Joint Committee Report JCS-7-79: General Explanation of the Revenue Act of 1978

The Congress believes that it is unrealistic to expect Federal spending not to grow as the economy and population grow and that some growth in real outlays beyond the rate of inflation is also to be expected. The Congress believes that it is unrealistic and economically irresponsible first to cut taxes and hope that this will then lead to expenditure reductions. The Congress also believes that making tax reductions automatic upon the achievement of spending goals several years in the future is excessively restrictive and ignores the uncertainties concerning the economic situation that far in advance which may necessitate different policies.

The Congress concluded that the best way to deal with these competing considerations is to make a firm statement of congressional policy concerning expenditure restraint and to combine this with a statement of congressional intent to company expenditure restraint with future tax reductions.

(secs. 101 and 106 of the Act and secs. 1, 21, 63, and 1302 of the Code)

Individual tax rates ranged up to 70 percent on taxable income in excess of $203,200 for joint returns ($102,200 for single returns). Table 3 shows the tax brackets and rates for joint returns under prior law and under the Act. Under prior law, there were 25 tax brackets.

Prior law also provided different rate schedules for single taxpayers, heads-of-households, married couple filing separately, and estates and trusts.

The Congress believed that tax reductions should be focused on those income groups that had not benefited a great deal from previous tax cuts and that were particularly hard hit by the recent inflation-induced and social security tax increases, namely, the middle- and upper-middle-income groups. Tax rate changes are a way to benefit these groups.

In the past, Congress has used the standard deduction (the minimum standard deduction) and the personal exemption to establish a tax-free income level approximating the poverty income level. This policy began with the Revenue Act of 19644. The Congress believed that a tax-free income level for married persons somewhat higher than the poverty level is needed in 1979 to offset recent increases in food and other consumer prices.

The extent to which the zero bracket amount and the personal exemption determine a tax-free income level and the extent to which the tax-free level compares with projected poverty levels are shown for various taxpayers in table 1. For example, under prior law, the tax-free income level for a married couple was $5,200. This amount is the sum of the $3,200 zero bracket amount plus two $750 personal exemptions plus two $35 general credits (which is equivalent to two $250 personal exemptions at the 14-percent income tax rate). With the increase in the zero bracket amount to $3,400, the tax-free income level will be $5,400 in 1979. This amount is the sum of the $3,400 zero bracket amount and the two $1,000 personal exemptions. (The $35 general tax credit expired at the end of 1978.) This compares with the projected poverty income levels of $4,621 in 1979 and $5,291 in 1981 for a married couple without dependents.

  TABLE 1.--TAX-FREE INCOME LEVELS UNDER PRIOR LAW AND THE ACT

² Without regard to the earned income credit.

Increase in zero bracket amount

The first change from present law is the increase in the zero bracket amount in the joint return schedule from $3,200 to $3,400. The increase is from $2,200 to $2,300 for single persons and heads-of-households, or one-half as much as for married couples, to avoid increasing the marriage tax penalty. For married persons filing separate returns, the increase is from $1,600 to $1,700.

Because the zero bracket amount, in effect, builds the old standard deduction into the tax rate schedule, it is necessary to permit itemizers to claim only those itemized deductions in excess of that amount if they are to be able to use the same tax rate schedule as nonitemizers. Otherwise, they would, in effect, get their itemized deductions plus the standard deduction amount. Thus the Act also increases the present floor under itemized deductions by $200 for joint returns, and $100 for single, head of household, and separate returns.

The increase in the zero bracket amount will cause 1.3 million returns to shift from itemizing deductions.

The benefits from the increase in the zero bracket amount are concentrated in the lower income ranges. Table 2 shows that more than 29 percent of the tax reduction from the increase in the zero bracket amount goes to returns with incomes under $10,000 and 73.2 percent to those with incomes below $20,000.

       TABLE 2.--TAX REDUCTION FROM INCREASED ZERO BRACKET AMOUNT,

² As a percent of positive liability before offset for the refundable portion of the earned income credit.

³ Less an $500,000 or less than .05 percent.

NOTE.--Details may not add to totals because of rounding.

The Act includes a technical amendment to the income averaging provisions (sec. 1302) relating to the addition of the zero bracket amount to base period income for years before the adoption of the zero bracket system (i.e., pre-1977). The Act specifies that the zero bracket amount to be added to base period taxable income is not to be the new, higher zero bracket amount but is to remain at the prior level (i.e., $3,200 for joint returns, $2,200 for single individuals and single heads of household and $1,600 for married individuals filing separately).

Widening of tax brackets

A new tax rate schedule is provided with only 15 brackets for joint returns and 16 for single taxpayers, a reduction from the 25 brackets of prior law. Consequently the size of the remaining brackets is increased, particularly in the upper brackets, as shown in table 3. In addition four tax rates are reduced by one or two points as indicated by an asterisk on that table. In the upper income brackets, some rates are decreased and some are increased, but direct comparison to prior law is difficult because of the change in size of taxable income brackets. (The new individual income tax rate schedules under the Act for joint returns, heads of households, unmarried individuals, married individuals filing separate returns, and for estates and trusts are shown in the Appendix.)

  TABLE 3.--TAX RATE SCHEDULE UNDER PRIOR LAW AND THE

* Reduction from prior rates.

Table 4 below shows the effect of increasing the zero bracket amount (which was shown separately in table 2 above) plus the reduction from widening the tax brackets and reducing tax rates. The effect of widening brackets and cutting tax rates by itself can be obtained by subtracting the tax reductions in table 2 from these reductions. This shows that the benefits of the bracket widening and rate reductions are concentrated in the income ranges of $10,000 to $50,000, which receive 79 percent of the total tax reduction of 9.3 billion.

 TABLE 4.--TAX REDUCTION FROM WIDENING TAX BRACKETS, RATE CUTS,

² As a percent of positive liability before offset for the refundable portion of the earned income credit.

Note.--Details may not add to totals because of rounding.

The Act specifically applies the rules for rate changes of fiscal year taxpayers (sec. 21 of the Code) to allow these taxpayers the benefits of the rate cuts and the increase in the zero bracket amount (as well as the increase in the personal exemption) for that part of their fiscal year which falls in 1979. In addition, the expiration of the general tax credit is treated as a change in the rate of tax. Under this provision, fiscal year taxpayers are to compute their tax liability for their full year both under 1978 law and 1979 law with respect only to the provisions listed. The difference in these two amounts is then to be prorated over the fiscal year, and the tax reduction is allowed to the extent of the amount of the fiscal year falling in 1979.

The section 21 proration rule for fiscal year taxpayers (sec. 106 of the Act) is made available only for the changes listed above in the case of individuals (those changes made by sec. 101 and 102 of the Act, and the expiration of the general tax credit) and for the corporate rate changes made by section 301 of the Act. Any gain in equity that might result from making the section 21 rule broader is outweighed by the additional complexity that would be created for forms, instructions, and taxpayers.

2. Increase in the Personal Exemption

(sec. 102 of the Act and secs. 151 and 6013(b)(3) of the Code)

Under both prior and present law, an additional personal exemption is provided for a taxpayer who is blind or age 65 or over.

The Congress concluded that an appropriate adjustment in the tax structure (in conjunction with the increase in the earned income credit, the increase in the zero bracket amount, and the tax bracket and rate changes discussed above) was to increase the personal exemption from $750 to $1,000. This is intended as a replacement for the temporary general tax credit, which was permitted to expire at the end of 1978. This change (along with the tax rate and bracket changes) was designed to focus relief primarily on taxpayers who have been moved rapidly up the tax rate schedule due to inflation, particularly those with larger families where the increase in the cost of living has had the most severe impact.

The $35 per exemption credit provided by the general tax credit was the equivalent of an additional $250 worth of personal exemption at the bottom tax rate (14% x $250 = $35). Therefore, the substitution of the $250 exemption increase for the credit will not increase the taxes of lower-income taxpayers and will result in a tax decrease for those whose income is taxed at a rate higher than 14 percent and who elected the $35 credit rather than the 2-percent alternative credit. It does not affect the tax-free income level.

While no taxpayers will experience a tax increase as a result of the replacement of the $35 per exemption credit by a $250 exemption increase, some taxpayers who elected the 2-percent-of-taxable-income alternative credit will have a tax increase which will not be offset by the rate changes in the Act. These are almost entirely single persons or married couples with no dependents who itemize their deductions. (For nonitemizers, the increase in the zero bracket amount prevents virtually any tax increases.) The overall effect of these changes is that only 109,000 taxpayers or about one-tenth of one percent of the total, will experience a tax increase from the combination of these three provisions.

The Congress was also concerned about two other aspects of the general tax credit which contributed to the conclusion that a $250 increase in the personal exemption would be preferable. First, the general tax credit was an additional provision. Although most taxpayers did not have to compute it because it had been built into the tax tables, it was a source of complexity. Some taxpayers who cannot use the tax tables (generally because their income is in excess of $20,000 for single persons and $40,000 for joint returns) had to compute the credit.

The existence of the general tax credit for even a few taxpayers required 7 lines on the tax computation schedule (schedule TC) out of the 11 lines used for the tax computation. It also required an explanation in both the regulations and instructions.

Second, the 2-percent alternate credit increased the marriage tax penalty that often results when two single persons with fairly equal earnings marry each other. Because single persons and joint returns were each limited to a maximum credit of $180, a total of $360 for the two single taxpayers, they lost as much as $180 of general tax credit when the married. The desire to reduce the marriage penalty resulting from the general tax credit is what necessitated many of the tax increases for single persons.

Substitution of the $1,000 personal exemption for the general tax credit changes tax liabilities of taxpayers with different incomes by different amounts. The effect of the change by income class is shown in Table 5 below. The tax increases shown result from the loss of the 2 percent of taxable income credit. These increases generally are offset by the rate cuts.

  TABLE 5.--TAX CRHANGE FROM SUBSTITUTING A

NOTE.--A negative number indicates a tax increase.

As discussed above in relation to the rate cuts, the Act applies the rules for rate changes of fiscal year taxpayers (sec. 21 of the Code) to allow these taxpayers the benefits of the personal exemption (as well as the rate cuts and increase in the zero bracket amount) for that part of their fiscal year which falls in 1979.

3. Changes in Filing Requirements and Withholding Changes

(secs. 101 and 102 of the Act and secs. 6012(a) and 3402(b) and (m) of the Code)

These amounts represented the zero bracket amount of $2,200 for single persons and heads of household and $3,200 for joint returns plus $750 for each personal exemption. (The filing requirements did not reflect the temporary general tax credit.) For each additional exemption resulting from the taxpayer or his spouse being age 65 or over, these amounts were increased by $750. Thus, a single person age 65 or over did not need to file until his or her income was $3,700 or more; a married couple, both under age 65, $4,700 or more; a married couple with only one spouse age 65 or over, $5,450 or more; and a married couple with both spouses age 65 or over, $6,200 or more.

The withholding schedules reflected the prior law tax rates, the zero bracket amount, the amount of the personal exemption, and the general tax credit (one and 3 $35 tax credits in single and married withholding rate schedules, respectively).

The withholding rates and tables are to be changed by the Secretary of the Treasury to reflect the increase in the zero bracket amount and the personal exemption and the tax rate changes. The percentage method withholding allowances are changed in the Act to reflect the increase in the personal exemption (sec. 3402(b) of the Code). A conforming change is made in the provision under which additional withholding exemptions can be claimed for itemized deductions in excess of the zero bracket amount to reflect the increase in that amount and the amount of the personal exemption.¹

Another group of taxpayers, single persons with earnings in excess of $33,167 and married taxpayers with earnings above $75,000 will have withholding increases because the top withholding rate was increased from 36 percent to 39 percent for single persons and from 36 to 37 percent for married couples. (These income levels assume that the taxpayers claim all the withholding exemptions to which they are entitled. If they claim fewer, the increase will occur at lower levels.) Most of these people are underwithholding, so is change will reduce their estimated tax or final payment.

The Treasury also changed the daily payroll period withholding table. The daily or miscellaneous withholding rate schedule and the associated withholding wage bracket tables were previously constructed on the assumption that the taxpayer works in a situation in which there are 365 separate payroll periods each year and that the taxpayer has earnings in every one of those 365 pay periods. As a result, the vast majority of earners who are paid on the basis of a daily payroll period but who do not work every day of the year were substantially overwithheld.

The new daily tables are based on withholding allowances which assume 365 pay periods per year, as specified by the Act, and withholding allowances based on 260 pay periods a year, or 5 days per week.

4. Earned Income Credit

(secs. 103, 104, and 105 of the Act and secs. 43 and 3507 of the Code)

Earn income eligible for the credit included all wages, salaries, tips, and other employee compensation, plus the amount of the taxpayer's net earnings from self-employment. Earned income was eligible for the credit, however, only if it was includible in the gross income of the taxpayer during the taxable year in which the credit was claimed. Amounts received as compensation or annuity benefits could not be taken into account for purposes of the credit, and the credit was not available with respect to income of non-resident alien individuals that was not connected with a U.S. trade or business.

An individual was eligible for the earned income tax credit only if that individual maintained a household in the United States for himself or herself and for one or more children who were under the age of 19, were students, or were disabled dependents. Further, in order to claim the credit, the individual must not have been entitled to exclude any amounts from gross income under section 911 (relating to earned income from sources outside the United States) or section 931 (relating to income from sources within the possessions of the United States).

For purposes of the maintenance of household requirement, an individual was considered to be maintaining a household if he or she (or, if married, the individual and his or her spouse) provided over half the cost of maintaining the household (including costs attributable to children who are dependents). Maintenance expenses of a household normally included items such as property taxes, mortgage interest, rent, utility charges, upkeep and repairs, property insurance, and food consumed on the premises.

Prior law required that the earned income credit not be taken into account as income for purposes of determining eligibility for, or the amount of, benefits or assistance under any Federal program or State or local program financed in whole or in part with Federal funds.

Under prior law, the earned income credit was scheduled to expire at the end of 1978.

The Congress also considered the amount of the credits which had not changed since 1975. Since the purpose of the credit has been to provide a work incentive, the Congress believed it to be appropriate to increase the amount of the credit to take into account the increase in the cost of living during the past several years as well as current minimum wage levels. As a result, the Act increases the credit so that it is equal to 10 percent of the first $5,000 of earned income (a maximum credit of $500), which is phased out between $6,000 and $10,000 of adjust gross income (or, if higher, earned income).

Congress also examined the administrative aspects of the earned income credit with a view to making it simpler and more effective. The major concern that the Congress focused on was the time at which eligible individuals can receive the benefit of the credit. Under prior law, an individual did not receive the benefit of the credit until the end of the year when he or she filed a tax return. The Congress believed that the credit can work more effectively if an individual is able to receive it during the year while he or she is working. This provides the tax relief at a time when the individual is more likely to need it. Therefore, the Act provides for advance payments of the credit to be made by employers to eligible employees. The Congress believes that this new procedure will increase the work incentive provided by the credit.

The Act also contains modifications which make it easier for the eligible individuals to determine eligibility for, and the amount of, the credit, and for the Internal Revenue Service to be able to determine eligibility and amount of the credit from other data filed with the tax return.

Finally, the Act repeals the provision that prohibits the credit from being taken into account for purposes of determining eligibility for, or amount of, Federal benefits, or for benefits under a State or local needs-tested program financed in whole or in part from Federal funds. The Congress believed that in order for the earned income credit to be an effective incentive to work and a disincentive for being on welfare, the credit should be treated as earned income for purposes of the aid to families with dependent children and Supplemental Security Income programs.

The Act makes the earned income credit permanent, and increases the amount of the credit to 10 percent of the first $5,000 of earned income; this results in a maximum credit of $500, beginning in 1979. The Act raises the income range over which the credit phases out from between $4,000 and $8,000 of income to between $6,000 and $10,000 of income.

Simplification of the credit

For example, a taxpayer with $4,000 of earnings and $8,000 of adjusted gross income would have an earned income credit of $250, which is the lower of (a) 10 percent of $4,000, or (b) $500 minus 12.5 percent of $2,000 ($8,000 - $6,000).

Compared with prior law, the Act extends the credit to two small groups of taxpayers: (1) married couples and surviving spouses now denied the credit because the only dependent child living with them is over 18 and neither disabled nor a student, and (2) heads of household who qualify for that status on the basis of either a dependent or nondependent child in the same category. The Act denies the credit to two other small groups: (1) married couples who qualify for the credit only because they have living with them a child who does not qualify for a dependency exemption and who is under 19 or a student, and (2) heads of household and single individuals who now qualify for the credit only because they have living with them a married, nondependent child who is either under 19 or a student.

Advance payment of the credit

The Act provides that an eligible individual may elect to receive advance payment of the earned income credit from his employer. Any individual who receives advance payments during a calendar year would be liable for the excess of such payments over the actual amount of the credit, which cannot be determined until the end of the year. Conversely, individuals whose advance payments for a year are less than the actual amount will be credited with the excess of the actual credit over the advance payments.¹

An employee who believes that he is eligible for the credit may claim advance payments by providing the employer with a certificate on which the employ certifies that he expects to be eligible for the credit and that he does not have a certificate in effect with another employer, and on which the employee states whether his spouse has a certificate in effect.

The Secretary will prescribe by regulation the form and contents of the certificate.² It should contain, however, a complete description of the conditions governing eligibility for the credit.

Any certificate remains in effect for the remainder of the calendar year unless revoked or unless a new certificate takes effect. If the employee's spouse puts into effect or revokes a certificate with his employer, or the employee becomes ineligible for the earned income credit, the employee must revoke the certificate or furnish a new one.

For any employee with a certificate in effect, the employer is required to add the advance payment to the employee's paycheck. The advance payment would be reflected in the employee's W-2 form as a separate item; it would not be treated as a reduction of withholding. The amount of advance payment is to be determined from tables which take into account the amount of wages paid in the pay period and whether an employee's spouse is claiming advance payments. If the employee certifies that his spouse is not claiming advance payments, then the employer would use a table which would treat the earned income credit as less than or equal to a credit of 10 percent of the first $5,000 of earned income, phasing out (at a 12.5 percent rate) between $6,000 and $10,000 of income. If the employee certifies that his spouse is claiming advance payments, then the employer would instead use a table which would treat the earned income credit as less than or equal to a credit of 10 percent of the first $2,500 of earned income, phasing out between $3,000 and $5,000 of income.³ The use of a separate table for those employees whose spouses also are claiming payment is intended to substantially reduce the probability of advance payments for such individuals exceeding the amount to which they are ultimately entitled. In other cases where the employee believes that the advance payments may be too large because they do not take into account other income (such as unearned income or income from a second job), the employee may offset a portion of the advance payment by increasing his ordinary income tax withholding. This can be accomplished simply by reducing the number of withholding allowances he claims on his withholding certificate. Furthermore, the Treasury is given the discretion to make advance payments of less than the full amount of the credit so that it can design the tables in such a way as to minimize the number of individuals whose advance payments are more than the actual credit to which they are ultimately entitled.

The aggregate amount of advance payments which the employer makes to employees in any pay period will be treated as payments, for that pay period, of withholding taxes on all employees, the employee share of FICA taxes, and the employer share of FICA taxes. Thus, the amount of these payments which the employer will make to the Federal government will be reduced by the amount of advance payments.⁴ If the aggregate amount of advance payments exceeds the total of these payroll taxes (which could occur for employers exempt from withholding for State or local governments not subject to FICA taxes, for example), then the employer may either reduce the amounts of advance payments to all eligible employees by a uniform rate in order to eliminate the excess, or, under regulations prescribed by the Secretary of the Treasury, he may treat the excess as advance payment of any other tax imposed under the Code. Employers who fail to make advance payments to an employee who furnishes a certificate shall be subject to the same penalty which would be imposed by the Code if the employer refused to withhold the same amount.

Treatment of credit as earned income

The Act repeals the provision in current law requiring that the credit be disregarded for purposes of cash or in-kind Federal or Federally-aided assistance programs. The Congress intended that the credit should be treated as earned income for purposes of the Aid to Families with Dependent Children (AFDC) and Supplemental Security Income (SSI) programs.

This treatment applies both to the actual amount of advance payments and to the excess of the actual credit for a year over the total amount of advance payments for that year. (This excess cannot actually be received until the following calendar year.) In the case where the advance payments exceed the actual credit, so that the individual must return the difference, earned income for the purpose of these programs must be reduced by the amount of the difference.

The budget cost (reduction in receipts and increase in outlays from the refundable part) of the increase in and simplifying changes made in the credit will be $82 million in fiscal year 1979, $1,227 million in fiscal year 1980, and $900 million in fiscal year 1983.

(sec. 111 of the Act and sec. 164(a)(5) of the Code)

A taxpayer who purchased and used gasoline for nonbusiness purposes could obtain the deductible amount of State gasoline taxes from tables printed in the instructions for the Federal income tax return (IRS Form 1040).¹ The table amounts were based on mileage driven during the year, the number of cylinders in the engine, and the gasoline tax rates in each State. Two or more calculations had to be made from the tables if the tax rate in the particular State changed during the year, or if the taxpayer purchased gasoline in States having different tax rates. If an itemizer did not want to use the gasoline tax tables, or had purchased and used other motor fuels for nonbusiness purposes, he or she had to obtain and keep receipts showing the exact amounts of State and local taxes paid.

The Congress also believes that the availability of this deduction places recordkeeping burdens on those taxpayers who keep receipts for all motor fuel purchases (as is required except for State gasoline taxes) or keep records as to miles driven; and if the taxpayer fails to keep such records, the amounts claimed may be based on guesswork. In addition, the deduction (which is claimed by virtually all itemizers) presents audit difficulties for the Internal Revenue Service, since there is no ready way of gauging the correctness of the amount claimed from data on the return or from easily obtainable records, or of verifying mileage claims made by taxpayers using the gasoline tax tables. Accordingly, repeal of the deduction will help achieve tax simplification for taxpayers and will reduce audit problems for the IRS. Also, the average amount of tax savings to itemizers resulting from the deduction is relatively small.

In addition, the Congress believes that, in view of the pressing national need to conserve energy and reduce oil imports, the Federal Government should not, in effect, partially subsidize nonbusiness consumption of motor fuels through a deduction for State-local taxes on such fuels. The repeal of this deduction, therefore, is an indication that the Congress is concerned with gasoline consumption.

2. Tax Treatment of Unemployment Compensation

(sec. 112 of the Act and new secs. 85 and 6050B of the Code)

In addition to these programs, the Internal Revenue Service has held that in certain circumstances benefits received as a substitute for unemployment compensation pursuant to state unemployment disability plans are excluded from gross income as unemployment compensation.²

In contrast to its rulings on unemployment compensation benefits paid under government programs, however, the Internal Revenue Service consistently has held that unemployment compensation benefits paid under private plans are taxable to the extent that they exceed the recipient's prior contributions.³

The base amount is $25,000 in the case of a married individual filing a joint return; zero in the case of a married individual filing a separate return, unless he or she lived apart from his or her spouse for the entire taxable year; and $20,000 in the case of all other individuals.⁴ The base amount is zero for married individuals filing separate returns because the Congress believes that the family should be treated as an integral unit in determining the amount which is includible under this provision. If a married taxpayer files a separate return, which includes only his or her own income and not his or her spouse's, the taxpayer should not be entitled to a higher base amount.

In determining the amount of disability income which may be excluded from adjusted gross income under section 105(d), the portion of unemployment compensation which is included in gross income under this provision is taken into account as part of the taxpayer's adjusted gross income for purposes of the phaseout of the exclusion of disability income when adjusted gross income exceeds $15,000.

For purposes of this provision, "unemployment compensation" means any amount received under a law of the United States or of a State which is in the nature unemployment compensation. Unemployment compensation programs are those designed to provide benefits to normally employed workers during periods of unemployment. An illustrative but not necessarily all-inclusive list of unemployment insurance programs is as follows: (1) Federal-State Regular Unemployment Insurance Program, (2) Federal-State Extended Unemployment Insurance Program, (3) Unemployment Compensation Program for Federal Civilian Employees, (4) Unemployment Compensation Program for Ex-Servicemen, (5) Railroad Unemployment Insurance Program, (6) Trade Readjustment Assistance pursuant to the Trade Act of 1974, (7) Redwood National Park Employee Protection Program, (8) Employee Protection Program under the Airline Deregulation Act of 1978, and (9) Unemployment Compensation under the Disaster Relief Act of 1974.

The definition of unemployment compensation covered by this provision also includes disability benefits paid under Federal or State law as a substitute for unemployment benefits to individuals who are ineligible for unemployment benefits because they are disabled.⁵ However, workmen's compensation or benefits in the nature of workmen's compensation are not unemployment compensation and will continue to be totally excludible from income under section 104(a)(1) of the Code. Benefits paid under private supplemental unemployment benefit plans will continue to be includible in gross income to the extent that they exceed the employee's prior contributions.

Under some government unemployment compensation programs, employees are required to make contributions based on their wages. If the taxpayer is not allowed a deduction for a contribution, then the benefits of such programs are not to be considered in the calculations made under this provision until an amount equal to the total nondeductible contributions has been received by the taxpayer.

Finally, the Act requires every person who makes payments of unemployment compensation aggregating $10 or more to any individual during any calendar year to make a return, according to forms or regulations prescribed by the Secretary, setting forth the aggregate amount of such payments and the name and address of the individual to whom paid. Also, every person who is required to make such a return must furnish to each individual whose name is set forth in the return a written statement showing (1) the name and address of the person making the return, and (2) the aggregate amount of payments to the individuals as shown on the return. No statement is required to be furnished to any individual unless the aggregate amount of payments to the individual is $10 or more.

3. Political Contributions

(sec. 113 of the Act and sec. 41 of the Code)

Alternatively, a taxpayer could elect an income tax credit equal to one-half of such political and newsletter fund contributions, but not more than $25 ($50 in the case of a joint return) (sec. 41). The credit could not exceed the taxpayer's income tax liability as reduced by the sum of any credits claimed for foreign taxes, for the elderly, and for investments in certain property.¹ An individual who did not itemize deductions could utilize the tax credit.

If an individual itemized deductions and made political contributions of $50 or less ($100 or less on a joint return), the credit generally would result in a greater tax benefit than the deduction, unless the contributor's marginal tax bracket was 50 percent or higher. For contributions of $100 or more ($200 or more on a joint return), the deduction (if the taxpayer itemizes) would result in a greater tax benefit than the credit, unless the contributor's tax bracket was less than 25 percent. To determine whether the credit or deduction would produce the greater tax benefit if a $50-$100 contribution was made ($100-$200 in the case of a joint return), taxpayers would have to calculate their tax both ways. The result depended on the amount of the contribution, other items on the return, and the taxpayer's marginal income tax bracket.

However, the availability of an itemized deduction for political or newsletter fund contributions, as an alternative to the credit available for such contributions, results in complications by requiring additional lines on the income tax return (IRS Form 1040), and additional instructions for the return. As a practical matter, the deduction-credit alternative may compel many taxpayers to calculate their tax liability both ways to determine which option would produce the greater tax benefit.

