. There is no “right” degree of progressivity, and individuals will disagree as to the
proper degree of progressivity. Greater progressivity produces a more equal after-tax
distribution of income in society, which many will argue enhances the stability of society.
Others argue that the more progressive is the tax structure, the more individual initiative and risk
taking is stifled as the government takes a growing share of the economic retums to work and
investment.

On balance, the 10-percent bracket and the reduction in rates, as provided for in
EGTRRA, had only modest effects on the progressivity of the rate structure, as the rates were all
reduced by approximately 10 percent, with the new 10-percent bracket substituting for a
reduction in the 15-percent rate. However, for taxpayers with incomes significantly below the
top of the 15-percent bracket, the effect of the 10-percent rate bracket was to reduce taxes paid
by significantly more than 10 percent, and thus on balance the rate structure was made more
progressive.

Marriage penalty relief
Marriage penalty equity issues

Any system of taxing married couples requires making a choice among three different
concepts of tax equity. One concept is that the tax system should be “marriage neutral;” that is,
the tax burden of a married couple should be exactly equal to the combined tax burden of two
single persons where one has the same income as the husband and the other has the same income
as the wife. A second concept of equity is that, because married couples frequently consume as a
unit, couples with the same income should pay the same amount of tax regardless of how the
income is divided between them. (This second concept of equity could apply equally well to
other tax units that may consume jointly, such as the extended family or the household, defined


Some have suggested that use of any single interest rate is inappropriate, and rather that
multiple interest rates should be used to reflect the varying times when benefits become payable
under a plan, because of, for example, different expected retirement dates of employees. The
rationale for this approach is that interest rates differ depending, in part, on the term ofan
obligation.* A graph of this relationship is known as a “yield curve.” Because plan liabilities
may be payable both in the short term and the long term, this approach determines the present
value of these liabilities with multiple interest rates, chosen to match the times at which the
benefits are payable under the plan. The proposal to use a corporate bond yield curve to
determine the present value of benefits is consistent with these views and is intended to improve
the accuracy of pension liability measures.

Some have raised concerns that a yield-curve approach is more complicated than the use
ofa single rate, particularly for smaller plans and for purposes of determining lump-sum
distributions. Some have suggested that this could have the effect of increasing administrative
costs associated with maintaining a defined benefit pension plan and discourage the continuation
and establishment of such plans. Some have also suggested that the use of a yield curve to
determine minimum and maximum lump-sum distributions may make it more difficult for plan
participants to understand and evaluate their distribution options under the plan.

Others have responded to these concerns by suggesting that, although a single interest
rate is used to determine required contributions under the present-law funding rules, a
yield-curve approach is commonly used for other purposes, such as corporate finance. Some
also note that the determination of current liability and lump-sum values already involve the
application of complicated actuarial concepts (particularly the determination of current liability)
and the proposal does not add significant complexity. They argue moreover that any additional
complexity is outweighed by the importance of measuring pension liabilities accurately,
including the timing of benefit payments from the plan. In addition, it has been suggested that
simplified methods (such as the use of a single composite rate) can be provided for smaller plans
and for purposes of determining lump-sum distributions.

The proposal also eliminates the four-year averaging period used to determine the interest
rate applicable for purposes of determining current liability under present law. Some have
suggested that such an averaging period is necessary to prevent rapid interest rate changes from
causing corresponding changes in current liability, which in turn may result in volatility in the
amount of minimum required and maximum deductible contributions. Others believe that the
interest rate used to value pension liabilities should be designed to measure those liabilities as
accurately as possible and that volatility in required contributions and deductible contributions
should be addressed through modifications to the funding and deduction rules.

34 Th general, longer term bonds provide a higher interest rate, and shorter term bonds a
lower interest rate.

238


contributions (and earnings thereon) and must be paid directly to a mortgage provider,
university, or business capitalization account at a financial institution. The Department of Health
and Human Services administers the individual development account program.

Description of Proposal

The proposal provides a nonrefundable tax credit for a qualified entity (i.e., qualified
financial institutions, qualified nonprofit organizations and qualified Indian tribes) that has an
individual development account program in a taxable year. The tax credit equals the amount of
matching contributions made by the eligible entity under the program (up to $500 per account
per taxable year) plus $50 for each individual development account maintained during the
taxable year under the program. Except in the first year that each account is open, the $50 credit
is available only for accounts with a balance of more than $100 at year-end. The amount of the
credit is adjusted for inflation after 2005. The $500 amount is rounded to the nearest multiple of
twenty dollars. The $50 amount is rounded to the nearest multiple of five dollars. No deduction
or other credit is available with respect to the amount of matching funds taken into account in
determining the credit.

The credit applies with respect to the first 900,000 individual development accounts
opened before January 1, 2010, and with respect to matching funds for participant contributions
that are made after December 31, 2004, and before January 1, 2012.

Nonstudent U.S. citizens or legal residents between the ages of 18 and 60 (inclusive) who
are not dependents of a taxpayer and who meet certain income requirements are eligible to open
and contribute to an individual development account. The income limit is modified adjusted
gross income of $20,000 for single filers, $40,000 for joint filers, and $30,000 for head-of-
household filers. Eligibility in a taxable year is based on the previous year’s modified adjusted
gross income and circumstances (e.g., status as a student). Modified adjusted gross income is
adjusted gross income, plus certain items that are not includible in gross income. The proposal
does not specify which items are to be added. The income limits are adjusted for inflation after
2005. This amount is rounded to the nearest multiple of 50 dollars.

Under the proposal, an individual development account must: (1) be owned by the
eligible individual for whom the account was established; (2) consist only of cash contributions;
(3) be held by a person authorized to be a trustee of any individual retirement account under
section 408(a)(2)); and (4) not commingle account assets with other property (except in a
common trust fund or common investment fund). These requirements must be reflected in the
written governing instrument creating the account. The entity establishing the program is
required to maintain separate accounts for the individual’s contributions (and earnings therein)
and matching funds and earnings thereon.

6 Married taxpayers filing separate returns are not eligible to open an IDA or to receive
matching funds for an IDA that is already open.

38


Effective date—The proposal is effective for installment agreements entered into on or
after the date of enactment.

Analysis

In general

Partial payment installment agreements may be beneficial to taxpayers and the
government by encouraging taxpayers to pay at least a portion of their tax liability. Partial
payment installment agreements may also be detrimental to the interests of the government if
they permit taxpayers who have the ability to pay their liability in full to pay in part.

It is difficult to assess the relative benefits and detriments of the proposal because some
details have not been specified. For example, the proposal does not specify whether IRS would
be required to review partial payment installment agreements periodically (such as every two
years), to determine whether the taxpayer has new or additional resources that would permit
increased payments (or full immediate payment of the balance). Such a requirement could
increase the total amount collected under the proposal. Also, if the unpaid balance remaining at
the conclusion of the partial payment installment agreement is treated like other tax debts under
IRS’ current administrative practices, little of it may be collected because at that point in time it
will be older than many other tax debts in IRS’ collection inventory, which reduces its relative
level of prioritization for collection activity. In addition, relatively little time may remain in the
statute of limitations®2! at the conclusion of the partial payment installment agreement, which
also could reduce the opportunities for collection activity. This means that in practical terms,
taxpayers may be able to achieve the same results as if they had entered into an offer in
compromise via a partial payment installment agreement.

The statutory mechanism by which the government and the taxpayer agree to reduce the
amount of tax liability of a taxpayer is an offer in compromise.>”* An offer may be made on the
basis of doubt as to collectibility, doubt as to liability, or because of other factors such as equity,
hardship, or public policy; most are entered because of doubt as to collectibility. It is unclear
how the proposal will interact with the offer in compromise provision of present law. For
example, to apply for an offer in compromise, a taxpayer must provide detailed financial
information. The proposal does not specify whether similar detailed financial information must
be provided prior to acceptance of a partial payment installment agreement. Paralleling those
requirements would minimize opportunities by taxpayers to pay an amount that is less than they
have the ability to pay. More generally, it is unclear whether the proposal would cause a
significant reduction in the number of taxpayers who enter into offers in compromise. If the
application process for a partial payment installment agreement is less rigorous than that
applicable to offers in compromise, taxpayers may prefer to apply for a partial payment

521 Tn general, enforced collection actions must commence within 10 years after
assessment of the tax (sec. 6502(a)).

522 Sec, 7122.

324


Sales of partial interests in property also qualify if the sale meets the present law
standards for qualified conservation contributions of partial interests within the meaning of
section 170(h).

To prevent abuse, significant penalties are imposed on any subsequent transfer or use of
the property other than exclusively for conservation purposes, or on any subsequent removal of a
conservation restriction contained in an instrument of conveyance of the property. Sales of the
property under the proposal at a price that is less than the fair market value of property qualify as
bargain sales,!© but only to the extent that the proceeds of the sale, net of capital gains taxes
under this provision, are lower than the after-tax proceeds that would have resulted if the
property had been sold at fair market value and the seller had paid tax on the full amount of the
resulting gain.

Effective date The proposal is effective for sales occurring on or after January 1, 2005,
and before January 1, 2008.

Analysis
Policy issues

In general, for sales of real estate, the maximum tax rate applied to capital gain income
(excluding improvements) is 15 percent for taxpayers who would otherwise be in the 25 percent,
28 percent, 33 percent, and 35 percent ordinary income tax brackets.’ If such a taxpayer sold
conservation property to a qualifying conservation organization, after the 50-percent exclusion,
the effective tax rate on the gain income would be 7.5 percent.’ Per $1,000 of gain, the
proposal could produce a benefit of up to $75 if the taxpayer were to sell to a qualifying
conservation organization rather than to another person offering the same purchase price. The
proposal seeks to increase sales of conservation property to qualifying conservation
organizations by making it possible for the seller to reap a higher after-tax return by selling
property to the qualifying conservation organization than by selling to a non-qualifying buyer.

The simple calculations above may suggest that the seller would reap the full benefit of
the lower effective tax rate. However, qualifying conservation organizations, recognizing that

165 See Sec. 1011(b) and Treas. Reg. sec. 1.1011-2.

167 Under present law, the maximum tax rate applied to capital gain income for taxpayers
in the 10 and 15-percent income tax brackets is five percent (zero percent after 2007).

168 Th the case of a taxpayer otherwise in the 10-percent or 15-percent marginal income
tax bracket, the result of the combination of the exclusion and the alternative five-percent tax rate
on income from capital gain is an effective tax rate of 2.5 percent on the gain.

169 tm the case of a taxpayer otherwise in the 10-percent or 15-percent marginal income
tax brackets, per $1,000 of gain, the proposal could produce a benefit of up to $25 if the taxpayer
were to sell to a qualifying conservation organization rather than to another person offering the
same purchase price.

118


Cash balance plans

A “hybrid” plan is a plan that combines the features of a defined benefit pension plan and
adefined contribution plan. In recent years, more employers have adopted cash balance plans
(and other hybrid plans).

A cash balance plan is a defined benefit pension plan with benefits resembling the
benefits associated with defined contribution plans. Under a cash balance plan, benefits are
defined by reference to a hypothetical account balance. An employee’s hypothetical account
balance is determined by reference to hypothetical annual allocations to the account (“pay
credits”) (e.g., a certain percentage of the employee’s compensation for the year) and
hypothetical earnings on the account (“interest credits”).

The method of determining interest credits under a cash balance plan is specified in the
plan. Under one common plan design, interest credits are determined in the form of hypothetical
interest on the account at a rate specified in the plan or based on a specified market index, such
as the rate of interest on certain Treasury securities. Alternatively, interest credits are sometimes
based on hypothetical assets held in the account, similar to earnings on an account under a
defined contribution plan, which are based on the assets held in the account,”

Overview of qualification issues with respect to cash balance plans

Cash balance plans are subject to the qualification requirements applicable to defined
benefit pension plans generally. However, because such plans have features of both defined
benefit pension plans and defined contributions plans, questions arise as to the proper application
of the qualification requirements to such plans. Some issues arise if a defined benefit pension
plan with a traditional defined benefit formula is converted to a cash balance plan formula, while
others arise with respect to all cash balance plans.”*" Issues that commonly arise include: (1) in
the case of a conversion to a cash balance plan formula, the application of the rule prohibiting a
cutback in accrued benefits:2” (2) the proper method for determining lump-sum distributions;

290 ‘The assets of the cash balance plan may or may not include the assets or investments
on which interest credits are based. As in the case of other defined benefit pension plans, a plan
fiduciary would be responsible for making investment decisions with respect to cash balance
plan assets.

291 The conversion of a defined benefit pension plan to a cash balance plan generally
means that the plan is amended to change the formula for accruing benefits from a traditional
defined benefit formula to a cash balance formula. In such cases, the plan with the old formula
and the plan as amended with the new formula are sometimes referred to as different plans, even
though legally there is not a separate new plan.

292 Code sec. 411(d)(6); ERISA sec. 204(g).

23 Code sec. 417(e); ERISA sec. 205(g).

212


various types of retirement savings arrangements, including contributions to a traditional or Roth
IRA.

Coverdell education savings accounts

Present law provides tax-exempt status to Coverdell education savings accounts, meaning
certain trusts or custodial accounts that are created or organized in the United States exclusively
for the purpose of paying the qualified higher education expenses of a designated beneficiary.”
The aggregate annual contributions that can be made by all contributors to Coverdell education
savings accounts for the same beneficiary is $2,000 per year. In the case of contributors who are
individuals, the maximum contribution limit is reduced for individuals with adjusted gross
income between $95,000 and $110,000 ($190,000 to $220,000 in the case of married taxpayers
filing a joint return).”®

Distributions from a Coverdell education savings account are not includible in the
distributee’s income to the extent that the total distribution does not exceed the qualified
education expenses incurred by the beneficiary during the year the distribution is made. Ifa
distribution from a Coverdell education savings account exceeds the qualified education
expenses incurred by the beneficiary during the year of the distribution, the portion of the excess
that is treated as earnings generally is subject to income tax and an additional 10-percent tax.
Amounts in a Coverdell education savings account may be rolled over to another Coverdell
education savings account of the same beneficiary or of a member of the family of that
beneficiary.

Qualified tuition programs”

Present law provides tax-exempt status to a qualified tuition program, defined as a
program established and maintained by a State or agency or instrumentality thereof, or by one or
more eligible educational institutions. © Under a qualified tuition program, a person may
purchase tuition credits or certificates on behalf of a designated beneficiary, or in the case of a

27 Sec, 530.

>8 ‘The present-law contribution limit and the adjusted gross income levels are subject to
the general sunset provision of EGTRRA. Thus, for example, the limit on annual contributions
to a Coverdell education savings account is $500 after 2010. A proposal to repeal the income
limits on contributions to Coverdell education savings accounts is discussed in Part III.G.3 of
this document.

29 proposal relating to qualified tuition programs is discussed in Part V.M of this
document.

> Sec. 529. The general sunset provision of EGTRRA applies to certain aspects of the
rules for qualified tuition programs, including tuition programs maintained by one or more
eligible educational institutions (which may be private institutions). Thus, for example, after
2010 a qualified tuition program may be established and maintained only by a State or agency or
instrumentality thereof.

17


F. Strengthen the Financial Integrity of Unemployment Insurance

Present Law

The Federal Unemployment Tax Act (“FUTA”) imposes a 6.2-percent gross tax rate on
the first $7,000 paid annually by covered employers to each employee. Employers in States with
programs approved by the Federal Government and with no delinquent Federal loans may credit
5.4 percentage points against the 6.2 percent tax rate, making the net Federal unemployment tax
rate 0.8 percent. Because all States have approved programs, 0.8 percent is the Federal tax rate
that generally applies. The net Federal unemployment tax revenue finances the administration of
the unemployment system, half of the Federal-State extended benefits program, and a Federal
account for State loans. Also, additional distributions (“Reed Act distributions”) may be made to
the States, if the balance of the Federal unemployment trust funds exceeds certain statutory
ceilings. The States use Reed Act distributions to finance their regular State programs (which
are mainly funded with State unemployment taxes) and the other half of the Federal-State
extended benefits program.

In 1976, Congress passed a temporary surtax of 0.2 percent of taxable wages to be added
to the permanent FUTA tax rate. Thus, the current 0.8 percent FUTA tax rate has two
components: a permanent tax rate of 0.6 percent, and a temporary surtax rate of 0.2 percent. The
temporary surtax has been extended through 2007.

Under present law, all States operate experience rating systems. Under these systems an
employer’s State unemployment tax rate is based on the amount of unemployment benefits paid
to the employer’s former employees. Generally, the more unemployment benefits paid to former
employees, the higher the State unemployment tax rates.

Description of Proposal

The proposal makes changes to the unemployment compensation system to deter
employer schemes to artificially lower their State unemployment taxes. Specifically, the
proposal requires the States to change their laws to address two types of employer schemes: (1)
employers with high experience rates who set up shell companies under common ownership and
management and who transfer employees to these shells to take advantage of lower experience
rates in the new shell; (2) employers with high experience rates who purchase an separate
business with low experience rates and then replace the operations of the purchased business
with their business.

In the first case, State law would be required to provide that when an employer transfers
its business or a segregable and identifiable part thereof, to another employer, the experience
attributable to the transferred business, or part thereof, must be transferred to the acquiring
employer, if there is a substantial commonality of ownership and management.

In the second case, State law would be required to prohibit the transfer of the experience
rate if the State agency finds that a person, who becomes the employer upon an acquisition,
acquired the business or a segregable and identifiable part thereof, solely or primarily for the
purpose of attaining a lower rate of contributions.

343


More broadly, in weighing the overall complexity effects of the present-law sunsets and
the proposed sunset repeal, some would point out that the sunset provisions are not the only
feature of EGTRRA and JGTRRA that generates “cliff effects” and similar sources of
uncertainty and complexity for taxpayers. For example, under EGTRRA’s estate tax provisions,
a decedent dying in 2008 has an exemption equivalent amount of $2 million, one dying in 2009
has an exemption equivalent amount of $3.5 million, and one dying in 2010 effectively has an
infinite exemption. Thus, the estates of individuals at certain wealth levels will incur significant
estate tax if they die in 2008, but none at all if they die in 2009; the estates of individuals at other
wealth levels will incur significant estate tax if they die in 2009, but none at all if they die in
2010, These discontinuities are not caused by the sunset provisions, but they generate a similar
sort of uncertainty and complexity for many taxpayers. Similar phase-ins and phase-outs are
found in other provisions of the EGTRRA and generate complexity and uncertainty, irrespective
of whether EGTRRA as a whole sunsets or not. In light of these issues, some may argue that a
more detailed reconsideration of the EGTRRA or certain of its provisions would better serve the
goal of tax simplification.

Beyond phase-ins and phase-outs, some may argue that EGTRRA included other
provisions that increased the complexity of the Code, and that allowing those provisions to
expire at the end of 2010 (or effectively requiring that they be reconsidered before then) may
reduce complexity, albeit potentially years in the future. Others would argue that some of
EGTRRA’s provisions reduced complexity, such as the repeal of the overall limitation on
itemized deductions and changes relating to the earned income tax credit, and that permanently
extending these provisions would contribute to simplification of the tax laws.

Prior Action

A similar proposal was included in the President’s fiscal year 2003 and 2004 budget
proposals.

12


I. Extend Deduction for Corporate Donations of Computer Technology

Present Law

In the case of a charitable contribution of inventory or other ordinary-income or short-
term capital gain property, the amount of the charitable deduction generally is limited to the
taxpayer’s basis in the property. In the case of a charitable contribution of tangible personal
property, the deduction is limited to the taxpayer’s basis in such property if the use by the
recipient charitable organization is unrelated to the organization’s tax-exempt purpose. In cases
involving contributions to a private foundation (other than certain private operating foundations),
the amount of the deduction is limited to the taxpayer’s basis in the property.

Under present law, a taxpayer’s deduction for charitable contributions of scientific
property used for research and for contributions of computer technology and equipment
generally is limited to the taxpayer’s basis (typically, cost) in the property. However, certain
corporations may claim a deduction in excess of basis for a “qualified research contribution” or a
“qualified computer contribution.”©! This enhanced deduction is equal to the lesser of (1) basis
plus one-half of the item’s appreciated value (i.e., basis plus one half of fair market value minus
basis) or (2) two times basis. The enhanced deduction for qualified computer contributions
expires for any contribution made during any taxable year beginning after December 31, 2003.

A qualified computer contribution means a charitable contribution of any computer
technology or equipment, which meets standards of functionality and suitability as established by
the Secretary of the Treasury. The contribution must be to certain educational organizations or
public libraries and made not later than three years after the taxpayer acquired the property or, if
the taxpayer constructed the property, not later than the date construction of the property is
substantially completed.” The original use of the property must be by the donor or the
donee,®*? and in the case of the donee, must be used substantially for educational purposes
related to the function or purpose of the donee. The property must fit productively into the
donee’s education plan. The donee may not transfer the property in exchange for money, other
property, or services, except for shipping, installation, and transfer costs. To determine whether
property is constructed by the taxpayer, the rules applicable to qualified research contributions
apply. That is, property is considered constructed by the taxpayer only if the cost of the parts
used in the construction of the property (other than parts manufactured by the taxpayer or a

69 Sec. 170(e)(1).

1 Secs, 170(e)(4) and 170(e)(6).

62 Tf the taxpayer constructed the property and reacquired such property, the
contribution must be within three years of the date the original construction was substantially
completed. Sec. 170(e)(6)(D)(i).

633 This requirement does not apply if the property was reacquired by the manufacturer
and contributed. Sec. 170(e)(6)(D)(ii).

397


INTRODUCTION

This document,! prepared by the staff of the Joint Committee on Taxation, provides a
description and analysis of the revenue provisions modifying the Internal Revenue Code of 1986
(the “Code”) that are contained in the President’s fiscal year 2005 budget proposal, as submitted
to the Congress on February 2, 2004.2 The document generally follows the order of the
proposals as included in the Department of the Treasury’s explanation of the President’s budget
proposal. For each provision, there is a description of present law and the proposal (including
effective date), an analysis of issues related to the proposal and a reference to relevant prior
budget proposals or recent legislative action.

' This document may be cited as follows: Joint Committee on Taxation, Description of
Revenue Provisions Contained in the President’s Fiscal Year 2005 Budget Proposal (JCS-3-04),
February 2004.

2 See Office of Management and Budget, Budget of the United States Government,
Fiscal Year 2005: Analytical Perspectives (H. Doc. 108-146, Vol. III), pp. 239-270.

3 See Department of the Treasury, General Explanations of the Administration’s Fiscal
Year 2005 Revenue Proposals, February 2004.


Certain costs of qualified clean-fuel vehicle property and clean-fuel vehicle refueling
property may be expensed and deducted when such property is placed in service (sec. 179A).
Qualified clean-fuel vehicle property includes motor vehicles that use certain clean-burning fuels
(natural gas, liquefied natural gas, liquefied petroleum gas, hydrogen, electricity and any other
fuel at least 85 percent of which is methanol, ethanol, or any other alcohol or ether). The
maximum amount of the deduction is $50,000 for a truck or van with a gross vehicle weight over
26,000 pounds or a bus with a seating capacity of at least 20 adults; $5,000 in the case of a truck
or van with a gross vehicle weight between 10,000 and 26,000 pounds; and $2,000 in the case of
any other motor vehicle. Qualified electric vehicles do not qualify for the clean-fuel vehicle
deduction. However, certain hybrid electric vehicles do qualify for the clean-fuel vehicle
deduction, The deduction for clean-fuel vehicles phases down in the years 2004 through 2006,
and is unavailable for purchases after December 31, 2006. The maximum value of the deduction
for vehicles weighing less than 10,000 pounds is $1,500 for 2004.

Clean-fuel vehicle refueling property comprises property for the storage or dispensing of
aclean-burning fuel, if the storage or dispensing is the point at which the fuel is delivered into
the fuel tank of a motor vehicle. Clean-fuel vehicle refueling property also includes property for
the recharging of electric vehicles, but only if the property is located at a point where the electric
vehicle is recharged. Up to $100,000 of such property at each location owned by the taxpayer
may be expensed with respect to that location. Expensing for clean-fuel vehicle refueling
property is unavailable for expenditures after December 31, 2006.

Description of Proposal

In general

The proposal provides a tax credit for the purchase of a qualified hybrid vehicle or fuel
cell vehicle purchased after December 31, 2003 and before January 1, 2008 for a hybrid vehicle
and after December 31,2003 and before January 1, 2013 for a fuel cell vehicle. The credits are
available for all qualifying light vehicles including cars, minivans, sport utility vehicles, and light
trucks. Taxpayers are able to claim only one of the credits per vehicle and taxpayers who claim
either credit are not able to claim the qualified electric vehicle credit or the deduction for clean-
fuel vehicles for the same vehicle. For business taxpayers the credit is part of the general
business credit and the taxpayer will reduce his or her basis in the vehicle by the amount of the
credit. A qualifying vehicle must meet all applicable regulatory requirements for safety and air
pollutants.

Hybrid vehicles

A qualifying hybrid vehicle is a motor vehicle that draws propulsion energy from on-
board sources of stored energy which include both an internal combustion engine or heat engine
using combustible fuel and a rechargeable energy storage system (¢.g., batteries). The amount of
credit for the purchase of a hybrid vehicle is the sum of two components, a base credit amount
that varies with the amount of power available from the rechargeable storage system and a fuel
economy credit amount that varies with the rated fuel economy of the vehicle compared to a
2000 model year standard. Table 4, below, shows the proposed base credit amounts.

130


Description of Proposal

The proposal extends the due date for filing and paying individual income taxes to
April 30 provided that the taxpayer files the return electronically and pays the entire balance due
electronically by that date. The due date for filing by any other method or for filing
electronically but paying the balance due by non-electronic means is not changed.

Effective date.The proposal is effective for taxable years beginning after December 31,
2003; these returns will be filed in 2005.

Analysis

In general, the goal of the proposal is to reduce the administrative burdens on the IRS by
encouraging more taxpayers to file and pay electronically. In particular, extending the date by
which payment must be made could provide encouragement to file electronically to a significant
number of filers of balance due returns, some of which are very complex. The proposal is,
however, unlikely to cause a substantial increase in electronic filing for returns due a refund
(which already constitute the vast majority of electronically filed returns) because one of the
primary reasons those taxpayers file electronically is to receive their refunds more rapidly; a
further extension of time to file contravenes that reason. The proposal would also reduce the
administrative burdens on individual taxpayers to the extent that they prepare the tax return
electronically but file a paper return (and that doing so is less of a burden on them) by
encouraging those individuals to file their returns electronically. The proposal could, in addition,
encourage return preparers to file electronically, in that it will give the preparers additional time
to prepare the returns.

Taxpayers must both file and pay electronically in order to receive the benefit of the
proposed extension of time. There are currently two electronic mechanisms” for paying the
balance due*2> with the return: (1) credit card; or (2) electronic funds withdrawal.°°° Credit card
providers charge a convenience feeTM” in addition to the amount of tax due, which may deter
some individuals from paying the balance due electronically.

534 It is possible that the IRS’ EFTPS electronic payment system, now used almost
entirely by business taxpayers to deposit payroll taxes, could accommodate individuals paying a
balance due on their individual income tax returns. Although a small number of individual
taxpayers now participate in EFTPS, this payment mechanism is not discussed as an option in
general IRS publications describing electronic filing.

535 As an alternative, taxpayers could increase their wage withholding or estimated tax
payments so as not to owe a balance due with the return.

536 ‘This permits the IRS to withdraw the amount owed from the taxpayer’s bank account
electronically (see E-Payment Options for 2003, FS-2003-7, January 2003); it is not offered as an
option when a paper return is filed.

537 The fee generally amounts to several percent of the total amount of taxes charged.

331


H. Ensure Foreign Subsidiaries of U.S. Companies Cannot Inappropriately
Avoid U.S. Tax on Foreign Earnings Invested in
U.S. Property Through Use of the Exceptions for Bank Deposits

Present Law

In general, the subpart F rules*** require the U.S. 10-percent shareholders of a controlled
foreign corporation to include in income currently their pro rata shares of certain income of the
controlled foreign corporation (referred to as “subpart F income”), whether or not such earnings
are distributed currently to the shareholders. In addition, the U.S. 10-percent shareholders of a
controlled foreign corporation are subject to U.S. tax currently on their pro rata shares of the
controlled foreign corporation’s earnings to the extent such earnings are invested by the
controlled foreign corporation in certain U.S. property."