To further expand individual participation in the electoral process, through the encouragement of political contributions, and to simplify the tax system, the Congress believed that it was appropriate to increase the maximum amount of the credit for political contributions, and to repeal the alternative deduction.

4. Child Care Credit for Payments to Related Individuals

(sec. 121 of the Act and sec. 44 of the Code)

The 1976 Act replaced the deduction with a nonrefundable credit equal to 20 percent of household and dependent care expenses incurred to care for a dependent child under the age of 15 or for an incapacitated dependent or spouse. The maximum tax credit for one year's qualifying expenses is $400 for one dependent and $800 for two or more dependents (sec. 44A of the Code).

The credit was allowed for amounts paid to a relative only if (1) neither the taxpayer nor the taxpayer's spouse was entitled to treat the relative as a dependent for whom a personal exemption deduction could be claimed, and (2) the services provided by the relative constituted "employment" as that term is defined for purposes of social security taxes (sec. 44A(f)(6)).

For social security tax purposes, child care or other domestic services performed in the taxpayer's home by the taxpayer's parent generally do not constitute "employment" (sec. 3121(b)(3)(B)). Also, services by the taxpayer's parent which are not performed in the course of the taxpayer's trade or business generally do not constitute employment, whether or not performed in the taxpayer's home. The Congress understood that the Internal Revenue Service took the position that child care services performed in a grandparent's home are not performed in the course of the taxpayer's trade or business. Under this view, both child care services performed by a grandparent in the taxpayer's home and child care services performed by a grandparent in the grandparent's home generally would not constitute "employment," and hence payments for such services would not qualify as expenses eligible for the child care credit.

However, services performed by a grandparent in caring for a child (living in the taxpayer's home) who is either under 18 or who is mentally or physically incapacitated may constitute "employment" if the taxpayer is a surviving spouse or is divorced and not remarried, or if the taxpayer has a mentally or physically incapacitated spouse who is unable to care for the child (sec. 3121(b)(3)(B)). In these circumstances, payments for child care services performed by the child's grandparents may have been eligible for the child care credit.

Services performed for the taxpayer by other relatives (other than by the taxpayer's child if under age 21) may constitute "employment" under the social security tax rules if a bona fide employer-employee relationship exists. Therefore, payments to these relatives may have qualified for the child care credit if neither the taxpayer nor the taxpayer's spouse could claim a personal exemption deduction for the relative.

The Act does not affect the rule of present law that disallows the child care credit for amounts paid to a relative (including amounts paid to a child or to a parent of the taxpayer for whom the taxpayer or the taxpayer's spouse could claim the deduction for personal exemptions for dependents. It does not matter for this purpose whether the taxpayer or spouse in fact actually claims the dependency exemption deduction on a tax return; the credit is denied if either spouse could have claimed the deduction for the relative. As a result, no credit would be allowed for otherwise qualifying amounts paid by a taxpayer for child care services performed by a grandparent of the child if either the taxpayer or the taxpayer's spouse, for the year in which such services are performed, could claim a personal exemption deduction for the grandparent.

The Act provides that the credit is not allowed for amounts paid by the taxpayer to his or her child (including a stepchild) for child care services if the child being paid is under the age of 19 as of the close of the year in which the services are performed. The credit is not allowed for any such payments to the child under 19 whether or not either the taxpayer or the taxpayer's spouse could claim a personal exemption deduction for the child being paid for child care services. If the taxpayer's child is 19 or over by the end of the year, payments for child care services performed by the child qualify for the credit only if neither the taxpayer nor the taxpayer's spouse could claim a personal exemption deduction for the child performing the services.

The Congress intends that amounts paid by a taxpayer to his or her spouse to care for the taxpayer's child (including a stepchild) do not qualify for the child care credit. Because parents have the duty of caring for their children, it would be inappropriate to permit the credit for payments between spouses for child care.

(sec. 131 of the Act and sec. 457 of the Code)

In addition, under certain conditions, a taxpayer is required to treat the receipt of noncash benefits as income. Under the cash method, a taxpayer is required to report any item of income that is received in cash or in the form of a "cash equivalent." (Treas. Regs. secs. 1.61-2(d) 1.446-1(a)(3), and l.446-1(c)(1)(i).)

If property transferred as compensation is subject to a substantial risk of forfeiture and is nontransferable, rules are provided which defer income inclusion until the property first becomes transferable or not subject to a substantial risk of forfeiture (sec. 83). The same general rules which apply to the transfer of property in connection with the performance of services generally apply to funded, nonqualified, deferred compensation arrangements (sec. 402(b)).

In applying the constructive receipt and cash equivalent doctrines to deferred compensation, an unsecured promise to make a future payment, not represented by a note, is not an item of gross income under the cash receipts and disbursements method.¹ Further, some courts have held that neither the constructive receipt doctrine nor the cash equivalent doctrine applies to a taxpayer merely because the taxpayer agreed with the payor in advance to receive compensation on a deferred basis rather than currently, as long as the agreement was made before the taxpayer had obtained an unqualified and unconditional right to the income.²

In 1960, the Internal Revenue Service published Revenue Ruling 60-31³ which set forth a broad policy statement regarding the application of the constructive receipt and cash equivalent doctrines to nonqualified deferred compensation arrangements.⁴ Revenue Ruling 60-31 set forth a number of principles regarding the constructive receipt and cash equivalent doctrines and then provided five examples of their application to deferred compensation arrangements.

The five examples set forth in the ruling made it clear that the constructive receipt and cash equivalent doctrines would not be applied to certain deferred compensation arrangements between an employee and an employer even though the employee might have obtained an agreement from the employer to make an immediate cash payment following the performance of services. Subsequent published rulings continued to confirm that the constructive receipt and cash equivalent doctrines would not be applied merely because an employee was permitted to elect, before the compensation was earned, to defer the compensation to a later time or receive it currently. In addition, some of these subsequent rulings indicated that a cash method employee would not be considered to have current income even though the employer set aside assets to fund its obligation to pay deferred compensation, as long as the employee did not acquire a present interest in either the amounts deferred or the assets used as the employer's funding medium.⁵

In 1972 the Internal Revenue Service issued the first favorable private letter ruling with respect to an unfunded deferred compensation arrangement where a State or local government unit was the employer.⁶ Subsequently, many States and local governments have obtained private rulings with respect to their deferred compensation plans which provide that participating employees who use the cash method will include in income benefits payable under the deferred compensation plan only in the taxable year in which such benefits are received or otherwise made available.

In Apri1 1977, the Internal Revenue Service stopped issuing private rulings dealing with the income tax treatment of individuals under unfunded deferred compensation plans of the type typically established by State and local governments, and began advising applicants for rulings that their applications would be delayed pending study. (The plans involved permitted individuals to elect to defer a portion of salary that would otherwise be payable.) Later, the Service publicly announced⁷ the suspension pending a review of the area.

After completion of its review of this area, the Internal Revenue Service issued proposed regulations⁸ which provide generally that, if under a plan or arrangement (other than a qualified retirement plan), payment of an amount of a taxpayer's fixed, basic, or regular compensation is deferred at the taxpayer's individual election to a taxable year later than that in which the amount would have been payable but for the election, the deferred amount will be treated as received in the earlier taxable year. These proposed regulations would have applied to plans maintained by State and local governments, as well as plans maintained by tax-exempt organizations and taxable employers.

Although the Congress did not believe that State and local government employees should be totally prohibited from participating in unfunded deferred compensation plans, it concluded that limitations should be imposed on the amounts of compensation that can be deferred under these arrangements and allowed to accumulate on a tax-deferred basis. Accordingly, the Congress concluded that a percentage-of-compensation limit on amounts that can deferred, as well as an absolute dollar limitation to prevent excessive deferrals by highly compensated employees, was necessary.

In general

Amounts of compensation deferred by a participant in an eligible State deferred compensation plan, plus any income attributable to the investment of such deferred amounts, will be includible in the income of the participant or his beneficiary only when it is paid or otherwise made available. For this purpose, the fair market value of any property (including an annuity contract or a life insurance policy) distributed to the participant from the plan will be includible in income. Amounts deferred are not "made available" solely by reason of the fact that an individual can elect, prior to the time he obtains an unconditional right to receive an amount of compensation, to defer some portion of it until a future date. In addition, amounts will not be considered "made available" merely because the participant is permitted to choose among various options that the plan may provide for the investment of deferred amounts, or to elect, prior to the earliest distribution date provided under the plan, the manner in which deferred amounts are to be paid.⁹ (However, because the Congress was concerned with preserving salary-reduction deferred compensation plans as a means of providing retirement income for employees of States and local governments and not as a means of deferring the receipt of income indefinitely, it is anticipated that the Secretary of the Treasury will prescribe rules concerning the time by which distributions must begin to be made from a plan and the length of time over which such payments can be spread.) Of course, if a participant actually assigns or alienates his benefit under a plan, the benefit is made available to him.

If life insurance is purchased with some, or all, of the amounts deferred under the plan, the cost of current life insurance protection will not be considered made available as long as the organization maintaining the plan (1) retains all of the incidents of ownership of the policy, (2) is the sole beneficiary under the policy, and (3) is under no obligation to transfer the policy or to pass through the proceeds of the policy, as such, to the participant or a beneficiary of the participant. However, if the plan provides a death benefit, whether or not funded by the employer through the purchase of life insurance on the participant, any such death benefit will not qualify for exclusion from gross income as life insurance proceeds under section 101(a) of the Code. Instead, it is intended that any death benefit will be taxed in accordance with the deferred compensation rules to the recipient.

Plan requirements

To qualify as an eligible State deferred compensation plan, the plan must be maintained by a State, a political subdivision of a Sate, an agency or instrumentality of a State or one of its political subdivisions, or a tax-exempt rural electric cooperative or one of its tax-exempt affiliates and must limit participation to individuals who perform services for it (i.e., partnerships and corporations cannot be participants).¹⁰ In addition, the plan by its terms must not allow the deferral of more than $7,500, or 33-1/3 percent of the participant's includible compensation for the taxable year, whichever is less.

Includible compensation (rather than gross compensation) was used in determining the percentage of an employee's compensation that may be deferred because of the necessity of coordinating with the provisions of section 403(b) which also are based on includible compensation. In addition, there may be contractual deferred compensation arrangements where only includible compensation is readily determinable. For example, if a consultant agrees to provide service to a State agency for one year in return for current payments of $25,000 plus payments of $5,000 per year for an additional five years, such payments to begin after a period of ten years, it is clear that includible compensation is $25,000, but until the present value of the right to receive the additional $5,000 per year for 5 years is determined, compliance with the percentage limitation cannot be determined. (See discussion in Present value of compensation below.) Also, from the terms of the contract it generally would not be possible to tell how much compensation the consultant could have received in the year the services were performed ("gross compensation") but for the agreement to take periodic payments beginning at a later date.

For most employee-participants in the typical deferred compensation arrangement maintained by States or local governments, the determination of the permissible amount of deferral will not be burdensome since the compensation to be received for a particular year will be fixed by statute or contract and the employee will enter into a salary-reduction agreement with the employer that will specify how much is to deferred. In the typical arrangement, the 33-1/3 percent-of-includible-compensation limitation is equal to 25 percent of the compensation that would be received but for the salary reduction agreement. For example, an employee who is scheduled to receive $12,000 during a taxable year could enter into a salary-reduction agreement and elect to defer $3,000 (25 percent of gross compensation of $12,000 and 33-1/3 percent of includible compensation of $9,000).

An eligible State deferred compensation plan may provide a limited "catch-up" provision for any, or all, of the last three taxable years of a participant ending before the normal retirement age specified by the plan (or if no normal retirement age is specified by the plan, then either the later of the normal retirement age specified in any other retirement plan maintained by the sponsoring entity or age 65.) Under the catch-up provision, in addition to the amount that may be deferred under the usual $7,000 and 33-1/3-percent-of-includible-compensation limitations, a participant may defer an additional amount equal to any deferral limitations not utilized for prior taxable years in which the participant was eligible to participate in the plan (even if nothing was deferred) and was subject to the deferral limitations imposed by the Act. (Thus, taxable years of participants beginning before December 31, 1978 may not be utilized for purposes of determining any catch-up deferral permitted.) The maximum amount that can be deferred in any taxable year through the utilization of both the normal deferral limitation and the catch-up provision is $15,000. (Of course, the deferred amount also cannot exceed the amount of the participant's compensation from the State, etc.) For example, a 62-year-old participant in a plan with a normal retirement age of 65 who is scheduled to receive a salary of $20,000 during the next taxable year, could elect to defer $15,000 of that compensation if the prior year's deferral limitations have been underutilized by at least $10,000. (The regular limitation is $5,000 ($20,000 minus $5,000 deferral) divided by 3 equals $5,000; the catch-up amount is $10,000 ($15,000 minus $5,000).) As illustrated, the current year's deferral limitation based on includible compensation is determined without regard to the catch-up deferral.

The underutilized deferral limitation for a taxable year is the difference between compensation actually includible in income for that year and compensation that would have been includible in income if the maximum deferral limitation had been utilized. For example, an individual with a salary of $20,000 who did not elect to defer any compensation would have an underutilized deferral limitation of $5,000 ($20,000 minus $15,000 (includible compensation if the 33-1/3 percent deferral limitation had been utilized)). In calculating the underutilized deferral limitation, the participant must use the actual plan limitations if they are less than the limitations provided by the Act.

In addition to providing limitations on amounts of compensation that can be deferred, the Act provides that the plan must not permit participants to defer compensation for a calendar month unless an agreement providing for such deferral has been entered into before the beginning of such month.

An eligible State deferred compensation plan cannot make benefits available to participants before the earlier of (1) separation from service with the sponsoring entity,¹¹ or (2) the occurrence of an unforeseeable emergency. While the Secretary of the Treasury is to prescribe regulations defining what constitutes an unforeseeable emergency, it is not intended that such term would include the purchase of a home or the need for funds to send children to college. In addition, it is expected that plans will permit the withdrawal of only the amount of funds reasonably needed to satisfy the emergency needs.

Finally, for a deferred compensation plan to be eligible under the Act, all amounts of compensation deferred under the plan, all property or rights to property (including rights as a beneficiary of life insurance protection) purchased with the amounts deferred, and any income earned on property purchased with amounts deferred must remain assets of the plan sponsor subject to the claims of its general creditors. Thus, while plan participants may select among any optional methods provided under the plan for investing amounts of deferred compensation, they cannot have any secured interest in the assets purchased with their deferred compensation and assets may not be segregated for their benefit in any manner which would put an interest therein beyond the reach of the general creditors of the sponsoring entity.

Any plan which is not administered in accordance with the Act's requirements for eligible State deferred compensation plans will lose its eligible status on the first day of the first plan year beginning more than 180 days after written notification by the Secretary of the Treasury that such requirements are not being met, unless satisfactory corrective action is taken by the first day of such plan year. If a plan loses its status as an eligible State deferred compensation plan, amounts subsequently deferred by participants will be includible in income when deferred (unless the amounts are subject to a substantial risk of forfeiture when deferred). However, it is intended that amounts previously deferred, and any earnings thereon, will still not be includible in income until paid or otherwise made available.

Participants in more than one eligible plan or in a section 403(b) annuity

Except for the limited "catch-up" provision, $7,500 is the maximum compensation that can be deferred in a taxable year by an employee or an independent contractor who is a participant in an eligible State deferred compensation plan. This dollar limitation applies at the individual level, as well as at the plan level. Thus, if a person participates in more than one eligible plan (whether or not maintained by the same sponsoring entity) he must determine how the $7,500 limitation will be allocated among the various plans in which he participates. If the $7,500 limitation is exceeded, all excess amounts deferred for the taxable year will be currently includible in income.

If an individual participates in an eligible State deferred compensation plan and also has amounts contributed by an employer for the purchase of a tax-sheltered annuity or mutual fund shares held in a custodial account, and part or all of such contributions are excludable under section 403(b), the contributions excludable under section 403(b) reduce both the $7,500 and the 33-1/3 percent of includible compensation limitations. For example, a public school official with a contract salary of $30,000 in his or her first year of service with the school system could be eligible to participate in both an eligible State deferred compensation plan and a tax-sheltered (section 403(b)) annuity plan sponsored by the employer. If the employee elected to participate in the tax-sheltered annuity plan to the maximum extent possible while still participating in the eligible deferred compensation plan, he or she could elect to defer $4,500 under section 403(b) for contributions used to purchase an annuity contract or mutual fund shares and $3,000 under the eligible State deferred compensation plan.¹²

For purposes of determining the exclusion allowance under section 403(b), any amount deferred in a prior taxable year of the employee under an eligible State deferred compensation plan (without regard to the sponsoring entity) will be treated as an amount contributed by the employer for annuity contracts and excluded by the employee, if the taxable year of deferral counts as a year of service in the computation of the exclusion allowance under section 403(b).¹³

Treatment of participants in an ineligible plan

If a deferred compensation plan fails to meet the requirements of an "eligible" plan, then all compensation deferred under the plan is includible currently in income by the participants unless the amounts deferred are subject to a substantial risk of forfeiture. If amounts deferred are subject to a substantial risk of forfeiture, then they are includible in the gross income of participants or beneficiaries in the first taxable year there is no substantial risk of forfeiture.

While amounts deferred under an ineligible State deferred compensation plan generally would be included in income in the year of deferral, earnings credited on such deferred amounts would not be subject to current taxation as long as the participant has no interest in the assets of the entity sponsoring the plan which is more secure than that of general creditors. Where the participant has no such interest, earnings on amounts deferred under the plan will not be taxable to the participant until paid or otherwise made available and then will be taxed according to the annuity rules (sec. 72). Of course, the distribution of an annuity contract purchased with the earnings will be taxable (based on the fair market value of the contract) just as if it had been distributed from a nonqualified pension or profit-sharing plan.

The tax treatment of participants in an ineligible State deferred compensation plan does not extend to participants in the State's regular retirement plan (whether or not qualified under sec. 401(a)). In addition, such treatment is not applicable whenever section 83 or 402(b) applies the taxation of deferred compensation.

Present value of compensation

The Act provides that compensation is to be taken into account at its present value. This rule was provided for those cases where the amount of deferral for a particular taxable year is not readily ascertainable.

In the case of the normal salary reduction deferral agreement entered into between an employee and a State or local government, the amount withheld by the State or local government will be considered to be the present value of the compensation deferred. This amount will then be compared to the includible compensation for the taxable year to determine if the limitations on deferral have been satisfied for the taxable year. However, in the case of an independent contractor or an employee who performs services during a taxable year in return for some compensation payable currently and additional compensation payable in a later taxable year, it will be necessary, as of the close of the taxable year, to determine (without regard to any restriction other than one having a substantial risk of forfeiture) the present value of the right to receive the future payment or payments and compare that to the includible compensation for the taxable year to determine if the limitations on deferral have been satisfied.

If future payments are subject to a substantial risk of forfeiture, then they will not be valued until there is no lounger a substantial risk of forfeiture. At the close of the first taxable year in which the future payments are no longer subject to a substantial risk of forfeiture, the present value of such payments must be compared to the includible compensation for such year to determine if the deferral limitations have been met.

2. Certain Private Deferred Compensation Plans

(sec. 132 of the Act)

The proposed regulations¹ issued by the Treasury Department on February 3, 1978, would have applied to nonqualified deferred compensation plans maintained by these entities, as well as to those maintained by State and local governments. Much uncertainty developed in the private plan sector because of the statement in the preamble to the proposed regulations that, if the regulations were adopted in final form, the Internal Revenue Service's acquiescenses in the decisions in James F. Oates² and Ray S. Robinson³ would be reconsidered. The Service also indicated that it would be necessary to examine the facts and circumstances of cases similar to those described in several published revenue rulings to determine whether the deferral of payment was in fact at the individual option of the taxpayers who earned the compensation.

One of the published rulings singled out by the Service involved a five-year employment contract between an employer and an executive employee under which a specified amount of compensation was to be credited to a bookkeeping reserve, accumulated, and then paid out in five equal annual installments beginning when the employee either (1) terminated employment with the employer, (2) became a part-time employee, or (3) became partially or totally incapacitated.⁴ Because the example cited by the Service involved an employment contract and not an annual election to defer compensation, uncertainty was created in the private plan sector as to the effect of the proposed regulation.

The Act is 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.

3. Deferred Compensation Payments to Independent Contractors

(sec. 133 of the Act and secs. 404(b) and 4&1(d) of the Code)

Under prior law, the rule permitting a deduction for deferred compensation only when there was a corresponding income inclusion by a plan participant applied only where there was an employer-employee relationship. Thus, an accrual basis taxpayer generally was able to establish an unfunded deferred compensation plan for a cash basis independent contractor and obtain a deduction for such liability in accordance with the usual accrual accounting rules.

The Congress also decided to make it clear that any nonqualified plan or arrangement which results in a deferral of the receipt of compensation is subject to the deferred compensation deduction-timing rules (sec. 404).

The Act clarifies current law by providing that a method of compensation or employer contributions having the effect of a plan deferring the receipt of compensation does not have to be similar to a stock bonus, pension, profit-sharing, or annuity plan to be subject to the deferred compensation deduction-timing rules (sec. 404). Under the Act, amounts of compensation deferred under an employment contract or year-end bonus declared by a corporate board of directors, but not paid within a reasonable period of time after the close of the taxable year, would be subject to the deduction-timing rules of section 404 to the extent that another Code provision (e.g., sec. 267(a)(2)) does not operate to deny the deduction.

Plans or arrangements which are not designed for the purpose of providing deferred compensation, or which do not have a substantial economic consequence of so providing, will not be subject to the deferred compensation deduction-timing rules. Thus, welfare benefit plans (for example, medical expense reimbursement plans), which do not have as a significant economic consequence the deferral of compensation, generally would not be subject to the deduction-timing rules.

With respect to the exception from application of the deduction-timing rule for accrued compensation paid within a reasonable time after the close of the taxable year, it is intended that the Treasury Department will prescribe rules for the application of the exception to accruals made under vacation pay plans and similar plans which are designed to provide, or have the economic consequence of providing, deferred compensation. In addition, it is intended that the Treasury Department will prescribe titles for any necessary coordination of the deduction-timing rules and the special vacation pay provisions (sec. 463). For this purpose, it is anticipated that accruals for vested vacation pay plans will be subject to no actual payment requirement for deductibility under the deduction-timing provision which is more stringent than required under section 463 for the deductibility or accrued vacation pay.

4. Tax Treatment of Cafeteria Plans

(sec. 134 of the Act and sec. 125 of the Code)

Under the Act, generally, employer contributions under a written cafeteria plan which permits employees to elect between taxable and nontaxable benefits are excluded from the gross income of an employee to the extent that nontaxable benefits are elected. For this purpose, nontaxable benefits include group-term life insurance up to $50,000 coverage, disability benefits, accident and health benefits, and group legal services to the extent such benefits are excludable from gross income, but do not include deferred compensation.

The Act limits plan participation to individuals who are employees. In this regard, the Congress intended that a plan could include former employees as participants and could provide benefits for beneficiaries of participants.

In the case of a highly compensated employee (an employee who is an officer, a more-than-5-percent shareholder, or within the highest paid group of all employees, or an employee who is a spouse or dependent of such an individual), amounts contributed under a cafeteria plan will be included in gross income for the taxable year in which the plan year ends, to the extent the individual could have elected taxable benefits unless the plan meets specified antidiscrimination standards with respect to coverage and eligibility for participation in the plan and with respect to contributions or benefits.

While it could be argued that a shareholder who controls a corporation always has the right to elect either taxable or nontaxable fringe benefits for himself by reason of controlling the corporation, it is not intended that the cafeteria plan rules apply in such a situation unless the election between taxable and nontaxable benefits is provided under the terms of a written arrangement.

Coverage and eligibility

A cafeteria plan will be considered to meet the coverage standards of the Act if it benefits a classification of employees found by the Secretary of the Treasury not to discriminate in favor of highly compensated employees. The plan will meet the eligibility standards of the Act if it (1) does not require and employee to complete more than three consecutive years of employment in order to become eligible to participate, and (2) allows an employee who is otherwise eligible to participate to enter the plan as a participant not later than the first day of the first plan year beginning after the date the employee completes three consecutive years of employment.

Contributions or benefits

The Act provides that a cafeteria plan must not discriminate as to contributions or benefits in favor of highly compensated employees. A plan will not be discriminatory if total benefits and nontaxable benefits attributable to highly compensated employees, measured as a percentage of compensation, are not significantly greater than total benefits and nontaxable benefits attributable to other employees (measured on the same basis), provided the plan is not otherwise discriminatory under the standards of the Act.

In the case of a cafeteria plan which provides health benefits, the plan will not be treated as discriminatory if: (1) contributions on behalf of each participant include an amount which equals either 100 percent of the cost of health benefit coverage under the plan of the majority of highly compensated participants who are similarly situated (e.g., same family size), or are at least equal to 75 percent of the cost of the most expensive health benefit coverage elected by any similarly situated plan participant, and (2) the other contributions or benefits provided by the plan bear a uniform relationship to the compensation of plan participants. Congress intended that a cafeteria plan will not be considered to be discriminatory where the other contributions or benefits provided (or total contributions or benefits in the case of a plan which does not provide health benefits) for a highly compensated employee are a lower percentage of that employee's compensation than the plan provides for employees who are not highly compensated.

Under the Act, a plan is considered to meet all discrimination tests if it is maintained under an agreement which the Secretary of the Treasury finds to be a collective bargaining agreement between employee representatives and one or more employers.

In testing a cafeteria plan for discriminatory coverage of employees and discriminatory contributions or benefits, the Act provides that all employees who are employed by a commonly controlled group of businesses are treated as if they were employed by a single employer. The rules for aggregating employees of businesses under common control are the same as the rules which are used in testing tax-qualified pension plans for discrimination (sec. 414(b) and (c)). The Congress intended that, where an employer maintains two or more cafeteria plans, the employer may choose to have the plans considered as a single plan for purposes of the discrimination tests.

5. Certain Cash or Deferred Arrangements

(sec. 135 of the Act and new secs. 401(k) and 402(a)(8) of the Code)

On December 6, 1972, the Internal Revenue Service issued proposed regulations which called into question the tax treatment of employees covered by cash or deferred profit-sharing plans. These proposed regulations were withdrawn in July, 1978. Under the rules in effect at the time of the proposal, an employee was not taxed currently on amounts he chose to have contributed to a tax-qualified cash or profit-sharing plan.

In order to allow time for Congressional study of this area, section 2006 of the Employee Retirement Income Security Act of 1974 (ERISA) provided for a temporary freeze of the status quo. Under ERISA, the tax treatment of contributions to cash or deferred profit-sharing plans in existence on June 27, 1974, was governed under the law as it was applied prior to January 1, 1972,¹ and this treatment was to continue at least through December 31, 1976, or (if later) until regulations were issued in final form in this area, which would change the pre-1972 administration of the law.

In the case of plans not in existence on June 27, 1974, contributions to a cash or deferred profit-sharing plan were treated as employee contributions (until January 1, 1977, or until new regulations were prescribed in this area). This was intended to prevent a situation where a new plan might begin in reliance on pre-1972 law before Congress determined what the law should be in the future.

The Tax Reform Act of 1976 (sec. 1506) extended the temporary freeze of the status quo until January 1, 1978, in order to allow additional time for congressional study of this area. The Foreign Earned Income Act of 1978 (P.L. 95-615) extended these rules until the related provisions of the Revenue Act of 1978 are effective (i.e., it extended the treatment through 1979).

The Act provides that a participant in a qualified cash or deferred arrangement will not have to include in income any employer contribution to the plan merely because he could have elected to receive such amount in cash instead. For the cash or deferred arrangement to be a tax-qualified plan, it must satisfy the usual profit-sharing or stock bonus plan qualification rules. In addition, it must satisfy the following requirements: (1) it must not permit the distribution of amounts attributable to employer contributions merely because of the completion of a stated period of plan participation or the passage of a fixed period of time (unlike profit-sharing plans in general, where distributions may be made in the third calendar year following the calendar year of the employer's contribution), and (2) all amounts contributed by the employer pursuant to an employee's election must be nonforfeitable at all times.

Special nondiscrimination rules are provided for these arrangements in lieu of the usual rules for testing discrimination in contributions to the plan. A cash or deferred arrangement will meet these nondiscrimination requirements for qualification for a plan year if (1) the actual deferral percentage² for the highest paid one-third of all participants does not exceed the deferral percentage for the other eligible employees by more than 50 percent, or (2) the actual deferral percentage for the highest paid one-third of all participants does not exceed the actual deferral percentage of the other eligible employees by more than three percentage points. (If this latter test is used, the actual deferral percentage for the highest paid one-third cannot exceed the actual deferral percentage of all other eligible employees by more than 150 percent.³) In determining the highest paid one-third of all participants, only amounts considered as compensation under the provisions of the plan are taken into account. Therefore, the plan will have to have participation by employees in the lower paid group in order to obtain any deferral for the highest paid one-third.

(sec. 141 of the Act and secs. 46, 48, 56, and 4975 and new secs. 409A and 6699 of the Code)

An employee stock ownership plan is a technique of corporate finance to build beneficial equity ownership of shares in the employer corporation into its employees substantially in proportion to their relative incomes, without requiring any cash outlay on their parts, any reduction in pay or other employee benefits, or the surrender of any rights on the part of the employees. The employee generally is not taxed on employer contributions to an employee stock ownership plan until they are distributed under the plan.

Under an employee stock ownership plan, a trust generally acquires common stock of the employer. (The trust may also acquire other equity securities of the employer, as well as certain bonds, debentures. notes and other evidences of indebtedness. Generally, stock is acquired either through direct employer contributions or with the proceeds of a loan made to the plan (sec. 4975(e)(7)). Under prior law this type of plan was generally called an ESOP or leveraged ESOP.

Under prior law, regulations required that if a plan participant received employer securities from an ESOP, the employee was also to receive a "put option" (i.e., an option to require the employer to repurchase the stock at a specified price) if the stock was not publicly traded.

TRASOPs

Under prior law, an employee stock ownership plan to which an employee contributed stock (or cash) in order to qualify for additional investment tax credit was generally called a TRASOP. The TRASOP provisions were to expire after December 31, 1980.

All TRASOPs have to meet certain statutory requirements. Under prior law, an employee who participated in a TRASOP at any time during the year for which an employer contribution was made was entitled to have a share of the employer contribution credited to his or her TRASOP account based upon the amount of the employees compensation from the employer.¹ Also, a plan participant was entitled to direct the voting of employer stock allocated to hiss or her account under a TRASOP, whether or not such stock was registered under Federal securities laws.²

In addition to these requirements, which had to be met by all TRASOPs, a TRASOP could be a tax-qualified plan only if it met the other requirements applicable to tax-qualified retirement plans. However, TRASOPs were not required to be tax-qualified under prior law. Even if a TRASOP was not a tax-qualified plan it had to satisfy special rules with respect to employee participation and limitations on contributions and benefits which were the same as those for tax-qualified plans.

A TRASOP had to be established within the taxable year for which the additional investment tax credit was claimed in order to be considered a tax-qualified plan for that year. However, a TRASOP could be established as late as the date for filing the employers tax return for a year (including extensions) in order for the additional investment tax credit to be claimed for that year. Therefore, under prior law, a TRASOP might have been nonqualified for its first plan year and qualified thereafter.

The employers contribution to a TRASOP must be in the form of employer securities or cash (provided the cash is used by the TRASOP to acquire employer securities). Under prior law, the securities contributed to (or purchased by) a TRASOP were required to be common stock with voting power and dividend rights no less favorable than the voting power and dividend rights of other common stock of the issuing corporation. Securities convertible into such common stock could also be contributed.

An employer could contribute stock of another corporation to a TRASOP, provided that the two corporations were under at least 80 percent common control. However, gain or loss may have been recognized where a corporation made a TRASOP contribution in other than its own stock.

The amount of additional investment tax credit contributed to a TRASOP reduces an employers income tax liability. Under prior law, this reduction in income tax could result in an increased minimum tax liability, even though the employees income tax savings was offset by its contribution to the TRASOP.

Under prior law, when an investment tax credit amount for a year was recaptured with the result that the credit originally claimed for the year was later decreased, the employer had three alternatives with respect to adjusting the TRASOP contribution: (1) the amount of the decrease could be applied to offset employer contributions for other years; (2) the amount of the decrease could be deducted; or (3) the decrease could be used as the basis for a withdrawal from the TRASOP.

Under prior law, the type of distribution that could be made from a leveraged ESOP or a TRASOP depended on the nature of the particular plan (i.e.. profit sharing stock bonus. etc.).

Statutory and a administrative rules developed with respect to TRASOPs which were different from those rules which apply to tax-qualified plans in general. The Congress believed that the interests of uniformity would best be served if, in general, TRASOPs were required to come tax-qualified under the same standards generally applicable to tax-qualified plans. This requirement also should help employers maintaining TRASOPs to obtain interpretations of statutory provisions, since long-standing interpretations are a available with respect to many of the rules governing tax-qualified plans.

Often, an employer does not establish a TRASOP until the time prescribed by law for filing its in return for the year (including extensions since the TRASOP does not have to be established before that time for the employer to claim the additional investment tax credit. Because of the requirement that a tax-qualified plan be established by the close of a taxable year in order to be tax-qualified for that year, many TRASOPs are not tax-qualified for their initial plan year. Since tax qualification for TRASOPs for all future years is required under the Act, the Congress believes that a TRASOP established on or before the due date for an employers tax return for a year (including extensions), and which otherwise qualifies, should be treated as tax-qualified for that year. The Congress does not intend, however, to change the prior law rule requiring that tax-qualified plans other than TRASOPs be established before the close of a taxable year to be tax-qualified for that year. Consequently, no deduction is allowed for a taxable year for contributions to a plan which was not in existence at the close of that year.

The Congress believes that undue complexity has resulted from the prior law provision requiring that contributions to a TRASOP for a plan year be allocated to all plan participants irrespective of their service with the employer for that plan year. The Act therefore replaces this provision with that general rule for tax-qualified plans for determining which participants are required to share in a contribution for a plan year.

The Congress recognized that giving participants in leveraged ESOPs and TRASOPs full voting rights with respect to shares allocated to their accounts may be unduly burdensome in the case where the corporation issuing the employer securities is closely held. However, the Congress also recognized the general need of leveraged ESOP and TRASOP participants for voting rights on closely held employer securities with respect to major corporate issues (such as mergers, acquisitions, consolidations, or sales of all or substantially all of the assets of a corporation).

Many subsidiary corporations were unable to establish TRASOPs with the stock of their parent corporations because the parent corporations did not meet the 80-percent stock ownership requirement of prior law. The Congress concluded that this 80-percent requirement was unduly restrictive and that the interests of the public in broader employee stock ownership would better served by a 50-percent stock ownership requirement. At the same time, a 50-percent requirement will provide a sufficient identity of interests between a parent corporation and a subsidiary corporation to make it reasonable to consider the stock of the parent corporation as employer securities of the subsidiary corporation.

The TRASOP provisions of prior law permitted subsidiary corporations to make contributions to TRASOPs of stock of their parent corporations. However, under prior law, it was not clear whether gain or loss was recognized with respect to such contributions. The Congress believed that it is inappropriate for the benefit of the additional investment tax credit to be offset by tax or gain recognized under these circumstances.

In certain cases, the additional investment tax credit attributable to TRASOP contributions could have increased an employers minimum tax liability under prior law. The Congress concluded that this result was not appropriate because the benefit of the credit is offset by the contribution of the employer.

The Congress decided that any participant (or beneficiary) who receives a benefit distribution from a leveraged ESOP or TRASOP should able to dispose of the distributed employer securities for cash. The Congress recognized that in some cases this conversion occurs almost simultaneously with the actual distribution. The Congress concluded that the administrative paperwork and expense which is required for the leveraged ESOP or TRASOP to make a distribution in employer securities and then immediately repurchase time securities for cash is unwarranted in these cases. Accordingly, the Congress believed that this process should be simplified when the leveraged ESOP or TRASOP wants to distribute benefits in cash. However, if a participant wishes to receive this benefit in securities of the employer, and retain ownership of these securities, he should be able to do so, and he should have the future right to convert these securities to their cash equivalent through a "put option" to the employer if the securities are not readily tradable on an established market.

The Act changes the meaning of the term "ESOP." The type of plan previously referred to as a TRASOP (or investment tax credit ESOP) is designated as an ESOP. The type of plan previously referred to as an ESOP or leveraged ESOP is designated as a leveraged employee stock ownership plan. For purposes of this explanation the new terminology is used.

The Act (1) made several amendments to the provisions of law which deal with ESOPs and with leveraged employee stock ownership plans, (2) made the ESOP provisions as amended by the Act, part of the Code for the first time, and (3) extended the expiration date of the ESOP provisions to December 31, 1983.

Qualification requirements for ESOPs

Under the Act, all ESOPs are required to be tax-qualified plans. This represents a departure from the prior law provision which allowed ESOPs to be nonqualified provided that they met certain specified statutory standards. The Congress expects that the regulations which generally apply to tax-qualified plans will henceforth also apply to ESOPs, and that the Treasury Department will not write separate regulations regarding the application of the tax-qualification standards to ESOPs, except where ESOPs are distinguished from other qualified plans by statute.

Under the Act, an ESOP may lie treated as tax-qualified from its effective date even though the ESOP is not actually established until the date for filing the employers tax return for its taxable year (including extensions).

Allocation of ESOP contributions

Because ESOPs are now subject to the qualification requirements generally applicable to tax-qualified plans, employer contributions to an ESOP for a plan year generally are to be allocated in accordance with the rules governing the allocation of contributions under tax-qualified defined contribution plans. However, the Act retains the requirement that the allocation of employer contributions to an ESOP for a year must made in proportion to the total compensation of all participants sharing in the allocation for the plan year: taking into account only the first $100,000 of compensation for an employee.

Provisions relating to employer services

The Act provides that if a leveraged employee stock ownership plan or an ESOP holds employer securities issued by a corporation the stock of which is registered under Federal securities laws, the plan must provide that the plan participants are entitled to exercise voting rights with respect to such employer securities. The Act also provides that if a leveraged employee stock ownership plan or an ESOP holds employer securities issued by a corporation the securities of which are not registered under Federal securities laws, the plan must provide that the plan participants are entitled to exercise voting rights with respect to such employer securities on any corporate issue which must by law (or charter) be decided by more than a majority vote of outstanding common shares voted on the issue.

The Act provides that, in the case of an ESOP, the only types of employer securities which may be acquired and held by the plan are (1) common stock of the issuing corporation and (2) preferred stock of the issuing corporation which is readily convertible into its common stock. The shares acquired by an ESOP, other than shares which are readily tradable on an established securities market, must, in the aggregate, have a combination of (1) voting rights equivalent to rights possessed by shareholders of the class of common stock of the issuing corporation having the greatest voting rights, and (2) dividend rights equivalent to rights possessed by shareholders of any other class of stock of the issuing corporation having the greatest dividend rights. Thus, an ESOP or a leveraged employee stock ownership plan could satisfy this requirement if it holds a mixture of employer securities which reasonably reflects the outstanding unties of the employer.

The Act modifies the definition of employer securities for purposes of the ESOP provisions by applying a 50-percent test in lieu of the present law 80-percent test in determining whether corporations are members of the same parent-subsidiary controlled group of corporations. Under the Act, the stock of a parent corporation in a parent-subsidiary controlled group of corporations (determined by applying the 50-percent test) may be contributed as employer securities by a subsidiary to its ESOP. The Ac does not disturb the present law rule under which an 80-percent test is applied in determining whether corporations are members of the same brother-sister controlled group for purposes of defining employer securities.

The Act provides that in a case where a parent corporation controls a subsidiary corporation (including a second tier subsidiary) under an 80-percent test for control, the subsidiary corporation will not recognize gain or loss on a contribution of stock of the parent corporation to an ESOP maintained by the subsidiary. The Act does not affect prior law applicable to other transactions.

Minimum tax

The Ac provides that in any case where an employer claims additional investment tax credit as a result of ESOP contribution, the additional credit will not result in the imposition of additional minimum tax on the employer. The Act makes no change in the present law provision under which each dollar of investment tax credit (other than investment tax credit attributable to ESOP contributions) may increase the base for computing the minimum tax.

Prohibition of withdrawal of ESOP contributions on recapture

The Act repeals the prior law rule permitting an employer to withdraw from an ESOP a contribution attributable to additional investment tax credit which is captured. Under the Act, an ESOP contribution made with respect to a particular qualified investment may not be withdrawn if all or a portion of the credit is later recaptured due to an early disposition of the property which gave rise to the credit. Under the Act as under prior law, an employer may either (1) deduct the amount of the contribution attributable to the recaptured additional investment tax credit for the taxable year in which the recapture occurs or 2) apply the mount of the contribution attributable to the recaptured additional investment tax credit against its obligation for a future ESOP contribution.

Distributions from ESOPs and leveraged employee stock ownership plans

Under the Act, a participant in a leveraged employee stock ownership plan or an ESOP who is entitled to a distribution under the plan is given the right to demand that the distribution be made in the form of employer securities rather than in cash (or other property). Subject to a participants right to demand distribution of employer securities, the plan may elect to distribute the participants interest to him in cash, in employer securities or partially in cash and partially in employer securities. Each participant should be advised in writing of the right to require a distribution of employer securities, before the leveraged employee stock ownership plan or the ESOP makes a distribution.

Put option on stock distributed from ESOP or leveraged employee stock ownership plan

Under the Act, any participant who receives a distribution of employer securities from an ESOP or a leveraged employee stock ownership plan must given a "put option" on the distributed employer securities if the employer securities are not readily tradable. The put option which a participant receives should have the following terms:

By extending the ESOP provisions through 1983, it is estimated that this provision will reduce budget receipts by $l78 million in fiscal year 1981, $446 million in fiscal year 1982, and $545 million in fiscal year 1983.

2. Estate Tax Exclusion for Certain Lump Sum Distributions

(sec. 1.42 of the Act and sec. 2039 of the Code)

It is intended that benefits payable to a surviving spouse under a tax-qualified plan will not be disqualified for purposes of the estate tax marital deduction merely because of the existence of an election to receive deferred payments. For example, the mere existence of an election to receive an annuity for life or a definite period will not result in treating the surviving spouses interest in benefits payable under a tax-qualified plan as a terminable interest which is ineligible for the marital deduction. Thus, if a surviving spouse elects 10-year averaging for a lump-sum distribution for income tax purposes (sec. 492(e)(4)) and, therefore, the distribution is ineligible for the estate tax exclusion for annuities payable under tax-qualified plans (sec. 2039) the distribution may be eligible for the estate tax marital deduction (sec. 2056) although an election was available under the plan to receive terminable survivor annuity payments. In addition, the mere existence of an election to choose between special 10-year averaging for lump sum distributions or the estate tax exclusion is not intended to affect eligibility of other property for the estate tax marital deduction although the amount of the other property passing to a surviving spouse may be affected by the election. For example, probate property passing to a surviving spouse under a maximum marital deduction formula bequest will not be ineligible for the marital deduction as a terminable interest merely because the value of such property passing to the surviving spouse may depend upon the lump sum distribution election.

3. Voting Rights on Employer Securities Held by Qualified Defined Contribution Plans

(sec. 143 of the Act and sec. 401(a)(22) of the Code)

(sec. 152 of the Act and secs. 219, 401, 404, 408, 414, and 41 of the Code)

Prior law and present law also provide for IRAs (individual retirement accounts, individual retirement annuities and individual retirement bonds) under which deductible contributions are limited to the lesser of 15 percent of earned income or $1,500 ($1,750 in the case of spousal IRAs). Employers may establish and maintain employer-sponsored individual retirement accounts or annuities for employees. IRAs are tax-exempt and amounts held in an IRA owned by an individual are generally not taxed to him or her until they are distributed. Reporting requirements with respect to IRAs are considerably less burdensome than those that apply to qualified pension plans. Fiduciary standards and self-dealing prohibitions are generally more easily complied with under an employer-sponsored IRA than under most qualified plans.

Many of the complex rules of the pension law are provided to give employers flexibility to tailor retirement plans to the particular needs of their businesses. Accordingly, where an employer does not require this flexibility, more simplicity can be obtained by using IRAs instead of a pension plan.

The Act raises the deduction limit for individual retirement accounts and individual retirement annuities to 7,500 or 15 percent of compensation (whichever is less) if the account or annuity qualifies as a simplified employee pension. The $7,5O0 limit applies only to employer contributions to simplified employee pension.

The deduction for employer contributions to an individuals simplified employee pension is allowed to an individual even though he or she is an active participant in a qualified plan, a tax-sheltered annuity, or a governmental plan. In other respects, however, the Act does not change the prior law limits on deductions for contributions to IRAs. Accordingly, if employer contributions to an individuals simplified employee pension for a year are less than the usual limit on deductible IRA contributions, the individual could make up the difference by making deductible contributions to an IRA if he or she is not an active participant in a qualified plan. etc., for that year.

Under the Act, an individual retirement account or individual retirement annuity maintained by an employee qualifies as a simplified employee pension for a calendar year if requirements of the Act as to withdrawals and the employers allocation formula are satisfied.

Special rules

Under the Act, the employers allocation formula must not discriminate in favor of employees who are officers, shareholders (more than 10 percent, directly or indirectly (sec. 318)), or highly compensated. The Act provides that, for this purpose, employer contributions are considered to be discriminatory unless they bear a uniform relationship to the total compensation (not in excess of the first $100,000) for each employee who is entitled to share in the allocation of contributions to simplified employee pensions.

The Act provides that, under the discrimination test, taxes paid by an employer with respect to an employee under the Federal Insurance Contributions Act (Sec. 3111) may be taken into account as employer contributions to the employees simplified employee pension. However, under the Act, if such taxes are taken into account as employer contributions, the tax on self-employment income of each owner-employee must also be taken into account as an employer contribution under the discrimination test, and the $7,500 limit on deductions for an officer, shareholder, or owner-employee, is reduced by the amount of the taxes taken into account.

Under the Act, in testing an employers allocation formula, employees of commonly controlled enterprises are considered to be employed by a single employer. Also, in applying the eligibility and discrimination rules (secs. 401(a)(4) and 410(b)) to a qualified plan maintained by an employer, simplified employee pensions may be treated as a qualified plan.

Employer contributions to simplified employee pensions for a taxable year reduce the limitation on deductions for employer contributions to a plan covering a self-employed individual, or to a profit-sharing or stock bonus plan for that taxable year.

2. Defined Benefit Plan Limits

(sec. 153 of the Act and sec. 415 of the Code)

3. Custodial Accounts for Regulated Investment Company Stock

(sec. 154 of the Act and sec. 403 of the Code)

4. Pension Plan Reserves

(sec. 155 of the Act and sec. 805(d) of the Code)

5. Rollover of Distributions From a Tax-Sheltered Annuity

(sec. 156 of the Act and sec. 4(b)(8) of the Code)

Under prior law, recipients of distributions under tax-sheltered annuity (described in sec. 403(b)) purchased by an employer that was a tax-exempt charitable organization or a public school were not eligible to roll distributors over to an IRA. However, a participant in a tax-sheltered annuity plan could exchange his or her annuity contract for another annuity contract tax-free (sec. 103 of the Code) regardless of the holding period of the contract or the period of participation in the plan.

It was not intended that the Act would affect the availability of the tax-free exchange provisions of sec. 1035 as they currently apply to the exchange of one tax-sheltered annuity contract for another.

6. Individual Retirement Account Technical Changes

(sec. 157 of the Act)¹

An excess contribution is subject to an annual 6 percent excise tax unless corrected. In order to correct an excess contribution, an individual must either (1) receive a distribution of the excess amount, or (2) contribute an amount in a future year which falls short of the maximum deduction allowable for that year, in which case the excess contribution is deemed to be corrected to the extent of the shortfall. However, under prior law, the deduction for the year did not include the amount of the shortfall.

If the individual erroneously took a deduction in a previous year for any part of the excess contribution and the period for assessing a deficiency for the previous year has expired, the amount allowed as a deduction under the Act would be correspondingly reduced.

The Act provides a transitional rule with respect to amounts of excess contributions made up by undercontributions for years prior to 1978. The rule allows a one-time catch-up deduction from gross income for those amounts for 1978 rather than requiring amended returns to filed for each year of undercontribution. For example, if an individual entitled to make a $1,500 contribution for 1978 had made an excess contribution of $800 for 1976, and $300 for 1977, he could correct the excess contributions (totaling $1,100) by making only a $400 contribution for 1978 and would be entitled to a $1,500 deduction for that year.

If the excess contributed for a year was withdrawn after the date for filing the individuals return, (1) it was subject to the 6-percent excise tax for each year for which the excess remained in the IRA, (2) it was subject to the 10-percent early distribution tax if the individual was not at least age 59-1/2 or disabled, and (3) it was includible in the individuals gross income for the year it was withdrawn.

The Congress concluded that these rules were overly harsh. Most excess contributions are inadvertent and may not detected for a substantial pen of time. While some individuals may in a position to correct the excess contribution by making an undercontribution for a later year ( described in the previous section), this alternative is not open to those who have lost their eligibility for IRA participation (as, for example, those who have become active participants in qualified retirement plans).

The Act provides a transitional rule for excess contributions to IRAs for taxpayers beginning before January 1, 1978. For such excess contributions, the provisions of the Act would apply without regard to the $1,750 limitation. Thus, an individual could withdraw all such excess contributions, regardless of amount, to the extent deductions we not previously allowed for the excess contributions.

The Act also allows an individual to withdraw an excess contribution (regardless of the amount) made with respect to a rollover contribution (including an attempt rollover contribution) in any case in which the excess contribution occurred because the individual making the contribution reasonably relied on erroneous information required to be supplied by the plan, trust, or institution making the distribution which was the subject of the rollover.

The Act applies to distributions from IRAs in taxable years beginning after December 31, 1975. Thus, under the Act, the IRS is to fund to taxpayers all penalties and income taxes based on distributions from IRAs after that date which correct previous excess contributions.

The Act provides a transitional rule under which the exchange before January 1, 1981, of any fixed premium individual retirement annuity issued on or before November 6, 1978, for a flexible premium annuity contract will, at the election of the individual, be treated as a nontaxable exchange. The exchange of annuity contracts is optional. An individual retirement annuity contract issued before November 7, 1978, will not fail to qualify merely because it provides for fixed premiums.

For example, assume that on September 1, 1980, an individual receives a lump-sum distribution consisting of $50,000 in cash and $50,000 worth of Corporation A stock (valued as of September 1, 1978). Assume further that on September 30, 1980, the individual sells all of the stock for $60,000. His maximum rollover contribution (to be completed within 60 days of the September 1, 1980 distribution date) would be $110,000 ($50,000 of cash, plus the $60,000 proceeds received on the sale of the stock). If the individual made a full $110,000 rollover, no gain would be recognized on the sale of the stock. (This is the same result which would have occurred it the property had been rolled over immediately before the sale).

The same rule would apply in the case of a loss on the sale of the stock. If, on September 30, 1980, the individual sold the Corporation A stock for $40,000, then his maximum rollover contribution would be $90,000, and if the rollover were completed within the 60-day rollover period, no loss would be recognized on the sale of the stock.

Generally, under prior law (and under the Act) where an employee received a distribution of property from a qualified plan, and this distribution is not rolled over, then the employee is required to treat the fair market value of the property as ordinary income, and the amount taken into income becomes the employees basis in the property.¹ Gain or loss subsequently realized on the sale of the stock is generally treated as capital gain or loss.

These same principles apply where there is a partial rollover of the proceeds of the sale of property, except that it will generally be necessary to allocate the retained proceeds between the ordinary income and capital gains portion of the retained amount. For purposes of these rules, the amount of ordinary income is determined by multiplying the fair market value of the property on the date of distribution by a fraction, the numerator of which is the amount of proceeds retained, and the denominator of which is the total proceeds of the sale. The amount of capital gain or loss is determined by multiplying the difference between the fair market value of the property on the date of sale, and the fair market value on the date of distribution by this same fraction (retained proceeds over total proceeds).

In some cases, where the individual receives both cash and property, or several pieces of property, it will be necessary to determine the extent to which the individual has rolled over cash (or proceeds from the sale of one piece of property as opposed to another) and to what extent he has rolled over proceeds. The Act expects the individual to make an election in this regard (not later than the date for filing his tax return for the year in question) by filing a written designation with the IRS. Once made, this designation is irrevocable. If no designation is made, the rollover amount is to be allocated pro rata between the cash distribution received from the plan and the value of any property received (determined as of the date of the distribution).

Thus, in the case of a partial rollover involving proceeds from the sale of property, the rollover amount will be tax free (until it is distributed from the IRA, at which point it will be treated as ordinary income) and the retained portion will taxed partly as ordinary income, and partly as capital gain or loss, in accordance with the computation outlined above.