For purposes of section 956, U.S. property generally is defined to include tangible
property located in the United States, stock of a U.S. corporation, an obligation of a U.S. person,
and certain intangible assets including a patent or copyright, an invention, model or design, a
secret formula or process or similar property right which is acquired or developed by the
controlled foreign corporation for use in the United States,

Specified exceptions from the definition of USS. property are provided for: (1)
obligations of the United States, money, or deposits with persons carrying on the banking
business; (2) certain export property; (3) certain trade or business obligations; (4) aircraft,
railroad rolling stock, vessels, motor vehicles or containers used in transportation in foreign
commerce and used predominantly outside of the United States; (5) certain insurance company
reserves and unearned premiums related to insurance of foreign risks; (6) stock or debt of certain
unrelated U.S. corporations; (7) moveable property (other than a vessel or aircraft) used for the
purpose of exploring, developing, or certain other activities in connection with the ocean waters
of the U.S. Continental Shelf; (8) an amount of assets equal to the controlled foreign
corporation’s accumulated earnings and profits attributable to income effectively connected with
a U.S. trade or business; (9) property (to the extent provided in regulations) held by a foreign
sales corporation and related to its export activities; (10) certain deposits or receipts of collateral
or margin by a securities or commodities dealer, if such deposit is made or received on
commercial terms in the ordinary course of the dealer’s business as a securities or commodities
dealer; and (11) certain repurchase and reverse repurchase agreement transactions entered into by
or with a dealer in securities or commodities in the ordinary course of its business as a securities
or commodities dealer.‘

458 Secs, 951-964.
459 Sec. 951(a)(1)(B).
4 Sec. 956(c)(1).

461 Sec, 956(c)(2).

292


plans on allocations, credit carryforwards, credit returns and a national pool of unused
allocations.

The qualified developers or investor partnerships will claim the credit for the five years
after the qualified property is sold to a qualified buyer. However, no credit is allowed with
respect to a housing unit unless that unit was sold within the one-year period beginning on the
date a certificate of occupancy was issued with regard to that unit. Rules similar to the present-
law LIHC rules apply to determination of eligible basis, present value calculations and reporting
requirements.

A qualified homebuyer (not the developer or investor partnership) is subject to recapture
if the qualified homebuyer (or subsequent buyer) sells to a non-qualified buyer within three years
of the initial sale of the qualified unit. The recapture tax is the lesser of: (1) 80 percent of the
gain upon resale, or (2) a recapture amount. The recapture amount equals one half the gain
resulting from the resale, reduced by 1/36" of that value for each month between the initial sale
and the sale to the nonqualified buyer. If a housing unit for which any credit was claimed is
converted to rental property within the initial three-year period, then no deductions for
depreciation or property taxes can be claimed with respect to such unit for the balance of that
three-year period. The proposal does not provide how the qualified homebuyer (or subsequent
buyer) will ascertain the recapture amount for their housing unit.

Effective date—The proposal is effective for first-year credit allocations beginning in
calendar year 2005.

Analysis
Complexity issues

The proposal adds to complexity in the tax law by creating a new tax credit with
numerous detailed rules and significant record keeping requirements for both the taxpayer
claiming the credit and subsequent homebuyers. This new credit, like the low-income rental
housing credit upon which it is based, will be inherently complex and detailed, and will require
significant additional paperwork by taxpayers. The proposal will require the creation of
additional tax forms and will require the Internal Revenue Service to devote resources to the
administration and enforcement of the rules under the proposal. Also, a system to identify
qualified buyers and advertise qualified properties for sale to such buyers will need to be
developed. This proposal can give rise to an increase in the number of individual taxpayers
requiring third-party assistance in preparing their tax returns. The factual inquiries necessitated
by the annual State credit authority cap, the per-unit expenditure requirements, the certification
of buyer income levels, the time limits on subsequent sales, and the recapture tules applicable to
homebuyers, will tend to lead to additional disputes, including litigation, between the IRS and
taxpayers. In addition, adding a new incentive to home ownership without repealing or
consolidating with present-law incentives (such as the low-income housing credit), which have a
similar policy goal but have somewhat different requirements, will cause a proliferation of
similar provisions, adding to tax law complexity.

108


requirements to apply to State continuation coverage as certain rules applicable to State
continuation coverage are inconsistent with such requirements.

Critics argue that it is extremely important for individuals to have the protections relating
to guaranteed issue, preexisting conditions, nondiscriminatory premiums and similar benefits.
They argue that if the applicable requirements are waived, individuals will loose valuable rights
with respect to their health care. In addition, opponents argue that if State continuation coverage
automatically meets the requirements for qualified health insurance, States will be less inclined
to work towards producing a qualifying option that includes the otherwise applicable
requirements. Critics of the proposal argue that if all State-based coverage must satisfy the
requirements, States will eventually produce a qualifying option which will allow its citizens
access to the credit while retaining the important consumer protections. This change is viewed
by critics as a substantive change from what was originally intended, rather than a clarification of
present law.

Other specified coverage of alternative TAA recipients

Removing the special rule for other specified coverage that applies only to alternative
TAA recipients results in applying the same definition of other specified coverage to all eligible
individuals. Under the proposal, for all eligible individuals, specified coverage would include
coverage under a health plan maintained by an employer (except for insurance substantially all of
which is for excepted benefits) than pays at least 50 percent of the cost of coverage and certain
governmental health programs. Proponents argue that the proposal would reduce complexity in
administering the credit, as similar rules would apply to all individuals. Some argue that despite
the complexity in having different rules, the special rule for alternative TAA recipients should be
retained.

Prior Action

No prior action.

67


appropriate to household employees, which may affect the unemployment benefit eligibility and
benefit amounts for individuals.

Prior Action

No prior action.

205


additional reporting requirements applicable to qualified tuition programs under present law do
not apply and distributions for purposes other than education are not subject to Federal tax."

Effective date
The proposal is effective on January 1, 2005.
Analysis

In general

The proposal is intended to accommodate taxpayers’ changing circumstances over time
by providing a new account that taxpayers may use for tax-favored saving over their entire
lifetimes, with no restrictions on withdrawals. The proposal also provides a new account for
individual retirement savings with fewer restrictions on eligibility than present-law IRAs. The
proposal is intended to simplify saving by permitting the consolidation of existing savings
accounts and allowing individuals to make contributions to these new accounts with no
limitations based on age or income level.

By providing additional tax incentives for saving, the proposal intends to encourage
additional saving. By providing a tax-favored savings account with no restrictions on
withdrawals, the proposal intends to encourage additional saving by those who are reluctant to
take advantage of existing tax-preferred savings accounts because of withdrawal restrictions.
Some argue that the national saving rate is too low, and that this is due in part to the bias of the
present-law income tax structure against saving and in favor of current consumption. By
providing tax incentives for saving--specifically, removing the tax on the return to saving--the
present-law income tax structure can be modified to function more like a consumption tax.
Proponents of such tax incentives argue that saving will increase if the return to saving is not
reduced by taxes. Others have argued that saving has not necessarily increased as a result of
existing tax incentives for savings. Some have argued that much existing savings have merely
been shifted into tax-favored accounts, and thus do not represent new saving.” Others have
argued that increasing the return to savings (by not taxing earnings) might cause some taxpayers
actually to save less, as a higher return to savings means that less saving is necessary to achieve a
“target” level of savings at some point in the future.

36 State tax law and qualified tuition program investment options may provide incentives
for savings used for educational purposes.

37 Unlike present-law IRAs, an LSA does not require that contributions be no greater
than compensation. Under the proposal, regardless of income, an individual may make
nondeductible annual contributions to an LSA of up to $5,000. To the extent an individual
makes contributions to his or her own LSA that exceed his or her income, then the amounts
transferred in excess of income must represent a transfer of assets from existing savings and not
new savings from forgoing current consumption. Additionally, individuals other than the LSA
owner may make contributions to an LSA.

22


useful life extending beyond the current year must be capitalized.**” However, deductions
allowed to a taxpayer under section 174 (or any other section) are reduced by an amount equal to
100 percent of the taxpayer’s research tax credit determined for the taxable year (Sec. 280C(c)).
Taxpayers may alternatively elect to claim a reduced research tax credit amount under section 41
in lieu of reducing deductions otherwise allowed (sec. 280C(c)(3)).

Description of Proposal

The research tax credit is made permanent.

Effective date—The proposal is effective on the date of enactment.

Analysis

Overview

Technological development is an important component of economic growth. However,
while an individual business may find it profitable to undertake some research, it may not find it
profitable to invest in research as much as it otherwise might because it is difficult to capture the
full benefits from the research and prevent such benefits from being used by competitors. In
general, businesses acting in their own self-interest will not necessarily invest in research to the
extent that would be consistent with the best interests of the overall economy. This is because
costly scientific and technological advances made by one firm are cheaply copied by its
competitors. Research is one of the areas where there is a consensus among economists that
government intervention in the marketplace can improve overall economic efficiency. ***
However, this does not mean that increased tax benefits or more government spending for
research always will improve economic efficiency. It is possible to decrease economic
efficiency by spending too much on research. However, there is evidence that the current level
of research undertaken in the United States, and worldwide, is too little to maximize society’s
well-being.**° Nevertheless, even if there were agreement that additional subsidies for research

587 Taxpayers may elect 10-year amortization of certain research expenditures allowable
as a deduction under section 174(a). Secs. 174(f)(2) and 59(e).

588 This conclusion does not depend upon whether the basic tax regime is an income tax
or a consumption tax.

58 See Zvi Griliches, “The Search for R&D Spillovers,” Scandinavian Journal of
Economics, vol. XCIV, (1992), M. Ishaq Nadiri, “Innovations and Technological Spillovers,”
National Bureau of Economic Research, Working Paper No. 4423, 1993, and Bronwyn Hall,
“The Private and Social Returns to Research and Development,” in Bruce Smith and Claude
Barfield, editors, Technology, R&D and the Economy, (Washington, D.C.: Brookings Institution
Press), 1996, pp. 1-14. These papers suggest that the rate of return to privately funded research
expenditures is high compared to that in physical capital and the social rate of return exceeds the
private rate of return. Griliches concludes, “in spite of [many] difficulties, there has been a
significant number of reasonably well-done studies all pointing in the same direction: R&D
spillovers are present, their magnitude may be quite large, and social rates of return remain
significantly above private rates.” Griliches, p. S43.

363


case is that they are needed to raise the awareness of the homeowner, or to lower the price
sufficiently to convince the homeowner that the investment is worthwhile, even though the
investment is in their interest even without the subsidy. These arguments have been called into
question recently on the grounds that the returns to the investments have been overstated by
manufacturers, or are achievable only under ideal circumstances. This view holds that the returns
to these investments are not dissimilar to other investments of similar risk profile, and that
homeowners have not been economically irrational in their willingness to undertake certain
energy saving investments. Of course, to the extent that there are negative externalities from the
private energy consumption, these households, though making rational private choices, will not
make the most socially beneficial choices without some form of subsidy.

A final justification offered for targeted tax credits in some instances is to “jump start”
demand in certain infant industries in the hopes that over time the price of such goods will fall as
the rewards from competition and scale economies in production are reaped. However, there is
no guarantee that the infant industry would ultimately become viable without continued
subsidies. This argument is often offered for production of electric cars--that if the demand is
sufficient the production costs will fall enough to make them ultimately viable without subsidies.
This justification is consistent with the current proposals in that the credits are available only for
a limited period of time.

Production tax credits

Two of the proposals related to energy and the environment (the wind and biomass tax
credit and the credit for landfill gas) are production tax credits. These credits differ from
investment tax credits in that the credit amount is based on production, rather than on
investment. Some argue that a production credit provides for a stream of tax benefits, rather than
an up-front lump sum, and that the stream of benefits can help provide financing for investment
projects that would use wind or biomass facilities. On the other hand, an up-front tax credit
provides more certainty, as the future production credits could possibly be curtailed by future
Congresses. In general, investors prefer certainty to uncertainty, and thus may discount the value
of future production credits. Another difference between a production credit and an investment
credit is that the latter provides only a temporary distortion to the market--once the investment is
made, normal competitive market conditions will prevail and the rational firm will only produce
its end product if it can cover its variable costs. With a production credit, a firm may actually
profitably produce even though it cannot cover its variable costs in the absence of the credit. This
would generally be considered an economically inefficient outcome unless there are positive
externalities to the production of the good that exceed the value of the credit. In the case of
electricity produced from wind or biomass, if it is presumed that the electricity produced from
these sources substitutes for electricity produced from the burning of fossil fuels, economic
efficiency will be improved so long as the credit does not have to be set so high in order to
encourage the alternative production that it exceeds the value of the positive externality. On the
other hand, by making some production of electricity cheaper, it is possible that the credit could
encourage more electricity consumption. On net, however, there would be less electricity
produced from fossil fuels.

The proposed structure of these two credits raises an additional question of efficiency.
The proposed credit for landfill gas would base the credit on the energy value of the gas

141


rate, and make other changes in the minimum funding requirements. They suggest that this type
of approach would provide relief to employers without resulting in potentially inappropriate
results in other cases, e.g., in determining lump-sum benefits. On the other hand, some argue
that funding relief is not appropriate at all, and that higher contributions should be required in
order to increase funding levels, thereby enhancing retirement security and reducing potential
PBGC liabilities.

Other issues that may arise in the context of the interest rate discussion include employer
flexibility in making contributions and the appropriate level of tax benefits for defined benefit
pension plans.“ For example, a given employer may prefer a lower interest rate that enables the
employer to make large deductible contributions and thereby maximize the tax benefit from
maintaining the plan. Alternatively, another employer may prefer a higher rate that would
reduce required contributions, thus freeing up funds for other business uses. Some argue that the
degree of flexibility in contributions to be provided to employers should be addressed through
means other than the choice of interest rate.

Analysis of interest-rate proposal

Under the proposal, the rate of interest on 30-year Treasury securities is replaced with the
rate of interest on high-quality corporate bonds for purposes of determining a plan’s current
liability and determining minimum and maximum lump-sum values. Initially, the interest rate
used to determine current liability is based on a weighted average of the yields on high-quality
long-term corporate bonds. After a transition period, in determining current liability and lump-
sum values, the proposal provides for the use of a series of interest rates drawn from a yield
curve of high-quality zero-coupon bonds with various maturities, selected to match the timing of
benefit payments expected to be made from the plan.

Some believe that, compared with the rate of interest on 30-year Treasury securities, an
interest rate based on corporate bonds better approximates the rate that would be used in
determining the cost of settling pension liabilities, i.e., by purchasing annuity contracts to
provide the benefits due under the plan. However, some argue for an interest rate index based on
Treasury or other Federal agency obligations (with an adjustment as necessary to approximate
annuity rates) out of concern that a rate based on a privately determined index could be
improperly manipulated because the elements on which the index is based, such as the bonds on
which a corporate bond index is based, may not be known (ie., the rate is not “transparent”) or
because those elements are subject to change by the organization determining the index. Some
who favor the use of an interest rate based on corporate bonds have raised similar transparency
concerns with respect to the Secretary of the Treasury’s determination of the interest rate
applicable for pension purposes. It has been suggested that the Secretary of the Treasury should
be required to explain the methodology to be used to determine such interest rate and to make
public the corporate bond indices on which the rate is based.

343A tax benefit results from the prefunding of the retirement benefit, which produces
tax-free inside buildup on the earnings from the assets held by the plan.

237


Table 15.-Percentage Distribution of Firms Claiming Research Tax Credit
and Percentage of Credit Claimed by Sector, 2001

Percent of Percent of
Corporations Total
Industry Claiming Credit R&E Credit

(Manufacturing 42.26 65.96
Information 18.28 15.60
Professional, Scientific, and Technical

Services 25.97 10.39
[Wholesale Trade 4.85 2.37
Finance and Insurance 0.76 1,90
[Holding Companies 0.68 1,27
[Retail Trade 1.26 0.63
|Administrative and Support and Waste

IManagement and Remediation Services 0.44 0.42
[Health Care and Social Services 0.88 0.34
Utilities 2.74 0.16
IMining 0.30 0.15
[Real Estate and Rental and Leasing 0.53 0.07
\Agriculture, Forestry, Fishing and Hunting 0.42 0.05
Transportation and Warehousing (1) (1)
Construction Q) qd)
[Arts, Entertainment, and Recreation (1) ()
[Accommodation and Food Services (1) (1)
|Educational Services Q) dd)
|Other Services @) (1)
lWholesale and Retail Trade not Allocable (1). qd)
[Not Allocable Q) QQ)

! Data undisclosed to protect taxpayer confidentiality.

Source: Joint Committee on Taxation calculations from Internal Revenue Service, Statistics of Income data.

367



Despite the central role of the measurement of the price elasticity of research activities,
there is little empirical evidence on this subject. What evidence exists generally indicates that
the price elasticity for research is substantially less than one. For example, one survey of the
literature reached the following conclusion:

In summary, most of the models have estimated long-run price elasticities of
demand for R&D on the order of -0.2 and -0.5. .. . However, all of the
measurements are prone to aggregation problems and measurement errors in
explanatory variables.

Although most analysts agree that there is substantial uncertainty in these estimates, the
general consensus when assumptions are made with respect to research expenditures is that the
price elasticity of research is less than 1.0 and may be less than 0.5. Apparently there have
been no specific studies of the effectiveness of the university basic research tax credit.

otherwise--so called marginal research expenditures--need be subject to the credit to have a
positive incentive effect.

598 Charles River Associates, An Assessment of Options for Restructuring the R&D Tax
Credit to Reduce Dilution of its Marginal Incentive (final report prepared for the National
Science Foundation), February, 1985, p. G-14. The negative coefficient in the text reflects that a
decrease in price results in an increase in research expenditures. Often, such elasticities are
reported without the negative coefficient, it being understood that there is an inverse relationship
between changes in the “price” of research and changes in research expenditures.

5 I a 1983 study, the Treasury Department used an elasticity of .92 as its upper range
estimate of the price elasticity of R&D, but noted that the author of the unpublished study from
which this estimate was taken conceded that the estimate might be biased upward. See,
Department of the Treasury, The Impact of Section 861-8 Regulation on Research and
Development, p. 23. As stated in the text, although there is uncertainty, most analysts believe
the elasticity is considerable smaller. For example, the General Accounting Office summarizes:
“These studies, the best available evidence, indicate that spending on R&XE is not very responsive
to price reductions. Most of the elasticity estimates fall in the range of 0.2 and 0.5. .. . Since it is
commonly recognized that all of the estimates are subject to error, we used a range of elasticity
estimates to compute a range of estimates of the credit’s impact.” See, The Research Tax Credit
Has Stimulated Some Additional Research Spending (GAO/GGD-89-114), September 1989, p.
23. Similarly, Edwin Mansfield concludes: “While our knowledge of the price elasticity of
demand for R&D is far from adequate, the best available estimates suggest that it is rather low,
perhaps about 0.3.” See, “The R&D Tax Credit and Other Technology Policy Issues,” American
Economic Review, Vol. 76, no. 2, May 1986, p. 191.

More recent empirical analyses have estimated higher elasticity estimates. One recent
empirical analysis of the research credit has estimated a short-run price elasticity of 0.8 anda
long-run price elasticity of 2.0. The author of this study notes that the long-run estimate should
be viewed with caution for several technical reasons. In addition, the data utilized for the study
cover the period 1980 through 1991, containing only two years under the revised credit structure.

370


As noted previously, such a circumstance generally results in a marriage bonus. By filing a joint
return, the lower earner may become subject to the marginal tax rate of the higher earner. By
creating higher marginal tax rates on secondary earners, joint filing may discourage a number of
individuals from entering the work force or it may discourage those already in the labor force
from working additional hours.'”

By maintaining the size of the fifteen-percent bracket for married taxpayers filing jointly
at twice that of single taxpayers, single taxpayers in the fifteen percent bracket or below will not,
under the President’s proposal, experience a higher marginal tax rate from marriage. Thus, the
labor supply of “secondary earners” is less likely to be discouraged under the President’s
proposal.

Expansion of child tax credit

One of the basic tenets of tax policy is that an accurate measurement of ability to pay
taxes is essential to tax fairness. Proponents of maintaining the size of the child credit at $1,000
argue that anything less would be inadequate, even if taken together with the personal exemption
available for each qualifying child, to adequately reflect the cost of raising a child. They argue
that the higher credit better reflects the reduced ability to pay of taxpayers with children. Others
argue that the full financial cost of raising a child should not be presumed to be a public
responsibility, and that the child credit and dependent exemptions are not designed to fully offset
the costs of raising a child.

Prior Action

The President’s budget proposal for fiscal year 2004 contained a similar acceleration
proposal for taxable years beginning in 2003 and 2004.

'7 The decision to work additional hours may be less sensitive to changes in the marginal
tax rate than the decision to enter the labor force. See, Robert K. Triest, “The Effect of Income
Taxation on Labor Supply in the United States,” Journal of Human Resources, 25, 1990.


Targeted investment tax credits

Three of the proposals related to energy and the environment (residential solar, combined
heat and power, hybrid vehicles) are targeted investment tax credits designed to encourage
investment in certain assets that reduce the consumption of conventional fuels and that reduce
the emissions of gases related to atmospheric warming and other pollutants. The following
general analysis of targeted investment tax credits is applicable to these proposals.

As a general matter of economic efficiency, tax credits designed to influence investment
choices should be used only when it is acknowledged that market-based pricing signals have led
to a lower level of investment in a good than would be socially optimal. In general, this can
occur in a market-based economy when private investors do not capture the full value of an
investment--that is, when there are positive externalities to the investment that accrue to third
parties who did not bear any of the costs of the investments. For example, if an individual or
corporation can borrow funds at 10 percent and make an investment that will return 15 percent,
they will generally make that investment. However, if the return were 15 percent, but only 8
percent of that return went to the investor, and 7 percent to third parties, the investment will
generally not take place, even though the social return (the sum of the return to the investor and
other parties) would indicate that the investment should be made. In such a situation, it may be
desirable to subsidize the return to the investor through tax credits or other mechanisms in order
that the investor's return is sufficient to cause the socially desirable investment to be made. In
this example, a credit that raised the return to the investor to at least 10 percent would be
necessary. Even if the cost of the credit led to tax increases for the third parties, they would
presumably be better off since they enjoy a 7-percent return from the investment, and the credit
would only need to raise the return to the investor by 2 percent for him or her to break even.
Thus, even if the third parties would bear the full cost of the credit, they would, on net, enjoy a 5-
percent return to the investment (7 percent less 2 percent).

There are certain aspects of targeted tax credits that could impair the efficiency with
which they achieve the desired goal of reduced atmospheric emissions. By targeting only certain
investments, other more cost-effective means of pollution reduction may be overlooked. Many
economists would argue that the most efficient means of addressing pollution would be through a
direct tax on the pollution-causing activities, rather than through the indirect approach of targeted
tax credits for certain technologies. By this approach, the establishment of the economically
efficient prices on pollutants, through taxes, would result in the socially optimal level of
pollution. This would indirectly lead to the adoption of the types of technologies favored in the
President's budget, but only if they were in fact the most socially efficient technologies. In many
cases, however, establishing the right prices on pollution-causing activities through taxes could
be administratively infeasible, and other solutions such as targeted credits may be more
appropriate.

A second potential inefficiency of investment tax credits is one of budgetary inefficiency,
in the sense that their budgetary costs could be large relative to the incremental investment in the
targeted activities. The reason for this is that there will generally have been investment in the
activities eligible for the credit even in the absence of the credit. Thus, for example, if investors
planned to invest a million dollars in an activity before a 10-percent credit, and the credit caused
the investment to rise $100,000 to $1.1 million because of the credit, then only $100,000 in

139


Table 13.-Comparison of Individual Tax Liability Without Extension of
Rules and With Extension, 2004

Without Proposal
Extension (With
Extension)
Adjusted gross income $80,000 $80,000
Less standard deduction 9,700 9,700
Less personal exemptions (6 @ $3,100) 18,600 18,600
Taxable income 51,700 51,700
Regular tax 7,040 7,040
Tentative minimum tax 5,720 5,720
HOPE Scholarship credit before limitation 3,000 3,000
Tentative minimum tax limitation:
Regular tax 7,040 7,040
Less tentative minimum tax 5,720 5,720
Limitation 1,320 7,040
HOPE Scholarship credit 1,320 3,000
Child tax credit 2,000 2,000
Net tax 3,720 2,040
Net tax reduction 1,680

Example 2.-Assume in 2005, a married couple has an adjusted gross income of
$100,000, they do not itemize deductions, and they have two dependent children who are eligible
for the child tax credit. The couple’s net tax liability with and without an extension of the AMT
exemption amount, are computed as shown in Table 14.

357


Analysis

In general

Nonqualified deferred compensation is a common form of executive compensation. A
variety of tax principles and Code provisions are used in determining the appropriate tax
treatment for nonqualified deferred compensation. There are no clear rules governing many
aspects of deferred compensation arrangements. As a result, arrangements have developed based
on varying interpretations of authority that may not be strictly applicable to the situation in
question. The restriction imposed by section 132 of the Revenue Act of 1978 has prevented
Treasury from issuing more guidance on nonqualified deferred compensation and may have
contributed to aggressive interpretations of present law.

The Joint Committee staff has recommended the repeal of section 132 of the Revenue
Act of 1978.57 Repealing section 132 would allow Treasury to provide more guidance to
taxpayers and may also help to stem inappropriate practices. Especially given the lack of
statutory rules regarding specific arrangements, the lack of administrative guidance in this area
allows taxpayers latitude to create and promote arrangements which push the limit of what is
allowed under the law. Because of the lack of rules and guidance in this area, the current state of
practice has, to a great extent, evolved from variations of private letter rulings issued by the IRS
to various taxpayers. Taxpayers continue to create new variations of arrangements that, in their
basic form, are generally perceived as allowed by the IRS. Guidance issued by the Secretary
should address current inappropriate practices, such as accelerated distributions and certain
suspect techniques used to prevent an arrangement from being considered funded, but should
also be sufficiently broad so that new inappropriate arrangements cannot be developed.

The effectiveness of the proposal will depend on the specifics of any guidance issued.
Additionally, in interpreting present law, guidance issued by the Secretary may not be able to
address all practices that are generally viewed as inappropriate. Additional statutory changes
may also be necessary.

Complexity issues

The proposal has elements that may both increase and decrease complexity depending on
the specific guidance issued by the Secretary. Clearer rules in the deferred compensation area
would add simplification. Whether any particular rules are complex will depend on the specific
rules. While the existence of clear rules in the deferred compensation area would add
simplification, because a variety of tax principles and Code provisions are used in determining
the appropriate tax treatment for nonqualified deferred compensation, additional complexity
could result if new guidance is unclear. Any complexity associated with deferred compensation
tules is elective, as the decision to defer compensation is voluntary.

547 See Joint Committee on Taxation, Report of Investigation of Enron Corporation and
Related Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations
(JCS-3-03), February 2003.

336


Section 132 of the Revenue Act of 1978

Section 132 of the Revenue Act of 1978°45 was enacted in response to proposed Treasury
regulation 1.61-16. Section 132 of the Revenue Act of 1978 provides that the taxable year of
inclusion in gross income of any amount covered by a private deferred compensation plan is
determined in accordance with the principles set forth in regulations, rulings, and judicial
decisions relating to deferred compensation which were in effect on February 1, 1978. The term,
“private deferred compensation plan” means a plan, agreement, or arrangement under which the
person for whom service is performed is not a State or a tax-exempt organization and under
which the payment or otherwise making available of compensation is deferred. However, the
provision does not apply to certain employer-provided retirement arrangements (e.g., a qualified
retirement plan), a transfer of property under section 83, or an arrangement that includes a
nonexempt employees trust under section 402(b). Section 132 was not intended to restrict
judicial interpretation of the law relating to the proper tax treatment of deferred compensation or
interfere with judicial determinations of what principles of law apply in determining the timing
of income inclusion.“

Description of Proposal

The Administration’s proposal repeals section 132 of the Revenue Act of 1978 and
amends the Code to authorize the Secretary to issue rules to address inappropriate nonqualified
deferred compensation arrangements. Under the proposal, examples of inappropriate
nonqualified deferred compensation arrangements include arrangements under which the
availability of deferred payments is not actually subject to a substantial limitation, arrangements
under which assets are, in effect, placed beyond the reach of the employer’s general creditors,
and arrangements under which the individual otherwise attempts to defer tax on amounts with
respect to which economic value is realized.