For example, assume that on September 1, 1980, an individual employed by Corporation B receives a lump sum distribution consisting of $5 ,000 in cash and $50,000 worth of Corporation A stock (valued as of September I 1980). Assume further that on September 30, 1980, that individual sells all of the stock for its then fair market value of $60,000. The maximum rollover contribution (to be completed within 60 days of the September 1, 1980, distribution date) would be $110,000 ($50,000 of cash, plus the $60,000 of proceeds received on the sale of the stock). As discussed above, if the individual made a full $110,000 rollover, no gain would be recognized on the sale of the stock. But, assume that the individual makes a rollover of only $80,000. He now may designate irrevocably on his tax return for the year of the rollover the extent to which he has rolled over cash from the plan and the extent to which he has rolled over proceeds from the sale of the stock.² Assume the individual designates the rollover as $30,000 of cash from the plan and $50,000 of proceeds. He then will have retained $20,000 ($50,000 - $30,000) of cash from the plan and $10,000 ($60,000 - $50,O00) of proceeds from the sale of the stock, and will be taxed as follows:

 Ordinary income:

An individual is permitted to make a rollover contribution of a distribution from an IRA to another IRA without including the amount of the distribution in gross income, providing the rollover occurs within 60 days after the date of the distribution. Under prior law, an individual could engage in this type of rollover only one time during any three-year period.

The Act also reduces the 3-year limitation on rollovers between IRAs to once each year. An individual is allowed to make rollover contributions of amounts from one IRA to another once each year.

(sec. 161 of the Act)

Public Law 95-171 provides that participants in the Uniformed Services Health Professions Scholarship Programs (including the Armed Forces and Public Health Services programs) entering before 1979 may exclude from their income amounts received under those programs through 1982.

National Research Service Awards

In 1977, the Internal Revenue Service ruled (Rev. Rul. 77-319) that Amounts received as National Research Service Awards under the Public Health Service Act of 1974 (42 U.S.C., sec. 2891(1)), which have no specific statutory exclusion, are not excludable scholarships or fellowship grants.

The Act extends the exclusion provided under prior law for participants in the Unified Services Health Professions Scholarship programs (including the Armed Forces and Public Health Professions Scholarship programs) so that students entering the programs in 1979 may exclude amounts received under these programs through 1983. This one-year extension generally will cover program participants entering medical school in 1979 for their four years of training.

National Research Service Awards

In addition, the Act provides tax-exempt scholarship treatment for National Research Service Awards made through 1979 for the duration of such awards.

The tax-exempt scholarship treatment for National Research Service Awards applies to awards made during calendar years 1974 through 1979.

The tax exemption for National Research Service Awards will reduce budget receipts by $52 million in fiscal year 1979 (which includes liabilities for prior years), $18 million in fiscal year 1980, $10 million in fiscal year 1981, and less than $5 million in fiscal year 1982.

2. Cancellation of Certain Student Loans

(sec. 162 of the Act and sec. 61 of the Code)

Under certain student loan programs established by the United States and by State and local governments, all or a portion of the loan indebtedness may be discharged if the student performs certain services for a period of time in certain geographical areas pursuant to conditions in the loan agreement. In 1973, the Internal Revenue Service ruled on a situation in which a State medical education loan scholarship program provided that portions of the loan indebtedness were discharged on the condition that the recipient practice medicine in a rural area of the State. The Service determined that amounts received from such a loan program were included in the gross income of the recipient to the extent that repayment of a portion of the loan is no longer required (Rev. Rul. 73-256, 1973-1 C.B. 56). On November 4, 1974, the Service determined that this ruling would be applicable only to loans made after June 11, 1973, the date of the ruling explained above (Rev. Rul. 74-540, 1974-2 C.B. 38).

Section 2117 of the Tax Reform Act of 1976 (P.L. 94-455) provided that in the case of loans forgiven prior to January 1, 1979, no amount was to be included in gross income by reason of the discharge of all or part of the indebtedness of the individual under certain student loan programs. The exclusion applies to a discharge of indebtedness if the discharge was pursuant to provision of the loan agreement under which all or part of the indebtedness would be discharged if the individual works for a certain period of time in certain professions in certain geographical areas or for certain classes of employers. The amendment made by the 1976 Act applies to student loans made to an individual to assist in attending an educational institution only if the loan was made by the United States or an instrumentality or agency thereof or by a State or local government either directly or pursuant to an agreement with a educational institution.

3. Tax Counseling for the Elderly

(sec. 163 of the Act)

The Congress believed that these problems would be mitigated if the Internal Revenue Service were to expand substantially its tax counseling service particularly tailored to the needs of the elderly. The Congress believed that the needs of the elderly in this area are not being adequately met because of the limited scope of the VITA program. Accordingly, the Act authorizes the Internal Revenue Service to enter into arrangements with private or public nonprofit institutions pursuant to which the IRS will furnish the training and technical assistance necessary to enable the nonprofit institutions to establish tax counseling programs for the elderly.

Under the Act, the Service is authorized to provide reimbursement to volunteers for transportation, meals, and other expenses incurred by them in training or providing counseling assistance. The amounts received by the volunteers as reimbursement for the expenses are to be exempt from income and social security taxes, except to the extent that a charitable contribution or other deduction is claimed for these expenses. The Secretary is authorized to provide the volunteers with preferential access to Internal Revenue Service taxpayer service representatives and make available technical information and material needed for their use.

Additionally, the Act provides that, from time to time, the IRS is to direct the attention of elderly individuals to tax measures of particular interest and application to the elderly, such as the tax credit for the elderly (under sec. 37 of the Code) and the provision reducing the tax on the capital gain on the sale of a residence for those age 55 and over (sec. 121 of the Code).

The Act authorizes to be appropriated to carry out the intent of this provision the amount of $2.5 million for fiscal year 1979 and $3.5 million for fiscal year 1980.

4. Employer Educational Assistance Programs

(sec. 164 of the Act and new sec. 127 of the Code)

Section 61 provides that, unless otherwise excluded by law, gross income means all income from whatever source derived including, but not limited to, compensation for services. Under section 117, subject to certain qualifications, amount received as scholarships at educational institutions and amounts received as fellowship grants are excluded from gross income.¹ The exclusion also covers incidental amounts received to cover expenses for travel, research, clerical help, and equipment.

The exclusion for scholarships and fellowship grants is restricted to educational grants by relatively disinterested grantors who do not require any significant consideration from the recipient.²

Under present law (Treas. Reg. sec. 1.162-5), educational expenditures made by an individual for his own education generally are deductible if they are for education that (1) maintains or improves skills required by the individual's employment or other trade or business, or (2) meets the express requirements of the individual's employer or the requirements of applicable law or regulations imposed as a condition to the retention by the individual of an established employment relationship, status, or rate of compensation. These types of education are commonly called "job-related education." However, no deduction is allowed for expenditures for education required of an individual in order to meet the minimum education requirements for employment qualification in the individual's employment or other trade or business or for expenditures for education which is part of a program of study which will qualify the individual in a new trade or business. Such expenses may not be deducted even if the education maintains or improves skills required by the individual in the individual's employment or other trade or business or meets the express requirements of the individual's employer or applicable law or regulations. Nondeductible educational expenditures are personal expenses of the employee. Similarly, expenses which are not incurred by an individual for recreation and which are not connected with a trade or business or the production of income, such as the taking courses in connection with a hobby, are personal expenses of the individual and are not deductible. Thus, unless the educational expenses are deductible to the individual under the above rules, an employee ordinarily will have income which is not offset by deductions in the following situations:

Generally, unless specifically excluded by statute, all remuneration paid to employees, regardless of the form in which paid, constitutes wages subject to withholding of income and employment taxes. Remuneration is not necessarily excluded from the definition of employment tax wages for purposes of employment taxes and income tax withholding simply because it is excludible from gross income under the Code. However, Treasury regulations provide that certain advances and reimbursements paid to employees for ordinary and necessary business expenses are excluded from the definition of wages for withholding and employment tax purposes. Pursuant to these regulations, the Internal Revenue Service has ruled that educational expenses paid on behalf of, or reimbursed to, an employee for courses which maintain or improve skills required in employment, or meet express requirements of an employer as a condition to retaining employment, that is, job-related educational expenses, are excludable from the wages of the employee for purposes of employment taxes and income tax withholding. If the courses do not satisfy these tests, their cost has been considered a personal expense of the employee and the advance or reimbursement is includible in wages and subject to employment taxes and withholding.⁴

Because ambiguities exist in the "improve or maintain skills" test, the taxability of educational assistance programs of particular employers necessarily has depended on IRS agents' case-by-case analyses of the skills needed for the jobs held by each employee participating in such programs.

The "job-related" distinction often seems both ambiguous and restrictive. For example, if a person with little or no work experience is employed in an entry-level position and receives training from his employer to advance to a job requiring some greater skills or experience, the value of the of the training may be taxable. This may discourage self-improvement. If a typist, for example, receives training to be a secretary, or if a secretary receives training in a paralegal program, it might be considered not job-related. Also, if a clerical employee receives computer training, it may be treated as not job-related, even though the employee's job may require computer skills in the future because of normal advances in business technology.

The Congress believed it is important to reduce the complexity of the law in this area. Not only must the Internal Revenue Service use valuable personnel time in making determinations of taxability, but employees and employers also must justify their positions. The employer also must determine whether income tax withholding and employment taxes apply to reimbursement.

More serious than the potential inequities of administration and the complexities of the tax law is the disincentive to upward mobility. Although most citizens recognize the need to provide greater access to educational and economic opportunity to those who have had limited access in the past, the tax law has required out-of-pocket tax payments for employer-provided educational assistance from those least able to pay, even though they receive services, not an increased paycheck.

Therefore, the Act provides an exclusion for employer-provided educational assistance. To avoid abuse of this expanded tax-free treatment of educational assistance, the Act limits the exclusion to benefits provided to employees and provides nondiscrimination rules.

The Act excludes from an employee's gross income amounts paid for expenses incurred by the employer for educational assistance to the employee if such amounts are paid or such expenses are incurred pursuant to a program which meets certain requirements. In the case of education paid for, or furnished by, an individual's employer under such a program, the provision eliminates the need to distinguish job-related educational expenses from personal educational expenses for income tax purposes.⁵

Excludable benefits

The educational benefits which may be excluded from income are those furnished by an employer only to employees. The types of educational assistance which may be furnished are not restricted. The employer may provide educational assistance to the employee directly or the employer may reimburse the employee for the latter's expenses. Under the Act, an employee can exclude from income tuition, fees, and similar payments, as well as the cost of books, supplies, and equipment paid for, or provided by, his employer; however, the employee cannot exclude tools or supplies which the employer provides and which the employee may retain after completion of the course of instruction. Meals, lodgings, or transportation also may not be excluded under this section. There is no restriction as to who may furnish the educational assistance. Such assistance may be furnished by an educational institution or any other party. Also, the employer, alone or in conjunction with other employers, may furnish the education directly to the employees. The education which may be furnished is not limited to job-related courses nor to courses which are part of a degree program. However, the exclusion does not apply to educational assistance furnished for courses involving sports, games, or hobbies, except where the education provided involves the business of the employer.

For a program to qualify under this provision, the employees must not be able to choose taxable benefits in lieu of the educational benefits. In administering this rule, the business practices of an employer, as well as the written program, are to be taken into account.

A taxpayer may not claim any deduction, for example, a business expense deduction, nor may he claim any credit with respect to any amount which is excluded from his income in under this provision. Thus, no double tax benefit may be obtained.

An employer educational assistance program is not required to be funded nor to be approved in advance by the Internal Revenue Service.

Nondiscrimination requirements

In order to be a qualified program, an educational assistance program also must meet requirements with respect to nondiscrimination in eligibility. The Act requires that a program must benefit employees who qualify under a classification set up by the employer and found by the Secretary not to be discriminatory in favor of employees who are officers, owners, highly compensated individuals, or their dependents. The program must he available to a broad class of employees rather than to a particular individual. However, employees may be excluded from a program if they are members of a collective bargaining unit and there is evidence that educational assistance benefits were the subject of good faith bargaining between the unit and the employer or employers offering the program.

The Act specifically provides that a program shall not be considered discriminatory merely because it is utilized to a greater degree by one class of employees than by another class or because successful completion of a course, or attaining a particular course grade, is required for, or considered in, determining reimbursement under the program.

Reasonable notification of the availability and terms of the program must be provided to eligible employees.

Operation

Under the Act, the exclusion does not apply if the program discriminates in favor of certain employees. A program is discriminatory if more than 5 percent of the benefits can be paid to shareholders or owners (or their spouse or dependents), each of whom (on any day of the year) owns more than 5 percent of the stock or of the capital or profits interest in the employer.

Special rules

An individual who qualifies as an employee within the definition of section 401(c)(1) of the Code also is a employee for purposes of these provisions. Thus, in general, the term "self-employed individual" means, and the term "employee" includes, individuals who have earned income for a taxable year, as well as individuals who would have earned income except that their trades or businesses did not have net profits for a taxable year.

An individual who owns the entire interest in an unincorporated trade or business is treated as his own employer. A partnership is considered the employer of each partner who is also an employee of the partnership.

For determining stock ownership in corporations, this provision adopts the attribution rules provided under subsections (d) and (e) of section 1563 (without regard to sec. 1563(e)(3)(C)). The Treasury Department is to issue regulations determining ownership interests in unincorporated trades or businesses, such as partnerships or proprietorships, following the principles governing the attribution of stock ownership.

The Act also provides that amounts excluded from income as educational assistance are not to treated as wages subject to withholding of Federal income tax nor as wages subject to employment taxes.

The first of these at risk rules--"the specific at risk rule"--applied to four specific activities: (1) farming: 2) exploring for, or exploiting, oil and natural gas resources; (3) holding, producing, or distributing motion picture films or video tapes; and (4) leasing of personal property (sec. 465). This specific at risk rule applied to all types of taxpayers other than regular corporations (that is, corporations which are not subchapter S corporations or personal holding companies).

Under the specific at risk rule, a taxpayer's loss for any taxable year from covered activities is limited to the amount the taxpayer has placed at risk and could actually lose from this activity. Initially, the amount at risk is generally the sum of (1) the taxpayers cash contributions to the activity, (2) the adjusted basis of other property contributed to the activity, and (3) amounts borrowed for use in the activity with respect to which the taxpayer has personal liability for repayment. Generally, this amount is increased by the taxpayer's share of income and it is decreased by his share of losses and withdrawals from the activity.

The taxpayer is not generally considered at risk with respect to the proceeds (or his share of the proceeds) of a nonrecourse loan used directly or indirectly to finance his participation in the activity.

Additional rules are provided to prevent avoidance of this rule by cross-collateralization of property involved in two different activities and borrowing from other participants in the same activity. Also, a taxpayer is not considered at risk to the extent his economic participation is protected from loss by guarantees, repurchase agreements, or insurance (except casualty insurance).

Losses which may not be deducted for any taxable year because of the specific at risk rule are deferred and may be deducted in any subsequent year in which this at risk limitation does not prevent the deduction.

The other at risk rule--"the partnership at risk rule"--applied generally to activities engaged in through partnerships. This rule (sec. 704(d)) provided that, for purposes of the limitation on allowance of partnership losses, the adjusted basis of a partner's interest did not include any portion of any partnership liability with respect to which the partner did not have any personal liability. However, there were two exceptions to this rule. First, the rule did not apply to any activity to the extent that the specific at risk rule (sec. 465) applied. Second, the rule did not apply to any partnership the principal activity of which was investing in real property (other than mineral property).

Except for the four activities to which the specific at risk rule applied, neither of the at risk rules applied to direct investments (i.e., investments made directly, not through partnerships). Essentially, the lack of any application of the at risk principles to direct investments constituted a major gap in the e tax law in dealing with tax shelter abuses.

Thus, the Act provides a revised at risk rule which will apply to investments (direct or indirect) in all activities except real estate.

Under in prior law, the at risk rule was applicable only to subchapter S corporations and personal holding companies, and not to other closely held corporations. Other closely held corporations were able to use tax shelter deductions to avoid the accumulated earnings tax or to shelter income on which owner-employees would otherwise pay tax at the individual level. To eliminate this type of income tax sheltering by these corporations, the Congress concluded that the at risk rules should be extended to closely held corporations, except those the primary activity of which involves equipment leasing.

Under a liberal interpretation of prior law, subsequent withdrawals of amounts originally placed at risk (or changes in the status of such amounts so that they are no longer at risk) could have been made without the recapture of previously allowed losses. Since this circumvented the intent of the at risk limitation, the Act requires the recapture of previously allowed losses when the amount at risk is reduced below zero by withdrawals or changes in the status of amounts from at risk to not at risk.

The Act revises the at risk rules by applying the specific activity at risk rule to all activities other than real estate. The partnership at risk rule is therefore repealed as redundant. The revised at risk rule also applies to corporations in which 5 or fewer individuals own more than 50 percent of the stock (except for certain situations involving equipment leasing). In the case of an affiliated group of corporations, the revised at risk rule is to apply to all corporations in the group if it applies to the common parent. Finally, the revised at risk rule requires a taxpayer to recapture losses previously claimed if he received distributions in excess of his at risk basis or if the amount which had previously been at risk is reduced below zero by the conversion of recourse debt to nonrecourse debt, by the commencement of a guarantee, or by similar changes in the amount of a taxpayer's at risk basis.

Extending the at risk rule to all activities other than real estate

The determination of whether a person actively participates in the operation or management of a trade or business depends upon the facts and circumstances. Factors which tend to indicate active participation include participating in the decisions involving the operation or management of the trade or business, actually performing services for the trade or business, or hiring and discharging employees (as compared to only the person who is the manager of the trade or business). Factors which tend to indicate a lack of active participation include lack of involvement in management and operation of the trade or business, having authority only to discharge the manager of the trade or business, or having a manager of the trade or business who is an independent contractor rather than an employee.

Furthermore, the Internal Revenue Service is given specific authority to prescribe regulations under which the activities which are made subject to the at risk limitation by the Act are to be aggregated or treated as separate activities. Thus, the regulations might provide for the aggregation of certain related activities which together do not necessarily constitute a trade or business, particularly where the activities involved do not have significant tax shelter potential. On the other hand, if one or more of the activities have tax shelter characteristics, the regulations may require separate activity treatment for one or more activities which constitute a single trade or business and which, under the rules described in the preceding paragraphs, would qualify for aggregation. Tax shelter characteristics which may be taken into account in the regulations include the presence of accelerated deductions, mismatching of income and deductions, substantial nonrecourse financing, novel financing techniques which do not conform to standard commercial practices, property whose value is subject to substantial uncertainty, and the marketing of the activity to prospective investors as a tax shelter. In the absence of regulations permitting or requiring aggregation, it is anticipated that each investment which is not part of a trade or business will be treated as a separate activity, and separate investments will not be aggregated.

In situations where a trade or business involves both the molding of real property (other than mineral property) and the provision of personal property and services which are not incidental to making real property available as living accommodations, the holding of the real property will be treated as a separate activity which is not subject to the at risk rule: the remainder of the trade or business will be treated as a separate activity (or separate activities) to which the at risk rule would apply.³ In these situations, an allocation of the receipts, income, deductions, and basis of the actives would be made. The allocation of income to the real property would equal that amount of income which bears the same ratio to the total amount of income as the real property related deductions bear to the total deductions.⁴ For this purpose, deductions for administrative expenses or general overhead relating to real estate and other activities are to be reasonably allocated.

As an alternative to the method of allocation described above, if the fair rental value of the real property can be clearly established, taxpayers may elect to treat the fair rental value of the real property involved as the amount of income allocable to that property.⁵

The Act does not change the treatment provided under the Tax Reform Act of 1976 with respect to real estate used in one of the specified activities covered by the 1976 Act provisions (farming, oil and gas activities, motion pictures, or leasing of personal property). This real estate would be treated as part of the activity, rather than as a separate activity. Thus, for example, real property used in farming would be considered a part of the farming activity subject to the at risk rules.

However, the Act continues a transitional rule in the 1976 Act. Under this transitional rule, the at risk rule is not to apply to partnership liabilities which were not subject to section 704(d) (as in effect before the date of the enactment of this Act) by reason of section 213(f)(2) of the Tax Reform Act of 1976.

Extension of at risk rules to closely held corporations

A determination of whether the stock ownership test is satisfied is generally made by reference to the stock ownership rule for personal holding companies under section 542(a)(2). Thus, corporation will be subject to the at risk rule if, at any time during the last half of the taxable year, no more than 50 percent in value of its outstanding stock is owned, directly or indirectly, by or for not more than 5 individuals. The term "individuals" includes estates and trusts. (See sec. 641 (b).) Moreover, in applying this stock ownership rule, a pension trust, a supplemental employment benefit trust (sec. 501(c)(17)) a charitable organization (described in sec. 509(a)), or at portion of a trust permanently set aside or to be used exclusively for charitable purposes (described in sec. 642(c)) shall be considered an individual. However, in determining whether 5 or fewer individuals own more than 50 percent of the stock of a corporation, the attribution rules of section 318, not section 544, are to apply.

If a corporation meets these ownership requirements, it will be subject to the at risk rule, even if it does not meet other definitional requirements of a personal holding company (see sec. 542(a)(1)) or because it is excepted from personal holding company status (by sec. 542(c)).

Losses attributable to any equipment leasing activity, which were suspended as a result of the application of the at risk rule, are to become fully deductible for the first taxable year in which the corporation meets the 50 percent or more gross receipts requirement. For the fist taxable year in which a corporation fails to meet the 50 percent or more gross receipts requirement, the at risk basis in the equipment leasing activity is be computed in accordance with the rules (including transitional rules¹⁰) normally applicable to computing at risk basis for the first year that an activity is subject to the at risk rule.

Recapture of losses where amount at risk is less than zero

Under a literal interpretation of prior law, the at risk rules may have only required the taxpayer to be at risk at the end of the taxable year for which the losses are claimed. Thus, arguably, subsequent withdrawals of amounts originally placed at risk may have been made without the recapture of previously allowed losses. However, in order to be consistent with the original intent of the at risk rules, the Act requires the recapture of previously allowed losses when the amount at risk is reduced below zero. This recapture the rule only applies to losses which are allowed (and reduce the taxpayer's at risk basis in the activity involved) for taxable years beginning after December 31, 1978.

Mechanically, this rule works by providing that, if the amount at risk is reduced below zero (by distributions to the taxpayer, by changes in the status of indebtedness from recourse to nonrecourse, by the commencement of a guarantee or other similar arrangement which affects the taxpayer's risk of loss, or otherwise),the taxpayer will recognize income to the extent that his at risk basis is reduced below zero. However, the amount recaptured is limited to the excess of the post-December 31, 1978, losses previously allowed in that activity (which reduced the taxpayer's at risk basis in the activity) over any amounts previously recaptured.

The types of events which can result in the at risk I basis being reduced below zero include distributions to the taxpayer, changes in the amount of recourse indebtedness attributable to the taxpayer, or the commencement of guarantees or similar arrangements which would reduce the taxpayer's amount at risk: losses cannot result in the at risk basis being reduced below zero (since the deduction of losses is allowed only to the point where the at risk basis is zero and further deduction of losses is suspended under the at risk rules). The effect of this recapture rule is to treat the reduction below zero in the amount at risk as if it had preceded the deductions which had been used to offset the original at risk amount. Consequently, an suspended deduction in the amount equal to the amount of income would be provided to the taxpayer. This suspended deduction would be allowed in a subsequent year if and to the extent the taxpayer's at risk basis is increased. A transitional rule provides that if the amount which the taxpayer is at risk in an activity as of the close the taxpayer's last taxable year beginning before January 1, 1979, is less than zero, the provision is applied as if this negative at risk amount were zero and only further decreases in the at risk basis would be required to be included in income.

However, with respect to leasing activities conducted by a closely held corporation which are subject to the at risk rule, the at risk rule will not apply to any type of leasing transaction where the property was either leased or ordered (by the lessor or lessee) before November 1, 1978, but only for those taxpayers who owned their interests in the property on October 31, 1978. For purposes of these transitional rules, an order, a lease, and the acquisition of an interest in the property will not be considered to have occurred until they are evidenced by binding and legally enforceable agreements which are complete as to all relevant terms. However, a lease agreement will he considered binding on the relevant dates under the above provisions even though it is later modified to increase (but not decrease) the lease term.

In addition, the loss recapture provision applies only to losses which were allowed and reduced the taxpayers at risk basis in the activity involved for taxable years beginning after December 31, 1978.

In applying the at risk provisions to activities which were not subject to the at risk rule in taxable years beginning before January 1, 1979 (and not exempted from the at risk provision by transitional rules in this Act or the 1979 Act), amounts paid or incurred in taxable years beginning prior to that date and deducted in such taxable years will generally be treated as first reducing that portion of the taxpayer's basis which is attributable to amounts not at risk. On the other hand, withdrawals made in taxable years beginning before January 1, 1989, will be treated as reducing the amount which the taxpayer is at risk.

Partnerships are required to file an annual information return setting forth the partnership income, deductions, and credits, names, and addresses of the partners, each partner's distributive share of these items, and certain other information required by the regulations. Neither the partnership nor any partner was subject to a civil penalty for failure to file ,or for late filing of, a partnership information return.

Since a partnership is a conduit rather than a taxable entity, adjustments in tax liability may not be made at the partnership level. Rather, adjustments are made to each partner's income tax return at the time that return is audited. A settlement agreed to by one partner with the Internal Revenue Service is not binding on any other partner or on the Service in dealing with other partners. Similarly, a judicial determination of an issue relating to a partnership item generally is conclusive only as to those partners who are parties to the proceeding.

The Code provides a period of limitations during which the IRS can assess a tax or a taxpayer may file a claim for refund. Generally, the period is 3 years from the date the tax return is filed (if filed before the due date, the due date is treated as the date filed). If more than 25 percent of the gross income is omitted from a return, the statutory period for assessment is 6 years. In the case of a partnership, the income tax return of each of the partners began that individual partner's period of limitations. The date of filing of the partnership return did not affect the individual partner's period of limitations. In order to extend the period of limitations with respect to partnership items, the IRS was required to Obtain a consent for extension of the statute of limitations from each of the partners -- not the partnership. Generally, an agreement to extend the period of limitations related to all items on the returns of the partner who consented to the extension.

The IRS has identified instances in which large complex partnerships have not filed the annual partnership information return or, if filed, the return does not contain the information necessary to identify the ultimate taxpaying partners. Consequently, the IRS has been forced to spend considerable time and resources attempting to determine who the partners are and whether the have reported their distributive shares of partnership items.

If the audit of the partnership return is expected to take a considerable length of time, as it often does in the case of the large complex tax shelter arrangements, the IRS has attempted to obtain waivers of the statute of limitations from each partner or other taxpayer who may be affected by the audit. 0btaining these waivers has been complicated, not only by the fact that it was difficult to identify these taxpayers, but also by the fact that in many cases the partners were widely dispersed geographically.

The Congress believed that the IRS would be better able to cope with auditing these large partnerships if it had complete and timely-filed return information with which to work. The Congress believed that the period of limitations in the case of large partnerships should not commence until a partnership return identifying the partners was properly filed. In addition, the Congress believed that in these situations the period of limitations with respect to partnership items should be extended for an additional year.

The Act adds a new provision (section 6698 of the Code) that imposes a penalty on the partnership for failure to timely file a complete partnership information return as required by existing Code sections 6031 (relating to the information to be included in a partnership return) and 6072 (relating to the time for filing the partnership return). The penalty is in addition to the criminal penalties imposed by Code section 7203 for willful failure to file a return, supply information, or pay a tax.

The penalty is assessed for each month, or fraction of a month (but not to exceed 5 months), that the partnership return is late or incomplete. The amount of penalty for each month, or fraction of a month, is 50 multiplied by the total number of partners in the partnership during the partnership's taxable year for which the return is due. The penalties assessed against the partnership. Partners are to be individually liable for the penalty to the extent of their liability for partnership debts generally.

The penalty will not be imposed if the partnership can show that failure to file a complete or timely return is due to reasonable cause. With respect to "small" general partnerships (those with 10 or fewer individual partners), it is anticipated that the reasonable cause requirement will be satisfied if each of the partners has fully reported all partnership items on his or her individual return.

The assessment of the penalty is not subject to the deficiency procedures of the Code. Thus, the partnership may not contest the assessment of the penalty in the United States Tax Court, but rather must pay the entire penalty and sue for refund in the U.S. District Court or Court of Claims.

The penalty only applies where a partnership return is required to be filed. Thus, an unincorporated organization which has properly elected (under section 761 (a)) not to be treated as a partnership) is not subject to these penalties since no partnership return is required to be filed by that organization.¹

Extension of statute of limitations

The Act amends Code sections 6501 and 6511 to extend the period of time in which assessments of deficiencies and claims for refund of tax attributable to "partnership items" may be made. These special periods of limitation apply only to partnership items that are attributable to "federally registered partnerships" (as discussed below).

With respect to deficiencies, the Act provides generally that the Service may assess a deficiency attributable to partnership items within 4 years after the partnership return for the partnership taxable year in which the item arose is filed. If the partnership return does not properly show the name and address of the person to be assessed the deficiency, the mode of assessment will not expire until 1 year after that information is provided to the Service in the manner prescribed by regulations. In the case of partnership tiering arrangements, it us anticipated that the in regulations will provide that this notification requirement is satisfied as to any taxpayer if each "pass through" entity within the tiering arrangement (e.g., partnerships, trusts, nominees, and subchapter S corporations) through which he traces his claim of ownership property discloses the name, address and taxpayer identification number of their respective owners.² If the partnership return is filed before the date prescribed by law for filing the return (determined without regard to extensions), the date filed will be considered the due date.

Any general partner of the partnership in which the partnership item arose, or any other person authorized by the partnership in writing, may consent to extend the 4-year period of limitation for all partners. The partnership may restrict the authority of any (or all) general partner(s) to execute such a consent by notifying the Secretary of the Treasury in writing in the manner prescribed by regulations.

With respect to credits and refunds, the Act provides generally that the taxpayer may file a claim for credit or refund of tax attributable to partnership items within 4 years after the due date (including extensions) of the partnership return for the partnership taxable year in which the item arose. If the taxpayer, or a general partner or a person authorized by the partnership, has entered into an agreement with the IRS to extend the period of time for assessing a deficiency attributable to partnership items, a claim for credit or refund of tax attributable to partnership items may be filed within 6 months after the expiration of the extension of the for assessment.

If a taxpayer incurs a net operating loss for a taxable year, the portion of the loss that is attributable to a partnership item may be carried back on a claim for refund filed at any time up to 4 years following the due date of the partnership return for the partnership taxable year in which the item arose.

These special periods of limitation for assessments or claims for refund of taxes attributable to partnership items are in addition to, and not a replacement of, the periods of limitations provided in present laws.³

Similarly, if a claim for credit or refund for any item on a return, including partnership items, could be filed under present new rules at a time later than the which is provided by the special rules for partnership items, the special rules do not preclude the filing of the claim.

Federally registered partnership

The special period of limitations applies only to partnership items flowing from "federally registered partnerships." A federally registered partnership means any partnership the interests in which have been offered for sale prior to the close of the taxable year in an offering required to be registered with the Securities and Exchange Commission, or any partnership which is or has been subject to the annual reporting requirements of the Securities and Exchange Commission relating to protection of investors in the partnership. For example, the reports required to be filed with the SEC by a brokerage firm or an accounting firm organized as partnerships for regulatory purposes do not cause these firms to be treated as Federally registered partnerships. A partnership may not avoid the extension of the period of limitations by failing to register or report as required by the SEC. If a partnership is excused from registration or reporting by either a statutory or regulatory exemption of the SEC, it is not to be treated as a Federally registered partnership.

Partnership item

With respect to any taxpayer, a partnership item is attributable to a federally registered partnership if it arose in a federally registered partnership or is taken into account by the taxpayer by reason of a chain of ownership that includes a federally registered partnership.

In determining whether an item is a partnership item, two tests are applied. First, the item must be one that is required to be taken into account by the taxpayer, or any other entity in which the taxpayer has a direct or indirect interest, under any provision of the partnership provisions (subchapter K of chapter 1 of the Code). Second, the Secretary of the Treasury must prescribe by regulation that the item is more appropriately determined at the partnership level than at the partner level. If either of these tests is not met, the item is not a partnership item. In addition, other items are partnership items to the extent they are affected by a partnership item.⁴

An item is considered required to be taken into account under subchapter K if, under any reasonable characterization of the item, it may affect the basis in partnership property, the distributive share or the basis in the partnership interest of any two or more partners, one of whom is the taxpayer.⁵

The statute of limitation provisions of the Act is effective for items arising in partnership taxable years beginning after December 31, 1978.

For taxable years ending after December 31, 1978, the normal tax was scheduled to return to 22 percent on all corporate taxable income, and a 26-percent surtax was to be reimposed on all taxable income in excess of $25,000. Thus, for taxable years ending after December 31, 1978, corporations would have corporate income tax of 22 percent on the first $25,000 of taxable income and 48 percent on taxable income in excess of $25,000.

Graduated corporate tax will also reduce the abrupt jump in tax rates under present law as taxable income increases above $50,000, under the expiring temporary provisions, and above $25,000, under the permanent provisions in present law. The tax rate increase from 22 percent to 48 percent under present law constitutes a 118-percent increase. Congress believes that this increase imposed too great a tax burden on the increment to taxable income. A more gradual increase from the lowest to highest corporate income tax rate will reduce this large increase in the marginal rate on incremental income.

Moreover, application of the graduated rates to corporations should reduce the impact of the tax laws in the selection of a form of organization for operation of small business. Under prior law, corporate tax rates increased from 22 percent to 48 percent for taxable income in excess of $50,000. Reduction in the corporate tax rates and application of graduated rates to corporations would reduce the relative importance of the tax laws on this choice. As a result, nontax economic factors will receive greater emphasis in selection of the corporate, partnership, or sole proprietorship form for the operation of a small business.

 Taxable income         Tax rate

The Act (sec. 106) specifically applies the rules for rate changes of fiscal year corporate taxpayers (sec. 21 of the Code) to allow these corporations the benefits of the new corporate rates for that part of their 1978-1979 fiscal year which falls in 1979. Under this provision, fiscal year taxpayers are to compute their tax liability for that year both without regard to these changes and taking these changes into account. The difference in these two amounts is then to be prorated over the fiscal year, and the tax reduction is allowed to the extent of the amount falling in 1979.

The combined effect of extending the present corporate tax rates and the additional revenue effects of enacting the rate structure in this provision will be a reduction in budget receipts of $3,208 million in fiscal year 1979, $7,434 million in 1980, and $9,759 million in 1983.

(sec. 311 of the Act, secs. 46(a)(2) and 48(c) of the Code, and sec. 301(c)(2) of the Tax Reduction Act of 1975)

Prior law also limited the availability of the credit for investment in qualified used property to $100,000 in each taxable year for any taxpayer. This limitation was increased temporarily from $50,000 to $100,000 under the Tax Reduction Act of 1975, and, as extended under subsequent legislation, was scheduled to return to $50,000 in 1981.

The Congress believed that, with respect to long-term investment. the effectiveness of the credit was reduced by the uncertainty as to whether the present temporary 10-percent credit would be extended or made permanent. This uncertainty could distort orderly investment programs as businesses rush to place equipment in service before the temporary rate is scheduled to expire.

2. Increase in Limitations on Investment Credit to 90 Percent of Tax Liability

(sec. 312 of the Act and sec. 46(a) of the Code)

Generally, investment credits which are not used in the year earned, because of the limitation on the amount of tax liability that may be offset, may be carried back to the preceding three taxable years and carried over to the seven following taxable years. Credits which are not used during these carryback and carryover periods expire, and the taxpayer no longer obtains tax benefits from the credits.

Special rules are also provided for railroads, airlines, and certain utilities so that the phase-in of this increase to the limitation does not reduce the amounts of investment credits these taxpayers may be entitled to use under the special increased limitations available to them in present law. For example, present law provides both railroads and airlines, if eligible, with a limitation of up to 80 percent for 1980, when the generally applicable limitations under the Act will be 70 percent. In this situation, eligible taxpayers investing in railroad property or in airline property may apply whichever limitation that entitles them to use the greater amount of investment credits.

3. Increased Credit for Pollution Control Facilities

(sec. 313 of the Act and sec. 46(c) of the Code)

In many cases, installation of the equipment in an existing facility neither increases productive efficiency nor increases the capacity to produce. The costs of pollution control then must be included in product prices, which has inflationary consequences and tends to reduce the rate of return on investment.

The need to use investable funds for pollution control, of course, reduces the funds available for investment in equipment directly related to the productive process. Congress has re-examined this area and has concluded that it is desirable to make the full investment credit available in conjunction with the election of five-year amortization because the taxpayer has incurred these costs in order to carry out a social policy. Congress also believes that the consequent reduction in the costs of complying with the antipollution regulations will free internally generated funds for investment in equipment which will increase productive capacity and efficiency.

A limitation is provided where five-year amortization is elected and the pollution control facility has also en financed in whole or in part by tax-exempt industrial development bonds. In order to reduce the duplication of tax incentives in such situations, the Act limits the amount of credit to, in effect, one-half of the full credit. In cases where the proceeds of industrial development bond have been used in part to finance the construction of a plant or factory, including a pollution control facility for which the taxpayer elects five-year amortization, a pro-rated portion of the tax-exempt financing should be allocated to the pollution control facility for purposes of applying this limitation.

4. Investment Credit for Single Purpose Agricultural Structures

(sec. 314 of the Act and sec. 48(a)(1) of the Code)

Under existing law, buildings and their structural components generally are not eligible for the investment credit. Ineligible buildings have been generally considered to include any structure which encloses a space within its wal1s (and usually covered by a roof) which is used primarily to provide shelter or working space. Examples of buildings include factory and office buildings, warehouses, and barns (Regs. sec. 1.48-1(e)(1)). While the Internal Revenue Service had ruled that barns, stables, and poultry houses were buildings and were ineligible for the credit, certain single purpose structures have not been considered ineligible buildings.² A single (or special) purpose structure which qualifies for the credit is one which houses property used as an integral part of a production activity (including farming) where the structure is so closely related to the use of the property that it is clearly expected to replaced when the property it houses is replaced. One characteristic of this type of structure is that it cannot be used economically for any purpose other than that related to the property it houses.³

In the Senate Finance Committee report on the Revenue Act of 1971, Congress stated that the single purpose structures used in unitary hog-raising systems would be considered single purpose structures which qualify for the investment credit and would not be considered buildings.⁴ The Internal Revenue Service continued to approach the question of eligibility of single purpose farm structures on a case-by-case basis. For example, in three recent cases, the IRS contended that structures which are designed and used for poultry-raising and egg-producing activities were not eligible for the investment credit.⁵ Although the IRS was reversed in two of these cases. it was understood that the Service continued to adhere to the position that single purpose poultry-raising and egg-producing structures were not generally eligible for the investment credit.

Greenhouses are structures which provide an environment for the controlled growth of flowers and other plants. These structures also provide working space for persons who care for the flowers and plants within the greenhouse. It is the position of the Internal Revenue Service hat greenhouses are buildings and consequently are ineligible for the credit. This position is based on the fact that these structures provide working space for persons tending the plants. The Service's position was sustained in two Tax Court cases decided in 1972.⁶ However, the Tax Court was overruled in one of these eases on appeal.⁷ In this latter case, the Ninth Circuit Court of Appeals found that the worker's activities in the greenhouse were "merely supportive of, and ancillary to" the principal use of the structure of providing an environment for controlled plant growth.

It is intended that this provision be broadly construed to apply to all types of single purpose structures and enclosures used to breed, raise and feed livestock and poultry (including the production of eggs and milk), and for the cultivation of plants. Thus, this provision will cover unitary hog, poultry, and cattle-raising systems, milking parlors, and commercial mushroom houses or greenhouses used to produce either plants or plant products.

If a single purpose structure becomes ineligible because of the usage test within seven years from the time it was placed in service, investment credits claimed on the structure may be partially or entirely recaptured under the investment credit recapture rules in present law. In addition, Congress wishes to emphasize that the specific provisions concerning the eligibility of these structures for the investment credit are not to create a negative inference regarding the eligibility of other single purpose agricultural and productive structures for the credit under existing law.

The amendment is not in intended to apply to general purpose agricultural structures, such as barns and other farm structures, which can be adapted to a variety of uses,

In addition, the Senate Finance Committee report stated that tangible personal property already eligible for the investment tax credit includes special lighting (including lighting to illuminate the exterior of a building or store, but not lighting to illuminate parking areas), false balconies, and other exterior ornamentation that have no more than an incidental relationship to the operation or maintenance of a building, and identity symbols that identify or relate to a particular retail establishment on restaurant such as special materials attached to the exterior or interior of a building or store and signs (other than billboards). Similarly, the Senate Finance Committee report stated that property eligible for the investment tax credit under prior law included floor coverings which are not an integral part of the floor itself, such as floor tile generally installed in a manner to be readily removed (that is it is not cemented, mudded, or otherwise permanently affixed to the building floor but, instead, has adhesives applied which are designed to ease its removal), carpeting, wall panel inserts such as those designed to contain condiments or to serve as a framing for pictures of the products of a retail establishment, beverage bars, ornamental fixtures (such as coats-of-arms), artifacts (if depreciable), booths for seating, moveable and removable partitions, and large and small pictures of scenery, persons, and the like which are attached to walls or suspended from the ceiling.

5. Investment Credit for Certain Rehabilitated Structures

(sec. 315 of the Act and sec. 48 of the Code)

Presently, there is a similar concern about the declining usefulness of existing, older buildings throughout the country, primarily in central cities and older neighborhoods of all communities. This situation, in part, reflects basic demographic and economic trends. It also is a response to changing architectural and engineering designs of buildings and the internal placement and flow of activities in manufacturing and commercial enterprise.

The Congress believed that it was appropriate now to extend the initial policy objective of the investment credit to enable business to rehabilitate and modernize existing structures. This change in the investment credit should promote greater stability in the economic vitality of areas that have been deteriorating.

The Act extends the investment credit to rehabilitation expenditures incurred in connection with existing buildings used in all types of business or productive activities except those, such as apartments, which are used for residential purposes. Eligible buildings include factories, warehouses, office buildings, hotels,¹ and retail and wholesale stores. The type of eligible building is to be determined on the basis of its use when placed in service after the rehabilitation, e.g. apartment building rehabilitated for use as an office building would be treated as an eligible office building.

In order to qualify as a rehabilitation expenditure, the expenditure must be incurred after October 31, 1978, in connection with the rehabilitation or reconstruction of a building which has been in use for a period of at least 20-years before the commencement of the rehabilitation. For this purpose, the determination of the 20-year period would be unaffected by periods during which a building was vacant or devoted to a personal use. In addition, the 20-year test is to be applied to the building without regard to the number of owners. The running of the 20-year period would commence at the earlier of the time depreciation deductions were first allowable with respect to the building or when it was first placed in use for any purpose (Treas. Reg. sec. 1.46-3(d)).

A rehabilitation of a building, or a major portion thereof, which had previously been rehabilitated would not be eligible for the credit until 20 years after building was placed in service following completion of a prior rehabilitation for which a credit was allowed. (However, this latter limitation should not be interpreted to require continuous rehabilitation activity and preclude allowing the credit where there are delays between phases of a rehabilitation plan.) In addition, in order to exclude minor repairs or improvements, the costs must be of the type which must be capitalized under existing law (and not expensed and must be incurred for property which has a useful life of at least five years.

In situations where a part of a building is rehabilitated, the rehabilitation costs will qualify for the credit only if the rehabilitated part constitutes a "major portion" of the building. In determining whether a part of a building constitutes a major portion, such factors as volume, floor space, and functional differences between the rehabilitated and unrehabilitated parts of the building should be taken into consideration. For example, where a substantial part of a building is used for commercial activities (such as retail stores) and another part is used for warehousing, each part will usually constitute a major portion of the building for purposes of these provisions. In addition, a rehabilitation of leased premises, by either the lessor or the lessee, of the entire leasehold interest of a major portion of a building will be considered an eligible rehabilitation.

Under these rules and existing law, qualifying expenditures will be eligible for a two-thirds investment credit if the improvements attributable to the expenditures have a useful life of five or six years, and a full credit where the useful life is seven years or more. Useful life for this purpose is the useful life used by the taxpayer for depreciation purposes. In addition, the existing rules concerning the recapture of investment credits will apply, so that, if the property is disposed of or ceases to be qualifying property before the end of the appropriate useful life for which the credit was allowed, all or part of the credit will be recaptured.

Qualified rehabilitation costs will be considered as incurred for new property and, therefore, not subject to the $100,000 used property limitation, except to the extent such costs are for property (such as used elevators) which otherwise qualify for the investment credit. In these latter cases, the costs will not considered as rehabilitation expenditures.

For purposes of this provision, the rehabilitation of a building will include the renovation, restoration, and reconstruction of an existing building. Thus, in interior or exterior renovation or restoration to materially extend the useful life of the building, to significantly upgrade its usefulness, or to preserve it will nominally qualify. Capital expenditures or the replacement of plumbing, electrical wiring, flooring, permanent interior partitions and walls, and the heating or air conditioning systems (including temperature control systems) could qualify as qualified rehabilitation expenditures when incurred in connection with a rehabilitation.² In addition, expenditures for the removal of existing interior walls, plumbing, electrical wiring, flooring, etc., would qualify if the expenditures were incurred in connection with the rehabilitation of a building and treated as capital expenditures for property with a useful life of at least 5 years.

If a rehabilitation is undertaken by a lessee, the lessee is eligible for the investment credit for qualified rehabilitation costs incurred by him, to the extent these costs are required to be capitalized by him and are not treated under other provisions of the law as payments in lieu of rent. Costs for which a lessee is entitled to reimbursement from the lessor would be taken into account for credit purposes by the lessor rather than the lessee. In determining qualified investment by a lessee, the useful life of a lessee's rehabilitation costs will be the useful life allowed to the lessee for purposes of depreciation or amortization of these costs under Code sections 167 and 178.

In the case of rehabilitation by a lessor, the investment credit may be flowed through to lessee under regulations prescribed by the Secretary of the Treasury under code section 48(d).

Nonqualifying expenditures

The costs of acquiring a building or an interest in a building (such as a leasehold interest) will not be considered as qualifying expenditures nor will costs that are incurred in connection with facilities, such is parking lots, which are related to an existing building. In addition, construction cost for a new building, or for completing a new building after it has been placed in service, will not qualify.

Limitations are also provided to exclude costs incurred for new construction or enlargement of an existing building. In the case of an enlargement, costs will not be considered qualifying expenditures to the extent incurred to expand the total volume of the existing building. However, an increase in floor space resulting from interior remodeling will not be considered an enlargement. In addition, construction costs will be considered for new construction rather than for the rehabilitation of a building if no more than 25 percent of the existing external walls of the building are replaced. This latter restriction, however, is not intended to be interpreted to cover situations where existing walls are covered (e.g. the outer walls are covered by new siding in connection with the rehabilitation) or reinforced.

Certified historic structures

In the case where expenditures are eligible for 5-year rapid amortization as rehabilitation expenditures for a certified historic structure, a taxpayer must choose between the benefits of 5-year rapid amortization for the rehabilitation expenditures or the investment tax credit on the expenditures. If rapid amortization is chosen, the expenditures will not be eligible for the investment tax credit. In addition, rehabilitation expenditures in connection with a certified historic structure must themselves be certified as appropriate by the Secretary of the Interior in order to qualify for the investment credit in those situations where the taxpayer elects to claim the credit rather than 5-year amortization.

6. Investment Credit for Cooperatives

(sec. 316 of the Act and sec. 46 of the Code)

Because of this special treatment, the amount of otherwise allowable investment credit which could have been used by a cooperative was limited under prior law by a fraction, the numerator of which was the cooperative's taxable income and the denominator of which was the cooperative's taxable income plus the deductible payments made to patrons and shareholders (sec. 46(e)(2)(C)). The portion not allowed to the cooperative was not passed through the patrons.

The investment credit earned by the cooperative for a taxable year will be applied to reduce the cooperative's tax liability for that taxable year. To the extent the cooperative cannot use an investment credit in the current year, the credit will not be carried back or carried forward but will be allocated to the patrons of the cooperative. However, it is not intended that these new rules apply to carryover credits of the cooperative from years prior to the effective date of this provision. As a result, the cooperative must apply these carryover credits first to its current year tax liability, which may indirectly increase the amount of credits allocated to patrons for the current year. In addition, credits disallowed to cooperatives under section 46(e) for taxable years ending prior to the effective date are not revived and may not be carried over or passed through to the patrons.

The investment credit rules (sections 46-48) will generally be applied at the level of the cooperative. Thus, the determination of qualified investment and useful lives will made by the cooperative. It will compute the amount of credits for the taxable year and will apply the credits to its tax liability to the extent allowed for the taxable year and apportion the remainder of these credits to its patrons. The passed-through credits are apportioned among the patrons on the basis of the quantity or value of business done with or for the cooperative's patrons for the taxable year.

The cooperative will report to the Internal Revenue Service the amount of credits apportioned to each patron for the taxable year using the same reporting system as is used for reporting patronage dividends and other distributions which are taxable to the patron for the taxable year.

The patron to whom investment credits are allocated is required to report these credits on his income tax return for the first taxable year which includes the payment period for the cooperative's taxable year in which the cooperative earned the credit. This tax liability limitation (under section 46(a)(3)) and carryback and carryover rules (under section 46 (b)) will be applied by the patron to the credits allocated to him by the cooperative.

With respect to any credit passed through to patrons, the investment credit recapture provisions are to applied by treating the cooperative as the taxpayer. If there is an early disposition of the property, which is subject to recapture under section 47, any recapture of credit will be made at the level of the cooperative and no recapture will be required of the patrons. The credit passed through to the patrons will be viewed as a credit used by the cooperative. Also, the carryover or carryback credits of patrons will not be effected by a disposition of property by the cooperative.

7. Transfers to ConRail not Treated as Dispositions for Purposes of the Investment Credit

(sec. 317 of the Act and sec. 47(b) of the Code)

Under the legislation which established it, ConRail, a taxable corporation, was to acquire , rehabilitate, and operate the railroad properties. The transferor railroads (and their subsidiaries and affiliates) received ConRail stock and certificates of value issued by the United States Railway Association, a nonprofit Government corporation formed to oversee the ConRail reorganization.

In 1976, the Congress also enacted legislation to deal with certain of the tax consequences of this reorganization to ConRail, the transferor railroads, and the shareholders and creditors of the transferor railroads. Under this legislation,² the transfer of rail properties to ConRail was treated like reorganizations in general (and other bankrupt railroad organizations in particular) so that the transferor companies and their shareholders and security holders did not reorganize gain or loss on the transfer and ConRail received a carryover basis in the properties it acquired.

However, this 1976 tax legislation did not deal with investment credit recapture which might arise to the transferor railroads because of the ConRail reorganization. In contrast, present law generally provides an exemption from investment credit recapture where assets are transferred in tax-free reorganization.

The Act corrects this uncontemplated result arising from the ConRail reorganization.

This provision will reduce budget receipts by 3 million in fiscal year 1979.

(sec. 321 of the Act and secs. 51, 52, and 53 of the Code)

The total amount of the credit had four limitations: (1) the credit could not be more than 50 percent of the increase in total wages paid by the employer for the year above 105 percent of total wages paid by the employer in the previous year. (2) the credit could be no more than 25 percent of the current year's FUTA wages (3) the credit for a year could not exceed $100,000 and (4) the credit could not exceed the taxpayer's tax liability. Credits which exceeded tax liability for a year could be carried back for 3 years and carried forward for 7 years.

Although most employer's were able to use the returns they filed for purposes of complying with FUTA as a basis for claiming the credit, special rules were provided for businesses, such as farms and railroads, not covered under FUTA.² Special rules also were provided for computation of the credit by groups of companies under common control, for businesses with employees working abroad, and for businesses affected by acquisitions, dispositions, and other changes in business form. Additional rules were provided for allocating the credit among members of a partnership and of a subchapter S corporation.

Prior law (adopted under the 1977 Act) also provided an additional nonincremental credit equal to 10 percent of the first $4,200 of FUTA wages paid to handicapped individuals (including handicapped veterans) who received vocational rehabilitation. The credit was based on the first $4,200 of wages paid to a handicapped individual whose first FUTA wages from the employer were paid in 1977 or 1978. Only wages paid during the 1-year period beginning when the individual was first paid FUTA wages by the employer were taken into account in computing the 10-percent credit. The credit for handicapped workers could not be greater than one-fifth of the regular 50-percent new jobs credit which wou1d have been allowable without regard to the $100,000 limitation. However, the special 10-percent credit was not itself subject to any specific dollar limitation.

The Congress, therefore, decided to let the current new jobs credit expire at the end of 1978. In its place, the Congress designed a provision which should provide an incentive for private employers to hire individuals in seven target groups. The groups have been defined on the basis of their low income or because their employment should be encouraged. Included among the targeted individuals are vocational rehabilitation referrals, economically disadvantaged youths, economically disadvantaged Vietnam-era veterans. Supplemental Security Income recipients, general assistance recipients, youths participating in a cooperative education program, and economically disadvantaged convicts.

Under the Act, it was intended that the jobs credit would be extended for a 3-year period to apply to eligible wages paid before 1982. However, due to a typographical error in the statute, the credit is extended only for a 2-year period, i.e., wages paid after 1980 are ineligible. It is anticipated that corrective legislation will be introduced in the 96th Congress.