Under the proposal, it is expected that new guidance would address when an individual’s
access to compensation is considered subject to a substantial limitation, the extent to which
company assets can be designated as available to meet deferred compensation obligations, and
when an arrangement is treated as funded. The new guidance would not include finalization of
Proposed Treasury Regulation section 1.61-16.

Effective date.—The proposal is effective on the date of enactment.

545 Dub. L. No. 95-600.

546 The legislative history to the provision states that the Congress believed that the
doctrine of constructive receipt should not be applied to employees of taxable employers as it
would have been under the proposed regulation. The Congress also believed that the uncertainty
surrounding the status of deferred compensation plans of taxable organizations under the
proposed regulation was not desired and should not be permitted to continue.

335


B. Impose Additional Registration Requirements on the Transfer
of Tax-Exempt Fuel by Pipeline, Vessel or Barge

Present Law

Registration

Blenders, enterers, pipeline operators, position holders, refiners, terminal operators, and
vessel operators are required to register with the Secretary with respect to fuels taxes imposed by
sections 4041(a)(1) and 4081.5 A non assessable penalty for failure to register is $50.°°° A
criminal penalty of $5,000, or imprisonment of not more than 5 years, or both, together with the
costs of prosecution also applies to a failure to register and to certain false statements made in
connection with a registration application.°” Registrants are not required to display proof of
registration.

Bulk transfer exemption

In general, gasoline, diesel fuel, and kerosene (“taxable fuel”) are taxed upon removal
from a refinery or a terminal.** Tax also is imposed on the entry into the United States of any
taxable fuel for consumption, use, or warehousing. The tax does not apply to any removal or
entry of a taxable fuel transferred in bulk (a “bulk transfer”) to a terminal or refinery if the
person removing or entering the taxable fuel and the operator of such terminal or refinery are
registered with the Secretary. For example, if a registered vessel or pipeline operator removes
fuel in bulk from a registered refiner and transfers the fuel to a registered terminal operator, tax is
not imposed on the bulk transfer. For the bulk transfer exemption to apply, the “position holder”
with respect to the taxable fuel, i.e., the person shown on the records of the terminal facility as
owning the fuel, must be registered with the Secretary.°”

Present law does not require that every vessel or pipeline operator that transfers fuel as
part of a bulk transfer be registered in order for the transfer to be exempt. For example, a
registered vessel or pipeline operator may remove fuel from a registered refiner and transfer the
fuel to an unregistered vessel or pipeline operator who in turn transfers fuel to a registered
terminal operator. The transfer is exempt despite the intermediate transfer by an unregistered
person.

56 Sec. 4101; Treas. Reg. sec. 48.4101-1(a) & (c)(1).
56 Sec, 7272(a).

587 Sec, 7232.

588 Sec, 4081(a)(1)(A).

58 Sec, 4081(a)(1)(B). The sale of a taxable fuel to an unregistered person prior to a
taxable removal or entry of the fuel is subject to tax. Sec. 4081(a)(1)(A).

570 Treas. Reg. sec. 48.4081-3(d).

347


Presence of qualifying children and amount of the earned income credit

The EIC is available to low and moderate-income working taxpayers. Three separate
schedules apply: one schedule for taxpayers with no qualifying children, one schedule for
taxpayers with one qualifying child, and one schedule for taxpayers with more than one
qualifying child.?*’

Taxpayers with one qualifying child may claim a credit in 2004 of 34 percent of their
earnings up to $7,660, resulting in a maximum credit of $2,604. The maximum credit is
available for those with earnings between $7,660 and $14,040 ($15,040 if married filing jointly).
The credit begins to phase down at a rate of 15.98 percent of earnings above $14,040 ($15,040 if
married filing jointly). The credit is phased down to 0 at $30,338 of earnings ($31,338 if married
filing jointly).

Taxpayers with more than one qualifying child may claim a credit in 2004 of 40 percent
of earnings up to $10,750, resulting in a maximum credit of $4,300. The maximum credit is
available for those with earnings between $10,750 and $14,040 ($15,040 if married filing
jointly). The credit begins to phase down at a rate of 21.06 percent of earnings above $14,040
($15,040 if married filing jointly). The credit is phased down to $0 at $34,458 of earnings
($35,458 if married filing jointly).

Taxpayers with no qualifying children may claim a credit if they are over age 24 and
below age 65. The credit is 7.65 percent of earnings up to $5,100, resulting in a maximum credit
of $390, for 2004. The maximum is available for those with incomes between $5,100 and
$6,390 ($7,390 if married filing jointly). The credit begins to phase down at a rate of 7.65
percent of earnings above $6,390 ($7,390 if married filing jointly) resulting in a $0 credit at
$11,490 of earnings ($12,490 if married filing jointly).

If more than one taxpayer lives with a qualifying child, only one of these taxpayers may
claim the child for purposes of the EIC. If multiple eligible taxpayers actually claim the same
qualifying child, then a tiebreaker rule determines which taxpayer is entitled to the EIC with
respect to the qualifying child. The eligible taxpayer who does not claim the EIC with respect to
the qualifying child may not claim the EIC for taxpayers without qualifying children.

Definition of qualifying child

In order to be a qualifying child, an individual must satisfy a relationship test, a residency
test, and an age test. The relationship test requires that the individual be (1) a child, stepchild, a
descendant of a child or stepchild, or a foster or adopted child of the taxpayer, or (2) a sibling,
stepsibling, or descendent of a sibling of stepsibling. The residency test requires that the
individual have the same place of abode as the taxpayer for more than half the taxable year. The

257 Aji income thresholds are indexed for inflation annually.

182


increased receipts to the government, in that the cessation of receipts due to termination of
installment agreements may outweigh increases in receipts through additional enforcement
activities.

The proposal is effective for failures occurring on or after the date of enactment. Some
may question whether it is fair to taxpayers who are currently in an installment agreement to
terminate those agreements.

Prior Action

An identical proposal was included in the President’s fiscal year 2003 and 2004 budget
proposals. An identical proposal was contained in the “Tax Administration Good Government
Act of 2004,” as passed by the Senate Committee on Finance on February 2, 2004.

5. Consolidate review of collection due process cases in the Tax Court
Present Law

In general, the IRS is required to notify taxpayers that they have a right to a fair and
impartial hearing before levy may be made on any property or right to property (sec. 6330(a)).
Similar rules apply with respect to liens (sec. 6320). The hearing is held by an impartial officer
from the IRS Office of Appeals, who is required to issue a determination with respect to the
issues raised by the taxpayer at the hearing. The taxpayer is entitled to appeal that determination
to acourt. That appeal must be brought to the United States Tax Court, unless the Tax Court
does not have jurisdiction over the underlying tax liability. If that is the case, then the appeal
must be brought in the district court of the United States (sec. 6330(d)). Special rules apply if
the taxpayer files the appeal in the incorrect court.

The United States Tax Court is established under Article I of the United States
Constitution®° and is a court of limited jurisdiction.”

Description of Proposal

The proposal consolidates all judicial review of these collection due process
determinations in the United States Tax Court.

Effective dateThe proposal applies to IRS Office of Appeals determinations made after
the date of enactment.

Analysis

Because the Tax Court is a court of limited jurisdiction, it does not have jurisdiction over
all of the taxes (such as, for example, most excise taxes) that could be at issue in collection due

5 Sec, 7441.

327 Sec. 7442.

327


Description of Proposal

The proposal allows the disclosure to the Department of Education and its contractors of
the adjusted gross income, filing status, total earnings from employment, Federal income tax
liability, type of return filed and taxpayer identity information for the financial aid applicant or of
the applicant’s parents (if the applicant is a dependent) or spouse (if married). Pursuant to the
proposal, the Department of Education could use the information not only for establishing a loan
repayment amount but also for verifying items reported by student financial aid applicants and
their parents.

The proposal allows the Department of Education to use contractors to process the
information disclosed to the Department of Education, eliminating the need for consents. It is
understood that the proposal imposes the present-law safeguards applicable to disclosures to
Federal and State agencies on disclosures to the Department of Education and its contractors.

Effective date. —The proposal is effective with respect to disclosures made after the date
of enactment.

Analysis

Contractors

The proposal permits the disclosure of a taxpayer’s return information to contractors and
agents of the Department of Education, not just to Department of Education employees. Some
might argue that the use of contractors significantly expands the risk of unauthorized disclosure,
particularly when return information is used by a contractor outside of the recipient agency. The
volume of taxpayer information involved under this proposal and the disclosure of millions of
taxpayer records, significantly contributes to the risk of unauthorized disclosure. On the other
hand, some might argue that it is appropriate to permit the disclosure of otherwise confidential
tax information to contractors to ensure the correctness of Federal student aid.

Opponents of the proposal may argue that it is not clear that the Internal Revenue Service
has the resources and computer specialists to implement and enforce the safeguards that the
proposal imposes. However, proponents of the proposal argue that the proposal alleviates some
of the burden on the Internal Revenue Service by requiring the Department of Education to
monitor its contractors as a supplement to the safeguard reviews conducted by the Internal
Revenue Service.

Burdens on IRS

In general, the proposal eases the burden on the financial aid applicant because the
applicant will not be required to produce copies of their tax returns for verification of their
financial aid applications. The proposal arguably provides simplification for the schools as well,
because the schools will no longer be required to match the information of 30 percent of its
applicants. On the other hand, the proposal tends to increase complexity for the Internal
Revenue Service by requiring it to resolve discrepancies between tax information and income
data on the financial aid application if the applicant is unable to resolve the discrepancy with the
school.

379


Under a general nondiscrimination requirement, the contributions or benefits provided under a
qualified retirement plan must not discriminate in favor of highly compensated employees.*®
Treasury regulations provide detailed and exclusive rules for determining whether a plan satisfies
the general nondiscrimination rules. Under the regulations, the amount of contributions or
benefits provided under the plan and the benefits, rights and features offered under the plan must
be tested.

Treasury regulations provide three general approaches to testing the amount of
nonelective contributions provided under a defined contribution plan: (1) design-based safe
harbors; (2) a general test; and (3) cross-testing.”® Elective deferrals, matching contributions,
and after-tax employee contributions are subject to separate testing as described below.

Qualified cash or deferred arrangements (section 401(k) plans)
In general

Section 401(k) plans are subject to the rules generally applicable to qualified defined
contribution plans.* In addition, special rules apply.

As described above, an employee may make elective deferrals to a section 401(k) plan.
The maximum annual amount of elective deferrals that can be made by an individual is $13,000
for 2004.°° An individual who has attained age 50 before the end of the taxable year may also
make catch-up contributions to a section 401(k) plan. Asa result, the limit on elective deferrals
is increased for an individual who has attained age 50 by $3,000 for 2004.5! An employee's
elective deferrals must be fully vested.

4 Sec, 401(a)(4). A qualified retirement plan of a State or local governmental employer
is not subject to the nondiscrimination requirements.

47 See, Treas. Reg. sec. 1.401(a)(4)-1.
48 See, Treas. Reg. sec. 1.401(a)(4)-2(b) and (c) and sec. 1.401(a)(4)-8(6).

* Except for certain grandfathered plans, a State or local governmental employer may
not maintain a section 401(k) plan.

5° The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”)
increased many of the limits applicable to employer-sponsored retirement plans, generally
effective for years beginning after December 31, 2001. Under EGTRRA, the dollar limit on
elective deferrals increases to $14,000 for 2005 and $15,000 for 2006. After 2006, the limit is
adjusted for inflation in $500 increments. The provisions of EGTRRA generally do not apply for
years beginning after December 31, 2010.

51 The additional amount permitted for catch-up contributions increases to $4,000 for

2005 and $5,000 for 2006. After 2006, the limit is adjusted for inflation in $500 increments.
The catch-up contribution provisions are subject to the general sunset provision of EGTRRA.

27


The proposal repeals the present-law provision that allows a custodial parent to release
the claim to a dependent exemption (and, by extension, the child credit) to a noncustodial parent,
except in those cases where there exists a child support instrument between parents that applies
to the dependent and that is in effect as of the date of the announcement of proposed legislation
establishing a uniform definition of a qualifying child.

The proposal eliminates the present-law requirement that a foster child live with the
taxpayer for the entire year.

Earned income credit

In general, the proposal adopts a definition of qualifying child that is similar to the
present-law definition under the earned income credit. The present-law requirement that a foster
child be cared for as the taxpayer’s own child is eliminated. The present-law tie-breaker rule
applicable to the earned income credit is used for purposes of the proposed uniform definition of
qualifying child.

Child credit

The present-law child credit generally uses the same relationships to define an eligible
child as the proposed uniform definition. The present-law requirement that a foster child be
cared for as the taxpayer’s own child is eliminated, as is the present-law requirement that a foster
child live with the taxpayer for the entire year. The age limitation under the proposal retains the
present-law requirement that the child must be under age 17, regardless of whether the child is
disabled.

Dependent care credit

The requirement that a taxpayer maintain a household in order to claim the dependent
care credit is eliminated. Thus, if other applicable requirements are satisfied, a taxpayer may
claim the dependent care credit with respect to a child who lives with the taxpayer for more than
one half the year, even if the taxpayer does not provide more than one half of the cost of
maintaining the household.

The rules for determining eligibility for the credit with respect to individuals other than
children remain as under present law.

Head of household filing status

Under the proposal, a taxpayer qualifies for head of household filing status with respect
to a child who is a qualifying child as defined under the proposal. An individual who is nota
qualifying child will qualify the taxpayer for head of household status only if, as is the case
under present law, the individual is a dependent of the taxpayer and the taxpayer is entitled to a
dependency exemption for such individual, or the individual is the taxpayer’s father or mother
and certain other requirements are satisfied. Thus, under the proposal a taxpayer is eligible for
head of household filing status only with respect to a qualifying child or an individual for whom
the taxpayer is entitled to a dependency exemption.

164


The President’s proposal addresses this concern generally by decreasing the benefit
available to the donor over time. The President’s proposal does not address how to permit
donors to benefit from property that is used by the charity but that does not generate income.
The Senate proposal permits such a benefit, but leaves the manner of determining the benefit to
the Secretary of the Treasury. Arguably, such a benefit should be provided.

Both proposals require that the donor completely relinquish ownership of the contributed
property; however both proposals appear to encourage the commercialization of intellectual
property, which some might argue is inconsistent with a charity’s general mission to further
exempt, not commercial, purposes.

The sliding scale percentage method proposed by the Administration (allowing 100
percent of revenue in year one, reduced to 10 percent in year 10 and zero thereafter) might be
viewed as inordinately benefiting donors for revenues received in the early years, and
inordinately penalizing donors for revenues received in the later years. This effect may be
compounded by the fact that tax benefits in later years generally are worth less than tax benefits
in earlier years, because of the time value of money.” For example, assume a $100 payment is
received by the donee in a single year during the 10-year period (with no other payments
received with respect to the donated property), a 35 percent income tax rate for the donor, and an
annual discount rate of five percent. A $100 payment received in year one by the donee would
entitle the donor to a tax benefit with a present value of $33.30 ($100 payment times 100 percent
allowed deduction, times 0.951 discount factor; see Table 12, below). The same $100 payment
received in year 10 by the donee would entitle the donor to a tax benefit with a present value of
$2.13 ($100 times 10 percent allowed deduction, times 0.609 discount factor; see chart
below). Table 12, shows the effect of the proposed sliding scale reduction and the time value
of money, using the assumptions of a five percent discount rate, a 35 percent tax rate, and an
annual payment of $100.

421 Of course, this assumes that the tax benefit may be used in the relevant years.

422 The disparity is less for lower discount rates, and more for higher discount rates.

272


required to provide over half the cost of maintaining the household in which the qualifying child
resides.

Claims for EIC for workers without children

The proposal modifies the rules for EIC claims made by multiple taxpayers residing in
the same principal place of abode in which a qualifying child resides. Under the proposal, if
multiple taxpayers residing in the same principal place of abode are eligible to claim the same
qualifying child, an otherwise eligible taxpayer may claim the EIC for workers without children
(maximum credit of $390 for 2004) even if another taxpayer within the same principal place of
abode claims the EIC with respect to the qualifying child. However, if unmarried parents reside
together with their child or children (sons, daughters, stepchildren, adopted children, or foster
children), then one parent may claim the EIC for taxpayers with qualifying children, but neither
parent may claim the EIC for workers without children.?*'

Eliminating the disqualified investment income test

The proposal eliminates the disqualified investment income test. Under the proposal, a
taxpayer who otherwise qualifies for the EIC is not disqualified for having investment income of
any type or amount.

TIN requirements

The proposal provides that both the taxpayer (including his or her spouse, if married) and
the qualifying child must have a social security number that is valid for employment in the
United States (that is, the taxpayer and qualifying child must be United States citizens,
permanent residents, or have certain types of temporary visas that allow them to work in the
United States). Under the proposal, taxpayers who receive social security numbers for non-work
reasons, such as for purposes of receiving Federal benefits or for any other reason, are not
eligible for the EIC.

The proposal also provides that if a qualifying child does not have a valid TIN, a taxpayer
is eligible to claim the EIC for workers without children (maximum credit of $390 for 2004). If
a taxpayer has two or more qualifying children, some of whom do not have a valid TIN, the
taxpayer may claim the EIC based on the number of qualifying children for whom there are valid
TINs.

Effective date

The proposal generally is effective for taxable years beginning after December 31, 2004.
The clarification that taxpayers and qualifying children must have social security numbers that
are valid for employment is effective for taxable years beginning after December 31, 2003.

261 Both under the proposal and present law, unmarried parents who reside together with
multiple qualifying children who are their sons, daughters, stepchildren, adopted children, or
foster children, may allocate the qualifying children between them for earned income credit

purposes.

184


Fund. Thus, proponents argue the Highway Trust Fund is penalized in two ways. First, the
Highway Trust Fund does not get 5.2 cents per gallon due to the reduced rates afforded alcohol
fuel mixtures. Second, of the tax that is collected, the Highway Trust Fund receives only a
portion, rather than the full amount. Vehicles using renewable fuels can cause as much wear and
tear on the highways as vehicles using traditional fuels. Asa result, proponents argue that at a
minimum, like traditional highway motor fuels, the full amount of tax imposed on alcohol fuel
mixtures should be available to the Highway Trust Fund, especially since outlays, even under
current law, are projected to exceed receipts.°

According to the Congressional Budget Office, this change will provide an additional
$4.8 billion dollars to the Highway Trust Fund for the period fiscal year 2004 through fiscal year
2009. Thus, there will be an additional $4.8 billion for highway spending, however, it also
means that there may be $4.8 billion less for programs funded out of the General Fund. The
proposal does not increase or decrease revenues coming into the Federal Government. It shifts
money between government funds. Opponents of the proposal may argue that in times of budget
deficits, there are competing funding priorities and the money being transferred from the General
Fund to the Highway Trust Fund should be used for other priorities.

Prior Action
A similar provision was in section 2006 of H.R. 6, the Energy Policy Act of 2003, as

passed by the Senate on July 31, 2003, and S. 1072, the “Safe, Accountable, Flexible and
Efficient Transportation Equity Act of 2004,” as passed by Senate on February 12, 2004.

564 The Highway Trust Fund is divided into two accounts, the Highway Account and the
Mass Transit Account. For fiscal year 2004, the CBO baseline shows that receipts for the
Highway Account should be approximately $29.5 billion, while outlays from the account are
projected to be approximately $33 billion. Under the baseline, the Highway Account is projected
to be in deficit by fiscal year 2008. The Mass Transit Account is projected to go into deficit in
fiscal year 2010.

346


Table 11.—Charitable Deduction for Contribution of a Patent

or Other Intellectual Property

Taxable Year

Deduction Permitted for Such Taxable Year

Basis plus 100 percent of revenue received by

Year of Contribution charity during the taxable year
1* year after contribution 100 percent of revenue
2" year after contribution 90 percent of revenue

3° year after contribution

80 percent of revenue

4" year after contribution

70 percent of revenue

5" year after contribution

60 percent of revenue

6" year after contribution

50 percent of revenue

7" year after contribution

40 percent of revenue

8" year after contribution

30 percent of revenue

9" year after contribution

20 percent of revenue

10" year after contribution

10 percent of revenue

Taxable years thereafter

No deduction permitted

No charitable deduction is permitted with respect to any revenues received by the
charitable donee after the expiration of the patent or intellectual property, or after the tenth
anniversary of the date the contribution was made by the donor.

The taxpayer is required to obtain written substantiation from the donee of the amount of
any revenue received from (and properly allocable to) the donated property during the charity’s
taxable year. In instances where the donor’s taxable year differs from the donee’s taxable year,
the donor bases its charitable deduction on the revenues received by the charitable donee during
the donee’s taxable year that ends within the donor’s taxable year.

Effective date.The proposal is effective for taxable years beginning after December 31,

2003.

268



“Zone”) of New York City is allowed.“ Property eligible for financing with these bonds
includes buildings and their structural components, fixed tenant improvements, and public
utility property (e.g., gas, water, electric and telecommunication lines). All business addresses
located on or south of Canal Street, East Broadway (east of its intersection with Canal Street), or
Grand Street (east of its intersection with East Broadway) in the Borough of Manhattan are
considered to be located within the Zone. Issuance of these bonds authorized is limited to
projects approved by the Mayor of New York City or the Governor of New York State, each of
whom may designate up to $4 billion of the bonds authorized under the bill.

If the Mayor or the Governor determines that it is not feasible to use all of the authorized
bonds that he is authorized to designate for property located in the Zone, up to $2 billion of
bonds may designated by each to be used for the acquisition, construction, and rehabilitation of
nonresidential real property (including fixed tenant improvements) located outside the Zone and
within New York City.” Bond-financed property located outside the Zone must meet the
additional requirement that the project have at least 100,000 square feet of usable office or other
commercial space in a single building or multiple adjacent buildings.

Subject to the following exceptions and modifications, issuance of these tax-exempt
bonds is subject to the general rules applicable to issuance of exempt-facility private activity
bonds:

() Issuance of the bonds is not subject to the aggregate annual State private activity
bond volume limits (sec. 146);

(2) The restriction on acquisition of existing property is applied using a minimum
requirement of 50 percent of the cost of acquiring the building being devoted to
rehabilitation (sec. 147(d));

(3) The special arbitrage expenditure rules for certain construction bond proceeds
apply to available construction proceeds of the bonds (sec. 148(f)(4)(C));

(4) _ The tenant targeting rules applicable to exempt-facility bonds for residential rental
property (and the corresponding change in use penalties for violations of those

5 Current refundings of outstanding New York Liberty Bonds bonds do not count
against the $8 billion volume limit to the extent that the amount of the refunding bonds does not
exceed the outstanding amount of the bonds being refunded. In addition, qualified New York
Liberty Bonds may be issued after December 31, 2004 to refund (other than advance refund)
qualified New York Liberty Bonds originally issued before January 1, 2005, to the extent the
amount of the refunding bonds does not exceed the outstanding amount of the refunded bonds.
The bonds may not be advance refunded.

66 Fixtures and equipment that could be removed from the designated zone for use
elsewhere are not eligible for financing with these bonds.

647 Public utility property and residential property located outside the Zone cannot be
financed with the bonds.

407


D. Increase Penalties for False or Fraudulent Statements
Made to Promote Abusive Tax Shelters

Present Law

A penalty is imposed on any person who organizes, assists in the organization of, or
participates in the sale of any interest in, a partnership or other entity, any investment plan or
arrangement, or any other plan or arrangement, if in connection with such activity the person
makes or furnishes a qualifying false or fraudulent statement or a gross valuation
overstatement.’” A qualified false or fraudulent statement is any statement with respect to the
allowability of any deduction or credit, the excludability of any income, or the securing of any
other tax benefit by reason of holding an interest in the entity or participating in the plan or
arrangement which the person knows or has reason to know is false or fraudulent as to any
material matter. A “gross valuation overstatement” means any statement as to the value of any
property or services if the stated value exceeds 200 percent of the correct valuation, and the
value is directly related to the amount of any allowable income tax deduction or credit.

The amount of the penalty is $1,000 (or, if the person establishes that it is less, 100
percent of the gross income derived or to be derived by the person from such activity). A
penalty attributable to a gross valuation misstatement can be waived on a showing that there was
a reasonable basis for the valuation and it was made in good faith.

Description of Proposal

The proposal modifies the penalty amount to equal 50 percent of the income derived by
the person from the activity for which the penalty is imposed. The enhanced penalty does not
apply to valuation overstatements.

Effective date. —The proposal is effective for activities after the date of enactment.

Analysis

See the general discussion in section V.A. following the description of the proposals to
combat tax avoidance transactions.

Prior Action

Several legislative proposals have included this proposal.“”°

49 Sec. 6700.

40 See, e.g., Joint Committee on Taxation, Description of the “Highway Reauthorization
and Excise Tax Simplification Act of 2004” (JCX-5-04), January 29, 2004; House Ways and
Means Committee Report of H.R. 2896, American Jobs Creation Act of 2003, (H. Rep. 108-393,
November 21, 2003); Senate Finance Committee Report of S. 1637, Jumpstart our Business
Strength (JOBS) Act, (S. Rep. 108-192, November 7, 2003).

265


The Committee believes a distinguishing feature of American society is the
singular degree to which the United States maintains a private, non-profit sector
of private higher education and other charitable institutions in the public service.
The Committee believes it is important to assist these private institutions in their
advancement of the public good. The Committee finds particularly inappropriate
the restrictions of present law which place these section 501(c)(3) organizations at
a financial disadvantage relative to substantially identical governmental
institutions. For example, a public university generally has unlimited access to
tax-exempt bond financing, while a private, non-profit university is subject to a
$150 million limitation on outstanding bonds from with it may benefit. The
Committee is concerned that this and other restrictions inhibit the ability of
America’s private, non-profit institutions to modemize their educational facilities.
The Committee believes the tax-exempt bond rules should treat more equally
State and local governments and those private organizations which are engaged in
similar actions advancing the public good.'°

Although the conference report on the 1997 Act noted the continued applicability of the
$150 million limitation to refunding and new-money bonds, no reason was given for retaining
the rule.'*' Thus, it appears that eliminating the discrepancy between pre-August 5, 1997, and
post-August 5, 1997, capital expenditures would not violate the policy underlying the repeal of
the $150 million limitation.

Prior Action

A similar proposal was included in the President’s fiscal year 2004 budget proposal.
8. Repeal restrictions on the use of qualified 501(c)(3) bonds for residential rental property

Present Law

In general

Interest on State or local government bonds is tax-exempt when the proceeds of the bonds
are used to finance activities carried out by or paid for by those governmental units. Interest on
bonds issued by State or local governments acting as conduit borrowers for private businesses is
taxable unless a specific exception is included in the Code. One such exception allows tax-
exempt bonds to be issued to finance activities of non-profit organizations described in Code
section 501(c)(3) (“qualified 501(c)(3) bonds”).

For a bond to be a qualified 501(c)(3) bond, the bond must meet certain general
requirements. The property that is to be provided by the net proceeds of the issue must be owned
by a 501(c)(3) organization, or by a government unit. In addition, a bond failing both a modified
private business use test and a modified private security or payment test would not be a qualified

150 § Rep. 105-33 (June 20, 1997), at 24-25.
'S|_ FH Rep. 105-220 (July 30, 1997), at 372-373.

96


Analysis for 1, 2, 4, 5, and 6.
General rationale for tax benefits for energy conservation and pollution abatement

The general rationale for providing tax benefits to energy conservation and pollution
abatement is that there exist externalities in the consumption or production of certain goods. An
externality exists when, in the consumption or production of a good, there is a difference
between the cost or benefit to an individual and the cost or benefit to society as a whole. When
the social costs of consumption exceed the private costs of consumption, a negative externality
exists. When the social benefits from consumption or production exceed private benefits, a
positive externality exists. When negative externalities exist, there will be over-consumption of
the good causing the negative externality relative to what would be socially optimal. When
positive externalities exist, there will be under consumption or production of the good producing
the positive externality. The reason for the over consumption or under consumption is that
private actors will in general not take into account the effect of their consumption on others, but
only weigh their personal cost and benefits in their decisions. Thus, they will consume goods up
to the point where their marginal benefit of more consumption is equal to the marginal cost that
they face. But from a social perspective, consumption should occur up to the point where the
marginal social cost is equal to the marginal social benefit. Only when there are no externalities
will the private actions lead to the socially optimal level of consumption or production, because
in this case private costs and benefits will be equal to social costs and benefits.

Pollution is an example of a negative externality, because the costs of pollution are borne
by society as a whole rather than solely by the polluters themselves. In the case of pollution,
there are two possible government interventions that could produce a more socially desirable
level of pollution. One such approach would be to set a tax on the polluting activity that is equal
to the social cost of the pollution. Thus, if burning a gallon of gasoline results in pollution that
represents a cost to society as a whole of 20 cents, it would be economically efficient to tax
gasoline at 20 cents a gallon. By so doing, the externality is said to be internalized, because now
the private polluter faces a private cost equal to the social cost, and the socially optimal amount
of consumption will take place. An alternative approach would be to employ a system of
payments, such as perhaps tax credits, to essentially pay polluters to reduce pollution. If the
payments can be set in such a way as to yield the right amount of reduction (that is, without
paying for reduction more than the reduction is valued, or failing to pay for a reduction where the
payment would be less than the value of the pollution reduction), the socially desirable level of
pollution will result. The basic difference between these two approaches is a question of who
pays for the pollution reduction. The tax approach suggests that the right to clean air is
paramount to the right to pollute, as polluters would bear the social costs of their pollution. The
alternative approach suggests that the pollution reduction costs should be borne by those who
receive the benefit of the reduction.

In the case of a positive externality, the appropriate economic policy would be to impose
a negative tax (i.e. a credit) on the consumption or production that produces the positive
externality. By the same logic as above, the externality becomes internalized, and the private
benefits from consumption become equal to the social benefits, leading to the socially optimal
level of consumption or production.

138


that the vast majority of the value of qualified technological equipment is foreign use property
that, absent the sale-leaseback transaction, would not be eligible for U.S. tax benefits. The types
of assets that have been used in foreign qualified technological equipment leasing transactions
include, among others, telecom equipment, baggage handling equipment, flight simulators, mail
sorting equipment, automatic train control systems, air traffic control systems, electronic toll
systems, automated food production lines, and automated fare collection systems. 3

For U.S. produced goods, the subsidy for foreign investment might be justified as an
export incentive. However, no similar justification exists where foreign produced goods are
leased or where previously acquired goods (regardless of where produced) are sold and leased
back. A related issue is the potential revenue cost if foreigners are able to take unrestricted
advantage of U.S. tax subsidies by leasing property from U.S. lessors.

Specific policy issues with respect to the proposal

Inclusion of all service contracts in lease term.—The present-law depreciation rules
applicable to tax-exempt use property subject to a lease were enacted to prevent tax-exempt
entities from transferring to a taxable entity the tax benefits of accelerated depreciation on
property used by the tax-exempt entity. These rules require that the leased property be
depreciated on a straight-line basis over a recovery period equal to the longer of the property’s
class life or 125 percent of the lease term. The policy requiring the recovery period be no less
than 125 percent of the lease term was intended to ensure that the recovery period would more
accurately reflect the economic life of the property.** To avoid the impact of these rules, a
taxpayer leasing tax-exempt use property may seek to shorten the depreciable life of the asset by
combining a shorter lease term with a subsequent service contract that would not be treated as
part of the lease term.*®> Thus, the taxpayer is able to accelerate tax depreciation deductions and
circumvent the tax policy rationale of the 125 percent rule. Including the service contract in the
term of the lease for depreciation purposes will prevent this technique.

On the other hand, there are bona fide reasons for service contracts between taxable and
tax-exempt entities. However, it is difficult to envision a non-tax business reason for a tax-
exempt entity structuring a transaction that converts a 20, 30, or 40-year lease into a service

453 These transactions have included property from, among other countries, Australia,
Austria, Canada, China, France, Germany, Netherlands, Portugal, Sweden, Switzerland, and the
United Kingdom.

454 In general, a taxpayer is not considered the owner of property if the lease extends
beyond 80 percent of the useful life of the asset. Thus, property subject to a lease term that is
for 80 percent of the property’s useful life would be recovered over its economic life under this
rule (80% x 125% = 1).

455 Bffectively, a service contract arrangement provides a relatively assured means of
achieving a minimum investment expectation by the lessor without requiring such contract term
to be included in the lease term. Removal of this feature would in some cases subject the lessor
to additional economic risk unless the lease term is extended.

289


average, thereby increasing the likelihood the foundation’s net investment income is taxed at the
two-percent rate, rather than the one-percent rate.!*®

For a foundation currently subject to the excise tax at the two-percent rate, an increase in
payout may qualify the foundation for the one-percent excise tax rate. If the increase does qualify
the foundation for the one-percent rate, and the foundation maintains the same payout for the
subsequent four years, the foundation generally will be eligible for the one-percent tax rate in
each of the five years. Hence the reduced tax rate can create an incentive to increase payout
rates. However, even in the case of a two-percent excise tax paying foundation, the present-law
two-tier excise tax can create a disincentive for a foundation to increase charitable distributions
substantially in any one year compared to a strategy of slowly increasing payouts over several
years. For example, consider a foundation which has had a payout rate of 5.0 percent for several
years. Suppose the foundation is considering increasing its payout rate. Consider two possible
strategies: increase the payout rate to 8.0 percent in the current year followed by rates of 5.5
percent thereafter; or gradually increase the payout rate by increments of one-tenth of one
percent annually for five years. While a substantial increase in any one year may qualify the
foundation for the one-percent tax rate, subsequent year payout rates of 5.5 percent would fail to
qualify the foundation for the one- percent tax rate.'”? Thus, under the first option, the
foundation would pay the one-percent tax rate for one year and be a two-percent tax rate payor
subsequently. Under the second option, the foundation would qualify for the one-percent rate in
each year. However, total payouts are greater under the first option.

In summary, the incentive effects of the present-law two-tier excise tax depend upon the
situation in which the foundation finds itself in the current year. In 1999, 42 percent of
foundations were one-percent tax rate payors and 58 percent were two-percent rate payors.
Among large foundations (assets of $50 million or greater) 58 percent were one-percent rate
payors and 42 percent were two-percent rate payors.'*° A number of analysts suggest the
optimal tax strategy for a private foundation is to choose a target rate of disbursement, maintain
that rate in all years, and never fall below the target in any year.

Critics of the present-law excise tax structure observe that the median payout rate of large
nonoperating private foundations (foundations with total assets of $50 million or more) was 5.1

138 Whether a reduction in payout rate causes the foundation to pay the two-percent tax
rate depends upon the specific pattern of its payout rate in the preceding five years and the
magnitude of the decrease in the current year.

'39 Th this example, after having paid out 8.0 percent, the five-year average payout for the
first year in which the foundation pays out 5.5 percent would be 5.6 percent.

140 See Figure E in Melissa Ludlum, “Domestic Private Foundations and Charitable
Trusts, 1999,” Internal Revenue Service, Statistics of Income Bulletin, 22, Fall 2002 at 143.

141. Steuerle and Sullivan, “Toward More Simple and Effective Giving: Reforming the
Tax Rules for Charitable Contributions and Charitable Organizations,” 438.

89


The modified reporting requirements apply after the date of enactment of the proposal to
all qualified tuition accounts (including savings accounts and prepaid tuition contracts).

Analysis

Overview

The President’s budget proposal addresses certain transfer tax anomalies with regard to
changes in designated beneficiaries by providing that a change of beneficiary to an eligible
beneficiary will not constitute a transfer for gift or generation-skipping transfer tax purposes, or a
distribution for income tax purposes. In addition, by requiring that no person other than a
designated beneficiary possess any beneficial interest in a qualified tuition account, the proposal
attempts to more closely align the gift tax treatment of contributions to qualified tuition accounts
(i.e., a completed gift of a present interest to the designated beneficiary) with the treatment of
contributions under generally applicable transfer tax principles. The proposal addresses potential
abuses of qualified tuition accounts by establishing eligibility rules for designated beneficiaries,
and imposing an excise tax on distributions that are not used for qualified higher education
expenses.

Section 529 transfer tax treatment and generally applicable transfer tax provisions

Overview

Certain aspects of present-law section 529 depart from otherwise generally applicable
transfer tax principles. For example, present law treats a contribution to a qualified tuition
account as a completed gift of a present interest to the designated beneficiary,"”° even though in
most instances, the designated beneficiary possesses no rights to control the qualified tuition
account or withdraw funds, and such control (including the right to change beneficiaries or to
withdraw funds, including for the benefit of someone other than the designated beneficiary) is
vested in the account owner. Absent section 529, such contributions generally would not be
treated as completed gifts to the designated beneficiary under otherwise applicable transfer tax
principles. 511 Further, present section 529 does not address the transfer tax consequences of a
change of account owners of a qualified tuition account.>

519 Sec, 529(c)(2).

511 Under otherwise applicable transfer tax principles, the designated beneficiary’s lack
of control over the qualified tuition account generally would be regarded as a future interest, and
any completed gift of a present interest would be regarded as having been made from the
contributor to the account owner (rather than to the designated beneficiary). In cases where the
contributor and the account owner are the same person, no gift would take place under generally
applicable transfer tax principles.

512 4 change of account owner might be regarded as a completed gift of a present interest
from the old account owner to the new account owner, or as having no tax consequences because
a completed gift had been made to the designated beneficiary. The President’s budget proposal
addresses the present uncertainty in the law, but not by addressing changes in account owners.

313


discrepancy between the value of the minimum lump-sum and the employee’s hypothetical
account balance. In particular, if the plan’s interest crediting rate is higher than the statutory
interest rate, then the resulting lump-sum amount will be greater than the hypothetical account
balance. This result is sometimes referred to as “whipsaw.” Several Federal appellate courts
have addressed the calculation of lump-sum distributions under cash balance plans and have all
followed the approach as described in IRS Notice 96-8."

Age discrimination

In general, the Code prohibits reductions in the benefit accrual rates (including the
cessation of accruals) for defined benefit pension plan participants on account of attainment of
any age.* Similarly, the Code prohibits a defined contribution plan from ceasing allocations, or
reducing the rate at which amounts are allocated to a participant’s account due to attainment of
any age. Parallel requirements exist in ERISA and the Age Discrimination in Employment Act
(“ADEA”). 310

These provisions do not necessarily prohibit all benefit formulas under which a reduction
in accruals is correlated with participants’ age in some manner. Thus, for example, a plan may
limit the total amount of benefits, or may limit the years of service or participation considered in
determining benefits.°"!

In general terms, an age discrimination issue arises under cash balance plans because
there is a longer time for interest credits to accrue on hypothetical contributions to the account of
a younger participant. For example, a $1,000 hypothetical contribution made when a plan
participant is age 30 will be worth more at normal retirement age (e.g., age 65) and thus provide
a higher annuity benefit at normal retirement age than the same contribution made on behalf of
an older participant closer to normal retirement age. This age discrimination issue is not limited
to cash balance plan conversions, but arises with respect to cash balance plans generally. Other
age discrimination issues may also arise, depending in part on plan design, e.g., whether the plan
has a “wearaway” (described below).

In December 2002, the Treasury Department issued proposed regulations relating to the
application of age discrimination prohibitions to defined benefit pension plans, including special
tules for cash balance plans.°!? Under the proposed regulations, subject to certain requirements,

308 See Berger v. Xerox Corp. Retirement Income Guarantee Plan, 338 F.3d 755 (7th Cir.
2003); Esden v. Bank of Boston, 229 F.3d 154 (2d Cir. 2000), cert. dismissed, 531 U.S. 1061
(2001); Lyons v. Georgia-Pacific Salaried Employees Retirement Plan, 221 F.3d 1235 (11th Cir.
2000), cert. denied, 532 U.S. 967 (2001).

30 Code sec. 411(b)(1)(H).
310 BRISA sec. 204(b)(1)(H); ADEA, 29 U.S.C. Code sec. 623(i).
311 Code sec. 411(b)(1)(H)(ii); ERISA sec. 204(g)(1)(H)(ii).

312 67 Fed. Reg. 76123 (Dec. 11, 2002). Prop. Treas. Reg. Code sec. 1.411(b)-2. The
proposed regulations provide guidance on how to determine the rate of benefit accrual under a

217


reduce complexity and make it easier for some taxpayers to file tax returns without having to
obtain information from other taxpayers.

The Administration proposal would increase the filing threshold for a number of
taxpayers, thereby simplifying tax administration through the elimination of numerous return
filings. The proposal would decrease, however, the amount of income subject to income tax.

The staff of the Joint Committee on Taxation recommended modifications to the kiddie
tax” The Joint Committee staff proposal would apply the tax rate schedule applicable to trusts
to net unearned income of a child under age 14. The use of trust rates may result in the
imposition of greater taxes than under present law, although it also would remove the linkage
between the child’s return and the parent’s return. Also, the staff's proposal would expand the
parental election to include the child’s income on the parent’s return to all types and amounts of
the child’s income, without regard to whether there was withholding or estimated tax payments
with respect to the child’s income. This would reduce the number of returns required to be filed
with respect to the income of children under age 14.

Some believe that the rationale for applying the kiddie tax rules to children under 14 also
applies to older children who have not yet attained the age of majority, and that the present-law
rules (or the proposed rules) should be extended to those under 18.

Prior Action

No prior action.

274 Joint Committee on Taxation, Study of the Overall State of the Federal Tax System
and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal
Revenue Code of 1986, Volume II, 144-49 (JCS-3-01), April 2001.

191


C. Repeal Installment Method for Payment of Heavy Highway Vehicle use Tax
Present Law

‘An annual use tax is imposed on heavy highway vehicles, at the rates below.”””

Under 55,000 pounds ........cceceeeceeeee No tax
55,000-75,000 pounds.....s.sssseerrecreeee $100 plus $22 per 1,000 pounds over 55,000
Over 75,000 pounds .......sseeseeeeeene $550

The annual use tax is imposed for a taxable period of July 1 through June 30. Generally,
the tax is paid by the person in whose name the vehicle is registered. In certain cases, taxpayers
are allowed to pay the tax in installments.°”* Exemptions and reduced rates are provided for
certain “transit-type buses,” trucks used for fewer than 5,000 miles on public highways (7,500
miles for agricultural vehicles), and logging trucks.°”> The tax applies only to use before
October 1, 2005.

States are required to obtain evidence before issuing tags for a vehicle, that the use tax
return has been filed and any tax due with the return has been paid.

Description of Proposal

The proposal eliminates the ability to pay the tax in installments for tax years beginning
after June 30, 2004.

Effective date.—The proposal is effective for taxable periods beginning after the date of
enactment.

Analysis

The heavy vehicle annual use tax is imposed once per twelve-month period, July 1
through June 30. Taxpayers are allowed to pay the tax (maximum of $550 per truck) in quarterly
installments. The "taxpayer" for this tax is the vehicle owner. This results in this tax having the
greatest number of persons actually remitting tax of any Highway Trust Fund tax. Further, many
taxpayers are liable only for relatively small amounts of tax.

Low compliance by smaller owner-operators and taxable vehicles having base

registrations in Canada or Mexico led the Congress to require States to verify with the IRS that
the tax has been paid before issuing annual State registrations. In the case of taxpayers that elect

573 Sec. 4481.
574 Sec, 6156.

575 See generally, sec. 4483.

350


B. Permanently Extend Certain Provisions Expiring
Under EGTRRA and JGTRRA

Present Law

The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”)

The Economic Growth and Tax Relief Reconciliation Act of 2001 (“EGTRRA”) made a
number of changes to the Federal tax laws, including reducing individual tax rates, repealing the
estate tax, increasing and expanding various child-related credits, providing tax relief to married
couples, providing additional education-related tax incentives, increasing and expanding various
pension and retirement-saving incentives, and providing individuals relief relating to the
alternative minimum tax. However, in order to comply with reconciliation procedures under the
Congressional Budget Act of 1974, EGTRRA included a “sunset” provision, pursuant to which
the provisions of the Act expire at the end of 2010. Specifically, EGTRRA’s provisions do not
apply for taxable, plan, or limitation years beginning after December 31, 2010, or to estates of
decedents dying after, or gifts or generation-skipping transfers made after, December 31, 2010.

EGTRRA provides that, as of the effective date of the sunset, both the Code and the
Employee Retirement Income Security Act of 1974 (“ERISA”) will be applied as though
EGTRRA had never been enacted. For example, the estate tax, which EGTRRA repeals for
decedents dying in 2010, will return as to decedents dying after 2010, in pre-EGTRRA form,
without the various interim changes made by the Act (¢.g., the rate reductions and exemption
equivalent amount increases applicable to decedents dying before 2010). Similarly, the top
individual marginal income tax rate, which EGTRRA gradually reduced to 35 percent by 2006,'8
will return to its pre-EGTRRA level of 39.6 percent in 2011 under present law. Likewise
beginning in 2011, all other provisions of the Code and ERISA will be applied as though the
relevant provisions of EGTRRA had never been enacted.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (“JGTRRA”)

In general

The Jobs and Growth Tax Relief Reconciliation Act of 2003 (“JGTRRA”) changed the
tax treatment of certain expensing, individual capital gains rates and the tax rate on dividends
received by individuals. The expensing provision sunsets for taxable years beginning after
December 31, 2005. The capital gains and dividend provisions sunset for taxable years
beginning after December 31, 2008.

Expensing provisions

JGTRRA provides that the maximum dollar amount that may be deducted under section
179 is increased to $100,000 for property placed in service in taxable years beginning before
2006. In addition, for purposes of the phase-out of the deductible amount, the pre JGTRRA

18 The Jobs and Growth Tax Relief Reconciliation Act of 2003 accelerated the reduction
to 35 percent for 2004 and thereafter.


7. Repeal $150 million limit for qualified 501(c)(3) bonds

Present Law

Interest on State or local government bonds generally is excluded from income if the
bonds are issued to finance activities carried out and paid for with revenues of these
governments. Interest on bonds issued by these governments to finance activities of other
persons, e.g., private activity bonds, is taxable unless a specific exception is provided in the
Code. One such exception is for private activity bonds issued to finance activities of private,
charitable organizations described in section 501(c)(3) (“section 501(c)(3) organizations”) if the
activities do not constitute an unrelated trade or business.

Section 501(c)(3) organizations are treated as private persons; thus, bonds for their use
may only be issued as private activity “qualified 501(c)(3) bonds,” subject to the restrictions of
section 145. Prior to the Taxpayer Relief Act of 1997 (the”1997 Act”), the most significant of
these restrictions limited the amount of outstanding bonds from which a section 501(c)(3)
organization could benefit to $150 million. In applying this “$150 million limit,” all section
501(c)(3) organizations under common management or control were treated as a single
organization. The limit did not apply to bonds for hospital facilities, defined to include only
acute care, primarily inpatient, organizations.

The “1997 Act” repealed the $150 million limit for bonds issued after the date of
enactment (August 5, 1997), to finance capital expenditures incurred after such date.

Description of Proposal

The proposal repeals the $150 million limit for qualified 501(c)(3) bonds in its entirety.

Effective date—The proposal is effective for bonds issued after the date of enactment.

Analysis

Because the 1997 Act provision applies only to bonds issued with respect to capital
expenditures incurred after August 5, 1997, the $150 million limit continues to govern the
issuance of other non-hospital qualified 501(c)(3) bonds (e.g., advance refunding bonds with
respect to capital expenditures incurred such on or before such date, or new-money bonds for
capital expenditures incurred on or such date). Thus, there are two rules governing qualified
501(c)(3) bonds for capital expenditures. The application of a particular rule depends on
whether the capital expenditures were incurred on or before or after the date the 1997 Act was
enacted.

As noted above, the $150 million volume limit continues to apply to qualified 501(c)(3)
bonds for capital expenditures incurred on or before August 5, 1997. (Typically, these will be
advance refunding bonds). The limit does not apply to bonds to finance capital expenditures
incurred after that date. The Senate Finance Committee report states that the purpose of the
repeal of the $150 million limit was to correct the disadvantage the limit placed on 501(c)(3)
organizations relative to substantially identical governmental institutions:

95


are warranted as a general matter, misallocation of research dollars across competing sectors of
the economy could diminish economic efficiency. It is difficult to determine whether, at the
present levels and allocation of government subsidies for research, further government spending
on research or additional tax benefits for research would increase or decrease overall economic
efficiency.

If it is believed that too little research is being undertaken, a tax subsidy is one method of
offsetting the private-market bias against research, so that research projects undertaken approach
the optimal level. Among the other policies employed by the Federal Government to increase
the aggregate level of research activities are direct spending and grants, favorable anti-trust rules,
and patent protection. The effect of tax policy on research activity is largely uncertain because
there is relatively little evidence about the responsiveness of research to changes in taxes and
other factors affecting its price. To the extent that research activities are responsive to the price
of research activities, the research and experimentation tax credit should increase research
activities beyond what they otherwise would be. However, the present-law treatment of research
expenditures does create certain complexities and compliance costs.

Scope of research activities in the United States and abroad

In the United States, private for-profit enterprises and individuals, non-profit
organizations, and the public sector undertake research activities. Total expenditures on research
and development in the United States are large, representing 2.8 percent of gross domestic
product in 2002.5" This rate of expenditure on research and development exceeds that of the
European Union and the average of all countries that are members of the Organisation for
Economic Co-operation and Development (“OECD”), but is less than that of Japan. See
Figure 1, below. In 2001, expenditures on research and development in the United States
represented 43.7 percent of all expenditures on research and development undertaken by OECD
countries, were 55 percent greater than the total expenditures on research and development
undertaken in the European Union, and were more than two and one half times such expenditures
in Japan.°"' Expenditures on research and development in the United States have grown at an
average real rate of 5.4 percent over the period 1995-2001. This rate of growth has exceeded
that of Japan (2.8 percent), Germany (3.3 percent), France (2.4 percent for the period 1997-
1999), Italy (2.7 percent for the period 1997-2000), and the United Kingdom, (2.3 percent), but
is less than that of Canada (5.6 percent), Ireland (7.5 percent), and Spain (6.5 percent).°”?

59 Organisation for Economic Co-operation and Development, OECD Science,
Technology and Industry Scoreboard, 2003, (Paris: Organisation of Economid Co-operation and
Development), 2003. The OECD, measuring in real 1995 dollars, calculates that the United
States spent approximately $253 billion on research and development in 2001.

5°! Tid.

$°2 Tid. The OECD calculates the annual real rate of growth of expenditures on rescarch
and development for the period 1995-2001 in the European Union and in all OECD countries at
3.7 percent and 4.7 percent, respectively.

364


Analysis
Claims by separated spouses

The proposal eliminates the household maintenance test for a separated spouse who
claims the EIC. Married taxpayers filing separate returns who reside with qualifying children
may claim the EIC if they live apart from their spouse for the last half of the year. As under
present law, such a taxpayer could not file as a head of household unless he or she also satisfies a
household maintenance test and resides with a dependent child. This proposal simplifies the
determination of whether a separated spouse is eligible to claim the earned income credit, and
increases the number of separated spouses living with a qualifying child who could claim the
EIC for taxpayers with qualifying children.

The proposal also expands the relationship component of the separated spouse test for
purposes of the EIC. Under present law, an otherwise eligible separated spouse only may file as
head of household for purposes of claiming the EIC (and not have to file married filing jointly) if
the separated spouse shares a principal place of abode with a son, daughter, or stepchild. Under
the proposal, an otherwise eligible separated spouse may claim the EIC (and not have to file
married filing jointly) if the separated spouse files as married filing separately and shares a
principal place of abode with a son, daughter, stepchild, adopted son, foster child, or any other
individual who constitutes a qualifying child under the proposed uniform definition of qualifying
child2® This increases the number of separated spouses living with a child who could claim the
EIC for taxpayers with qualifying children.

Claims for EJC for workers without children

Some may argue that the proposal to permit a taxpayer to claim the EIC for taxpayers
without qualifying children (maximum of $390 for 2004) in cases where the taxpayer has a
qualifying child, but another taxpayer claims the qualifying child for EIC purposes, has the
potential to add administrative complexity for both taxpayers and the IRS. Under the proposal,
each eligible taxpayer has an incentive to calculate his or her taxes under two alternatives to
determine the maximum aggregate EIC available to the multiple taxpayers who could claim the
qualifying child: one alternative in which the taxpayer claims the qualifying child for the EIC
(and the other taxpayer claims the EIC for taxpayers without qualifying children), and one in
which the taxpayer claims the EIC without the qualifying child (and the other taxpayer claims
the EIC for taxpayers with a qualifying child). Presumably the taxpayers would wish to select
that filing combination that yields the lowest tax cost, or the highest tax benefit, to the parties.
The proposal provides flexibility to taxpayers so that they are able to allocate the qualifying child
to a taxpayer in a manner that maximizes the aggregate earned income credit, and may increase
the aggregate credit paid when compared to present law, but might do so at the cost of increasing
the complexity of the tax system. Others may argue that the proposal does not increase
selectivity or materially increase complexity, because multiple taxpayers who are eligible to
claim the same qualifying child for the EIC currently have an incentive to calculate their taxes

202 separate proposal of the President’s budget proposal establishes a uniform
definition of qualifying child for EIC and other family-related tax benefits.

185


D. Extend, Increase and Expand the Above-the-Line Deduction
for Qualified Out-of-Pocket Classroom Expenses

Present Law

Deduction for out-of-pocket classroom expenses incurred by teachers and other educators

In general, ordinary and necessary business expenses are deductible (sec. 162).
However, in general, unreimbursed employee business expenses are deductible only as an
itemized deduction and only to the extent that the individual’s total miscellaneous deductions
(including employee business expenses) exceed two percent of adjusted gross income. An
individual’s otherwise allowable itemized deductions may be further limited by the overall
limitation on itemized deductions, which reduces itemized deductions for taxpayers with
adjusted gross income in excess of $142,700 (for 2004). In addition, miscellaneous itemized
deductions are not allowable under the alternative minimum tax.

Certain expenses of eligible educators are allowed an above-the-line deduction.
Specifically, for taxable years beginning in 2002 and 2003, an above-the-line deduction is
allowed for up to $250 annually of expenses paid or incurred by an eligible educator for books,
supplies (other than nonathletic supplies for courses of instruction in health or physical
education), computer equipment (including related software and services) and other equipment,
and supplementary materials used by the eligible educator in the classroom. To be eligible for
this deduction, the expenses must be otherwise deductible under 162 as a trade or business
expense. A deduction is allowed only to the extent the amount of expenses exceeds the amount
excludable from income under section 135 (relating to education savings bonds), 529(c)(1)
(relating to qualified tuition programs), and section 530(d)(2) (relating to Coverdell education
savings accounts).

An eligible educator is a kindergarten through grade 12 teacher, instructor, counselor,
principal, or aide in a school for at least 900 hours during a school year. A school means any
school, which provides elementary education or secondary education, as determined under State
law.

The above-the-line deduction for eligible educators is not allowed for taxable years
beginning after December 31, 2003.

General rules regarding education expenses

An individual taxpayer generally may not deduct the education and training expenses of
the taxpayer or the taxpayer’s dependents. However, a deduction for education expenses
generally is allowed under section 162 if the education or training (1) maintains or improves a
skill required in a trade or business currently engaged in by the taxpayer, or (2) meets the express
requirements of the taxpayer’s employer, or requirements of applicable law or regulations,
imposed as a condition of continued employment.'*> Education expenses are not deductible if

155 Treas. Reg, sec. 1.162-5.

100


responsible for making up the difference. Within certain limits, most defined benefit pension
plan benefits are guaranteed by the PBGC. Investments of defined benefit pension plan assets
are subject to ERISA’s fiduciary rules and limitations on the amount of plan assets that may be
invested in stock of the employer. In addition, defined benefit pension plans are subject to
certain spousal benefit requirements that do not apply to most defined contribution plans. That
is, defined benefit plans are required to provide benefits in the form of a joint and survivor
annuity, unless the participant and spouse consent to another form of benefit.