Also, the Act amends the provisions of the jobs credit so that a credit is allowed only for hiring members of seven target groups. The credit allowed to a taxpayer who elects the credit in any taxable year is equal to 50 percent of qualified first-year wages and 25 percent of qualified second-year wages. Qualified first-year wages consist of wages attributable to service rendered by a member of a target group during the one-year period beginning with the day the individual first begins work for the employer. For a vocational rehabilitation referral, however, the period begins the day the individual begins work for the employer on or after the beginning of this individual's vocational rehabilitation plan. Qualified second-year wages consist of the wages attributable to service rendered during the one-year period which begins at the close of the first year described just above. Thus, the date on which the wages are paid does not determine whether the wages are first-year or second-year wages; rather, the wages must be attributed to the period during which the work was performed. With respect to employees in the target groups other than vocational rehabilitation referrals for whom credits currently are being claimed under existing law, qualified wages do not include wages paid or incurred after December 31, 1978, to employees who were first hired by the employer before September 27, 1978. However, employees who are hired on or after that date shall be treated for the purpose of applying the amendments made by this section of the Act as if they began work for the employer on January 1, 1979, or, if later, the actual date they began work.

No more than $6,000 of wages during either the first or second year of employment may be taken into account with respect to any individual.³ Thus, the maximum credit per individual is $3,000 in the first year of employment and $1,500 in the second year of employment. However, the deduction for wages is reduced by the amount of the credit (determined without regard to the tax liability information). Thus, for an employer who hires an eligible employee who earns $6,000 in his first year of employment, the credit causes an actual reduction in taxes which ranges from $900 (for an employer in the 70-percent bracket) to $2,580 (for an employer in the 14-percent bracket).

Two other rules apply to the definition of qualified wages. First, any wages paid to an employee for whom an employer is simultaneously receiving payments for on-the-job training under Federally-funded programs such as the Comprehensive Employment and Training Act (CETA) would not be qualified wages. Second, no wages paid to an employee for whom a WIN-welfare recipient credit is claimed are qualified wages.

Certification of members of target groups

In order to encourage employer participation in the credit, the Act establishes certification provisions which relieve the employer of responsibility for proving to the Internal Revenue Service that an individual is a member of a target group. Rather, the Act requires that the Secretaries of Treasury and Labor jointly designate a single employment agency in each locality, such as the Employment Service, to make this determination and to issue a certificate which, without further investigation on the part of the employer, is sufficient evidence that the individual is a member of such group.

The Act provides that this designated local employment agency issue certification even when another agency, such as the Social Security Administration or a state welfare agency, is in a position to determine whether an individual is a member of a target group. There are several reasons for this provision. First, the Congress believes that by placing responsibility for certifications with the designated local employment agency, the labor market exchange role of such agencies will be strengthened. Second, the various other agencies involved would be extremely reluctant to deal with a myriad of employer inquiries, but would be willing to deal with a single local employment agency.

Furthermore, the Congress believes that the credit can be effective only if the Secretary of Labor, the Employment Service, and local employment and training agencies aggressively promote the credit, use it as a tool for finding jobs for members of the target groups, and provide prompt certification. The Act explicitly provides that the Secretary of Labor, in consultation with the Internal Revenue Service, must take whatever steps are necessary to keep employers informed of the availability of the credit, including use of the mass media and private industry councils established under CETA. The Congress believes that only through such publicity, and through the resulting interchange between employers and public employment agencies, will the intended results be achieved.

Target groups

For this purpose a qualified school is (1) a specialized high school used exclusively or principally for the provision of vocational education to individuals who are available for study in preparation for entering the labor market, (2) the department of a high school used exclusively or principally for providing vocational education to persons who are available for study in preparation for entering the labor market, or (3) a technical or vocational school used exclusively or principally for the provision of vocational education to persons who have completed or left high school and who are available for study in preparation for entering the labor market. In order for a nonpublic school to be a qualified school, it must be exempt from income tax under section 501(a) of the Code. In the case of individuals in this group, wages paid or incurred by the employer are taken into account only if the school certifies that the wages are attributable to services performed as an integral part of the program, while the individual is enrolled in and actively pursuing the qualified cooperative education program and that the individual is age 16 through 18 and not a vocational or high school graduate.

Limitation on amount of qualified wages

To prevent the hiring of targeted employees from displacing a substantial number of non-targeted employees, the Act provides that qualified first-year wages during a taxable year cannot exceed 30 percent of aggregate FUTA wages for all employees during the calendar year ending in that taxable year. FUTA wages are the first $6,000 of wages per employee per calendar year. While for a taxpayer whose taxable year does not end in a calendar year, this limitation does not permit a perfect match between the qualified first-year wages of targeted employees, and the wages of all employees, the percentage is believed to be sufficiently high to compensate for whatever mismatch is likely to occur between time periods as a result of comparing taxable year wages with calendar year wages. This limitation is much simpler than the incremental limitation which previously applied under prior law to the extra credit for vocational rehabilitation referrals.

Special rules are provided for certain agricultural and railroad employers not covered by FUTA. These rules are similar to those in effect under prior law for the new jobs credit and allow these employers to use their records under the social security tax (FICA) and the Railroad Unemployment Insurance Act (RUTA), respectively.

Definition of wages

Wages eligible for the credit are defined by reference to the definition of wages under FUTA, in section 3306 (b) of the Code, except that the dollar limits do not apply. Special rules, similar to those referred to in the previous paragraph, are provided for certain agricultural and railroad employers.

The Act provides the credit only for employees of a trade or business of the employer. This provision excludes, for example, maids, chauffeurs, and other household employees. The Act does not allow a credit unless more than half the employee's wages are for services in the employee's trade or business. The test as to whether more than one-half of an employee's wages are for services in a trade or business is applied to each separate employer, without treating related employers as a single employer. (See discussion under Other rules, below.)

Other rules

In order to prevent taxpayers from escaping all tax liability by reason of this credit, the amount of the credit may not exceed 90 percent of the taxpayer's income tax liability. Furthermore, the credit is allowed only after all other nonrefundable credits have been taken. If, after applying all other nonrefundable credits, 90 percent of a person's remaining tax liability for a year is less than the targeted jobs credit, the excess credit can be carried back three years and carried forward seven years, beginning with the earliest years.

The Act retains several provisions of the prior new jobs credit which are relevant to the targeted jobs credit. Thus, all employees of all corporations are that are members of a controlled group of corporations are to be treated as if the they were employees of the same corporation for purposes of determining the years of employment of any employee, wages for any employee up to $6,OOO, and the 30-percent FUTA cap. Generally, under the controlled group rules, the credit allowed the group is the same as if the group were constituted as a single company. A comparable rule is provided in the case of partnerships, proprietorships, and other trades or businesses (whether or not incorporated) which are under common control, so that all employees of such organizations generally would be treated as if they were employed by a single person. The amount of targeted jobs credit allowable to each member of the controlled group will be its proportionate share of the wages giving rise to the credit.

On the one hand, several rules which were thought necessary for the general jobs credit were not retained in the Act. The purpose of the targeted jobs credit is to encourage employers to hire employees from certain specifically enumerated groups, the hiring of which the Congress believes is deserving of special incentives. Because the Congress' overriding concern is to provide an incentive for the hiring of employees from these groups, the Act provides for no dollar limitation on the amount of the credit. Also, because most tax shelter activities would not be able to obtain sufficient credits to increase the value of the shelter, the Congress decided not to limit the credit allowed to a partner, shareholder of an electing small business corporation, or beneficiary of a trust or estate to the proportionate part of the tax for the year attributable to the taxpayer's interest in the particular partnership. etc., from which the credit is derived.

A transitional mile is included to coordinate the effective date of the targeted credit for 1979 with the expiration of the prior new jobs tax credit at the end of 1978 for fiscal year taxpayers. Under the transition rule a taxpayer with a fiscal year beginning in 1978 will compute his general job credit under prior law (but without regard to the 100 percent of tax liability limitation) for wages paid in 1978 and his targeted jobs credit under the Act also without regard to the 100 percent of tax liability limitation) for wages paid in 1979, add the two credits together and then apply the 100 percent of tax liability limitation. The resulting credit is the amount allowed for that fiscal year.

2. WIN and Welfare Recipient Tax Credits

(sec. 322 of the Act and secs. 50A, 50B and 280C of the Code)

Qualified wages do not include wages provided to employees who were first hired by the employer before September 27, 1978, for services rendered after the one-year period beginning with the date the individual first began work for the employer. However, the employer shall treat eligible employees, who are hired on or after that date, for the purpose of applying the amendments made by this section of the Act as if they began work for the employer on January 1, 1979, or, if later, the actual date they began work.

No more than $6,000 of wages during either the first or second year may be taken into account for a year of employment after 1978 with respect to any individual.¹ Thus, the maximum credit per individual employed in a trade or business is $3,000 in the first year of employment and $1,500 in the second year of employment. In order to prevent the credit and the ordinary wage deduction from causing a tax reduction greater than the amount of eligible wages, and to make the percentage reduction in labor cost equal for all trade or bunnies employers, regardless of their tax bracket, the Act provides that the ordinary deduction for wages is reduced by the amount of the credit. Thus, for a trade or business employer who hires an eligible employee who earns $6,000 in his first year of employment, the credit causes an actual reduction in taxes which ranges from $900 (for an employer in the 70-percent bracket) to $2,580 (for an employee in the 14-percent bracket).

The Act increases the current limitation of the credit from $50,000 of tax liability plus 50 percent of tax liability in excess of $50,000 to 100 percent of tax liability. In addition, the current limitation on eligible wages paid for employment not in a trade or business is increased to $12,000; this will allow any taxpayer to claim credit for up to two full-time nonbusiness employees. The credit for dependent care expenses may not be claimed with respect to any wages for which the taxpayer is allowed a WIN credit. The separate limitation on wages paid with respect to child day care services is eliminated.

The Act provides that the rules defining an eligible employee and the restrictions on the availability of the credit are the same for AFDC recipients and WIN registrants. Thus, an employee will have to fulfill two conditions in order to make the employer eligible for the credit. First, the employee will be either a member of an

AFDC family which have been receiving AFDC at least 90 continuous days immediately preceding the date on which the individual is hired by the taxpayer or must be placed in employment under the WIN program. Second, the employee will have to be employed by the taxpayer in excess of 30 consecutive days on a substantially full-time basis. All rules relating to recapture of the credit, which applied only to WIN registrants, are repealed. WIN registrants, as well as AFDC recipients, will be eligible employees even if employed in nontrade or business activities.

Rules are provided so that all employees of all corporations that are members of a controlled group of corporations are to treated as if they were employees of the same corporation for purposes of determining the years of employment and the $6,000 wage limit for an employee. Generally, under the controlled group rules, the credit allowed the group is the same as if the group were constituted as a single company. A comparable rule is provided in the case of partnerships, proprietorships, and other trades or businesses (whether or not incorporated) which are under common Control, so that all employees of such organizations generally would be treated as if they were employed by a single person. The amount of credit allowable to each member of the controlled group will be its proportionate share of the wages giving rise to the credit.

The Act provides that the credit is permanent.

Finally, the Act, provides that the WIN-welfare recipient tax credit will not be allowed in the case of: (1) expenses reimbursed by a grant; (2) employees who displace other employees from employment; (3) migrant workers; or (4) employees who are close relatives, dependents, or major stockholders of the employer.

An exception to the general rule of taxability of interest on industrial development bonds is provided for certain small issues (sec. 103(b)(6)). This exception applies to issues in amounts of $1 million or less, if the proceeds are used for the acquisition, construction, or improvement of land or depreciable property. At the election of the issuer, the $1 million limitation can be increased to $5 million. If this election is made, the exception is restricted to projects where the aggregate amount of a outstanding exempt small issues and capital expenditures (financed otherwise than out of proceeds of an exempt small issue) made over a six-year period do not exceed $5 million.

Both the $1 million and $5 million limitations are determined by a aggregating the face amount of all outstanding related prior issues, plus, in the case of the $5 million limitation, certain capital expenditures for all facilities used by the same or related principal users which are located within the same county or the same incorporated municipality. However, facilities located in a county are not aggregated, for this purpose, with facilities located in incorporated municipalities within that county.

In addition in order to promote economic development in the areas where it is most needed, the Congress believes that the capital expenditure limitation for certain economically distressed areas should be increased to $20 million.

The Act also, in general, increases the capital expenditure limitation for facilities with respect to which an urban development action grant has been made to $20 million. However, only $10 million of the funds used to finance an urban development action grant facility may be provided through the use of tax-exempt elective small issue industrial development bonds.

Under the Act, if substantially all the proceeds of an elective exempt small issue industrial development bond are used to provide facilities with a respect to which an urban development action grant has been made, then in determining the aggregate face amount of such an issue, capital expenditures in an amount up to $10 million (financed otherwise than out of the proceeds of an exempt small issue) will not be taken into account. For purposes of this provision, "facilities with respect to which an urban development action grant has been made" means facilities owned by, leased to, or assigned to companies or developers named on an original or amended application for an urban development action grant. However, facilities will not meet the requirements of this provision unless the named companies and developers have received an urban development action grant, that they make a firm financial commitment to an urban development project, and that their commitments bear a clear, direct relationship to the activities for which the grant is being made available.

Further, for purposes of determining the total capital expenditures made or incurred with respect to a facility which qualified for the $20 million capital expenditure limitation, existing law shall be used to determine whether amounts expended from an urban development action grant are included or excluded from expenditures.

Although the use of facilities for the local furnishing of electric energy is one specified exempt purpose for industrial development bonds (sec. 103(b)(4)(E)), many bond issues for electric energy facilities cannot qualify for the exemption under current Treasury Department regulations (sec. 1.103-8(f)(2)(iii)(d)), which interpret the term "facilities for the local furnishing of electric energy" to mean in general facilities furnishing electric energy to the general populace in a service area comprising no more than two contiguous counties. The regulation also provides that a city will in general be treated as a county if it is within one or more counties or does not consist of one or more counties.

The Congress believed it to be appropriate to allow tax-exempt financing of facilities which furnish electric energy to a city. The Congress also concluded that to allow tax-exempt financing of electric energy facilities in such cases is consistent with the current Treasury regulation which in some instances treats the city as a county. However, the Congress also believed, since the purpose of allowing tax-exempt financing of electric facilities is to benefit primarily small communities or small geographic service areas, that when an exception to the two contiguous county rule is made it should be limited to a service area consisting of no more than one city and one contiguous county.

In the implementation of this specific amendment to the Code, a question may arise about the effect of an interconnection with other electric utilities. Congress intends that in the case of a facility added to the local furnishing exception by the amendment, that is, a facility which furnishes electric energy solely within the area consisting of one city and one contiguous county, such a facility will not fail the local furnishing test merely because the facility is interconnected with other facilities. The amendment was not intended to affect the local furnishing rules for other facilities. With respect to a facility covered by the amendment, it is expected that procedures will be developed by the Treasury Department under which it may be demonstrated that the local furnishing requirement has been met notwithstanding the interconnection of the facility with other facilities.

Finally, the provision does not affect the meaning of the term "facilities for the local furnishing of gas."

Certain industrial development bonds qualify for tax exemption, where the proceeds of the bonds are used to provide certain exempt activities facilities which include facilities for the furnishing of water if available on reasonable demand to members of the general public (sec. 103(b)(4)(G)).

The Internal Revenue Service has interpreted the exemption for facilities for the furnishing of water as being inapplicable where a substantial amount of the capacity of the facility is committed to the use of a small number of industrial users. The Service's interpretation is premised on the public use requirement of present law and on its view that these industrial users are not members of the general public, but rather, non-exempt persons. See Rev. Rul. 76-494, 1976-2 C.B. 26. See also, Rev. Rul. 78-21, 1978-3 I.R.B. 3 (January 16, 1978).

In addition, the Internal Revenue Service interpreted prior law as not permitting a government unit to finance a portion of its water lines or other water facilities with tax exempt bonds unless the segment itself serves the public, notwithstanding that it may be part of an overall facility operated by the governmental unit which serves the general public in its service area. The Congress believes the public use test is satisfied if the system (of which the segment being financed in a part) serves the general public, provided the segment in question is a facility for the furnishing of water and not a production facility, and provided the segment is operated by a governmental unit or a regulated public unit as a part of its overall system.

Generally, in order for bond to be eligible for tax-exempt status under the Act, the facility must meet three requirements. It must be for the furnishing of water, it must be operated by a governmental unit or regulated public utility, and it must make available water to members of the general public.

The first requirement under the Act is that a facility is in fact a facility for the furnishing of water and not a production facility. In order to satisfy this requirement, a facility must be a component of a system or project which furnishes water. Ordinarily, a system or project would include only those components necessary for the collection, treatment and distribution of water to a service area, and any other functionally related and subordinate components. Thus, a facility will not constitute a facility for the furnishing of water if the facility uses the water in its own production process. For example, the internal water facilities of a private plant or a cooling pond would not constitute a facility for the furnishing of water or property functionally related and subordinate to such a facility.

In addition, in determining whether a facility is a component of a system or project which furnishes water, a facility shall be viewed in conjunction with its affiliated system or project. In general, a reservoir and its functionally related and subordinate components will constitute a single system. On the other hand, a series of dams will not, in general, constitute a single system, but rather a series of individual systems. Thus, in order for a facility affiliated with one of these dams to qualify under the Act, the system (dam) must be one which furnishes water and the individual facility must be a component of the qualifying system.

Further, the fact that an electric utility is a customer of a governmental unit or a regulated public utility which operates facilities for the furnishing of water does not, in general, transform those water facilities into facilities for the furnishing of electric energy. Thus, a reservoir or dam would not be denied tax-exempt financing merely because one of the uses of the water is for the production of electricity. If substantially all of the water is used for other purposes in addition to the production of electricity, tax-exempt financing may be allowed to the extent the facility qualifies as a facility for the furnishing of water. However, tax-exempt financing will not be allowed for those portions of a dam or reservoir which relate to the production of electricity (such as for generators and turbines) under this provision. In order for such facilities (electric facilities) to qualify for tax-exempt financing, they must meet the requirements of section 103(b)(4)(E) or section 103(d).

The second requirement under the Act is that the facility be operated by a governmental unit or a regulated public utility. In order for a facility to meet the operation test, it must in fact be operated by a governmental unit or regulated public utility (i.e., the governmental unit or regulated public utility must bear the cost of and be in control of maintenance and repairs of the facility.) For example, if a facility is leased to an industrial user on a long-term basis, and the industrial user bears the cost of, or controls maintenance and repair of, then facility, then the facility is not considered to be operated by a governmental unit or a regulated public utility.

The third requirement under the Act is that the water is, or will be, made available to the general public. The general public is not limited merely to residential users or municipal water districts; it also includes electric utility, industrial, agricultural, or other commercial users within the facility's service area.

In order to satisfy the third requirement of the provision, a facility cannot in general deny access to water to residential users or municipal water districts within its service area. However, because electric utility, industrial, agricultural, and commercial users also are members of the general public, a facility does not have to satisfy the water needs of all the residential users in its service area, provided it makes available a substantial portion of its overall supply of water to residential users in its service area. Generally, 25 percent of a facility's capacity may be considered a substantial portion for purposes of this provision. For example, where a reservoir is originally built to serve a single industrial user and the industrial user agrees to "take or pay" for the entire capacity of the reservoir (but is guaranteed only 25 to 75 percent of the capacity), the facility will meet the availability test if the remainder of the water will be offered to residential users.

However, water is not made available to residential users merely because it is available for their recreational use. Thus, a reservoir which denies access to water to residential users except for swimming, water skiing, etc., will not be considered to make water available to members of the general public.

In addition, a facility does not have to make water available to all nonresidential classes of the general public. For example, a reservoir that provides water to residential to residential users is nonetheless eligible for tax-exempt financing even though the reservoir does not also furnish water for agricultural or irrigation purposes.

Additionally, in determining whether water is or will be made available to members of the general public, a particular facility is to be viewed as a whole. Thus, if a water transmission system consisting of a main system of canals and pipelines and connecting lines serving individual industrial users and municipal water districts is extended to serve only one or two industrial users, the extensions will satisfy the availability test since the system as a whole serves the general public.

Finally, under the provision, there is no requirement that the water facility serve the general public immediately after it is constructed. It is sufficient that the facility is avai1able to serve the general public and that the general public has an opportunity to take water from the pipeline. For example, where a pipeline is built to serve a region that is sparsely inhabited because of lack of water, there is no requirement that the pipeline serve the general public immediately after it is completed. It is sufficient that the pipeline will serve the general public that, attracted by a new source of water, moves into the region.

Certain industrial development bonds qualify for tax exemption, where the proceeds of the bonds are used to provide facilities for certain exempt activities. Such facilities include convention and trade show facilities (sec. 103(b)(4)(C), airports, docks, wharves, and facilities for mass commuting, parking, or storage and training directly related to these installations (sec. 103(b)(4)(D).

In general, in order for a facility to qualify as an exempt activity facility, the facility must satisfy a public use requirement; that it serves or is available on a regular basis for general public use or is a part of a facility so used. (sec. 1.103-8(a)(2) Treas. Regs.) Transportation facilities will in general satisfy the public use requirement by being available for use by members of the general public or for use by common carriers or charter carriers which serve members of the general public. (sec. 1.103-8(e)(1) Treas. Regs.) Further, a dock or wharf which is part of a public port satisfies the public use requirement. (sec. 1.103-8(e)(1) Treas. Regs.) Convention and trade show facilities will in general satisfy the public use requirement by being available for an appropriate charge or rental for use by members of the general public. On the other hand such facilities will not satisfy the public use test where use is limited by long-term leases to a single user or group of uses. (sec. 1.103-8(d)(1) Treas. Regs.)

Prior to December 1977, if an issue of industrial development bonds qualified as a tax-exempt bond, a refunding issue¹ of that issue may have also qualified as a tax-exempt bond. However, under proposed regulations issued December 6, 1977, advance refunding issues for industrial development bonds that are issued more than 180 days before the original issue is redeemed do not qualify as tax-exempt bonds.

The Treasury proposed this amendment to the refunding regulations because it believed that their issuance contravenes the statutory requirement that substantially all of the proceeds of an industrial development bond must be used to provide a facility described in the statute in order to qualify for tax exemption. The Treasury further believes that advance refunding issues violate this requirement, since they permit the issuance of a face amount of tax-exempt bonds which when aggregated with the outstanding issue exceed the cost of a given facility commencing with the issuance of the refunding issue and ending with the call or retirement of the original issue.

However, because advance refunding tends to increase the total outstanding tax-exempt bonds, the Congress decided not to allow the advance refunding of bonds used to provide essentially private facilities. The refunding bonds, which are essentially private, it is argued compete with true municipal debt for a share of the tax-exempt market, thus increasing the costs of financing public facilities.

The Act, in general, applies only to the advance refunding of industrial development bonds substantially all the proceeds of which were used to provide transportation and convention and trade show facilities which directly serve or are available on a regular basis for general public use. Facilities which qualify as exempt activities facilities because they are available for public use by common carriers or charter carriers which serve members of the general public will not be considered qualified public facilities for purposes of the provision unless such facilities directly serve the general public or are available on a regular basis for the general public use. Further, facilities which are part of a qualified public facility will not be considered qualified public facilities unless such facilities directly serve the general public or are available on a regular basis for general public use.

Thus, a facility which is part of a qualified public facility (e.g., a hangar, a repair facility, a wharf, or a dock) which is owned by a nonexempt person, or leased to or assigned to a nonexempt person permanently or for the major portion of its useful life, will fail the availability test if the facility does no t provide services to the general public (e.g., repair or storage services for all airplanes) or is not available on a regular basis for general public use. On the other hand, a facility which is owned by a governmental unit shall be considered to be available to the general public, if it is leased to or assigned to a nonexempt person on a short-term basis, provided that the facility will be available to the general public for the major portion of its useful life.

Notwithstanding the above, a tax-exempt industrial development bond used to provide a facility which is not a qualified public facility may in certain instances be advance refunded in a multipurpose issue.

The Act also prohibits the advance refunding of an advance refunding issue where a prior issue is still outstanding. Thus, no more than two tax-exempt issues will be outstanding for any one project at the same time.

The Act applies to refunding obligations issued after the date of enactment. For example, if industrial development bonds were issued in 1967 and substantially all the bond proceeds were used to provide a qualified public facility, then tax-exempt advance refunding of the 1967 bonds will be allowed so long as the refunding obligations are assumed after the date of enactment.

The Act is not intended to affect (by implication or otherwise) the tax treatment of the advance refunding of general obligation or general revenue municipal bonds which are legal obligations of the issuing government.

2. Other Tax-Exempt Bond Provisions

Although it is not necessary for the issuer of State and local bonds to obtain a determination as to the tax status of a bond issue, as a practical matter, if an issue is seemingly in conflict with any ruling or regulations published by the Internal Revenue Service, it cannot be marketed. This is the case, regardless of the validity of the Service's ruling or regulations

In addition, a bond issue may not be marketable due to uncertainty as to whether it is issued by a State or local government within the meaning of section 103(a), e.g., whether the obligations are issued by an authority "on behalf of" a State or local government.

The Congress believes that a State or local government should have a right to court adjudication in the situation described above. The Act deals with the problem by providing that, in the event of an unfavorable private letter ruling (or failure to issue a ruling), the State or local government may ask the United States Tax Court for a declaratory judgment as to the tax status of a proposed issue of municipal bonds.

The Act provides that the United States Tax Court is to have exclusive jurisdiction in the case of an actual controversy involving a determination (or failure to make a determination) by the Internal Revenue Service as to whether interest on a prospective obligation is exempt from Federal income taxation. For purposes of this provision, a prospective obligation means an obligation (whether an original issue or a refunding issue) which has not been issued at the time a petition seeking a declaratory judgment is filed with the Tax Court. A suit under this provision can be brought only by the Prospective issuer which has sought a determination regarding the tax-exempt status of its proposed issue.

While this new declaratory judgment procedure is being made available to State and local governments that desire to use it, there is no requirement that they use this new procedure to determine the tax status of municipal bonds. Further, the Act imposes no requirement that a request for a private letter ruling be made as a condition for tax exemption.

In order to satisfy the court that an actual controversy exists, a prospective issuer will have to adopt a bond resolution, or take such other required action as may be necessary, in accordance with State or local law authorizing the issuance prior to the time it files a petition with the Tax Court. However, the bond resolution may be contingent on a favorable determination.

The Tax Court is to have jurisdiction to make a declaration as to whether interest on an obligation is exempt from Federal income taxation. Any such declaration is to have the force and effect of a final judgment or decree and is to be reviewable as such. While it is anticipated the Tax Court will expedite resolution of these cases, such treatment will be at the discretion of the Tax Court so as not to restrict the Court's flexibility in handling the remainder of its caseload.

The Court is to base its determination upon the reasons provided by the Internal Revenue Service in its notice to the party making the request for a determination and on any other facts or arguments which the Service and/or the proposed issuer wish to introduce at the time of trial. However, any such facts or arguments must be relevant to the issues raised in the administrative record. Neither party may raise new issues at the time of tria1. Of course, if an unfavorable determination is based on a published ruling or regulation (including a proposed regulation), the court may rule on the validity of the published ruling or regulation.

A judgment in a declaratory judgment proceeding is to be binding upon the parties to the case, and is to foreclose future legal action by them to redetermine the tax status of the bonds.