In contrast, defined contribution plans do not promise a specific benefit, but instead pay
the value of the participant’s account. The plan participant bears the risk of investment loss.
Benefits provided by defined contribution plans are not guaranteed by the PBGC. The extent to
which ERISA’s fiduciary rules apply to a defined contribution plan depends on the particular
plan structure; in many cases defined contribution plans allow plan participants to direct the
investment of their accounts, in which case more limited fiduciary protections apply than in the
case of defined benefit pension plans. ERISA’s limitations on the amount of plan assets that
may be invested in employer stock generally do not apply to defined contribution plans. In
addition, under most defined contribution plans, the spouse has only the right to be named the
beneficiary of the amount (if any) remaining upon the death of the employee.

Cash balance plans have become an increasing prevalent plan design and, as well, an
increasing element in discussions regarding retirement income security and the future of the
defined benefit plan system.

During the 1990s, conversions of traditional defined benefit pension plans to cash
balance formulas were common among mid- to large-size employers. There was considerable
media attention regarding such conversions, particularly in cases in which the plan contained a
“wearaway” or in which older or longer-service employees close to retirement were denied the
opportunity to continue to accrue benefits under the old plan formula. While perhaps complying
with the law, such plan designs were viewed by many as unfair to certain participants. There
was concern that some employers were adversely affecting participants in order to reduce costs.
There was also concern that participants might not understand the effect of the conversion on
their benefits (including future benefits the participant may have accrued under the old
formula).*!”

The proposal addresses three common issues that have been raised with respect to cash
balance plans. In the case of two of the issues, the calculation of lump-sum benefits and age
discrimination, the proposal codifies current employer practices with respect to cash balance
plans. By providing certainty with respect to some aspects of cash balance plans, and by
allowing such plans to continue in their current form, the proposal will help make cash balance
plans a viable plan design for many employers.

Many view preserving cash balance plans as a means of preserving the defined benefit
pension plan system, and as an important step in helping to ensure retirement income security.

317 These concerns led to the enactment of the present-law notice requirements regarding
future reductions in benefit accruals. Code sec. 4980F and ERISA sec. 204(h).

221


tuition program may not allow any interest in an account or contract (or any portion thereof) to
be used as security for a loan.

Special rules apply to coordinate qualified tuition programs with other education benefits,
including Coverdell education savings accounts, the HOPE credit, and the lifetime learning
credit.

Income tax treatment

A qualified tuition program, including a savings account or a prepaid tuition contract
established thereunder, generally is exempt from income tax, although it is subject to the tax on
unrelated business income.**? Contributions to a qualified tuition account (or with respect to a
prepaid tuition contract) are not deductible to the contributor or includible in income of the
designated beneficiary or account owner. Earnings accumulate tax-free until a distribution is
made. Ifa distribution is made to pay qualified higher education expenses, no portion of the
distribution is subject to income tax. 4 Tf a distribution is not used to pay qualified higher
education expenses, the earnings portion of the distribution is subject to Federal income tax,"
and a 10-percent additional tax (subject to exceptions for death, disability, or the receipt ofa
scholarship).“° A change in the designated beneficiary of an account or prepaid contract is not
treated as a distribution for income tax purposes if the new designated beneficiary is a member of
the family of the old beneficiary.”

41 Sec, 529(b)(5).
42 Sec. 529(c)(3)(B)(v) and (vi).

43 Sec, 529(a). An interest in a qualified tuition account is not treated as debt for
purposes of the debt-financed property rules. Sec. 529(e)(4).

44 Sec, 529(c)(3)(B). Any benefit furnished to a designated beneficiary under a
qualified tuition account is treated as a distribution to the beneficiary for these purposes. Sec.

529(c)(3)(B)(iv).
45 Sec. 529(c)(3)(A) and (B)(ii).
496 Sec, 529(c)(6).

47 Sec. §29(c)(3)(C)(ii). For this purpose, “member of family” means, with respect to a
designated beneficiary: (1) the spouse of such beneficiary; (2) an individual who bears a
relationship to such beneficiary which is described in paragraphs (1) through (8) of section
152(a) (i.e., with respect to the beneficiary, a son, daughter, or a descendant of either; a stepson
or stepdaughter; a sibling or stepsibling; a father, mother, or ancestor of either; a stepfather or
stepmother; a son or daughter of a brother or sister; a brother or sister of a father or mother; and a
son-in-law, daughter-in-law, father-in-law, mother-in-law, brother-in-law, or sister-in-law), or
the spouse of any such individual; and (3) the first cousin of such beneficiary. Sec. 529(e)(2).

308


they were U.S. citizens or U.S. residents in that taxable year. Individuals who relinquish
citizenship or terminate residency for tax purposes often do not want to fully sever their ties to
the United States. Under present law, these individuals may continue to spend significant
amounts of time - approximately four months every year - without being treated as a U.S.
resident under the “substantial presence” ° test.” Consequently, the proposal acts as a deterrent
to individuals who want to relinquish their citizenship or terminate their residency and maintain
significant ties with the United States.

Under the present-law gift tax rules that apply to individuals who relinquish U.S.
citizenship or terminate U.S. residency, an individual is subject to gift tax on gifts of stock of
USS. corporations made during the 10 years following citizenship relinquishment or residency
termination. However, under present law, gifts of stock of foreign corporations that hold U.S.-
situated assets are not subject to the gift tax as such transfers are under the estate tax in certain
circumstances. Accordingly, the present-law rules incentivize former citizens and long-term
residents who are subject to the alternative tax regime and | who wish to gift U.S.-situated
property to transfer such property to a foreign corporation“ ® and then make a gift of stock of
such corporation free of gift tax. Thus, the proposal rationalizes the gift and estate tax regimes.

Annual reporting is required for individuals subject to the alternative tax regime, even if
they have no U.S. tax liability that year. Obtaining annual information on the income and assets
of former citizens and long-term residents who are subject to the alternative tax permits the IRS
to monitor more effectively both the income generated by the assets as well as any dispositions
of assets that may be subject to the U.S. tax. Although additional reporting requirements may
aid the IRS in enforcement of the alternative tax regime, the most significant practical obstacle to
enforcement of the alternative tax regime remains - it applies to individuals who are not
physically present in the United States.

With respect to the proposal as a whole, it should be noted that it does not eliminate all
tax incentives for citizenship relinquishment and residency termination. Because the proposal is
limited to U.S.-source income and U.S.-situated assets in the case of estate and gift tax, a tax
incentive remains for taxpayers with foreign-situated assets to expatriate. Furthermore, the
proposal is applicable during the 10-year period after citizenship relinquishment or residency
termination, so taxpayers who are willing to wait for 10 years before disposing of their assets
still have a tax incentive to expatriate.

487 The “substantial presence” test treats a noncitizen as a U.S. resident for U.S. Federal
income tax purposes if he or she is present in the United States for a substantial period of time
(i.e., 183 or more weighted days during a three-year period, weighted toward the current year).
In general, an individual is considered to be a resident of the United States for estate and gift tax
purposes if the individual is “domiciled” in the United States.

458 Although such a transfer may be subject to section 367, the individual is still able to

avoid a higher-rate transfer tax based on the total value of the property transferred at the cost ofa
lower-rate tax income tax on the appreciation in the property transferred.

298


Description of Proposal

In general

The proposal provides a uniform definition of eligible hider education institution and
provides more consistent definitions of qualified higher education expenses for purposes of the
various provisions relating to education.

Definition of qualifying higher education institution

The proposal defines qualifying higher education institutions for purposes of provisions
relating to higher education by reference to institutions eligible to participate in Federal student
aid programs under Title IV of the Higher Education Act of 1965.

Tuition and fees

The proposal provides that qualifying education expenses for all education provisions
include tuition and fees required for enrollment or attendance, other than: (1) expenses with
respect to any course or other education involving sports, games, or hobbies, unless such course
or other education is part of the individual’s degree program; (2) nonacademic fees, and (3)
tuition or fees that entitle the student to any services for room or board.

Books, supplies, and equipment

With respect to those provisions that include books, supplies, and equipment as
qualifying expenses under present law,”’* the proposal provides a uniform definition of such
expenses. Under the proposal, for such provisions, qualifying expenses include books, supplies,
and equipment required for enrollment or attendance. The definition excludes books, supplies,
and equipment expenses with respect to any course or other education involving sports, games,
or hobbies, unless such course or other education is part of the individual’s degree program. In
addition, the amount of expenses for books, supplies, and equipment may not exceed the
allowance (applicable to the student) for books and supplies included in the cost of attendance ad
determined by the education institution for purposes of Federal financial aid programs. The
proposal does not affect provisions that do not include books, supplies, and equipment as
qualifying expenses under present law.

Special needs services

The proposal provides a definition of special needs services for those provisions that,
under present law, include such services as qualifying expenses. Under the proposal, special
needs services are defined as expenses incurred with respect to personal attendants (such as
readers for the blind) and adaptive equipment, including adaptive computer software, incurred in
connection with a student’s enrollment, attendance, or courses of instruction.

278 These provisions are the exclusion for distributions from qualified tuition plans, the
exclusion for distributions from Coverdell education savings accounts, and the exclusion for
scholarships.

199


Effective date—The proposal is effective for taxable years beginning in 2004.
Analysis

Complexity issues

Advocates of the proposal may argue that repealing the present-law rule requiring a
mutual life insurance company to reduce its deductions by the differential earnings amount
simplifies the tax law. It can be argued that the present-law rule adds complexity to the tax law
in several respects. The rule imposes an additional set of calculations in two separate taxable
years of the affected insurance companies. Part of the complexity of these rules arises from the
fact that a portion of the calculation of the mutual companies’ disallowed deduction is based on
earnings rates of other companies, the 50 largest stock companies. In addition, some mutual
companies may be able to manipulate these rules by planning capital gains realizations. Changes
in the composition of the life insurance industry, including demutualizations and other
transactions that minimize the impact of the rule, have had the effect of disrupting the
functioning of the rule (which was based on the assumption of a particular balance between the
stock segment and the mutual segment of the life insurance industry).

On the other hand, it could be argued that the present-law rule applies to a shrinking
group of mutual life insurance companies that are familiar with the rule because it has been in
the law since 1984. Further, the differential earnings rate has been zero for most years in the
recent past (before the enactment of the temporary zero rate for 2001, 2002, and 2003), so the
rule has had limited application. Thus, little simplification would be gained by repealing the
tule.

Policy issues

Advocates of the proposal could argue that repealing the present-law rule is not
inconsistent with the tax policy goal of accurate income measurement. Although a purpose of
the present-law rule may have been to treat a portion of mutual policyholder dividends as a
return on equity (like dividends to shareholders of a stock company), the rule is not currently
carrying out this purpose. The rule does not accurately measure the portion of policyholder
dividends that are conceptually equivalent to shareholder dividends, because the application of
the average earnings rate of the 50 largest stock companies no longer produces the right result
due to changes in the composition of the life insurance industry. Further, flaws in the
mechanisms of the rule result in an uneven effect of the rule among mutual companies.
Moreover, if a goal of the present-law provision was to balance the tax burden as between the
stock and mutual segments of the life insurance industry to parallel their respective share of the
life insurance business, it can be argued that the respective shares of the business have changed
since enactment of the provision. Thus, the provision is no longer appropriate or needed to
achieve this goal.

Opponents of the proposal may argue that retaining the present-law rule (even though it
may be flawed) is appropriate until a replacement rule can be developed to carry out the goal of
preventing deduction of returns on mutual company equity. Opponents of the proposal might
alternatively argue that extending the temporary zero-rate rule under the present-law provision

375


Description of Proposal

The proposal modifies the standard deduction for all dependents. Under the proposal, the
standard deduction for a taxpayer who is a dependent of another taxpayer is $800 (indexed for
inflation) plus the amount of the dependent’s eared income, but not to exceed the standard
deduction for a single filer who is not a dependent of another taxpayer.

The proposal also modifies the present law rules regarding the kiddie tax for children
under age 14, Under the proposal, a child under age 14 would be required to file his or her own
tax return if his or her income exceeded the standard deduction amount. The election to include
the child’s investment income on the parent’s tax return is eliminated.

The income of a child under age 14 is subject to special tax rates. For such children, all
earned income, and the first $2,500 (indexed after 2005) of taxable investment income, is taxed
at the child’s own tax rates. Any taxable investment income (other than dividends or capital
gains) above the indexed $2,500 amount generally is taxed at the highest regular income tax rate,
regardless of the child’s or the parent’s tax rates. Any dividends or capital gains included in the
child’s taxable investment income above the indexed $2,500 amount, however, are taxed at the
highest dividends or capital gains tax rates, respectively, generally applicable for the taxable
year.

Effective date—The proposal is effective for taxable years beginning after December 31,
2004.

Analysis

The “kiddie tax” was enacted to restrict the practice of high-income individuals
transferring income-producing property to their children so that the income would be taxed at
lower rates.

The proposal eliminates the parental election to report the income of a child under age 14
on the parent’s tax return. Under the proposal, every child who exceeds the applicable income
requirements, regardless of age, is required to file his or her own separate return. This may
increase the number of returns that a family with children is required to file. It also prevents a
parent from being able to report the income of several children on the parent’s return.

Under the proposal, a child’s income would no longer be taxed by reference to the tax
rate of his or her parents. Instead, the child’s income would be taxed at the child’s own rates, or
in some cases, at the highest individual income tax rates. This may result in the child’s income
being taxed at higher or lower rates than is the case under present law, depending upon the
respective rates of the child and the parent and the highest individual income tax rates. By
removing the linkage between the child’s return and the parent’s return, however, information
regarding the parent’s income would not be needed to complete the child’s return?” This may

273 ‘Under present law, information regarding a sibling’s return also is needed if a parent
has more than one child subject to the kiddie tax. In such cases, the net unearned income of all
children is combined, a single kiddie tax is calculated, and each child is allocated a proportionate
share of the allocable parent tax.

190


Income tax provisions relating to contributions of capital gain property and qualified
conservation interests

Charitable contributions generally

In general, a deduction is permitted for charitable contributions, subject to certain
limitations that depend on the type of taxpayer, the property contributed, and the donee
organization. The amount of deduction generally equals the fair market value of the contributed
property on the date of the contribution. Charitable deductions are provided for income, estate,
and gift tax purposes (secs. 170, 2055, and 2522 respectively).

In general, in any taxable year, charitable contributions by a corporation are not
deductible to the extent the aggregate contributions exceed 10 percent of the corporation’s
taxable income computed without regard to net operating or capital loss carrybacks. For
individuals, the amount deductible generally is a percentage of the taxpayer’s contribution base,
which is the taxpayer’s adjusted gross income computed without regard to any net operating loss
carryback. The applicable percentage of the contribution base varies depending on the type of
donee organization and property contributed.

Gifts of certain types of property interests are subject to special restrictions, either as to
the amount deductible or as to the types of property interests for which a deduction is permitted.
For example, a contribution of less than the donor’s entire interest in property generally is not
allowable as a charitable deduction unless the gift takes the form of an interest in a unitrust,
annuity trust, or a pooled income fund.

Capital gain property

Capital gain property is property, which if sold at fair market value at the time of
contribution, would have resulted in gain that would have been long-term capital gain.
Contributions of capital gain property to a qualified charity are deductible at fair market value
within certain limitations. Contributions of capital gain property to charitable organizations
described in section 170(b)(1)(A) (e.g., public charities, private foundations other than private
non-operating foundations, and certain governmental units) generally are deductible up to 30
percent of the taxpayer’s contribution base. Contributions of capital gain property to charitable
organizations described in section 170(b)(1)(B) (¢.g-, private non-operating foundations) are
deductible up to 20 percent of the taxpayer’s contribution base.

For purposes of determining whether a taxpayer’s aggregate charitable contributions in a
taxable year exceed the applicable percentage limitation, contributions of capital gain property
are taken into account after other charitable contributions. Contributions of capital gain property
that exceed the percentage limitation may be carried forward for five years.

Qualified conservation contributions

Qualified conservation contributions are not subject to the “partial interest” rule, which
generally bars deductions for charitable contributions of partial interests in property. A qualified
conservation contribution is a contribution of a qualified real property interest to a qualified
organization exclusively for conservation purposes. A qualified real property interest is defined

116


health insurance program offered to State employees or a comparable program; (5) coverage
through an arrangement entered into by a State and a group health plan, an issuer of health
insurance coverage, an administrator, or an employer; (6) coverage offered through a State
arrangement with a private sector health care coverage purchasing pool; (7) coverage under a
State-operated health plan that does not receive any Federal financial participation; (8) coverage
under a group health plan that is available through the employment of the eligible individual’s
spouse; and (9) coverage under individual health insurance if the eligible individual was covered
under individual health insurance during the entire 30-day period that ends on the date the
individual became separated from the employment which qualified the individual for the TAA
allowance, the benefit for an eligible alternative TAA recipient, or a pension benefit from the
PBGC, whichever applies.”

Qualified health insurance does not include any State-based coverage (i.¢., coverage
described in (2)-(8) in the preceding paragraph), unless the State has elected to have such
coverage treated as qualified health insurance and such coverage meets certain requirements.”*
Such State coverage must provide that each qualifying individual is guaranteed enrollment if the
individual pays the premium for enrollment or provides a qualified health insurance costs
eligibility certificate and pays the remainder of the premium. In addition, the State-based
coverage cannot impose any pre-existing condition limitation with respect to qualifying
individuals. State-based coverage cannot require a qualifying individual to pay a premium or
contribution that is greater than the premium or contribution for a similarly situated individual
who is not a qualified individual. Finally, benefits under the State-based coverage must be the
same as (or substantially similar to) benefits provided to similarly situated individuals who are
not qualifying individuals. A qualifying individual is an eligible individual who seeks to enroll
in the State-based coverage and who has aggregate periods of creditable coverage” of three
months or longer, does not have other specified coverage, and who is not imprisoned. A
qualifying individual also includes qualified family members of such an eligible individual.

Qualified health insurance does not include coverage under a flexible spending or similar
arrangement or any insurance if substantially all of the coverage is of excepted benefits.

Other rules

Amounts taken into account in determining the credit may not be taken into account in
determining the amount allowable under the itemized deduction for medical expenses or the
deduction for health insurance expenses of self-employed individuals. Amounts distributed from

97 For this purpose, “individual health insurance” means any insurance which constitutes
medical care offered to individuals other than in connection with a group health plan. Such term
does not include Federal- or State-based health insurance coverage.

%8 For guidance on how a State elects a health program to be qualified health insurance
for purposes of the credit, see Rev. Proc. 2004-12, 2004-9 LR.B. 1.

® Creditable coverage is determined under the Health Care Portability and
Accountability Act (Code sec. 9801(c)).

63


Vv. TAX SHELTERS, ABUSIVE TRANSACTIONS AND TAX COMPLIANCE
A. Proposals Designed to Combat Abusive Tax Avoidance Transactions
1. Penalty for failure to disclose reportable transactions
Present Law

Regulations under section 6011 require a taxpayer to disclose with its tax return certain
information with respect to each “reportable transaction” in which the taxpayer participates.“

There are six categories of reportable transactions. The first category is any transaction
that is the same as (or substantially similar to)*° a transaction that is specified by the Treasury
Department as a tax avoidance transaction whose tax benefits are subject to disallowance under
present law (referred to as a “listed transaction”).°“”

The second category is any transaction that is offered under conditions of confidentiality.
The second category is any transaction that is offered under conditions of confidentiality and for
which the taxpayer has paid the advisor a minimum fee. A transaction is considered to be
offered under conditions of confidentiality if the advisor who is paid the minimum fee places a
limitation on disclosure by the taxpayer of the tax treatment or tax structure of the transaction
and the limitation on disclosure protects the confidentiality of the advisor's tax strategies. The
minimum fee is $250,000 for a transaction if the taxpayer is a corporation and $50,000 for all
other transactions not involving a corporation.

The third category of reportable transactions is any transaction for which (1) the taxpayer
has the right to a full or partial refund of fees if the intended tax consequences from the

345 On February 27, 2003, the Treasury Department and the IRS released final
regulations regarding the disclosure of reportable transactions. In general, the regulations are
effective for transactions entered into on or after February 28, 2003.

The discussion of present law refers to the new regulations. The rules that apply with
respect to transactions entered into on or before February 28, 2003 are contained in Treas. Reg.
sec. 1.6011-4T in effect on the date the transaction was entered into.

346 ‘The regulations clarify that the term “substantially similar” includes any transaction
that is expected to obtain the same or similar types of tax consequences and that is either
factually similar or based on the same or similar tax strategy. Further, the term must be broadly
construed in favor of disclosure. Treas. Reg. sec. 1-6011-4(c)(4).

347 Treas. Reg. sec. 1.6011-4(b)(2).

48 Treas. Reg. sec. 1.6011-4(b)(3).

240


(2) contributions of cash to private foundations and certain other charitable organizations
generally may be deducted up to 30 percent of the taxpayer’s contribution base; and

(3) contributions of capital gain property to private foundations and certain other charitable
organizations generally may be deducted up to 20 percent of the taxpayer’s contribution base.

Contributions by individuals in excess of the 50-percent, 30-percent, and 20-percent
limits may be carried over and deducted over the next five taxable years, subject to the relevant
percentage limitations on the deduction in each of those years.

In addition to the percentage limitations imposed specifically on charitable contributions,
present law imposes an overall limitation on most itemized deductions, including charitable
contribution deductions, for taxpayers with adjusted gross income in excess of a threshold
amount. The threshold amount for 2004 is $142,700 ($71,350 for married individuals filing
separate returns). The threshold amount is indexed for inflation. For those deductions that are
subject to the limit, the total amount of itemized deductions is reduced by three percent of
adjusted gross income over the threshold amount, but not by more than 80 percent of itemized
deductions subject to the limit. Beginning in 2006, the Economic Growth and Tax Relief
Reconciliation Act of 2001 phases-out the overall limitation on itemized deductions for all
taxpayers. The overall limitation on itemized deductions is reduced by one-third in taxable years
beginning in 2006 and 2007, and by two-thirds in taxable years beginning in 2008 and 2009.
The overall limitation on itemized deductions is eliminated for taxable years beginning after
December 31, 2009; however this elimination of the limitation sunsets on December 31, 2010.

Description of Proposal

The proposal provides a deduction from adjusted gross income for charitable
contributions of cash made by taxpayers who do not itemize deductions. This deduction is
allowed in addition to the standard deduction and generally is subject to the tax rules normally
governing charitable deductions, such as the substantiation requirements and percentage
limitations. The deduction is allowed in computing alternative minimum taxable income and
would not affect the calculation of adjusted gross income.

Taxpayers are allowed to deduct aggregate cash contributions that exceed a floor of $250
($500 for married taxpayers filing a joint return). The deduction is limited to no more than $250
($500 for married taxpayers filing a joint return). The deduction floors and limits are indexed for
inflation after 2004.

Effective date—The proposal is effective for taxable years beginning after December 31,
2003.

Analysis

Policy issues

The standard deduction provides a minimum exemption from income that provides relief
to taxpayers who choose not to itemize but who may make charitable contributions, pay
mortgage interest, or incur other expenses that otherwise are permitted as itemized deductions
under the Code. Taxpayers generally will choose to itemize deductions, rather than claim the

69


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L. Require Increased Reporting for Noncash Charitable Contributions
Present Law

In general, a deduction is permitted for charitable contributions, subject to certain
limitations that depend on the type of taxpayer, the property contributed, and the donee
organization.*”° In the case of non-cash contributions, the amount of the deduction generally
equals the fair market value of the contributed property on the date of the contribution.

In general, if the total charitable deduction claimed for non-cash property exceeds $500,
the taxpayer must file IRS Form 8283 (Noncash Charitable Contributions) with the IRS. C
corporations (other than personal service corporations and closely-held corporations) are
required to file Form 8283 only if the deduction claimed exceeds $5,000.

Taxpayers are required to obtain a qualified appraisal for donated property (other than
money and publicly traded securities) with a value of more than $5,000.*” Corporations (other
than a closely-held corporation, a personal service corporation, or an S corporation) are not
required to obtain a qualified appraisal. Taxpayers are not required to attach a qualified appraisal
to the taxpayer’s return, except in the case of contributed artwork valued at more than $20,000.
Under Treasury regulations, a qualified appraisal means an appraisal document that, among other
things, (1) relates to an appraisal that is made not earlier than 60 days prior to the date of
contribution of the appraised property and not later than the due date (including extensions) of
the return on which a deduction is first claimed under section 170;*” (2) is prepared, signed, and
dated by a qualified appraiser; (3) includes (a) a description of the property appraised; (b) the fair
market value of such property on the date of contribution and the specific basis for the valuation;
(c) a statement that such appraisal was prepared for income tax purposes; (d) the qualifications of

475 Charitable deductions are provided for income, estate, and gift tax purposes. Secs.
170, 2055, and 2522, respectively.

476 DL, 98-369, sec. 155(a)(1) through (6) (1984) (providing that not later than
December 31, 1984, the Secretary shall prescribe regulations requiring an individual, a closely
held corporation, or a personal service corporation claiming a charitable deduction for property
(other than publicly traded securities) to obtain a qualified appraisal of the property contributed
and attach an appraisal summary to the taxpayer’s return if the claimed value of such property
(plus the claimed value of all similar items of property donated to one or more donees) exceeds
$5,000). Under P.L. 98-369, a qualified appraisal means an appraisal prepared by a qualified
appraiser that includes, among other things, (1) a description of the property appraised; (2) the
fair market value of such property on the date of contribution and the specific basis for the
valuation; (3) a statement that such appraisal was prepared for income tax purposes; (4) the
qualifications of the qualified appraiser; (5) the signature and TIN of such appraiser; and (6) such
additional information as the Secretary prescribes in such regulations.

477 Ih the case of a deduction first claimed or reported on an amended return, the deadline
is the date on which the amended return is filed.

303


G. Extend District of Columbia Homebuyer Tax Credit

Present Law

First-time homebuyers of a principal residence in the District of Columbia are eligible for
a nonrefundable tax credit of up to $5,000 of the amount of the purchase price. The $5,000
maximum credit applies both to individuals and married couples. Married individuals filing
separately can claim a maximum credit of $2,500 each. The credit phases out for individual
taxpayers with adjusted gross income between $70,000 and $90,000 ($11 0,000-$130,000 for
joint filers). For purposes of eligibility, “first-time homebuyer” means any individual if such
individual did not have a present ownership interest in a principal residence in the District of
Columbia in the one-year period ending on the date of the purchase of the residence to which the
credit applies. The credit is scheduled to expire for residences purchased after December 31,
2003.

Description of Proposal

The proposal extends the first-time homebuyer credit for two years, through
December 31, 2005.

Effective date—The proposal is effective for residences purchased after December 31,
2003.

Analysis

A temporary extension provides some stability for potential homebuyers and the housing
market in the District of Columbia. The additional extension also provides additional time to
evaluate the effectiveness of the incentive. On the other hand, some might argue that since the
incentive has been in place since August 1997, a permanent decision could be made based on the
experience during that time period.

The proposal is designed to encourage greater homeownership in the District of
Columbia by extending for two years the tax credit for first-time homebuyers. According to the
Treasury Department, the homeownership rate in the District of Columbia is significantly below
the rate for the neighboring States and the nation as a whole. Extending the credit enhances the
District of Columbia’s ability to attract new homeowners and establish a stable residential base.

In the case of tax benefits that are intended to create an incentive for particular taxpayer
behavior, some may argue that a retroactive extension rewards behavior that occurred without
the incentive and, therefore, is unnecessary. Others may respond that taxpayers have relied on

627 The District of Columbia first-time homebuyer credit was enacted as part of the
Taxpayer Relief Act of 1997, and was scheduled to expire on December 31, 2000. The Tax
Relief Extension Act of 1999 extended the first-time homebuyer credit for one year, through
December 31, 2000. The Community Renewal Tax Relief Act of 2000 extended the first-time
homebuyer credit for two additional years, through December 31, 2003.

391


Description of Proposal

The proposal repeals the requirement that an offer-in-compromise of $50,000 or more
must be supported by a written opinion from the Office of Chief Counsel. The Secretary must
establish standards for determining when a written opinion is required with respect to a
compromise.

Effective date—The proposal applies to offers-in-compromise submitted or pending on or
after the date of enactment.

Analysis

Repealing the requirement that an offer-in-compromise of $50,000 or more be supported
by a written opinion from the Office of Chief Counsel will simplify the administration of the
offer-in-compromise provisions by the IRS. Repealing this requirement also would increase the
level of discretionary authority that the IRS may exercise, which may lead to increasingly
inconsistent results among similarly situated taxpayers. Some may believe that Chief Counsel
review is appropriate for all offers-in-compromise above specified dollar thresholds, similar to
the review of large refund cases by the Joint Committee on Taxation.”

Prior Action

An identical proposal was included in the President’s fiscal year 2003 and 2004 budget
proposals. An identical proposal was contained in the “Taxpayer Protection and IRS
Accountability Act of 2003,” as passed by the House of Representatives on June 19, 2003. An
identical proposal was contained in the “Tax Administration Good Government Act of 2004,” as
passed by the Senate Committee on Finance on February 2, 2004. The $50,000 threshold was
raised from $500 in 1996.°°

532 Sec, 6405. The threshold for Joint Committee review is currently $2 million.

533 Sec, 503 of the Taxpayer Bill of Rights 2 (P.L. 104-168; July 30, 1996).

329


contributions can be made up to the dollar limit for each spouse if the combined compensation of
the spouses is at least equal to the contributed amount. An individual who has attained age 50
before the end of the taxable year may also make catch-up contributions to an IRA. As a result,
the maximum deduction for IRA contributions for an individual who has attained age 50 is
increased by a certain dollar amount ($500 for 2004).24 Under present law, IRA contributions
generally must be made in cash.

Traditional IRAs

An individual may make deductible contributions to a traditional IRA up to the IRA
contribution limit if neither the individual nor the individual’s spouse is an active participant in
an employer-sponsored retirement plan. If an individual (or the individual’s spouse) is an active
participant in an employer-sponsored retirement plan, the deduction is phased out for taxpayers
with adjusted gross income over certain levels for the taxable year. The adjusted gross income
phase-out limits for taxpayers who are active participants in employer-sponsored plans are as
follows.

Table 2.-AGI Phase-Out Range for Deductible IRA Contributions
Single Taxpayers
Taxable years beginning in: Phase-out range
45,000-55,000
50,000-60,000

Joint Returns
Taxable years beginning in: Phase-out range

65,000-75,000
70,000-80,000
75,000-85,000
2007 and thereafter ........cccccccssssecesssetetseseseresscatsceeseesssenenseeeaseessensenenes 80,000-100,000

The adjusted gross income phase-out range for married taxpayers filing a separate return
is $0 to $10,000.

make the EGTRRA provisions that expire on December 31, 2010, permanent is discussed in
Part I.B of this document.

24 Under EGTRRA, the additional amount permitted for catch-up contributions to an

TRA is $500 for 2004 and 2005 and $1,000 for 2006 and thereafter. As a result of the general
sunset provision of EGTRRA, catch-ups contributions are not permitted after 2010.

14


Servicemembers Civil Relief Act

In general, section 510 of the Servicemembers Civil Relief Act” provides that if a

servicemember’s ability to pay Federal or State income tax liability falling due before or during
military service is materially affected by military service (whether or not in a combat zone),
collection activities with respect to the tax liability is deferred for the period of military service
and up to 180 days after the servicemember’s termination or release from military service. No
interest or penalties accrue on the unpaid income tax liability during the period of deferment.
The statute of limitations for the collection of the taxes affected by the deferral is also extended.
The deferral does not apply to certain Social Security taxes.

Description of Proposal

The proposal makes the provisions of section 7508 that are currently available to
members of the Armed Forces in combat zones or contingency operations applicable to all
Armed Forces reservists and National Guardsmen called to active duty. Active duty for persons
in the National Guard is defined as being called to active duty by the President or the Secretary
of Defense for a period of more than 30 consecutive days under section 502(f) of Title 32, United
States Code. Accordingly, calls to active duty by a Governor are ineligible for this expanded
provision. Parallel rules apply to Armed Forces reservists. In addition, training duty is not
considered to be active duty for this purpose.

The proposal extends Section 510 of the Servicemembers Civil Relief Act to suspend the
assessment and collection of any state income tax liability for all servicemembers (including
Armed Forces reservists and National Guardsmen) serving in a designated combat zone and for
all other Armed Forces reservists and National Guardsmen called to active duty.

Effective date.The proposal would be effective upon enactment.
Analysis
The proposal increases administrative complexity for the Internal Revenue Service.
Particularly in cases where the servicemember’s ability to pay is not materially affected, it is
unclear whether this administrative complexity is warranted.
A separate issue is whether it is appropriate to extend these benefits to all reservists on
active duty who in some cases may be stationed alongside regular army members who would not

enjoy these benefits.

Prior Action

No prior action.

652 Bub, L. No. 108-189, December 19, 2003.

413


The rationale for the WOTC is that employers will not hire certain individuals without a
subsidy, because either the individuals are stigmatized (e.g., convicted felons) or the current
productivity of the individuals is below the prevailing wage rate. Where particular groups of
individuals suffer reduced evaluations of work potential due to membership in one of the
targeted groups, the credit may provide employers with a monetary offset for the lower perceived
work potential. In these cases, employers may be encouraged to hire individuals from the
targeted groups, and then make an evaluation of the individual’s work potential in the context of
the work environment, rather than from the job application. Where the current productivity of
individuals is currently below the prevailing wage rate, on-the-job-training may provide
individuals with skills that will enhance their productivity. In these situations, the WOTC
provides employers with a monetary incentive to bear the costs of training members of targeted
groups and providing them with job-related skills which may increase the chances of these
individuals being hired in unsubsidized jobs. Both situations encourage employment of

members of the targeted groups, and may act to increase wages for those hired as a result of the
credit.

As discussed below, the evidence is mixed on whether the rationales for the credit are
supported by economic data. The information presented is intended to provide a structured way
to determine if employers and employees respond to the existence of the credit in the desired
manner.

Efficiency of the credit

The credit provides employers with a subsidy for hiring members of targeted groups. For
example, assume that a worker eligible for the credit is paid an hourly wage of w and works
2,000 hours during the year. The worker is eligible for the full credit (40 percent of the first
$6,000 of wages), and the firm will receive a $2,400 credit against its income taxes and reduce
its deduction for wages by $2,400. Assuming the firm faces the full 35-percent corporate income
tax rate, the cost of hiring the credit-eligible worker is lower than the cost of hiring a credit-
ineligible worker for 2,000 hours at the same hourly wage w by 2,400 (1-.35) = $1,560." This
$1,560 amount would be constant for all workers unless the wage (w) changed in response to
whether or not the individual was a member of a targeted group. If the wage rate does not
change in response to credit eligibility, the WOTC subsidy is larger in percentage terms for
lower wage workers. If w rises in response to the credit, it is uncertain how much of the subsidy
remains with the employer, and therefore the size of the WOTC subsidy to employers is
uncertain.

To the extent the WOTC subsidy flows through to the workers eligible for the credit in
the form of higher wages, the incentive for eligible individuals to enter the paid labor market
may increase. Since many members of the targeted groups receive governmental assistance
(e.g., Temporary Assistance for Needy Families or food stamps), and these benefits are phased
out as income increases, these individuals potentially face a very high marginal tax rate on

619 The after-tax cost of hiring this credit eligible worker would be ((2,000)(w)-2,400)(1-
.35) dollars. This example does not include the costs to the employer for payroll taxes (e.g.,
Social security, Medicare and unemployment taxes) and any applicable fringe benefits.

386


the taxpayer is not treated as meeting the relationship test unless the taxpayer is entitled to a
dependency exemption with respect to the married child (e.g., the support test is satisfied) or
would be entitled to the exemption if the taxpayer had not waived the exemption to the
noncustodial parent.?!

Residency test

The residency test is satisfied if the individual has the same principal place of abode as
the taxpayer for more than one half of the taxable year. The residence must be in the United
States.’!? As under the dependency exemption (and head of household filing status), temporary
absences due to special circumstances, including absences due to illness, education, business,
vacation, and military service are not treated as absences for purposes of determining whether
the residency test is satisfied.”'* Under the earned income credit, there is no requirement that the
taxpayer maintain the household in which the taxpayer and the qualifying individual reside.

Age test

In general, the age test is satisfied if the individual has not attained age 19 as of the close
of the calendar year.”!> In the case of a full-time student, the age test is satisfied if the individual
has not attained age 24 as of the close of the calendar year. In the case of an individual who is
permanently and totally disabled, no age limit applies.

Child credit”

Taxpayers with incomes below certain amounts are eligible for a child credit for each
qualifying child of the taxpayer. The amount of the child credit is up to $1,000, in the case of
taxable years beginning in 2003 or 2004. The child credit is $700 for taxable years beginning in
2005 through 2008, $800 for taxable years beginning in 2009, and $1,000 for taxable years

212 Sec, 32(c)(3)(B)(ii).

213 ‘The principal place of abode of a member of the Armed Services is treated as in the
United States during any period during which the individual is stationed outside the United
States on active duty. Sec. 32(c)(4).

214 IRS Publication 596, Earned Income Credit (EIC), at 14. H. Rep. 101-964 (October
27, 1990), at 1037.

215 ‘The IRS has issued guidance stating that for purposes of the earned income credit, an
individual attains a specified age on the anniversary of the date that the child was born (¢.g., a
child born on January 1, 1987, attains the age of 17 on January 1, 2004). Rev. Rul. 2003-72,
2003-33 I.R.B. 346.

216 Sec. 24.

158


market value of plan assets or (b) the actuarial value of plan assets.”*’ However, the full funding
limitation may not be less than the excess, if any, of 90 percent of the plan’s current liability
(including the current liability normal cost) over the actuarial value of plan assets. In general,
current liability is all liabilities to plan participants and beneficiaries accrued to date, whereas the
accrued liability under the full funding limitation may be based on projected future benefits,
including future salary increases.

Timing of plan contributions

In general, plan contributions required to satisfy the funding rules must be made within
8% months after the end of the plan year. If the contribution is made by such due date, the
contribution is treated as if it were made on the last day of the plan year.

In the case of a plan with a funded current liability percentage of less than 100 percent for
the preceding plan year, estimated contributions for the current plan year must be made in
quarterly installments during the current plan year.*>? The amount of each required installment is
25 percent of the lesser of (1) 90 percent of the amount required to be contributed for the current
plan year or (2) 100 percent of the amount required to be contributed for the preceding plan
year.

Deductions for contributions

Employer contributions to qualified retirement plans are deductible, subject to certain
limits. In the case of a defined benefit pension plan, the employer generally may deduct the
greater of: (1) the amount necessary to satisfy the minimum funding requirement of the plan for

331 For plan years beginning before 2004, the full funding limitation was generally
defined as the excess, if any, of (1) the lesser of (a) the accrued liability under the plan (including
normal cost) or (b) a percentage (170 percent for 2003) of the plan’s current liability (including
the current liability normal cost), over (2) the lesser of (a) the market value of plan assets or
(b) the actuarial value of plan assets, but in no case less than the excess, if any, of 90 percent of
the plan’s current liability over the actuarial value of plan assets. Under the Economic Growth
and Tax Relief Reconciliation Act of 2001 (“EGTRRA”), the full funding limitation based on
170 percent of current liability is repealed for plan years beginning in 2004 and thereafter. The
provisions of EGTRRA generally do not apply for years beginning after December 31, 2010.

332 Code sec. 412(m); ERISA sec. 302(e).

333 Tm connection with the expanded interest rate range available for 2002 and 2003,
special rules apply in determining current liability for the preceding plan year for purposes of
applying the quarterly contributions requirements to plan years beginning in 2002 (when the
expanded range first applies) and 2004 (when the expanded range no longer applies). In each of
those years (“present year”), current liability for the preceding year is redetermined, using the
permissible range applicable to the present year. This redetermined current liability will be used
for purposes of the plan’s funded current liability percentage for the preceding year, which may
affect the need to make quarterly contributions, and for purposes of determining the amount of
any quarterly contributions in the present year, which is based in part on the preceding year.

230


VII. REAUTHORIZE FUNDING FOR THE HIGHWAY TRUST FUND

A. Deposit Full Amount of Excise Tax Imposed on Gasohol
in the Highway Trust Fund

Present Law

An 18.4 cents-per-gallon excise tax is imposed on gasoline. The tax is imposed when the
fuel is removed from a refinery unless the removal is to a bulk transportation facility (e.g.,
removal by pipeline or barge to a registered terminal). In the case of gasoline removed in bulk
by registered parties, tax is imposed when the gasoline is removed from the terminal facility,
typically by truck (i.e., "breaks bulk"). If gasoline is sold to an unregistered party before it is
removed from a terminal, tax is imposed on that sale. When the gasoline subsequently breaks
bulk, a second tax is imposed. The payor of the second tax may file a refund claim if it can
prove payment of the first tax. The party liable for payment of the gasoline excise tax is called a
"position holder," defined as the owner of record inside the refinery or terminal facility.

A 52-cents-per-gallon income tax credit is allowed for ethanol used as a motor fuel (the
"alcohol fuels credit"). The benefit of the alcohol fuels tax credit may be claimed as a reduction
in excise tax payments when the ethanol is blended with gasoline ("gasohol"). The reduction is
based on the amount of ethanol contained in the gasohol. The excise tax benefits apply to
gasohol blends of 90 percent gasoline/10 percent ethanol, 92.3 percent gasoline/7.7 percent
ethanol, or 94.3 percent gasoline/S.7 percent ethanol. The income tax credit is based on the
amount of alcohol contained in the blended fuel.

In general, 18.3 cents per gallon of the gasoline excise tax is deposited in the Highway
Trust Fund and 0.1 cent per gallon is deposited in the Leaking Underground Storage Tank Trust
Fund (the "LUST" rate). In the case of gasohol with respect to which a reduced excise tax is
paid, 2.5 cents per gallon of the reduced tax (2.8 cents in the case of gasoline to be blended) is
retained in the General Fund. The balance of the reduced rate (less the LUST rate) is deposited
in the Highway Trust Fund.

Description of Proposal

The proposal transfers the 2.5 cents per gallon of excise tax on gasohol (2.8 cents in the
case of gasoline to be blended) that currently is retained in the General Fund to the Highway
Trust Fund.

Effective date—The proposal is effective for taxes collected after September 30, 2003.

Analysis

The proposal increases receipts to the Highway Trust Fund by eliminating the General
Fund retention of tax on alcohol fuel mixtures. Under present law, only 13.2 cents per gallon is
being collected on gasohol (rather than the 18.4 cents per gallon imposed on gasoline) and of that
13.2 cents the Highway Trust Fund receives only 10.6 cents per gallon, because the General
Fund retains 2.5 cents and the other .1 cent goes to the Leaking Underground Storage Tank Trust

345


501(c)(3) bond. Under the modified private business use test at least 95 percent of the net
proceeds of the bond must be used by a 501(c)(3) organization in furtherance of its exempt
purpose. Under a modified private security or payment test, the debt service on not more than 5
percent of the net proceeds of the bond issue can be (1) secured by an interest in property, or
payments in respect of property, used by a 501(c)(3) organization in furtherance of an unrelated
trade or business or by a private user, or (2) derived from payments in respect of property, or
borrowed money, used by a 501(c)(3) organization in furtherance of an unrelated trade or
business or by a private user.

Qualified 501(c)(3) bonds are not subject to (1) the State volume limitations, (2) the land
and existing property limitations, (3) the treatment of interest as a preference item for purposes
of the alternative minimum tax and (4) the prohibition on advance refundings.

ualified residential rental projects

In general

The Code provides that a bond which is part of an issue shall not be a qualified 501(c)(3)
bond if any portion of the net proceeds of the issue are to be used directly or indirectly to provide
residential rental property for family units (sec. 145(d)(1)). Exceptions to this rule are provided
for facilities that meet the low-income tenant qualification rules for qualified residential rental
projects financed with exempt facility private activity bonds,'® or are new or substantially
rehabilitated (sec. 142(d) and 145(d)(2)).

Acquisition of existing property

Qualified 501(c)(3) bonds issued to acquire existing residential rental property that is not
substantially rehabilitated must meet certain low-income tenant qualification rules. Section
142(d) sets forth those rules. Section 142(d) requires for the qualified project period (generally
15 years) that (1) at least 20 percent of the housing units must be occupied by tenants having
incomes of 50 percent or less of area median income or (2) 40 percent of the housing units in the
project must be occupied by tenants having incomes of 60 percent or less of the area median
income.

New construction or substantial rehabilitation

In the case of a “qualified residential rental project” that consists of new construction or
substantial rehabilitation, qualified 501(c)(3) bonds are not required to meet the low-income
tenant qualification rules that otherwise would be applicable.

'2 Section 142(a)(7) describes an exempt facility bond as any bond issued as part of an
issue of bonds if 95 percent or more of the net proceeds of the issue are to be used to provide
qualified residential rental projects.

97


applicable limit by $500 in 2004, $600 in 2005, $700 in 2006, $800 in 2007, $900 in 2008, and
$1,000 in 2009 and thereafter.

Archer medical savings accounts (“MSAs”)

An Archer medical savings account (“MSA”) is a trust or custodial account used to
accumulate funds on a tax-preferred basis to pay for medical expenses.” Within limits,
contributions to an Archer MSA are deductible if made by an individual and are excludable from
income and employment taxes if made by the individual’s employer. Distributions from an
Archer MSA for qualified medical expenses are not taxable.

Archer MSAs are available to employees covered under an employer-sponsored high
deductible plan of a small employer and self-employed individuals covered under a high
deductible health plan. For purposes of MSAs, a high deductible plan is a health plan with an
annual deductible (for 2004) of at least $1,700 and no more than $2,600 in the case of individual
coverage and at least $3,450 and no more than $5,150 in the case of family coverage. In
addition, the maximum out-of-pocket expenses with respect to allowed costs (including the
deductible) must be no more than $3,450 in the case of individual coverage and no more than
$6,300 in the case of family coverage (for 2004).

The number of taxpayers benefiting annually from an Archer MSA contribution is limited
to a threshold level (generally 750,000 taxpayers). The number of Archer MSAs established has
not exceeded the threshold level. After 2003, no new contributions may be made to Archer
MSAs except by or on behalf of individuals who previously had Archer MSA contributions and
employees who are employed by a participating employer.

Description of Proposal

In general

The proposal consolidates traditional and Roth IRAs into a single type of account, a
Retirement Savings Account (“RSA”). The proposal also creates a new type of account that can
be used to save for any purpose, a Lifetime Savings Account (“LSA”).

The tax treatment of both RSAs and LSAs is generally similar to that of present-law Roth
IRAs; that is, contributions are not deductible and earnings on contributions generally are not
taxable when distributed. The major difference between the tax treatment of LSAs and RSAs is
that all distributions from LSAs are tax free, whereas tax-free treatment of earnings on amounts
in RSAs applies only to distributions made after age 58 or in the event of death or disability.

Retirement Savings Accounts

Under the proposal, an individual may make annual contributions to an RSA up to the
lesser of $5,000° or the individual’s compensation for the year. As under present-law rules for

2 Sec. 220.

33 The contribution limit is indexed for inflation.

19


The exclusion for employer-provided health coverage does not apply to self-employed
individuals. However, under present law, self-employed individuals (i.¢., sole proprietors or
partners in a partnership)” are entitled to deduct 100 percent of the amount paid for health
insurance for themselves and their spouse and dependents for income tax purposes. 8

Under present law, individuals who itemize deductions may deduct amounts paid during
the taxable year for health insurance (to the extent not reimbursed by insurance or otherwise) for
the taxpayer, the taxpayer’s spouse, and dependents, only to the extent that the taxpayer’s total
medical expenses, including health insurance premiums, exceeds 7.5 percent of the taxpayer’s
adjusted gross income.

Under the Trade Adjustment Assistance Reform Act of 2002,” eligible individuals can
receive a refundable tax credit for the cost of qualified health coverage. The credit is equal to 65
percent of the amount paid by certain individuals receiving a trade readjustment allowance, or
who would be eligible to receive such an allowance but for the fact that they had not exhausted
their regular unemployment benefits, or by certain individuals who are receiving pension
benefits from the Pension Benefit Guaranty Corporation.®! The credit is payable on an advance
basis.

Reimbursements under a health insurance policy for medical expenses are generally
excludable from gross income regardless of whether the insurance is purchased by the individual
or employer-provided. In the case of a self-insured medical reimbursement plan,
reimbursements are excludable for highly compensated employees only if certain
nondiscrimination rules are satisfied.

Health savings accounts
In general

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003* added
provisions for health savings accounts (“HSAs”), effective for taxable years beginning after

77 Self-employed individuals include more than two-percent shareholders of S
corporations who are treated as partners for purposes of fringe benefit rules pursuant to section
1372.

8 Sec, 162(1). The deduction does not apply for self-employment tax (SECA) purposes.

Sec. 213. The adjusted gross income percentage is 10 percent for purposes of the
alternative minimum tax. Sec. 56(b)(1)(B).

80 Pub. L. No. 107-210, sec. 201(a), 202 and 203 (2002).

81_Amounts taken into account in determining the credit are not treated as expenses paid
for medical care under sections 162(1) or 213.

82 Pub. L. No. 108-173.

48


tax is intended as a penalty for incurring unrelated business income. Proponents also would
argue that although an alternative approach, for example, to tax the unrelated business income as
an excise tax but not again when distributed, would avoid any perceived double taxation of the
unrelated income, such an alternative would have undesired effects. Proponents would argue
that if unrelated income is not taxed when distributed, a trust might have a strong incentive to
invest in assets that produce unrelated income in order to convey a benefit to the beneficiary that
is not available under present law (capital gain income or tax-free return of corpus instead of
ordinary income). In addition, proponents would note, the charitable remainderman’s interest
would be diminished to the extent a trust invested significantly in unrelated business income
producing assets.

The proposal simplifies the operation of charitable remainder trusts in that a trust with a
small amount of unrelated business taxable income does not lose its tax exemption and therefore
does not need to file income tax returns and compute its taxable income as if it were a taxable
trust. This has the effect of not discouraging trustees to make investments that might entail
having a small amount of unrelated business taxable income.

Prior Action

A similar proposal was included in the President’s fiscal year 2003 and 2004 budget
proposals.

H.R. 7, the “Community Solutions Act of 2001,” as passed by the House of
Representatives on July 19, 2001, included a similar provision, except that unrelated business
income would be excluded from the determination of (1) the value of a charitable remainder
unitrust’s assets, (2) the amount of charitable remainder unitrust income for purposes of
determining the unitrust’s required distributions, and (3) the effect on the income character of
any distributions to beneficiaries by a charitable remainder annuity trust or charitable remainder
unitrust. H.R. 7, as reported by the Senate Committee on Finance on July 18, 2002, included the
proposal.

H.R. 7, the “Charitable Giving Act of 2003,” as passed by the House of Representatives
on September 17, 2003, included a proposal similar to the proposal in the Community Solutions
Act of 2001.

S. 476, The “CARE Act of 2003,” as agreed to by the Senate on April 9, 2003, contained
a similar proposal.

6. Modify the basis adjustment to stock of S corporation contributing appreciated property
Present Law
Under present law, if an S corporation contributes money or other property to a charity,

each shareholder takes into account the shareholder’s pro rata share of the contribution in
determining its own income tax liability.'4” A shareholder of an S corporation reduces the basis

47 Sec, 1366(a)(1)(A).

93


hospitalization resulting from injury received in the combat zone! or (2) time in missing in
action status, plus the next 180 days.

The suspension of time applies to the following acts:

(1) Filing any return of income, estate, or gift tax (except employment and
withholding taxes);

(2) Payment of any income, estate, or gift tax (except employment and
withholding taxes);

(3) Filing a petition with the Tax Court for redetermination of a deficiency, or
for review of a decision rendered by the Tax Court;

(4) Allowance of a credit or refund of any tax;

(5) Filing a claim for credit or refund of any tax;

(6) Bringing suit upon any such claim for credit or refund;
(7) Assessment of any tax;

(8) Giving or making any notice or demand for the payment of any tax, or
with respect to any liability to the United States in respect of any tax;

(9) Collection of the amount of any liability in respect of any tax;

(10) Bringing suit by the United States in respect of any liability in respect of
any tax; and

(11) Any other act required or permitted under the internal revenue laws
specified by the Secretary of the Treasury.

Individuals may, if they choose, perform any of these acts during the period of
suspension. Spouses of qualifying individuals are entitled to the same suspension of time, except
that the spouse is ineligible for this suspension for any taxable year beginning more than two
years after the date of termination of combatant activities in the combat zone.

651 Two special rules apply to continuous hospitalization inside the United States. First,
the suspension of time provisions based on continuous hospitalization inside the United States
are applicable only to the hospitalized individual; they are not applicable to the spouse of such
individual. Second, in no event do the suspension of time provisions based on continuous
hospitalization inside the United States extend beyond five years from the date the individual
returns to the United States. These two special rules do not apply to continuous hospitalization
outside the United States.

412


shown that it is not practicable to identify such a rate accurately because of variation in the
manner in which prices of private annuity contracts are determined. As a result, the interest rate
used to value pension benefits is intended to approximate the rate used in pricing annuity
contracts.2*2 Some have described this standard as a rate comparable to the rate earned on a
conservatively invested portfolio of assets.

Under present law, the interest rate used for these purposes is based on the interest rate on
30-year Treasury obligations. The interest rate issue has received attention recently in part
because the Treasury Department stopped issuing 30-year obligations. As a result, there is no
longer a 30-year Treasury interest rate, and statutory changes are necessary to reflect this. In
addition, as discussed below, concerns have been raised that the 30-year Treasury rate was too
low compared to annuity purchase rates and therefore caused inappropriate results.

For plan funding purposes, the use of a lower interest rate in determining current liability
results in a higher present value of the benefits and larger contributions required to fund those
benefits. Alternatively, the use of a higher interest rate results in a lower present value of future
liabilities and therefore lower required contributions. Because minimum lump-sum distributions
are calculated as the present value of future benefits, the interest rate used to calculate this
present value will affect the value of the lump-sum benefit. Specifically, the use of a lower
interest rate results in larger lump-sum benefits; the use of a higher interest rate results in lower
lump-sum benefits.

Some have argued that the 30-year Treasury rate has been too low compared to annuity
rates, resulting in inappropriately high levels of minimum funding requirements on employers
that are not necessary to maintain appropriate retirement income security. In addition, some
argue that the 30-year Treasury rate has been so low as to make lump-sum benefits
disproportionately large in comparison with a life annuity benefit payable under the plan, thus
providing an incentive for employees to take benefits in a lump sum rather than in the form of a
life annuity. Some argue that lump sums should not be favored as a form of benefit, because
they can cause a cash drain on the plan. In addition, an annuity assures the individual of an
income stream during retirement years, which may not be available in the case of a lump-sum
payment, depending on what use the individual makes of the payment (e.g., whether the
individual spends the lump sum currently or uses the funds to purchase an annuity).

Some have pointed out that a variety of policy issues relating to the funding requirements
may arise in the context of the interest rate discussion, and that some of these issues are better
resolved through means other than the interest rate. For example, recent declines in defined
benefit pension plan assets have adversely affected the funded status of many plans, resulting in
what some view as unduly burdensome funding requirements on employers. Some in favor of
funding relief believe it should be provided through interest rate adjustments. Others argue that,
if funding relief is desired, it would be better to prescribe a more theoretically correct interest

3 Tn practice, the price of an annuity contact encompasses not only an interest rate
factor but also other factors, such as the costs of servicing the contract and recordkeeping. Under
present law, the interest rate used for determining current liability is intended to embody all of
these factors. See H.R. Rpt. No. 100-495, at 868 (1987).

236


elective contributions on a dollar-for-dollar basis up to three percent of the employee’s
compensation. Under a special rule applicable only to SIMPLE IRAs, the employer can elect a
lower percentage matching contribution for all employees (but not less than one percent of each
employee’s compensation). In addition, a lower percentage cannot be elected for more than two
out of any five years. Alternatively, for any year, an employer is permitted to elect, in lieu of
making matching contributions, to make a two percent of compensation nonelective contribution
on behalf of each eligible employee with at least $5,000 in compensation for such year, whether
or not the employee makes an elective contribution.