Exhaustion of administrative remedies required

For a proposed issuer to receive a declaratory judgment under this provision, it must demonstrate to the court that it has exhausted all published administrative remedies which are available to it within the Internal Revenue Service for a private ruling letter, that the Internal Revenue Service has either failed to act or has acted adversely, and that it has exhausted its right to appeal any adverse determination. Moreover, to exhaust its administrative remedies, a proposed issuer must satisfy all procedural requirements of the Service relating to municipal bond rulings. For example, the Service may decline to issue a private letter ruling if a State or local government fails to supply the Service with the necessary information on which to make a determination.

A proposed issuer is not to be deemed to have exhausted its administrative remedies in cases where the Internal Revenue Service has failed to make a determination before the expiration of 180 days after a request (complying with the procedural requirements of the Internal Revenue Service) for such a determination was made. Once this 180-day period has elapsed, a proposed issuer that exhausted its remedies may bring an action even though no private letter ruling has been issued by the Internal Revenue Service.

Of course, if the Service makes a determination during this 180-day period, then the proposed issuer need not wait until the end of the 180-day period to initiate the declaratory judgment proceeding. However, no action for declaratory judgment may be filed after 90 days from the date on which the Secretary or his delegate sends notice to a person of a private letter ruling (including refusals to issue such a ruling) as to the tax status of the bonds.

Tax Court Commissioners

In order to provide the Tax Court with flexibility in carrying out this provision, the Act authorizes the Chief Judge of the Tax Court to assign the commissioners of the Tax Count to hear and make determinations with respect to petitions for a declaratory judgment, subject to such conditions and review as the Court may provide, by an appropriate rule, directive, or order, whether or not published.

In order to comply with the yield restrictions on obligations acquired with the proceeds of their obligations, some State and local governments purchased taxable bonds at a premium. This has had the effect of reducing the effective yield on the acquired obligation and creating an arbitrage or windfall profit for the seller of the obligation. Typically, the windfa1l profit created from the payment of a premium would go either to the bond broker selling the acquired obligation, or would be diverted to charity. Where the charity performed functions which the issuer would otherwise perform, the benefit to the issuer arguably constituted a prohibited return on the investment of proceeds.

On September 24, 1976, the Treasury Department announced proposed regulations which would affect bonds issued after that date. The proposed regulations provided that in determining whether yield on obligations acquired with the proceeds of a refunding issue is materially higher than that of the refunding issue, the market price of the acquired obligation as determined by reference to an established market shall be used. The effect of these regulations is to prevent issuers from diverting arbitrage profits (or windfall) to underwriters or other third parties. Although the regulations, by their terms, apply prospectively only, the Internal Revenue Service rulings policy has been to apply the regulations retroactively.

In view of the circumstances, the Congress believes that it is unfair and inequitable to apply these regulations retroactively where the arbitrage profits would go to charity.

Under the Act, payment of a refund profit to a charitable organization in accordance with a qualified agreement shall not cause the refunding obligation (which gave rise to the refund profit) to be treated as an arbitrage bond or cause the imposition of any penalty upon the issuer ("blacklisting") if certain conditions are met. First, the refund profit (arbitrage profit) must have been generated by or arisen out of an advance refunding of a tax-exempt State or local government obligation which occurred before September 24, 1976. Second, the refund profit (arbitrage profit) must be held (1) in a trust fund, (2) in an escrow account, or (3) by an underwriter or other person, under a qualified agreement. Finally, such an agreement must provide for, or contemplate, the payment of the refund profit to one or more organizations described in section 501(c)(3) and exempt from taxation under section 501 (a) (other than an organization described in sec. 509 (a)).

In addition, where a State or local government has accounted to the United States for the refund profit by direct payment or by purchase of low-interest United States obligations because of the Internal Revenue Service's rulings policy, the Treasury shall return such accounted-for refund profits, which within 90 days of receipt by the State or local government shall be given to the intended beneficiary. Repayment by the Treasury shall be required under the Act, only if on or before January 1, 1977, the State or local government which entered into a qualified agreement requested, in writing, a ruling from Internal Revenue Service on the tax consequences of paying refund profits to charitable organizations and failed to receive a favorable ruling, and did not pay the refund profit to a charitable organization. The repayment shall be paid out of any amounts in the Treasury not otherwise appropriated.

Under prior law, in order to be eligible for a subchapter S election, the corporation generally must have had 10 or fewer shareholders. After a corporation had been an electing subchapter S corporation for 5 consecutive taxable years, it may have increased its number of qualifying shareholders to 15. In addition, the number of shareholders may have exceeded 10 (but not 15) where the additional shareholders acquired their stock through inheritance.

Also, a surviving spouse and the estate of a deceased spouse (or the estates of both deceased spouses) were treated as one shareholder where the husband and wife were treated as one shareholder at the time of the death of the deceased spouse.

The provision also clarifies existing law by providing that the grantor of a grantor trust is treated as the shareholder, rather than the trust, for purposes of determining whether the corporation qualifies as a small business corporation.

In effect, the period of time during which an election could be made by a newly-formed corporation for its first taxable year was only one month since a new corporation cannot make the election until it is in existence under State law, which generally occurs at the same time as the beginning of its first taxable year. J. William. Frentz, 44 T.C. 485 (1965), aff'd, 375 F.2d 662 (6th Cir. 1967). In other situations, it was difficult to determine when the 1-month period begins for a new corporation because of several alternative rules used to determine when its first taxable year begins.

The limited 2-month rule, applicable to corporations making the election for a year other than the year in which they are formed, was intended to require the corporation to make the election before it could predict its profitability for the year with any certainty. This rule helps preclude use of subchapter S as a tax avoidance mechanism. Extending the period of election to encompass the entire preceding year does not provide any tax avoidance possibilities, and should reduce inadvertent untimely elections by allowing them to be made when they are first considered during the preceding year, rather than having to wait until the last month of the year.

The Act also provides that where the election is made prior to the taxable year for which it is effective, the shareholders who are required to consent to the election are those who hold stock on the day the election is made rather than on the first day of the taxable year for which the election is effective. Where the election is made during the taxable year preceding the year for which it is to be effective, no additional consents will be required where shareholders acquire stock prior to the beginning of the year for which the election is effective. This rule will also apply when an election is not timely filed for the intended taxable year but is effective for succeeding taxable years. In these cases, an individual who becomes a shareholder after the election is filed will have to affirmatively refuse to consent to the election within 60 days of becoming a shareholder to render the election ineffective.

2. Small Business Corporation Stock

(sec. 345 of the Act and sec. 1244 of the Code)

Ordinary loss treatment, rather than capital loss treatment, is provided in certain cases for small business corporation stock (section 1244 stock) which is disposed of at a loss. This special treatment is accorded only to individual shareholders (not trusts or estates) to whom the stock was originally issued.¹

The maximum amount of ordinary loss from the disposition of section 1244 stock that may be claimed in any taxable year is limited to $25,000, except for married taxpayers filing joint returns, in which case ordinary loss treatment is limited to $50,000.² Any loss in excess of the applicable annual limitation is treated as a capital loss.

For stock to qualify as section 1244 stock, eight requirements must be met: (1) the stock must be common stock; (2) the corporation issuing the stock must adopt a written plan under which the stock will be issued and the stock may be offered for sale only during the two-year period beginning with the date of plan adoption; (3) the corporation issuing the stock must be a domestic corporation; (4) the amount of section 1244 stock issued by the corporation may not exceed $500,000, and the total stock issued plus the equity capital of the corporation may not exceed $1,000,000; (5) no prior offering of stock of the corporation or any portion of a prior offering of stock may be unissued; (6) the stock must be issued for money or other property, subject to certain exceptions; (7) more than 50 percent of the gross receipts of the corporation must be derived from the active conduct of a trade or business during the corporation's existence or for its five most recent taxable years prior to the taxable year during which the loss is incurred, whichever period is less;³ and (8) no subsequent offering of stock, simultaneous with, or subsequent to, the adoption of a plan to issue section 1244 stock may be made.⁴

Additionally, the organizers of many small business corporations that could have issued section 1244 stock have failed to comply with the written plan requirement, thus losing the intended benefits. The Congress believes that the written plan requirement should be eliminated so that issuance of small business stock will not be disqualified either because of an unfamiliarity with the provision or because of the lack of qualified advice upon organization or a subsequent issuance of stock.

The Act increases the amount of section 1244 stock that a qualified small business corporation may issue from $500,000 to $1,000,000. The $1,000,000 limit is determined by reference to the aggregate amount of money and other property received (and to be received) by the corporation (1) for stock, (2) as a contribution to capital, and (3) as paid-in surplus as of the time of issuance of the stock. The value of the property other than money which was (or is to be) received by the corporation for its stock is equal to the adjusted basis to the corporation of such property for determining gain, reduced by any liability to which the property was subject or which was assumed by the corporation. For example, if a qualified small business corporation that was organized after the date of enactment of this provision issues common stock for money amounting to $600,000, the corporation subsequently may issue additional common stock which qualifies under the provisions of section 1244 in the amount of $400,000. For this purpose, the determination of the $600,000 amount is to be made at the time that stock was issued, and the determination of the $400,000 amount to be made at the time that stock was issued.

If a qualified corporation issues common stock the aggregate value of which exceeds $1,000,000, the Congress intends that the issuing corporation must designate which of the shares of stock issued are to be treated as section 1244 stock. The designation must be made in accordance with regulations to be issued by the Treasury Department.

Under prior law, a domestic corporation was not treated as a small business corporation for purposes of section 1244 unless the aggregate dollar amount to be paid for its stock plus the equity capital (defined as the sum of the corporation's money and other property, such other property taken into account at its adjusted basis for determining gain) less the amount of indebtedness to persons other than shareholders did not exceed $1,000,000. The Act repeals the equity capital limitation. Thus a corporation, assuming other requirements are met, may issue additional common stock under the provisions of section 1244 without regard to the amount of its equity capital to the extent that the amount received for the common stock to be issued does not exceed $1,000,000 reduced by the amount received for the stock already issued.

The Act provides for an increase in the maximum amount an individual may treat as an ordinary loss on section 1244 stock for any taxable year. Under the provisions of the Act, the maximum amount that may be treated as an ordinary loss is increased to $50,000; in the case of a husband and wife filing a joint return for the taxable year in which the loss is incurred, the maximum amount that may be treated as an ordinary loss is increased to $100,000.

The Act repeals the requirement that a written plan to issue section 1244 stock must be adopted by the issuing corporation. Additionally, the requirement that provides that no prior offering of stock of the corporation or any portion of a prior offering of stock may be unissued at the time a written plan is adopted is not necessary under the Act and also has been repealed. The Act provides that a corporation issue common stock under the provisions of section 1244 without adopting a written plan, but that only the first $1,000,000 worth of common stock may qualify as section 1244 stock. If the $1,000,000 stock limitation is exceeded, the regulations are to provide which portion of the aggregate amount of issued common stock is qualified stock and how such shares of stock are to be distinguished as qualifying stock by both the issuing corporation and its shareholders.

(sec. 351 of the Act and sec. 447 of the Code)

A taxpayer is required to use a method of accounting for tax purposes which clearly reflects income (sec. 446). Most taxpayers who are in the business of selling nonfarm products are required to report gross income using an accrual method of accounting and to accumulate their production costs in inventory until the products are sold. However, by reason of administrative rulings issued more than 50 years ago, taxpayers engaged in farming have been allowed to report income and expenses from farm operations on the cash method of accounting, which does not require the accumulation of inventory costs. Except for special capitalization rules applicable to citrus and almond groves, farmers also have been allowed to deduct the cost of seed and young plants purchased in one year which are intended to be sold as farm products in a later year.¹ In addition, administrative rulings have permitted farmers to deduct currently many of the costs of raising farm assets (such as costs related to breeding animals, orchards, and vineyards) which are used in the trade or business of farming. (In nonfarming businesses, such as manufacturing, similar costs generally are treated as capital expenditures and are depreciated over the useful lives of the assets acquired.) The special farming tax rules discussed above are still generally applicable to most farmers, although some restrictions were imposed on certain farming corporations and farming syndicates by the Tax Reform Act of 1976.

Also, under the accrual method of accounting as applied to farming, if crops are harvested and unsold at the end of the taxable year, the costs attributable to such crops cannot be deducted in the taxable year but must be treated as inventory. However, even under the accrual method, it had been a long-standing Treasury position to permit a farmer to deduct expenses paid in the taxable year so long as the crops to which these expenses related were unharvested at the end of the taxable year.² In 1976, the Internal Revenue Service reversed this longstanding position and ruled that an accrual method taxpayer engaged in farming is required to inventory growing crops (unless the taxpayer uses the crop method of accounting).³ The effective date of this ruling has been postponed so that it applies only to taxable years beginning on or after January 1, 1978.⁴

1976 Act

With certain exceptions, the Tax Reform Act of 1976 required corporations (and partnerships in which non-excepted corporations are partners) engaged in farming to use an accrual method of accounting and to capitalize preproductive period expenses (sec. 447). However, subchapter S corporations, family corporations (in which one family owns at least 50 percent of the stock), corporations with annual gross receipts of $1 million or less, and nurseries are not required to use an accrual method of accounting or to capitalize preproductive period expenses.⁵

A taxpayer who is required to change to an accrual method of accounting (or to revise his accrual method of accounting to capitalize preproductive period expenses) pursuant to the 1976 Act is generally allowed to spread the accounting adjustments required by the change in method over a period of ten years.⁶

The 1976 Act provisions generally are effective for taxable years beginning after December 31, 1976. However, the Tax Reduction and Simplification Act of 1977 postponed the effective date of the required accrual accounting provision until taxable years beginning after December 31, 1977, for any farm corporation if, as of October 4, 1976 (the date of enactment of the 1976 Act), either (a) two families owned at least 65 percent of the stock; or (b) three families owned at least 50 percent of the stock and substantially all of the rest of the stock was owned by employees, their families, or exempt pension, etc., trusts for the benefit of the employees.

In general, Congress believes that is desirable to retain the cash method of accounting for certain corporations controlled by two or three families just as it remains available for corporations controlled by one family. These multi-family situations are generally thought to be similar to the situations of corporations controlled by a single family. In addition, the adjustments which would be required to be taken into account (generally over a 10-year period) for an existing corporation may adversely affect the corporation's ability to compete and its financial position.

In order to provide some degree of flexibility in encouraging employee ownership of the corporations, it is provided that, with respect to corporations described in the preceding paragraph, stock acquired from the corporation, or one of the families described above, after October 4, 1976, by the corporation's employees, their families, or a tax-exempt trust for their benefit will be treated as owned by one of the two or three families whose combined stock ownership was used to establish the initial qualification for this provision (as of October 4, 1976). No similar rule is applicable for purposes of the one-family exception of present law.

Since this provision is intended to preserve the use of the cash method of accounting only for certain corporations that were engaged in farming as of the date of enactment of the 1976 Act, the provision contains an additional limitation which requires that eligible corporations must have been engaged in the trade or business of farming on October 4, 1976, and at all time thereafter. The purpose of this requirement is to prevent organizations which had the appropriate stock ownership as of that date but were not engaged in farming to subsequently engage in farming and qualify for this special exemption.

2. Accounting for Costs of Growing Crops

(sec. 352 of the Act)

Similarly, the Internal Revenue Service ruled that nurserymen on the accrual method of accounting could inventory their young trees only where they had reached a marketable size and stage of development and where the market value was definitely known. Also, the Internal Revenue Service has held that florists are not required to use inventories of growing plants for the purpose of calculating their net income for Federal income tax purposes and should not compute the costs of goods sold during the year by using an inventory value of growing plants on hand at the beginning and end of the taxable year.²

However, in 1976 the Internal Revenue Service reversed its longstanding positions and ruled that an accrual method taxpayer engaged in farming is required to inventory growing crops (unless the taxpayer uses the crop method of accounting). This ruling also provided that nurserymen using an accrual method of accounting must inventory growing trees and that florists using an accrual method of accounting must inventory growing plants. In each case an exception was provided for taxpayers who use the crop method of accounting.³ The changes made by this ruling were to be applied only for taxable years beginning on or after June 28, 1976, the date the ruling was published in the Internal Revenue Bulletin. However, the effective date of this ruling has been postponed so that it applies only to taxable years beginning on or after January 1, 1978.⁴

On July 18, 1978, the Service announced that farmers, nurserymen and florists who have been using an accrual method of accounting without inventorying growing crops and who relied on the Service's former position would be allowed to change their method of accounting to the cash receipts and disbursements method of accounting, which does not require the accumulation of costs in inventory.⁵

With certain exceptions, the Tax Reform Act of 1976 required corporations and partnerships (in which non-excepted corporations are partners) engaged in farming to use an accrual method of accounting and to capitalize preproductive period expenses (sec. 447). However, subchapter S corporations, family corporations (in which one family owns at least 50 percent of the stock), corporations with annual gross receipts of $1 million or less, and nurseries are not required to use an accrual method of accounting or to capitalize preproductive period expenses. In general, the requirement that preproductive period expenses be capitalized would have the effect of requiring taxpayers to inventory (or capitalize) the costs of growing crops.

The 1976 Act provisions generally are effective for taxable years beginning after December 31, 1976.

It has come to the attention of the Congress that the Internal Revenue Service's change of position, as announced in Rev. Rul. 76-242, may have substantial adverse impact upon many farmers, florists, and nurserymen who have been using an accrual method of accounting without inventories of growing crops. At the time they made the election of accounting methods, these taxpayers had relied on the Service's long-standing position as to inventorying of growing crops. Also, at the time they elected their accounting methods, these taxpayers were generally eligible to elect the cash method of accounting for the income and deductions from their trades or businesses involving growing crops. The Congress believes that it is appropriate to allow these taxpayers to continue to use their accrual methods of accounting without inventorying growing crops until the Congress has an opportunity to examine this matter in more detail. Also, the Congress believes that taxpayers who are potentially affected by the ruling, but not required to use accrual accounting (under sec. 447), should be allowed to make an automatic change to the cash method of accounting for a limited period of time.

This provision also allows those farmers, nurserymen, or florists who are eligible to use an accrual method of accounting without inventorying growing crops to elect, without the prior approval of the Internal Revenue Service, to change to the cash receipts and disbursements method of accounting with respect to any trade or business in which the principal activity is growing crops. However, this election may be initiated only with respect to a taxable year of the taxpayer beginning after December 31, 1977, and before January 1, 1981.

If a taxpayer elects to change to the cash method of accounting under this provision (or if he elects to modify his treatment of growing crops because of the operation of this provision), his change in method of accounting shall not require the consent of the Internal Revenue Service and shall be treated, for purposes of section 481 of the Code (relating to the adjustments to be made in cases involving a change in method of accounting), as a change in method of accounting initiated by the taxpayer.⁷

3. Treatment of Certain Farms for Purposes of Rules Requiring Accrual Accounting

(sec. 353 of the Act and sec. 447 of the Code)

(sec. 361 of the Act and sec. 274 of the Code)

Under present law, deductions are allowable for ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business or for the production of income (secs. 162 and 212). Whether an expense is ordinary and necessary depends largely upon the particular facts and circumstances involved in each case. Ordinary and necessary business expenses which are deductible may include the cost of club dues or fees, and certain other expenditures relating to facilities. However, these expenses are deductible only if they both satisfy certain substantiation requirements (sec. 274(d)), and meet the other prerequisites for deductibility.

Generally, no deduction is allowed for entertainment expenses unless the taxpayer substantiates by adequate records, or by sufficiently corroborative evidence, (1) the amount of the expense, (2) the time and place of its occurrence, (3) its business purpose, and (4) the business relationship to the taxpayer of the person or persons entertained (sec. 274(d)). In addition, ordinary and necessary expenses are deductible only if the expenses are allocable to the taxpayer's business, and are reasonable in amount, i.e., not lavish or extravagant.

Entertainment facilities

Expenses with respect to entertainment "facilities" were deductible under prior law if (1) they were ordinary and necessary, (2) the facility was used primarily for the furtherance of the taxpayer's business (i.e., more than 50 percent of the time that it was used), and (3) the expense in question was "directly related" to the active conduct of the taxpayer's business.

For this purpose, an entertainment facility was any item of personal or real property owned, rented or used by a taxpayer during the taxable year for, or in connection with, any activity which was of a type generally considered to constitute entertainment, amusement, or recreation. For example, entertainment facilities included yachts, hunting lodges, fishing camps, swimming pools, tennis courts, bowling alleys, automobiles, airplanes, apartments, hotel suites, and vacation homes. However, a facility was not considered to be an "entertainment facility" if it was used only incidentally during a taxable year in connection with entertainment, and that use was insubstantial in relation to its business use. In the case of individuals and subchapter S corporations, apartments, rental suites, vacation homes, and boats also may be subject to "vacation home" special disallowance rules under present law if there is a certain amount of personal use of the facility, i.e., the personal use exceeds the greater of 14 days or 10 percent of rental days (sec. 280A).

If an item of property was considered to be an entertainment facility, the expenditures subject to the special entertainment facility rules included depreciation, rent, utility charges, maintenance and repair expenses, insurance premiums, salaries for caretakers and watchmen, and losses realized on the sale or other disposition of the property. These expenditures also included dues and fees paid to any social, athletic, or sporting club or organization.¹ However, expenditures were not treated as being made with respect to a facility if they were out-of-pocket expenses, e.g., nonoperating costs such as expenditures for food and beverages. In addition, expenses attributable to a non-entertainment use of a facility were not treated as being expenses with respect to an "entertainment" facility" e.g., the use of an automobile or airplane for business travel purposes. Finally, expenses which were deductible without regard to their connection with a taxpayer's trade or business were not considered to be expenditures with respect to an entertainment facility, e.g., taxes, interest, and casualty losses.

In determining whether an entertainment facility was used primarily for business purposes, all the ordinary and necessary business use of the facility could be taken into account even though the use was not "directly related to" or "associated with" the active conduct of the taxpayer's profit-seeking activities (Rev. Rul. 63-144, 1963-2 CB-129, 137). However, only the portion of the expenses which were "directly related" to the active conduct of the taxpayer's trade or business were deductible. Thus, the use of the facility in providing entertainment "associated with" the active conduct of a trade or business was taken into account in determining if the facility was used primarily for business purposes, but only those expenses attributable to a use which was "directly related" to the active conduct of a trade or business were deductible. For example, if 60 percent of the use of a yacht was for business entertaining but only 45 percent of the use satisfied the "directly related" test, only 45 percent of the facility expenditures would have been deductible.

Generally, the term "facility" includes any item of real or personal property which is owned, rented, or used by a taxpayer in conjunction or connection with an entertainment activity. Thus, expenses incurred with regard to entertainment facilities which are disallowed, include yachts, hunting lodges, fishing camps, swimming pools, tennis courts, and bowling alleys. Facilities also may include airplanes, automobiles, hotel suites, apartments, and houses (such as beach cottages and ski lounges) located in recreational areas. However, the deduction is not affected unless the property is used in connection with entertainment. Expenses of an automobile or an airplane used on business trips will continue to be allowed.

As under prior law, club dues may be deductible³ if a taxpayer can establish that the club is used primarily for the furtherance of his or her business, and that the expense in question is directly related to the active conduct of that business. In addition, the Act does not preclude a deduction for business meals or entertainment simply because the expense was incurred in a club with respect to which the taxpayer is not allowed a deduction for dues or fees, if the quiet business meal or associated with business test is satisfied for entertainment activities.

Similarly, the Act does not disallow an otherwise allowable deduction for meal and lodging expenses incurred while away from home overnight. For example, the Act generally does not apply to travel expenses incurred by an individual away from home at a bona fide business, trade, or professional organization meeting or convention. These expenses, however, continue to be subject to the generally applicable rules relating to the deductibility of business travel, convention, and entertainment activity expenses. For example, if a salesman took a customer hunting for a day at a commercial shooting preserve, the expenses of the hunt, such as hunting rights, dogs, a guide, etc.) would be deductible provided that the current law requires substantiation, adequate records, ordinary and necessary, directly related, etc. are met. However, if the hunters stayed overnight at a hunting lodge on the shooting preserve, the cost attributable to the lodging would be nondeductible but expenses for any meals would be deductible if they satisfied the requirements of current law. The shooting preserve should provide the taxpayer with an allocation of charges attributable to the overnight lodging for the taxpayer and guests.

The provisions of the Act also are inapplicable to expenditures for tickets to sporting and theatrical events, regardless of whether the tickets are purchased individually, in a series or by the season, or by an equivalent fee which entitles the taxpayer to use a seat. Ticket costs generally remain subject to the provisions of present law relating to entertainment activities, or to those which govern the deductibility of business gifts.

In addition, the Act continues a number of the present statutory exceptions to the facility expense rules. Thus, for example, otherwise allowable deductions for expenditures relating to the following items are not covered by the Act: (1) facilities located on the taxpayer's business premises and used in connection with furnishing food and beverages to employees, (2) certain employee recreational facilities, (3) facility expenses treated as employee compensation, (4) facilities made available to the general public, (5) facilities used in connection with a taxpayer's trade or business of selling entertainment for adequate and full consideration in bona fide transactions, and (6) facilities actively used in the taxpayer's business of selling such facilities. The Act, however, also continues any applicable present law limitations on these exceptions, including those pertaining to substantiation and allocation of expenses.

In addition to the above enumerated expenses, the disallowance rule does not apply to the extent allocable to that portion of the facility which otherwise qualifies as one which is not an entertainment facility, or to the extent that a facility, with respect to which expenses ordinarily would be denied as deductions, qualifies under one of the above exceptions. Similarly, expenses incurred with respect to certain transportation facilities, for example automobiles and airplanes, are allowable to the extent allocable to travel undertaken primarily for the furtherance of a trade or business even if the taxpayer engages in entertainment activities during the business trip.

Although the Act disallows deductions which are predicated upon a profit-seeking intent, it does not apply to any deduction allowable without regard to the taxpayer's trade or business or income producing activity, e.g., interest (sec. 163), taxes (sec. 164), or casualty losses (sec. 165).

The Act applies to items paid or incurred (including the allowance for depreciation) after December 31, 1978, in taxable years ending after that date. Therefore, in the case of fiscal year taxpayers, only so much of an otherwise allowable depreciation deduction as is allowable with respect to periods prior to January 1, 1979 will be allowed.

2. Deficiency Dividend Procedure for Regulated Investment Companies

(sec. 362 of the Act and sec. 860 of the Code)

In order to qualify for conduit treatment, a company must satisfy a number of requirements. Generally, the company must be a domestic corporation which is registered under the Investment Company Act of 1940 either as a management company or as a unit investment trust. In addition, a company must satisfy requirements relating to the portion of gross income which must consist of investor-type income, the portion of assets which must be represented by cash and securities, the portion of its income which must be distributed to the investors, and its stock ownership. With respect to distributions, the company must distribute at least 90 percent of its taxable income, determined with certain modifications and without regard to the deduction for dividends paid, within its taxable year or, with certain limitations, within the 12-month period after the taxable year (secs. 852(a) and 855).