No contributions other than employee elective contributions, required employer matching
contributions or employer nonelective contributions can be made to a SIMPLE plan and the
employer may not maintain any other plan. All contributions to an employee's SIMPLE account
must be fully vested.

In the case of a SIMPLE IRA, the group of eligible employees generally must include
any employee who has received at least $5,000 in compensation from the employer in any two
preceding years and is reasonably expected to receive $5,000 in the current year. A SIMPLE
IRA is not subject to the nondiscrimination rules generally applicable to qualified retirement
plans. In the case of a SIMPLE section 401(k) plan, the group of employees eligible to
participate must satisfy the minimum coverage requirements generally applicable to qualified
retirement plans. A SIMPLE section 401(k) plan does not have to satisfy the ADP or ACP test
and is not subject to the top-heavy rules. The other qualified retirement plan rules generally
apply.

Salary reduction simplified employee pensions (“SARSEPs”

A simplified employee pension (“SEP”) is an IRA to which employers may make
contributions up to the limits applicable to defined contribution plans. All contributions must be
fully vested. Any employee must be eligible to participate in the SEP if the employee (1) has
attained age 21, (2) has performed services for the employer during at least three of the
immediately preceding five years, and (3) received at least $450 (for 2004) in compensation
from the employer for the year. Contributions to a SEP generally must bear a uniform
relationship to compensation. For this purpose permitted disparity may be taken into account.

Effective for taxable years beginning before January 1, 1997, certain employers with no
more than 25 employees could maintain a salary reduction SEP (a “SARSEP”) under which
employees could make elective deferrals. The SARSEP rules were generally repealed with the
adoption of SIMPLE plans. However, contributions may continue to be made to SARSEPs that
were established before 1997. Salary reduction contributions to a SARSEP are subject to the
same limit that applies to elective deferrals under a section 401(k) plan ($13,000 for 2004,
increasing to $15,000 by 2006). An individual who has attained age 50 before the end of the
taxable year may also make catch-up contributions to a SARSEP up to a limit of $1,500 for 2004
(increasing to $2,500 by 2006).

31


with a qualifying child, and five that apply to claimants without a qualifying child);”*

© Child credit: four pages;”*°

© Dependent care credit: ten pages, including a flow chart for use in determining
eligibility for the credit, and a flow chart for determining whether a child of divorced
or separated parents qualifies the taxpayer for the credit;”*°

© Head of household filing status: two pages, including a chart illustrating the
requirements for head of household filing status.”

In addition, there is a separate IRS publication for the earned income credit (Publication
596), which includes a seven-page description of the rules relating to qualifying children.?°*

The rules relating to qualifying children are a source of errors for taxpayers both because
the rules for each provision are different and because of the complexity of particular rules.

Complexity due to varying rules

The variety of present-law rules cause taxpayers inadvertently to claim tax benefits for
which they do not qualify as well as to fail to claim tax benefits for which they do qualify. For
example, a taxpayer who is entitled to a dependency exemption with respect to a child whom the
taxpayer supports but with whom the taxpayer does not live may erroneously believe that the
taxpayer also is eligible for the earned income credit with respect to the child.° As another

234 Td. at 254-266.

235 Iq. at 244-247.

236 Td. at 227-236.

237 Iq. at 25-27.

238 IRS Publication 596, Earned Income Credit (EIC), 11-17.

239 The President’s budget proposal states that a recent earned income tax credit
compliance study found that nearly one in five children who were claimed as dependents and as
earned income credit qualifying children in 1999 were disallowed for one, but not both, of these
tax benefits. In a study of earned income credit compliance for credits claimed on 1997 returns,
the IRS reported that the single largest amount of overclaims of the earned income credit--about
22 percent--was due to claiming the credit with respect to children who did not meet the
eligibility requirement for a qualifying child. The IRS attributed most of these errors to
taxpayers claiming children who did not meet the residency requirements. Department of the
Treasury, Internal Revenue Service, Compliance Estimates for Earned Income Tax Credit
Claimed on 1997 Returns (September 2000), at 10. In its more recent study of earned income
credit compliance with respect to credits claimed on 1999 returns, the IRS estimated that
approximately 25 percent of the overclaims of the earned income credit for which the type of

166


VII. EXPIRING PROVISIONS
A. Extend Alternative Minimum Tax Relief for Individuals
Present Law

The alternative minimum tax (“AMT”) is the amount by which the tentative minimum
tax exceeds the regular income tax. An individual’s tentative minimum tax is an amount equal to
(1) 26 percent of the first $175,000 ($87,500 in the case of a married individual filing a separate
return) of alternative minimum taxable income (“AMTI”) in excess of an exemption amount that
phases out and (2) 28 percent of the remaining AMTI. The maximum tax rates on net capital
gain used in computing the tentative minimum tax are the same as under the regular tax. AMTI
is the individual’s taxable income adjusted to take account of specified preferences and
adjustments. The exemption amounts are: (1) $58,000 ($45,000 in taxable years beginning after
2004) in the case of married individuals filing a joint return and surviving spouses; (2) $40,250
($33,750 in taxable years beginning after 2004) in the case of other unmarried individuals;

(3) $29,000 ($22,500 in taxable years beginning after 2004) in the case of married individuals
filing separate returns; and (4) $22,500 in the case of an estate or trust. The exemption amounts
are phased out by an amount equal to 25 percent of the amount by which the individual’s AMTI
exceeds (1) $150,000 in the case of married individuals filing a joint return and surviving
spouses, (2) $112,500 in the case of other unmarried individuals, and (3) $75,000 in the case of
married individuals filing separate returns or an estate or a trust. These amounts are not indexed
for inflation.

Present law provides for certain nonrefundable personal tax credits (i.e., the dependent
care credit, the credit for the elderly and disabled, the adoption credit, the child tax credit,” the
credit for interest on certain home mortgages, the HOPE Scholarship and Lifetime Learning
credits, the IRA credit, and the D.C. homebuyer’s credit).

For taxable years beginning before 2004, all the nonrefundable personal credits are
allowed to the extent of the full amount of the individual’s regular tax and alternative minimum
tax.

Without an extension of these rules for taxable years beginning after 2003, these credits
(other than the adoption credit, child credit and IRA credit) would be allowed only to the extent
that the individual’s regular income tax liability exceeds the individual’s tentative minimum tax,
determined without regard to the minimum tax foreign tax credit. The adoption credit, child
credit, and IRA credit are allowed to the full extent of the individual’s regular tax and alternative
minimum tax.

Description of Proposal

The proposal extends the higher individual AMT exemption amounts ($58,000, $40,250,
and $29,000).

579 4 portion of the child credit may be refundable.

355


K. Permanently Extend IRS User Fees

Present Law

The IRS provides written responses to questions of individuals, corporations, and
organizations relating to their tax status or the effects of particular transactions for tax purposes.
The IRS generally charges a fee for requests for a letter ruling, determination letter, opinion
letter, or other similar ruling or determination.®” Public Law 108-89°°* extended the statutory
authorization for these user fees through December 31, 2004, and moved the statutory
authorization for these fees into the Code.*”*

Description of Proposal
The proposal permanently extends the statutory authorization for these user fees.
Effective date—The proposal is effective for requests made after the date of enactment.

Analysis

In general, IRS user fees are designed to affect complex requests that relate to specific
facts of particular taxpayers, rather that widespread issues of general applicability.

Prior Action

A substantially similar proposal was included in the President’s fiscal year 2004 budget
proposal. A substantially similar proposal was contained in the “Tax Administration Good
Government Act of 2004,” as passed by the Senate Committee on Finance on February 2, 2004.

637 These user fees were originally enacted in section 10511 of the Revenue Act of 1987
(Pub. L. No. 100-203, December 22, 1987). Public Law 104-117 (An Act to provide that
members of the Armed Forces performing services for the peacekeeping efforts in Bosnia and
Herzegovina, Croatia, and Macedonia shall be entitled to tax benefits in the same manner as if
such services were performed in a combat zone, and for other purposes (March 20, 1996))
extended the statutory authorization for these user fees through September 30, 2003.

638 117 Stat. 1131; H.R. 3146, signed by the President on October 1, 2003.

639 Pub. L. No. 108-89 also moved into the Code the user fee provision relating to
pension plans that was enacted in section 620 of the Economic Growth and Tax Relief
Reconciliation Act of 2001 (Pub. L. No. 107-16, June 7, 2001).

0 ‘That proposal extended the statutory authorization for these user fees through
September 30, 2005.

401


Table 4.-Hybrid Vehicle Base Credit Amount Dependent Upon the Power
Available from the Rechargeable Energy Storage System As a Percentage
of the Vehicles Maximum Available Power

If Rechargeable Energy Storages System Provides:
Base Credit at least but less than
Amount
$250 5% of maximum available power | 10% of maximum available power
$500 10% of maximum available power | 20% of maximum available power
$750 20% of maximum available power | 30% of maximum available power
$1,000 30% of maximum available power

For these purposes, a vehicle’s power available from its rechargeable energy storage
system as a percentage of maximum available power is calculated as the maximum value
available from the battery or other energy storage device during a standard power test, divided by
the sum of the battery or other energy storage device and the SAE net power of the heat engine.

Table 5, below, shows the proposed additional fuel economy credit available to hybrid
vehicles whose fuel economy exceeds that of a base fuel economy. For these purposes the base
fuel economy is the 2000 model year city fuel economy rating for vehicles of various weight
classes (see below).

Table 5.-Additional Fuel Economy Credit for Hybrid Vehicles

If Fuel Economy of the Hybrid Vehicle Is:
Credit at least but less than

$500 125% of base fuel economy 150% of base fuel economy
$1,000 150% of base fuel economy 175% of base fuel economy
$1,500 175% of base fuel economy 200% of base fuel economy
$2,000 200% of base fuel economy 225% of base fuel economy
$2,500 225% of base fuel economy 250% of base fuel economy
$3,000 250% of base fuel economy

Fuel cell vehicles

A qualifying fuel cell vehicle is a motor vehicle that is propelled by power derived from
one or more cells which convert chemical energy directly into electricity by combining oxygen
with hydrogen fuel which is stored on board the vehicle and may or may not require reformation

131


If the individual is not an active participant in an employer-sponsored retirement plan, but
the individual’s spouse is, the deduction is phased out for taxpayers with adjusted gross income
between $150,000 and $160,000.

To the extent an individual cannot or does not make deductible contributions to an IRA
or contributions to a Roth IRA, the individual may make nondeductible contributions to a
traditional IRA, subject to the same limits as deductible contributions. An individual who has
attained age 50 before the end of the taxable year may also make nondeductible catch-up
contributions to an IRA.

An individual who has attained age 70-% prior to the close of a year is not permitted to
make contributions to a traditional IRA.

Amounts held in a traditional IRA are includible in income when withdrawn, except to
the extent the withdrawal is a return of nondeductible contributions. Early withdrawals from an
IRA generally are subject to an additional 10-percent tax.?5 That is, includible amounts
withdrawn prior to attainment of age 59-4 are subject to an additional 10-percent tax, unless the
withdrawal is due to death or disability, is made in the form of certain periodic payments, is used
to pay medical expenses in excess of 7.5 percent of adjusted gross income, is used to purchase
health insurance of certain unemployed individuals, is used for higher education expenses, or is
used for first-time homebuyer expenses of up to $10,000.

Distributions from traditional IRAs generally are required to begin by the April 1 of the
year following the year in which the IRA owner attains age 70-%. If an IRA owner dies after
minimum required distributions have begun, the remaining interest must be distributed at least as
rapidly as under the minimum distribution method being used as of the date of death. Ifthe IRA
owner dies before minimum distributions have begun, then the entire remaining interest must
generally be distributed within five years of the IRA owner’s death. The five-year rule does not
apply if distributions begin within one year of the IRA owner’s death and are payable over the
life or life expectancy of a designated beneficiary. Special rules apply if the beneficiary of the
IRA is the surviving spouse.

Roth IRAs

Individuals with adjusted gross income below certain levels may make nondeductible
contributions to a Roth IRA. The maximum annual contribution that may be made to a Roth IRA
is the lesser of a certain dollar amount ($3,000 for 2004) or the individual’s compensation for the
year. An individual who has attained age 50 before the end of the taxable year may also make
catch-up contributions to a Roth IRA up to a certain dollar amount ($500 for 2004).

The contribution limit is reduced to the extent an individual makes contributions to any
other IRA for the same taxable year. As under the rules relating to traditional IRAs, a
contribution of up to the dollar limit for each spouse may be made to a Roth IRA provided the
combined compensation of the spouses is at least equal to the contributed amount. The maximum
annual contribution that can be made to a Roth IRA is phased out for single individuals with

5 Sec, 72(t).

15


With regard to the exception for deposits with persons carrying on the banking business,
the U.S. Court of Appeals for the Sixth Circuit in The Limited, Inc. v. Commissioner*® (“The
Limited’) concluded that a U.S. subsidiary of a U.S. corporation was “carrying on the banking
business” even though its operations were limited to the administration of the private label credit
card program of the U.S. shareholder. Therefore, the court held that a controlled foreign
corporation of the U.S. corporation could make deposits with the subsidiary under this exception
(e.g., through the purchase of certificates of deposit), and avoid taxation of the deposits as an
investment in U.S. property.

Description of Proposal

The proposal limits the bank deposit exception for foreign earnings invested in U.S.
property as bank deposits to deposits with institutions regulated as banks.

Effective date—This proposal is effective after the date of enactment.

Analysis
Policy issues

The result in The Limited is inconsistent with the policy underlying the bank deposit
exception from the imposition of U.S. tax on repatriated foreign earnings. This exception is one
of several exceptions that generally are designed to ensure that assets in the United States held by
a controlled foreign corporation for business purposes are not characterized as a disguised
repatriation. The result in The Limited inappropriately extends the exception for bank deposits to
cases in which the deposits should be characterized as repatriations. Therefore, this exception
should be clarified so that it applies only to deposits with financial institutions that actually are in
the banking business.

Multiple options are available to clarify the bank deposit exception, with each option
having certain advantages and disadvantages. One possible option would be to limit the present-
law bank deposit exception to deposits made with unrelated persons carrying on the banking
business. This approach would be similar to the present-law exception for investments inU.S.
corporate stock and debt, which is limited to investments in stock and debt of unrelated
issuers.” Unlike clarifying directly the term “carrying on the banking business”, adding a
related party prohibition to the existing exception would avoid reliance upon non-tax banking
definitions and concepts which are subject to change and, in fact, have changed significantly in
recent years. This approach would ensure that the bank deposit exception applies only to deposit
recipients that are actively engaged in providing banking services to customers. On the other
hand, a related party prohibition could affect U.S. banks with foreign operations that currently
utilize the bank deposit exception, although this approach might be viewed alternatively in this
regard as equalizing the treatment of such banks with other similarly situated taxpayers that have

482. 986 F.3d 324 (6th Cir. 2002), rev’g 113 T.C. 169 (1999).
463 See Sec. 956(c)(2)(F).

293


rules) do not apply to such property financed with the bonds (secs. 142(d) and
150(b)(2));

(5) Repayments of bond-financed loans may not be used to make additional loans,
but rather must be used to retire outstanding bonds (with the first such retirement
occurring 10 years after issuance of the bonds);“* and

(6) _ Interest on the bonds is not a preference item for purposes of the alternative
minimum tax preference for private activity bond interest (sec. 57(a)(5)).

Description of Proposal

The proposal extends authority to issue New York Liberty Bonds though December 31,
2009.

Effective Date

The provision is effective for bonds issued after the date of enactment and before January
1, 2010.

Analysis

Proponents of the proposal argue that the extraordinary circumstances require an
extension of this authority. They propose that additional time is necessary to utilize these bonds
and complete the recovery of New York City from the terrorist attacks of September 11, 2001.
Opponents may argue that New York City has adequate bonding authority and that any
additional extension of this authority is unnecessary.

Prior Action

No prior action.

48 ‘It is intended that redemptions will occur at least semi-annually beginning at the end
of 10 years after the bonds are issued; however amounts less than $250,000 are not required to be
used to redeem bonds at such intervals.

408


On the other hand, some argue that present law already provides an appropriate level of
benefits for dependents, including those with long-term care needs. For example, present law
provides for an itemized deduction for long-term care expenses and other medical expenses of
the taxpayer in excess of a floor. In addition, to the extent a caregiver of a person with long-term
care needs incurs expenses in order to work, the caregiver may be eligible for the dependent care
credit.

Prior Action

Similar proposals were included in the President’s fiscal year 2002, 2003, and 2004
budget proposals.

5, Expand human clinical trials expenses qualifying for the orphan drug tax credit

Present Law

Taxpayers may claim a 50-percent credit for expenses related to human clinical testing of
drugs for the treatment of certain rare diseases and conditions, generally those that afflict less
than 200,000 persons in the United States. Qualifying expenses are those paid or incurred by the
taxpayer after the date on which the drug is designated as a potential treatment for a rare disease
or disorder by the Food and Drug Administration (“FDA”) in accordance with section 526 of the
Federal Food, Drug, and Cosmetic Act.

Description of Proposal

The proposal expands qualifying expenses to include those expenses related to human
clinical testing paid or incurred after the date on which the taxpayer files an application with the
FDA for designation of the drug under section 526 of the Federal Food, Drug, and Cosmetic Act
as a potential treatment for a rare disease or disorder, if certain conditions are met. Under the
proposal, qualifying expenses include those expenses paid or incurred after the date on which the
taxpayer files an application with the FDA for designation as a potential treatment for a rare
disease or disorder if the drug receives FDS designation before the due date (including
extensions) for filing the tax return for the taxable year in which the application was filed with
the FDA. As under present law, the credit may only be claimed for such expenses related to
drugs designated as a potential treatment for a rare disease or disorder by the FDA in accordance
with section 526 of such Act.

Effective date The provision is effective for expenditures paid or incurred after
December 31, 2003.

Analysis

Approval for human clinical testing and designation as a potential treatment for a rare
disease or disorder require separate reviews within the FDA. As a result, in some cases, a
taxpayer may be permitted to begin human clinical testing prior to a drug being designated as a
potential treatment for a rare disease or disorder. If the taxpayer delays human clinical testing in
order to obtain the benefits of the orphan drug tax credit, which currently may be claimed only
for expenses incurred after the drug is designated as a potential treatment for a rare disease or

59


generally a question of plan design. For example, an employer may create an opening account
balance that is designed to approximate the benefit a participant would have had, based on the
participant’s compensation and years of service, if the cash balance formula had been in effect in
prior years. As another example, an employer may convert the preconversion accrued benefit
into a lump-sum amount and establish this amount as the opening account balance. Depending
on the interest and mortality assumptions used, this lump-sum amount may or may not equal the
actuarial present value of the participant’s accrued benefit as of the date of conversion,
determined using the statutory interest and mortality assumptions required for lump-sum
calculations.

Under a “wearaway” approach, a participant does not accrue any additional benefits after
the conversion until the participant’s benefits under the cash balance formula exceed the
participant’s preconversion accrued benefit. Because of this effect, plans with a wearaway are
also referred to as using the “greater of” method of calculating benefits. Plan design can greatly
affect the length of any wearaway period.

Under the wearaway approach, the participant’s protected benefit is compared to the
normal retirement benefit®” that is provided by the account balance (plus pay and interest
credits), and the participant does not earn any new benefits until the new benefit exceeds the
protected accrued benefit. For example, suppose the value of the protected accrued benefit is
$40,000, and the opening account balance under the cash balance formula provides a normal
retirement benefit of $35,000. The participant will not earn any new benefits until the
hypothetical balance under the cash balance formula increases to the extent that it provides a
normal retirement benefit exceeding $40,000.

No wearaway (or “sum of” approach)

Under a plan without a wearaway, a participant’s benefit under the cash balance plan
consists of the sum of (1) the benefit accrued before conversion plus (2) benefits under the cash
balance formula for years of service after the conversion. This approach is more favorable to
plan participants than the wearaway approach, because they earn benefits under the new plan
formula immediately. This approach is also sometimes referred to as the “A + B” method, where
A is the protected benefit and B is the benefit under the cash balance formula.

303 These rules apply to normal retirement benefits. Other issues may arise with respect
to wearaway of early retirement benefits.

304 In some cases, the plan may convert the protected benefit into a lump-sum equivalent
for purposes of the opening account balance. Even if at the time of the initial calculation the
opening balance equals the value of the protected benefit, the account balance may not continue
to reflect the value of the protected benefit over time, depending on the actuarial assumptions
used. Thus, a cash balance plan may not rely on the cash balance formula to protect accrued
benefits because it may encounter problems under the anticutback rule (depending on the
actuarial assumptions used).

215


Clarify treatment of transfers of qualified funds and deductibility of decommissioning costs

The proposal clarifies the Federal income tax treatment of the transfer of a qualified fund.
No gain or loss would be recognized to the transferor or the transferee as a result of the transfer
ofa qualified fund in connection with the transfer of the power plant with respect to which such
fund was established. In addition, the proposal provides that all nuclear decommissioning costs
are deductible when paid.

Contributions to a qualified fund after useful life of powerplant

The proposal also allows deductible contributions to a qualified fund subsequent to the
end of a nuclear powerplant’s estimated useful life. Such payments are permitted to the extent
they do not cause the assets of the qualified fund to exceed the present value of the taxpayer’s
allocable share (current or former) of the nuclear decommissioning costs of such nuclear
powerplant.

Effective date
The proposal is effective for taxable years beginning after December 31, 2003.

Analysis
Policy issues

The cost of service limitation on the amount of deductible contributions to a qualified
nuclear decommissioning fund reflects the regulatory environment that existed when the
legislation was originally enacted in 1984 and all taxable entities producing nuclear power were
subject to rate regulation. More recently, the process of deregulating the electric power industry
has begun at both the Federal and state level. Proponents of the proposal argue that the present-
law limitation is outdated, and that the rules relating to deductible contributions to nuclear
decommissioning funds should be modernized to reflect industry deregulation.

The process of deregulation takes different forms in different jurisdictions. A jurisdiction
may choose to eliminate rate regulation and allow rates to be set by the market instead of the
public utility commission. Although such market rates may include an element compensating a
generator of nuclear power for its anticipated decommissioning costs, there is no regulatory cost
of service amount against which to measure a deductible contribution. A line charge or other fee
could be imposed by a State or local government or a public utility commission to ensure that
adequate funds will be available for decommissioning, but there is no assurance that this will be
the case. The taxpayer generating the electricity may not be the same as the taxpayer distributing
it. In those cases, the use of line charges and other customer based fees as a vehicle to satisfy the
requirement that deductible contributions not exceed cost of service may not be successful.

The exception allowing a taxpayer responsible for nuclear power plant decommissioning

to deduct contributions to a qualified nuclear decommissioning fund for future payment costs
was enacted in Congress’ belief that the establishment of segregated reserve funds for paying

128


Prior Action

A similar proposal was included in the President’s fiscal year 2002, 2003 and 2004
budget proposals.

112


C. Modify Qualification Rules for Tax-Exempt Property
and Casualty Insurance Companies

Present Law

Qualification rules for tax-exempt property and casualty insurance companies

A property and casualty insurance company generally is subject to tax on its taxable
income (sec. 831(a)). The taxable income of a property and casualty insurance company is
determined as the sum of its underwriting income and investment income (as well as gains and
other income items), reduced by allowable deductions (sec. 832).

A property and casualty insurance company is eligible to be exempt from Federal income
tax if its net written premiums or direct written premiums (whichever is greater) for the taxable
year do not exceed $350,000 (sec. 501(c)(15)).

A property and casualty insurance company may elect to be taxed only on taxable
investment income if its net written premiums or direct written premiums (whichever is greater)
for the taxable year exceed $350,000, but do not exceed $1.2 million (sec. 83 1(b)).

For purposes of determining the amount of a company’s net written premiums or direct
written premiums under these rules, premiums received by all members of a controlled group of
corporations of which the company is a part are taken into account. For this purpose, a more-
than-50-percent threshhold applies under the vote and value requirements with respect to stock
ownership for determining a controlled group, and rules treating a life insurance company as part
of a separate controlled group or as an excluded member of a group do not apply (secs.
501(c)(15), 831(b)(2)(B) and 1563).

Definition of insurance company

Present law provides specific rules for taxation of the life insurance company taxable
income of a life insurance company (sec. 801), and for taxation of the taxable income of an
insurance company other than a life insurance company (sec. 831) (generally referred to as a
property and casualty insurance company). For Federal income tax purposes, a life insurance
company means an insurance company that is engaged in the business of issuing life insurance
and annuity contracts, or noncancellable health and accident insurance contracts, and that meets
a 50-percent test with respect to its reserves (sec. 816(a)). This statutory provision applicable to
life insurance companies explicitly defines the term “insurance company” to mean any company,
more than half of the business of which during the taxable year is the issuing of insurance or
annuity contracts or the reinsuring of risks underwritten by insurance companies (sec. 816(a)).

The life insurance company statutory definition of an insurance company does not
explicitly apply to property and casualty insurance companies, although a long-standing Treasury
regulation“ that is applied to property and casualty companies provides a somewhat similar

403 The Treasury regulation provides that "the term ‘insurance company’ means a
company whose primary and predominant business activity during the taxable year is the issuing
of insurance or annuity contracts or the reinsuring of risks underwritten by insurance companies.

258


note that the imposition of tax on the fuel may cause accounting issues related to taxed and
untaxed fuel being comingled at the terminal.

The proposal increases penalties for failing to register and requires display of proof of
registration. Proponents of the proposal may argue that increasing the penalties for failure to
register and display proof of registration will encourage unregistered parties to become
registered. On the other hand, if insufficient personnel are available to monitor for violations,
such penalties would be ineffective as unregistered persons will doubt the ability of the
Government to detect their activities and continue to divert fuel.

Prior Action

On February 12, 2004, the Senate passed a similar proposal as part of S. 1072, the “Safe,
Accountable, Flexible and Efficient Transportation Equity Act of 2004”. However, the Senate
proposal also imposes a penalty on persons transferring fuel to unregistered parties.

349


Prior Action

No prior action.

279


depreciation deduction and the property is treated as section 1245 property. Thus, deductions for
qualified environmental remediation expenditures are subject to recapture as ordinary income
upon a sale or other disposition of the property. In addition, sections 280B (demolition of
structures) and 468 (special rules for mining and solid waste reclamation and closing costs) do
not apply to amounts that are treated as expenses under this provision.

Eligible expenditures are those paid or incurred before January 1, 2004.

Description of Proposal

The proposal eliminates the requirement that expenditures must be paid or incurred
before January 1, 2004, to be deductible as eligible environmental remediation expenditures.
Thus, the provision becomes permanent.

Effective date.—The proposal is effective on the date of enactment.

Analysis
Policy issues

The proposal to make permanent the expensing of brownfields remediation costs would
promote the goal of environmental remediation and remove doubt as to the future deductibility of
remediation expenses. Removing the doubt about deductibility may be desirable if the present-
law expiration date is currently affecting investment planning. For example, the temporary
nature of relief under present law may discourage projects that require a significant ongoing
investment, such as groundwater clean-up projects. On the other hand, extension of the
provision for a limited period of time would allow additional time to assess the efficacy of the
law, adopted only recently as part of the Taxpayer Relief Act of 1997, prior to any decision as to
its permanency.

The proposal is intended to encourage environmental remediation, and general business
investment, at contaminated sites. With respect to environmental remediation tax benefits as an
incentive for general business investment, it is possible that the incentive may have the effect of
distorting the location of new investment, rather than increasing investment overall. If the
new investments are offset by less investment in neighboring, but not qualifying, areas, the
neighboring communities could suffer. On the other hand, the increased investment in the
qualifying areas could have spillover effects that are beneficial to the neighboring communities.

Complexity issues

By making the present law provision permanent, the proposal may simplify tax planning
and investment planning by taxpayers by providing more certainty. However, in general, the
proposal would treat expenditures at certain geographic locations differently from otherwise

165 For a discussion of the economic effects of targeting economic activity to specific
geographic areas, see Leslie E. Papke, “What Do We Know About Enterprise Zones,” in Jim
Poterba, ed., Tax Policy and the Economy (Cambridge, MA: The MIT Press), 1993.

114


The following table summarizes the aggregate information contained in the GAO report
with respect to the 54 vehicles tracked by the GAO from donation to the taxpayer’s claim for a
charitable deduction.*”°

Vehicle gross | Net proceeds Donated Gross sale Proceeds to Charity
sales price (loss) to vehicle value price as charity as a receipt
(dollars) charity from | claimed on tax percent of percent of (loss)
vehicle sale return amount donor gross sale as percent of
(dollars) (dollars) claimed price (loss) donor claim
17,205 9,970 129,656 13.3% 57.9% 1.1%

It is noted that with respect to the GAO table from which this summary information is
obtained, the GAO stated: “Information on this judgmental set of 54 vehicle donations were
obtained from 4 charities in 4 states. The individual cases or cases in aggregate are for
illustration only, and cannot be used to generalize vehicle donations overall.”°°

Based on the GAO study of these specific 54 vehicles, the net proceeds received by the
charities with respect to the vehicles was less than eight percent of the amount claimed by the
donors as charitable deductions for the vehicle donations. The vehicles were sold for an
aggregate selling price of approximately 13 percent of the aggregate charitable deductions
claimed for the vehicles. The charities received proceeds of approximately 58 percent of the
gross sales proceeds for the 54 vehicles. The average (mean) charitable deduction for each of the
vehicles in the study was $2,401, and the average (mean) gross sales price for each of the
vehicles was $319, with the charity receiving average net proceeds of $185 per vehicle.

The GAO reported that proceeds from vehicle donation sales were not a crucial source of
income for the majority of the charities it reviewed."*’ From the perspective of the charitable
donee, there arguably is little incentive to maximize the selling price of a donated vehicle,
because the charity frequently receives net cash proceeds it would not otherwise receive, with
little effort expended by it. It generally is easier for a charity to have an agent sell the donated
vehicles at auction, even at prices substantially less than at retail price, than it is to hold the
vehicle to extract the maximum selling price.

The proposal attempts to address the overvaluation problem by requiring that a taxpayer
obtain a qualified appraisal by an independent and competent appraiser in order to claim a
charitable deduction for a donated automobile or other vehicle. A qualified appraisal prepared
by an independent and competent appraiser would provide an appraised value that takes into
account geographic markets and the condition of the specific vehicle being donated by the

435 Iq. at Table 4, p. 37. The following table was prepared by the staff of the Joint
Committee on Taxation, based on data contained in the GAO table.

36 Td. at p. 37.

87 Td. at 15.

277


the advisor acted as an organizer or seller (or a person who assisted an organizer or seller) with
respect to the reportable transaction, and (2) contains other information as may be required by
the Secretary. In addition, the Secretary is authorized (but not required) to prescribe regulations
which provide that, in cases in which 2 or more persons are required to maintain the same list,
only one person would be required to maintain the list.

Penalty for failing to maintain investor lists

The proposal modifies the penalty for failing to maintain the required list by making it a
time-sensitive penalty. Thus, a material advisor who is required to maintain an investor list and
who fails to make the list available upon written request by the Secretary within 20 business days
after the request will be subject to a $10,000 per day penalty. The penalty applies to a person
who fails to maintain a list, maintains an incomplete list, or has in fact maintained a list but does
not make the list available to the Secretary. The penalty can be waived if the failure to make the
list available is due to reasonable cause.>””

Effective date
The proposal generally is effective after the date of enactment.
4. Actions to enjoin conduct with respect to tax shelters and reportable transactions
Present Law

The Code authorizes civil action to enjoin any person from promoting abusive tax
shelters or aiding or abetting the understatement of tax liability.””!

Description of Proposal

The proposal expands this rule to confirm that injunctions may also be sought with
respect to the requirements relating to the reporting of reportable transactions’” and the keeping
of lists of investors by material advisors.>” Thus, under the proposal, an injunction may be
sought against a material advisor to enjoin the advisor from (1) failing to file an information

return with respect to a reportable transaction, or (2) failing to maintain, or to timely furnish

3 The terms “reportable transaction” and “listed transaction” have the same meaning as
previously described in connection with the taxpayer-related proposals.

370 In no event will failure to maintain a list be considered reasonable cause for failing to
make a list available to the Secretary.

3" Sec, 7408.
372 Sec, 6707, as amended by other proposals of this package.

33 Sec, 6708, as amended by other proposals of this package.

246


Indexing for inflation the $5,000 and $500,000 amounts may be appropriate because such
amounts arguably should automatically increase as inflation increases values of properties.
Another approach would be to make periodic adjustments to the amounts should circumstances

justify changes to the reporting thresholds.

Prior Action

No prior action.

305


I. MAKING PERMANENT THE TAX CUTS ENACTED IN 2001 AND 2003
A. Extend Through 2010 Certain Provisions Relating to Individuals
Present Law

Ten-percent regular income tax rate

Table 1, below, shows the scheduled size of the 10-percent regular income tax rate
bracket for the next several years.

Table 1.-Scheduled Size of 10-Percent Regular Income Tax Rate Bracket

Unmarried Joint Heads of
Year Taxpayers Returns Household
2003-2004! $7,000 $14,000 $10,000
2005-2007" $6,000 $12,000 $10,000
2008-2010° $7,000 $14,000 $10,000
2011* No 10-Percent Bracket

' ‘The taxable income levels for the 10-percent regular income tax rate bracket will be adjusted
for inflation for taxable years beginning in 2004 only.

? No inflation adjustment.

3 The taxable income levels for the 10-percent regular income tax rate bracket will be adjusted
annually for inflation for taxable years beginning after December 31, 2008.

* The 10-percent regular income tax rate bracket is repealed for taxable years beginning after
December 31, 2010, under the sunset provision of the Economic Growth Tax Relief
Reconciliation Act of 2001 (“EGTRRA”). A separate proposal in the budget eliminates the
sunset.

Basic standard deduction marriage penalty relief

The basic standard deduction amount for married taxpayers filing a joint return is twice
the basic standard deduction amount for single individuals for taxable years beginning in 2003
and 2004. For taxable years beginning in 2005-2008, the relationship between the standard
deduction for joint filers and single filers reverts to amounts less than twice the basic standard
deduction for single individuals, but which gradually increases under the provisions of EGTRRA
until 2009 when the basic standard deduction amount for married taxpayers filing a joint return
again equals twice the basic standard deduction amount for single individuals. For taxable years


A trust does not qualify as a charitable remainder annuity trust if the annuity for a year is
greater than 50 percent of the initial fair market value of the trust’s assets. A trust does not
qualify as a charitable remainder unitrust if the percentage of assets that are required to be
distributed at least annually is greater than 50 percent. A trust does not qualify as a charitable
remainder annuity trust or a charitable remainder unitrust unless the value of the remainder
interest in the trust is at least 10 percent of the value of the assets contributed to the trust.

Distributions from a charitable remainder annuity trust or charitable remainder unitrust
are treated in the following order as: (1) ordinary income to the extent of the trust’s current and
previously undistributed ordinary income for the trust’s year in which the distribution occurred;
(2) capital gains to the extent of the trust’s current capital gain and previously undistributed
capital gain for the trust’s year in which the distribution occurred; (3) other income (e.g., tax-
exempt income) to the extent of the trust’s current and previously undistributed other income for
the trust’s year in which the distribution occurred; and (4) corpus.'*°

In general, distributions to the extent they are characterized as income are includible in
the income of the beneficiary for the year that the annuity or unitrust amount is required to be
distributed even though the annuity or unitrust amount is not distributed until after the close of
the trust’s taxable year.'*6

Charitable remainder annuity trusts and charitable remainder unitrusts are exempt from
Federal income tax for a tax year unless the trust has any unrelated business taxable income for
the year. Unrelated business taxable income includes certain debt financed income. A charitable
remainder trust that loses exemption from income tax for a taxable year is taxed as a regular
complex trust. As such, the trust is allowed a deduction in computing taxable income for
amounts required to be distributed in a taxable year, not to exceed the amount of the trust’s
distributable net income for the year.

Description of Proposal

The proposal imposes a 100-percent excise tax on the unrelated business taxable income
ofa charitable remainder trust. This replaces the present-law rule that removes the income tax
exemption of a charitable remainder trust for any year in which the trust has any unrelated
business taxable income. Under the proposal, the tax is treated as paid from corpus. The
unrelated business taxable income is considered income of the trust for purposes of determining
the character of the distribution made to the beneficiary.

Effective date.The proposal is effective for taxable years beginning after December 31,
2003, regardless of when the trust was created.

'4 Sec, 664(b).

\46 Treas, Reg. sec. 1.664-1(d)(4).

91


contributions at a higher rate (up to four percent) was believed to be sufficient incentive to
induce participation by nonhighly compensated employees. It was also hoped that the safe
harbors would reduce the complexities associated with qualified plans, and induce more
employers to adopt retirement plans for their employees.

To the extent that the ERSA safe harbor requires an employee’s elective deferrals to be
matched at only a 50 percent rate and requires a total of only three percent in matching
contributions, some argue that the proposal not only weakens the matching contribution
alternative under the safe harbor, but also makes that alternative clearly less expensive for the
employer than the nonelective contribution alternative, thereby reducing the incentive for an
employer to provide nonelective contributions. In addition, because, as under the present-law
safe harbor, the matching contribution alternative is satisfied by offering matching contributions
(without regard to the amount actually provided to nonhighly compensated employees), some
argue that employers may no longer have a financial incentive to encourage employees to
participate. This may reduce participation by rank-and-file employees. The argument may also
be made that the matching contribution requirement under the ERSA safe harbor is less rigorous
than the matching contribution requirement that applies to a SIMPLE plan under present law,
even though an ERSA is not subject to the limitations on SIMPLE arrangements (ie.
contributions are subject to lower limits and SIMPLEs are available only to small employers).
On the other hand, some believe that the present law safe harbor for section 401(k) plans has
failed to provide an adequate incentive for employers to offer retirement plans to their employees
and further incentive is needed. Some argue that the proposal makes the safe harbor more
attractive for employers, especially small employers, and will thus increase coverage and
participation.

Consolidation of various types of employer-sponsored plans

One of the sources of complexity in the present-law rules relating to employer-sponsored
retirement plans is the existence of numerous vehicles with similar purposes but different rules,”?
Thus, employers desiring to adopt a retirement plan must determine which vehicles are available
to that employer and which of the various vehicles available it wishes to adopt. This
determination may entail a costly and time-consuming analysis and comparison of a number of
different types of plans. By providing only one type of defined contribution plan to which
employee contributions may be made, i.e., an ERSA, the proposal makes it easier for employers
to determine whether to adopt a plan and what type of plan to provide. Having a single type of
plan may also make it easier for employees to understand their retirement benefits, particularly
when employees change jobs.

On the other hand, many employers already have plans and are familiar with the present-
law rules applicable to their plans. Converting a present-law arrangement to an ERSA will

59 This issue is discussed in Joint Committee on Taxation, Study of the Overall State of
the Federal Tax System and Recommendations for Simplification, Pursuant to Section
8022(3)(B) of the Internal Revenue Code of 1986 (JCS-3-01), April 2001. See, Vol. IL, Part
II.A.1 (General simplification issues, pages 149-150), and Part III.C.5 (Sources of Complexity,
page 186).

36


custodial and administrative accounts (to the extent the Government Accounting Office does not
exercise its option to preempt under the CFO Act).

Description of Proposal

The President’s budget proposes the merger of the Treasury Inspector General and the
Treasury Inspector General for Tax Administration into a new Inspector General office, to be
called the Inspector General for Treasury.“

Effective date.—No effective date is specified.

Analysis

Proponents of the proposal believe that the consolidation of these two organizations will
“maximize efficiencies and effectiveness.”°’ Others may question why a structure that was
examined intensively and enacted in 1998 needs to be readjusted so soon thereafter. Some may
also be concerned that this consolidation will result in a diminution of focus and attention on the
IRS, since there will no longer be an inspector general with that exclusive responsibility. In
addition, some might argue that the merging of tax and non-tax administration investigative
functions increases the risk of unauthorized disclosure of returns and return information for
nontax purposes because Treasury IG personnel may not be assigned exclusively to tax
administration investigations; accordingly, the possibility exists of inadvertent disclosure
because of a mixed tax and non-tax workload.

Prior Action

An identical proposal was included in the President’s fiscal year 2004 budget proposal.

666 See Office of Management and Budget, Budget of the United States Government,
Fiscal Year 2005: Appendix (H. Doc. 108-146, Vol. I), p. 830.

667 See Office of Management and Budget, Budget of the United States Government,
Fiscal Year 2005: Appendix (H. Doc. 108-146, Vol. ID), p. 830.

422


Minimum employment period

No credit is allowed for qualified wages paid to a member of the targeted group unless
they work at least 400 hours or 180 days in the first year of employment.

Coordination of the work opportunity tax credit and the welfare-to-work tax credit

An employer cannot claim the work opportunity tax credit with respect to wages of any
employee on which the employer claims the welfare-to-work tax credit.

Other rules

The welfare-to-work tax credit incorporates directly or by reference many of these other
rules contained on the work opportunity tax credit.

Description of Proposal

Combined credit

The proposal combines the work opportunity and welfare-to-work tax credits and extends
the combined credit for two years.

Targeted groups eligible for the combined credit

The combined credit is available on an elective basis for employers hiring individuals
from one or more of all nine targeted groups. The welfare-to-work credit/long-term family
assistance recipient is the ninth targeted group.

The proposal repeals the requirement that a qualified ex-felon be an individual certified
as a member of an economically disadvantaged family.

Qualified wages

Qualified first-year wages for the eight WOTC categories remain capped at $6,000
($3,000 for qualified summer youth employees). No credit is allowed for second-year wages. In
the case of long-term family assistance recipients the cap is $10,000 for both qualified first-year
wages and qualified second-year wages. For all targeted groups, the employer’s deduction for
wages is reduced by the amount of the credit.

Calculation of the credit

First-year wages.For the eight WOTC categories, the credit equals 40 percent (25
percent for employment of 400 hours or less) of qualified first-year wages. Generally, qualified
first-year wages are qualified wages (not in excess of $6,000) attributable to service rendered by
a member of a targeted group during the one-year period beginning with the day the individual
began work for the employer. Therefore, the maximum credit per employee for members of any
of the eight WOTC targeted groups generally is $2,400 (40 percent of the first $6,000 of
qualified first-year wages). With respect to qualified summer youth employees, the maximum

384


There was no intent on the part of the taxpayer or the woman to change her principal place of
abode.

Support test

In general.The support test is satisfied if the taxpayer provides over one half of the
support of the individual for the taxable year. To determine whether a taxpayer has provided
more than one half of an individual’s support, the amount the taxpayer contributed to the
individual’s support is compared with the entire amount of support the individual received from
all sources, including the individual’s own funds.”°° Governmental payments and subsidies (e.g.,
Temporary Assistance to Needy Families, food stamps, and housing) generally are treated as
support provided by a third party. Expenses that are not directly related to any one member of a
household, such as the cost of food for the household, must be divided among the members of
the household. If any person furnishes support in kind (e.g., in the form of housing), then the fair
market value of that support must be determined.

Multiple support agreements.—In some cases, no one taxpayer provides more than one
half of the support of a individual. Instead, two or more taxpayers, each of whom would be able
to claim a dependency exemption but for the support test, together provide more than one half of
the individual’s support. If this occurs, the taxpayers may agree to designate that one of the
taxpayers who individually provides more than 10 percent of the individual’s support can claim a
dependency exemption for the child. Each of the others must sign a written statement agreeing
not to claim the exemption for that year. The statements must be filed with the income tax return
of the taxpayer who claims the exemption.

Special rules for divorced or legally separated parents.—Special rules apply in the case of
a child of divorced or legally separated parents (or parents who live apart at all times during the
last six months of the year) who provide over one half the child’s support during the calendar
year°° If such a child is in the custody of one or both of the parents for more than one half of
the year, then the parent having custody for the greater portion of the year is deemed to satisfy
the support test; however, the custodial parent may release the dependency exemption to the
noncustodial parent by filing a written declaration with the irs.”

204 Rev, Rul. 66-28, 1966-1 C.B. 31.

205 Th the case of a son, daughter, stepson, or stepdaughter of the taxpayer who is a full-
time student, scholarships are not taken into account for purposes of the support test. Sec.
152(d).

206 For purposes of this rule, a “child” means a son, daughter, stepson, or stepdaughter
(including an adopted child or foster child, or child placed with the taxpayer for adoption). Sec.
152(e)(1)(A).

207 Special support rules also apply in the case of certain pre-1985 agreements between
divorced or legally separated parents. Sec. 152(e)(4).

156


Description of Proposal

The proposal extends the placed in service date for facilities that produce electricity from
wind and closed-loop biomass to include electricity from those facilities placed in service before
January 1, 2007. The proposal does not extend the placed in service date for facilities that
produce electricity from poultry waste.

The proposal expands the set of qualifying facilities to include facilities that produce
electricity from qualifying open-loop biomass and open-loop biomass (but not closed-loop
biomass) co-fired with coal. For these purposes open-loop biomass is defined as any solid,
nonhazardous, cellulosic waste material that is segregated from other waste materials and is
derived from:

qd) any of the following forest-related resources: mill residues, pre-commercial
thinnings, slash and brush, but not including old growth timber or wood waste
incidental to pulp and paper production;

(2) waste pallets, crates, and dunnage, and landscape or right-of-way tree trimmings,
but not including unsegregated municipal solid waste (garbage) and post-
consumer waste paper;

(3) agricultural sources, including orchard tree crops, vineyard, grain, legumes, sugar,
and other crop byproducts or residues.

Qualifying open-loop biomass facilities are any facility placed in service before
January 1, 2007. In the case of facilities placed in service before January 1, 2004, taxpayers are
eligible for credit for production from newly eligible sources from January 1, 2004 through
December 31, 2008 (rather than ten years of production from the date the facility was placed in
service) and the credit is equal to 60 percent of the otherwise allowable credit.

In the case of open-loop biomass co-fired with coal, qualifying facilities are any facility
placed in service before January 1, 2007. Taxpayers producing electricity from such facilities
will only be eligible to claim credit for electricity produced from newly eligible sources from
January 1, 2004 though December 31, 2006 (rather than ten years of production from the date the
facility was placed in service) and the credit will be at a rate equal to 30 percent of the otherwise
allowable credit, regardless of the amount of open-loop biomass fuel burned with the coal.

The proposal also permits a lessee to claim the credit rather than the owner of any
qualified facility for leases entered into after the date of enactment. Lastly, the proposal
modifies the current limitation on the credit allowable for projects financed with tax-exempt
financing such that the credit claimed by a taxpayer is reduced by an amount equal to the value
of the tax exemption.

Effective date—The proposal is effective on the date of enactment.

123


G. Reform the Tax Treatment of Leasing Transactions
with Tax-Indifferent Parties

Present Law

Overview of depreciation

A taxpayer is allowed to recover, through annual depreciation deductions, the cost of
certain property used in a trade or business or for the production of income. The amount of the
depreciation deduction allowed with respect to tangible property for a taxable year is determined
under the modified accelerated cost recovery system (“MACRS”). Under MACRS, different
types of property generally are assigned applicable recovery periods and depreciation methods
based on such property’s class life. The recovery periods applicable to most tangible personal
property (generally tangible property other than residential rental property and nonresidential
real property) range from 3 to 25 years and are significantly shorter than the property’s class life
which is intended to approximate the economic useful life of the property. In addition, the
depreciation methods generally applicable to tangible personal property are the 200-percent and
150-percent declining balance methods, switching to the straight-line method for the taxable year
in which the depreciation deduction would be maximized.

Characterization of leases for tax purposes

In general, a taxpayer is treated as the tax owner and is entitled to depreciate property
leased to another party if the taxpayer acquires and retains significant and genuine attributes of a
traditional owner of the property, including the benefits and burdens of ownership. No single
factor is determinative of whether a lessor will be treated as the owner of the property. Rather,
the determination is based on all the facts and circumstances surrounding the leasing transaction.

A sale-leaseback transaction is respected for Federal tax purposes if “there is a genuine
multiple-party transaction with economic substance which is compelled or encouraged by
business or regulatory realities, is imbued with tax-independent considerations, and is not shaped
solely by tax-avoidance features that have meaningless labels attached.’”*°

Recovery period for tax-exempt use property

Under present law, “tax-exempt use property” must be depreciated on a straight-line basis
over a recovery period equal to the longer of the property’s class life or 125 percent of the lease
term.“! For purposes of this rule, “tax-exempt use property” is tangible property that is leased
(other than under a short-term lease) to a tax-exempt entity.” For this purpose, the term “tax-

440 Frank Lyon Co. v. United States, 435 U.S. 561, 583-84 (1978).

441 Sec, 168(g)(3)(A). Under present law, section 168(g)(3)(C) states that the recovery
period of “qualified technological equipment” is five years.

42 Sec, 168(h)(1).

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Description of Proposal

The proposal repeals the low-income tenant qualification and substantial rehabilitation
tules for the acquisition of existing property with qualified 501(c)(3) bonds.

Effective date—The proposal is effective for bonds issued after the date of enactment.

Analysis

The current low-income tenant rules to qualified 501(c)(3) bonds resulted from
Congressional concern that qualified 501(c)(3) bonds were being used in lieu of exempt facility
bonds to avoid the low-income tenant rules applicable to exempt facility bonds. The Ways and
Means Committee report noted:

The Committee has become aware that, since enactment of the Tax Reform Act of
1986, many persons have sought to avoid the rules requiring that, to qualify for
tax-exempt financing, residential rental property serve low-income tenants to a
degree not previously required. The most common proposals for accomplishing
this result have been to use qualified 501(c)(3) or governmental bonds to finance
rental housing. Frequently, the proposals have involved the mere churning of
“burned-out” tax shelters with the current developers remaining as project
operators under management contracts producing similar returns to those they
received in the past. The committee finds it anomalous that section 501(c)(3)
organizations--charities--would attempt in these or any other circumstances to
finance with tax-exempt bonds rental housing projects that serve a more affluent
population group than those permitted to be served by projects that qualify for
tax-exempt exempt-facility bond financing.'

In conference, the applicability of the low-income tenant rules was limited to the
acquisition of existing property." + It has been argued that the disparity in the treatment of
existing facilities versus new facilities causes complexity. Some degree of simplification might
be achieved through the elimination of the low-income tenant rules. Nonetheless, some might
argue that the concerns that prompted the application of the low-income tenant tules to existing
property would once again arise upon removal of these limitations.

There have been reports that there is a shortage of affordable rental housing. By
removing the restrictions on existing property, some might argue that charities would not be
inclined to serve low-income tenants to the same degree. Proponents of the restrictions might
argue that charities, in particular, should provide affordable housing to low-income persons as
part of their charitable mission to serve the poor and distressed.

153 HER. Rep. No. 100-795 at 585 (1988). The report also noted: “The press has reported
housing industry representatives stating publicly that a primary attraction of some housing
financed with governmental and qualified 501(c)(3) bonds is that the low-income tenant
requirements and State volume caps applicable to for-profit developers do not apply.” Id.

'S4 HR. Conf. Rep. 100-1104, vol. I at 126 (1988).

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Contributions to individual development accounts by individuals are not deductible and
earnings thereon are taxable to the account holder. Matching contributions and earnings thereon
are not taxable to the account holder.

The proposal permits individuals to withdraw amounts from an individual development
account for qualified expenses of the account owner, owner’s spouse, or dependents.
Withdrawals other than for qualified expenses (“nonqualified” withdrawals) may not be made
from the portion of the accounts attributable to the matching contributions before the account
owner attains age 61. In addition, nonqualified withdrawals from the portion of the account
attributable to the individual contributions may result in forfeiture of some or all of the amounts
attributable to matching contributions. Qualified expenses include qualified: (1) higher
education expenses (as generally defined in section 529(e)(3); (2) first-time homebuyer costs (as
generally provided in section 72 (t)(8); (3) business capitalization or expansion costs
(expenditures made pursuant to a business plan that has been approved by the financial
institution, nonprofit, or Indian tribe); (4) rollovers of the balance of the account (including the
parallel account) to another individual development account for the benefit of the same owner,
and (5) final distributions in the case of a deceased account owner. Withdrawals for qualified
home and business capitalization expenses must be paid directly to another financial institution.
Withdrawals for qualified educational expenses must be paid directly to the educational
institution. Such withdrawals generally are not permitted until the account owner completes a
financial education course offered by a qualified financial institution, qualified nonprofit
organization, qualified Indian tribe or governmental entity. The Secretary of the Treasury (the
“Secretary”) is required to establish minimum standards for such courses. Withdrawals for
nonqualified expenses may result in the account owner’s forfeiture of some amount of matching
funds.

The qualified entity administering the individual development account program is
generally required to make quarterly payments of matching funds on a dollar-for-dollar basis for
the first $500 contributed by the account owner in a taxable year. This dollar amount is adjusted
for inflation after 2005. Matching funds may be provided also by State, local, or private sources.
Balances of the individual development account and parallel account are reported annually to the
account owner. If an account owner ceases to meet eligibility requirements, matching funds
generally are not contributed during the period of ineligibility. Any amount withdrawn from a
parallel account is not includible in an eligible individual’s gross income or the account
sponsor’s gross income.

Qualified entities administering a qualified program are required to report to the
Secretary that the program is administered in accordance with legal requirements. If the
Secretary determines that the program is not so operated, the Secretary has the power to
terminate the program. Qualified entities also are required to report annually to the Secretary
information about: (1) the number of individuals making contributions to individual
development accounts; (2) the amounts contributed by such individuals; (3) the amount of
matching funds contributed; (4) the amount of funds withdrawn and for what purpose;

(5) balance information; and (6) any other information that the Secretary deems necessary.

The Secretary is authorized to prescribe necessary regulations, including rules to permit
individual development account program sponsors to verify eligibility of individuals seeking to

39


proposing a specific set of measures.°°’ Consequently, no detailed policy or complexity analysis
is appropriate with respect to the submission.

Prior Action

In July 2002, Mr. Thomas, Chairman of the House Committee on Ways and Means,
introduced H.R. 5095, the “American Competitiveness and Corporate Accountability Act of
2002.” Among other provisions, H.R. 5095 provided for repeal of the ETI regime, accompanied
by a number of changes to the U.S. international tax rules.

The President’s Fiscal Year 2004 Budget Proposal outlined general principles that should
govern the U.S. response to the FSC/ETI decisions of the WTO and proposed that the repeal of
the ETI regime should be accompanied by other changes to the U.S. international tax rules.

In April 2003, Representatives Phillip Crane and Charles Rangel, House Ways and
Means Trade Subcommittee chairman and the Committee on Ways and Means’s ranking
member, respectively, introduced H.R. 1769. The bill provided for the repeal of the ETI regime,
accompanied by a deduction relating to income attributable to United States production
activities.

In July 2003, Mr. Thomas introduced H.R. 2896, the “American Jobs Creation Act of
2003.” Among other provisions, H.R. 2896 generally provided for the repeal of the ETI regime,
accompanied by a number of business tax law changes and a number of changes to the U.S.
international tax rules. In October 2003, the Committee on Ways and Means reported H.R.
2896, as modified, out of committee. As modified, the bill also provided for a reduced corporate
income tax rate for domestic production activities.

In September of 2003, Senators Grassley and Baucus, Chairman of the Senate Committee
on Finance and the committee’s ranking member, respectively, introduced S. 1637, the
“Jumpstart our Business Strength Act.” Among other provisions, S. 1637 provided for the repeal
of the ETI regime, accompanied by several business tax law changes, several U.S. international
tax law changes, and a deduction relating to income attributable to United States production
activities. In October 2003, the Senate Committee on Finance reported H.R. 2896, as modified,
out of committee.

657 The President’s budget also contains proposals for the permanent extension of
increased expensing for small businesses (sec. I. B), the extension of the research and
experimentation tax credit (sec. VIII. B.), and the extension of the waiver on the use of net
operating losses under the alternative minimum tax (sec. VIII. J).

416