Under present law, a real estate investment trust is taxed generally in the same manner as a regulated investment company. The Tax Reform Act of 1976 added a deficiency dividend procedure for real estate investment trusts. However, unlike the treatment of real estate investment trusts, no deficiency dividend procedure was provided for regulated investment companies, under prior law, so that, under certain conditions, dividends paid after the taxable year and the following 12-month period may be taken into account for purposes of the 90-percent distribution requirement. Thus, a subsequent audit change by the Internal Revenue Service which increases income may have caused the company to fail to meet the distribution requirement.

Moreover, the Congress believes that providing a deficiency dividend procedure for regulated investment companies is consistent with the treatment presently accorded to real estate investment trusts which are taxed in generally the same manner.

Interest at the regular rate would be imposed on the amount of the deficiency dividend. In addition, a penalty equal to the interest charge would be imposed, but the penalty could not exceed 50 percent of the deficiency dividend. The imposition of a penalty and interest is designed to discourage a company from reducing its current distributions of income in reliance on the availability of the deficiency dividend procedure to retain is qualified status.

The procedure is similar to the deficiency dividend procedure provided for real estate investment trusts by the Tax Reform Act of 1976.

3. Safe Harbor Rule for Real Estate Investment Trusts

(sec. 363 of the Act and secs. 856 and 857 of the Code)

Under one of these rules that was in effect prior to the Tax Reform Act of 1976, a REIT could not hold any property primarily for sale in the ordinary course of its trade or business. If a REIT did hold any property primarily for sale, it did not qualify for tax conduit treatment that year.

This "primarily held for sale" rule produced a particularly harsh result where the REIT acquired property through a foreclosure of a lease or mortgage. As a result, Congress provided in 1974 a special rule for foreclosure property which permitted the REIT to hold property acquired by foreclosure for a period of 2 years (with permissible extensions by the IRS for another 2 years) if the REIT paid the normal corporate income tax on income from the foreclosure property. This special rule for foreclosure property permitted a REIT a reasonable period to orderly liquidate the foreclosure property.

While the foreclosure property rules provided substantial relief, disqualification was a harsh penalty to impose where a REIT had only a relatively small amount of property primarily held for sale which was not subject to the foreclosure property rule. As a result, Congress, in the Tax Reform Act of 1976, removed the restriction for property held for sale and, in its place, imposed a 100-percent tax on gain from property held primarily for sale. The Congressional intent in imposing the 100-percent penalty tax was to permit a REIT to hold property primarily for sale, but to not let the REIT derive any profit from holding property primarily for sale.

For purposes of the four-year holding requirement, the length of time that the REIT is deemed to hold the property that was acquired by the REIT through foreclosure (or deed in lieu of foreclosure), or termination of a lease, includes the period that the REIT held the loan which secured the property or that the REIT was the lessor of the property.

For purposes of the 20-percent expenditure requirement, any expenditures on property that has been acquired by the REIT through foreclosure (or deed in lieu of foreclosure) or termination of a lease, which are made by, or for the account of, a mortgagor or lessee after the default became imminent, are considered to be expenditures made by the REIT. Nonetheless, expenditures (including expenditures regarded as made by the REIT under the prior rule) do not count towards the 20-percent limitation if the expenditures relate to the foreclosure property and those expenditures did not cause the property to lose its status as foreclosure property. In addition, expenditures made solely to comply with standards or requirements of any government and expenditures made to restore property as a result of losses arising from fire, storm, or other casualty are not counted towards the 20-percent limitation. Lastly, where a REIT makes a loan under which the debtor is advanced additional monies at different times (such as is typically done in the case of a construction loan), the advance on the loan is not treated as an expenditure by the REIT unless default on the loan has become imminent.

With regard to the not more than five sales per year rule, the sale of more than one property to one buyer as part of one transaction is to be treated as one sale. For this purpose, the properties need not be contiguous or located near each other. However, all of the properties sold to the one buyer must be part of the same transaction. In addition, the Act provides that sales where the net selling price (total selling price less related selling expenses) is less than $10,000 are to be disregarded for purposes of counting the permissible 5 sales per year. If a REIT sells more than five properties tinder the rule, the safe harbor rule does not apply to the REIT for that taxable year and none of the sales is protected by the safe harbor rule. Any sale or other disposition of property is counted towards this rule (unless excluded under the $10,000 exception) regardless of whether the transaction resulted in a gain or a loss to the REIT.

For purposes of the rental test, any rental of the property at an insignificant rate of rent or for a use which indicates that the purpose of the rental arrangement was not for the production of rental income is to be disregarded. For example, where a REIT holds developed land in order to derive gain from the sale of the property, the property cannot qualify under the safe harbor rule simply by having the REIT rent the property at a rent substantially below the rental rate of comparable property. Similarly, where a REIT holds undeveloped land in order to derive gain from the sale of the property, the property cannot qualify under the safe harbor rule by having the REIT rent the property for a use such as for horseback riding trails or for hunting even though the rent received by the REIT is a fair rent from the property for that use.

The Act also provides that the fact that a sale does not come within the requirements of the safe harbor rule (including transactions occurring before the effective date of the provision) is not to be taken into account in determining whether the sale constitutes a prohibited transaction. Whether or not such a sale constitutes a prohibited transaction is to be determined under the facts and circumstances of each case as if the safe harbor rule had not been enacted. In addition, the mere fact that a sale comes within the safe harbor rule is not to be taken into account in determining whether any gain or loss on the sale is entitled to capital gain treatment.

In addition, the Act would increase the additional period that the IRS may grant to a REIT to hold foreclosure property from two years to four years (for a total of six years that foreclosure property may be held).

4. Contributions in Aid of Construction to Regulated Electric or Gas Public Utilities

(sec. 364 of the Act and sec. 118 of the Code)

Generally, contributions to the capital of a corporation, whether or not contributed by a shareholder, are not includible in the gross income of the corporation (sec. 118). Nonshareholder contributions of property to the capital of a corporation have a zero basis to the corporation. If money is contributed by a nonshareholder, the basis of any property acquired with the money during the 12-month period beginning on the date the contribution is received, or of certain other property, is reduced by the amount of the contribution (sec. 362(c)).

Tax treatment prior to the Tax Reform Act of 1976

Early in the development of the Federal income tax laws, there were a number of court decisions which held that customer contributions to public utilities to pay for the costs of extension service lines were to be treated as contributions to capital, and not as income, of the public utility.

In 1958, the Internal Revenue Service announced that it would apply that early case law with respect to contributions in aid of construction, but only with respect to regulated utilities (Rev. Rul. 58-535, 1958-2 C.B. 25). In 1975, the Internal Revenue Service issued Rev. Rul. 75-557 (1975-2 C.B. 33) which revoked the 1958 ruling, withdrew the acquiescences in the early line of cases, and held that amounts paid by the purchaser of a home in a new subdivision as a connection fee to obtain water service were includible in the utility's income. The ruling was made prospective for transactions entered into on or after February 1, 1976.

Tax treatment after the Tax Reform Act of 1976

Generally, the Tax Reform Act of 1976 provided that contributions in aid of construction to regulated public water and sewerage utilities (but not other utilities) are to be treated as nontaxable contributions to capital. However, nontaxable treatment was not provided for customer connection fees. Customer connection fees include payments made by a customer to the utility for the cost of installing the connection between the customer's line and the utility's main water or sewer lines (including the cost of meters and piping) and any amounts paid as service charges for stopping or starting service. In addition, a water or sewerage utility which receives a nontaxable contribution in aid of construction is not entitled to any depreciation deductions or investment tax credits with respect to property acquired with the nontaxable contribution.

A contribution to the capital of a regulation public water or sewerage utility qualifies for nontaxable treatment if it is a contribution in aid of construction under regulations prescribed by the Secretary of the Treasury¹ and if the property contributed, or property acquired with the contribution, is not included in the rate base for rate-making purposes. Where the contribution is in property which is other than water or sewerage disposal facilities, the contribution must be used for a qualified expenditure.² Amounts not used for qualified expenditures must be included in income for the taxable year in which received.³

The 1976 Act did not affect the treatment of contributions to utilities other than water and sewerage utilities.

A gas transmission utility which provides gas services which are resold to the general public is considered to be a regulated public gas utility for purposes of the provision. Also, contributions in aid of construction of steam facilities are covered by the provision.

In providing special rules for gas and electric utilities, the Congress intends that no inference should be drawn as to the proper treatment of contributions in aid of construction to other utilities.

On the other hand, if Revenue Ruling 75-557 were held to be incorrect by court decisions, then the proposal to broaden section 2120 of Public Law 94-455 would have no revenue effect because it could be viewed as codifying the pre-1976 tax treatment of contributions in aid of construction (other than customer connection fees) of regulated utilities.

5. Liabilities of Controlled Corporations

(sec. 365 of the Act and secs. 357(c) and 358(d) of the Code)

In recent years, considerable uncertainty has arisen over the treatment of certain liabilities (such as accounts payable) if assumed by the corporation when property is transferred, upon incorporation or in other generally tax-free asset-for-stock exchanges under section 351, by a taxpayer using the cash-basis accounting method.

Until recently, the United States Tax Court has given the term "liabilities" as used in section 357 (c) an all-inclusive meaning.² Under this interpretation, a cash-basis taxpayer may be subject to recognition of gain upon incorporation of his or her trade or business. Thus, if the sum of the liabilities (including accounts payable) of a cash-basis taxpayer exceeds the basis of the taxpayer's assets, gain is recognized under section 357(c) even though there were neither tax benefits realized by the transferor on liabilities assumed by the corporation withdrawal of borrowed cash through loans made against assets transferred to the corporation prior to the transfer.

Three approaches have been developed by courts to alleviate this problem.

One alternative is that adopted by the Second Circuit in Bongiovanni v. Comm'r, 470 F. 2d 921 (2d Cir. 1972), which held that the term "liability" for purposes of section 357(c) does not include accounts payable. The Second Circuit stated that

Third, the Tax Court in the Focht case⁵ reversed its longstanding position on the treatment of accounts payable under section 357(c). Under the Tax Court's revised approach, the term "liability" under section 357(c) would be limited to those obligations which, if transferred, cause gain recognition under Crane v. Comm'r, 331 U.S. 1 (1947), and an obligation would not be treated as a liability to the extent that its payment would have been deductible if made by the transferor. The Tax Court also held in Focht that under section 358, deductible liabilities are excluded in determining the transferor's basis in stock received as part of the exchange.

For purposes of this provision, a determination of whether a transferor is a cash basis taxpayer is to be made for each item. For example, a taxpayer on a hybrid method of accounting which utilizes inventories in computing income from purchases and sales, and utilizes the cash method in computing all other items of income and expense shall be considered a cash basis taxpayer for purposes of this provision. Accordingly, the transferor's accounts payable for items computed on the cash method of accounting may be excluded under this provision to the extent payment thereof (by the transferor) would have given rise to a deduction.

Additionally, for purposes of this provision, accounts payable mean, in general, those trade accounts payable and other liabilities (e.g., interest, and taxes) which relate to the transferred trade or business and which constitute cash method items.

The provision further provides that in determining the transferor's basis in stock received in the exchange, liabilities excluded from the provisions of section 357(c) would not be treated as liabilities assumed, or to which property is subject, for purposes of section 358(d). Thus, the amount of such excluded liabilities would not reduce the transferor's basis in stock received in the exchange.

Finally, the provision is not intended to affect the corporate-transferees' tax treatment of the excluded liabilities. It also is not intended to affect the definition of the term liabilities for any other provision of the Code, including sections 357(a) and 357(b).

6. Medical Expense Reimbursement Plans

(sec. 366 of the Act and sec. 105 of the Code)

The Act applies only to an employer's uninsured plan or arrangement for reimbursement of employee expenses incurred for medical care (as defined in sec. 213(e)) for the employee, the employee's spouse, or the employee's dependents. Under the Act, a plan is considered self-insured if reimbursement is not provided under a policy of accident insurance, health insurance, or accident and health insurance.

Under the Act, a plan satisfies the nondiscriminatory eligibility requirements if it meets either of two standards which are similar to the nondiscriminatory eligibility requirements applicable to qualified pension plans (sec. 410 (b)). Under the first alternative eligibility standard, a plan must benefit at least 70 percent of all employees (or at least 80 percent of all eligible employees if at least 70 percent of the employees are eligible). Under the second alternative eligibility standard, a plan must benefit a classification of employees set up by the employer and found by the Secretary of the Treasury not to be discriminatory in favor of employees who are highly compensated individuals. In applying the alternative eligibility standards, the Act provides that there may be excluded from consideration any employee who (1) has not completed 3 years of service, (2) has not attained age 25, or (3) is a part-time or seasonal employee. Under the Act, an employee whose customary weekly employment is for less than 35 hours is considered part-time and an employee whose customary annual employment is for less than 9 months is considered seasonal.

In addition, employees in a collective bargaining unit can be excluded from consideration under rules similar to those provided for qualified pension plans (sec. 410(b)(2)(A)) if there is evidence that accident and health benefits were the subject of good faith bargaining. Similarly, the Act provides for the exclusion of nonresident aliens as under the pension plan rules (sec. 410(b)(2)(C)).

In addition to the requirement of nondiscriminatory eligibility, the Act provides that benefits under a medical reimbursement plan must not discriminate in favor of participants who are highly compensated individuals. The Act specifies that a plan does not meet the requirement of nondiscriminatory benefits unless all benefits provided for participants who are highly compensated individuals are also provided for all other participants. In testing plan benefits for discrimination, all facts and circumstances are to be taken into account. (Consequently, if a plan (or a particular benefit provided by a plan) is terminated, the termination would cause plan benefits to be discriminatory if the limited duration of the plan (or benefit) has the effect of discrimination in favor of the highly compensated. This situation could arise, for example, where the duration of a particular benefit roughly coincides with the period during which a highly compensated individual utilizes that benefit.)

The requirements of the Act as to nondiscriminatory eligibility and benefits are not violated merely because benefits under an employer's plan are offset by benefits paid under a self-insured or insured plan of the employer or another employer, or by benefits paid under Medicare or other Federal or State law.

Under the Act, a highly compensated individual is (1) one of the five highest paid officers, (2) a shareholder (owning more than 10 percent of stock, directly or indirectly), or (3) one of the highest paid 25 percent of all employees (other than employees who may be excluded from consideration).

Medical reimbursement benefits provided for an employee who qualifies for the benefits on (or before) November 6, 1978, and who is not employed by the employer after that date are not considered to be provided under a medical reimbursement plan. Accordingly, the employee and the benefits are disregarded in testing any medical reimbursement plan of the employer for discriminatory eligibility benefits and the tax treatment of the benefits paid to the employee not affected by the medical reimbursement plan rules of the Act.

The Act provides that an excess reimbursement to a highly compensated individual during a plan year under a self-insured medical reimbursement plan is includible in the gross income of the individual for the taxable year in which (or with which) the plan year ends. Under the Act, a reimbursement is an excess reimbursement if it is a discriminatory benefit, that is, if it is made tinder a plan benefit which is provided for a participant who is a highly compensated individual, but not to all participants who are not highly compensated individuals.

Also, under the Act, a portion of the total amount reimbursed during a plan year to each participant who is a highly compensated individual is an excess reimbursement if the plan does not meet the nondiscriminatory eligibility requirements. The excess reimbursement portion is determined by multiplying the total amount reimbursed to the participant during the plan year by a fraction, the numerator of which is the total amount reimbursed during that year to all participants who are highly compensated individuals and the denominator of which is the total amount reimbursed during that year to all participants. In computing the amount of an excess reimbursement because a plan does not meet the nondiscriminatory eligibility requirements, however, discriminatory benefits are not taken into account.

The Act authorizes the Secretary of the Treasury to prescribe necessary regulations. It is anticipated that these regulations will provide that reimbursement for diagnostic procedures (medical examinations, X-rays, etc.) need not be considered by an employer to be a part of a medical reimbursement plan. However, this exception is to apply only for diagnostic procedures performed at a facility which provides no services other than medical services and ancillary services and applies to travel expenses only to the extent such expenses are ordinary and necessary. Under the Act, if a self-insured medical reimbursement plan is included in a "cafeteria plan", the medical reimbursement plan rules determine the status of a benefit as a taxable or nontaxable fringe benefit and the cafeteria plan rules determine whether an employee is taxed as though he elected all available taxable benefits (including taxable benefits under a discriminatory medical reimbursement plan).

Although no advance rulings from the Internal Revenue Service are required, it is expected that, in a typical case, advance rulings will be available. It is also anticipated that a determination by the Service that a plan is discriminatory will not be applied retroactively where the plan has made reasonable efforts to comply with the discrimination rules.

7. Extension of 5-Year Amortization for Low-Income Rental Housing

(sec. 367 of the Act and sec. 167(k) of the Code)

Under the special depreciation rules for low-income rental property, taxpayers can elect to compute depreciation on certain rehabilitation expenditures under a straight-line method over a period of 60 months, if the additions or improvements have a useful life of 5 years or more. Under present law, only the aggregate rehabilitation expenditures for any housing which do not exceed $20,000 per dwelling unit qualify for the 60-month depreciation. In addition, for the 60-month depreciation to be available, the sum of the rehabilitation expenditures for 2 consecutive taxable years -- including the taxable year -- must exceed $3,000 per dwelling unit.

8. Postponement of Effective Date for Special Limitations on Net Operating Loss Carryovers

(sec. 368 of the Act and sec. 382 of the Code)

In the case of a tax-free reorganization, loss carryovers were allowed on a declining scale. If the former owners of the loss company received 20 percent or more of the fair market value of the stock of the acquiring company, the loss carryovers were allowed in full. For each percentage point less than 20 which the former owners received, the loss carryover was reduced by 5 percent. It was immaterial whether the business of the loss company was continued after the reorganization.

The 1976 Act extensively revised the Code provisions dealing with the carryover of net operating losses in cases of acquisitions of loss corporations. The limitations on loss carryover attributes were to apply to acquisitions made by purchase or through corporate reorganizations. The new provisions changed the basic concepts underlying the rules by deleting continuity of business requirements for purchases and establishing a new continuity of ownership test applicable to both purchases and reorganizations.

These new provisions were to apply to plans of reorganization adopted on or after January 1, 1978, and to sales or exchanges in taxable years beginning after June 30, 1978.

9. Use of Certain Expired Net Operating Loss Carryovers and Redemptions of United States Railway Association Certificates of Value in a Tax-Free Reorganization of a Transferor Railroad

(sec. 369 of the Act and sec. 374 of the Code)

Under this legislation, ConRail, a taxable corporation, was to acquire, rehabilitate, and operate the railroad properties. The transferor railroads (and their subsidiaries and affiliates) will receive ConRail stock and "certificates of value" issued by the United States Railway Association, a nonprofit Government corporation formed to oversee the ConRail reorganization. A special court will eventually determine the value of these certificates in order to set the amount of compensation the transferor railroads will receive for their properties.

In 1976, the Congress also enacted legislation to deal with the tax consequences of this reorganization to ConRail, the transferor railroads, and the shareholders and creditors of the transferor railroads. Under this legislation,² the transfer of rail properties to ConRail is treated like reorganizations in general (and other bankrupt railroad reorganizations in particular) so that the transferor companies and their shareholders and security holders do not recognize gain or loss on the transfer and ConRail receives a carryover basis in the properties it acquired.

This legislation also included rules which allowed a transferor railroad's net operating losses eligible for carryover (at the time of the transfer of property to ConRail) to be extended beyond the normal expiration date,³ but only for use by the transferor against any future income arising from awards of the courts and the redemption of certificates of value. Literally, the language of these rules (sec. 374(e)(1)(A)) required that net operating loss carryovers which were extended could not be applied to income arising from the certificates of value received by any corporation other than the corporation which had originally received these certificates.

In this situation, an affiliated group of transferor corporations filed consolidated income tax returns for a number of years preceding the April 1, 1976, ConRail transfer and have sizable consolidated net operating loss carryovers which are eligible for the special extended carryover period. Many of the subsidiaries in this group transferred all of their railroad assets to ConRail and presently hold as their only assets the certificates of value or the right to receive these certificates. The parent corporation would like to simplify the corporate structure by merging or liquidating many of its now nonoperating subsidiaries into other members of the group. However, the language of the existing Code provision appeared to prevent the use of the extended net operating loss carryovers against income from the certificates of value because the surviving corporation which receives the certificates of value in a merger or liquidation would not be the original recipient of the certificates.

The Act corrects this uncontemplated result arising from the ConRail reorganization.

10. Income From Certain Railroad Rolling Stock Treated as From Sources Within the United States

(sec. 370 of the Act and sec. 861 of the Code)

Typically, under a lease financing of railroad rolling stock (i.e., the rolling stock is purchased by a financial institution and leased to the railroad), the lease produces a tax loss during its early years to the lessor (primarily as a result of accelerated depreciation or amortization deductions). Under prior law, where the rolling stock was used in Canada or Mexico, the loss arising on the lease for the period during which the rolling stock was in those countries was considered to be a foreign source loss under the generally applicable source rules. The characterization of the loss as foreign source operated to reduce the lessor's foreign source taxable income and thus its foreign tax credit limitation. Under certain circumstances, this may have caused the lessor to lose a foreign tax credit, to which it would otherwise entitled, for foreign taxes paid with respect to its other foreign operations. As a result, this type of lease-financing transaction could be less attractive than a lease-financing transaction involving equipment to be used exclusively in the United States.

Ships and aircraft are financed through similar long-term leases from financial institutions, and lessors expressed similar concern about the loss of foreign tax credits. Under the Revenue Act of 1971, lessors of certain ships and aircraft were given an election to treat all income and loss from the rental of the ships or aircraft as from sources within the United States (Code sec. 861(e)).

The provision applies only to railroad rolling stock which is "section 38 property" (or would be section 38 property if not used by certain governmental units). "Section 38 property" is property eligible for the investment tax credit.

The provision does not apply to a lease between two members of the same controlled group of corporations if any member of the group is a domestic common carrier by railroad or a switching or terminal company owned by such a carrier or carriers. This is to prevent a taxpayer which owns the cars from leasing them to a related taxpayer to tam the benefit of the modified source rules under the provision.

No foreign tax credit is to be allowed to the lessor for any payments to foreign countries with respect to any amount received with respect to railroad rolling stock which is subject to the special source rules under the provision. The Congress believed that if the rental income from these cars is to be treated as from U.S. sources, no foreign tax credit should be allowed for the foreign taxes paid on it. At present, no foreign taxes are imposed on rental income which would be subject to the modified source rules under the provision.

11. Net Operating Losses Attributable to Product Liability Losses

(sec. 371 of the Act and sec. 172 of the Code)

Product liability losses include not only the liability for damages under product liability claims, but also the expenses incurred in the investigation or settlement of, or opposition to, product liability claims. Indirect corporate expense, or overhead, is not to be allocated to product liability claims so as to become a product liability loss. Only expenses directly incurred in connection with a product liability claim are to be included in determining the amount of the product liability losses for the year.

The definition of product liability under the Act is intended to include the kinds of damages that are recoverable under prevalent theories of product liability. The laws of the several states regarding product liability are not uniform, but it is believed that the definition of product liability provided in the Act is sufficiently broad to encompass the kinds of damages that may be recovered under product liability theories in most states. If a type of injury or damage is included within the Act's definition (such as emotional harm without physical injury) it is to be considered a product liability loss (assuming it otherwise qualifies) even though it may not be recoverable under State law. Thus, if a taxpayer settles out of court on such a claim, the payment may be classified as a product liability loss even though the law of the State would not then have allowed recovery.

The definition of product liability in the Act does not include liabilities arising under warranty, which essentially are contract liabilities.² Nor does the definition include liabilities based on services performed by the taxpayer. For example, medical or legal malpractice is not a product liability under the definition.³ Where both product and services are an integrated part of the transaction, such as in the sale and installation of a boiler by the taxpayer, no product liability arises under the definition until all operations have been completed (or terminated) and the taxpayer has relinquished possession of the product. If the loss occurs prior to that point in time, it is not a product liability loss under the definition.

The Act also makes it clear t-hat self-insurance of product liability risks is a business need for which earnings and profits may be accumulated to a reasonable extent without imposition of the tax on unreasonable accumulation of earnings. This provision is consistent with, and merely clarifies, present law. Under the Act, the Secretary of the Treasury will prescribe regulations regarding the determination of the amount that may reasonably be accumulated to meet product liabi1ity self-insurance needs. It is expected that the regulations will provide that in determining what is a reasonable accumulation, it is appropriate to take into account the taxpayer's product liability experience, the extent of its commercial coverage for product liability, and the tax consequences of the taxpayer's ability to deduct product liability losses and related expenses for income tax purposes. Estimates of product liability claims that may be made against the taxpayer in the future must be reasonable both as to probability of occurrence and amount.

12. Tax Treatment of Returns of Magazines, Paperbacks, and Records

(sec. 372 of the Act and new sec. 458 of the Code)

In some cases, the seller expects that accrued sales income will be reduced on account of events subsequent to the date of sale, such as returns of unsold merchandise for credit or refund pursuant to a pre-existing agreement or understanding between the seller and the purchaser. In these instances, the reduction in sales income generally may be recognized only in the taxable year during which the subsequent event, such as the return of unsold merchandise, occurs. Deductions or exclusions based on estimates of future losses, expenses, or reductions in income ordinarily are not allowed for Federal income tax purposes.

Under these general tax accounting rules, the Internal Revenue Service has taken the position that accrual-basis publishers and distributors of magazines, paperbacks, or records must include the sales proceeds of these items in income when they are shipped to the purchaser, and may reduce income for returned items only in the taxable year the items actually are returned unsold by the purchaser.

The generally accepted method of accounting for returns in the publishing industry is to record sales at the time merchandise is shipped and to establish an offsetting reserve for estimated returns. The effect of this accounting treatment is to report sales net of estimated returns. Tax accounting rules, however, do not permit gross income to be reduced for returns until the returned items are received, which may not occur until a taxable year subsequent to that in which the sale was recorded.

The Congress concluded that the present method of tax accounting for returns of magazines, paperbacks, and records does not accurately measure income for Federal income tax purposes and that it adversely affects publishers and distributors of these items.

For taxpayers who account for sales of magazines, paperbacks, or records on an accrual method, the Act provides an election to exclude from gross income for a taxable year the income attributable to unsold merchandise returned within a certain time (the "merchandise return period") after the close of the taxable year (new sec. 458 of the Internal Revenue Code).¹ In the case of magazines, the merchandise return period extends for 2 months and 15 days after the close of the taxable year. In the case of paperbacks and records, the merchandise return period extends for 4 months and 15 days after the close of the taxable year.²

Scope of election

The election applies only with respect to sales of magazines, paperbacks, and records. The term "magazine" includes other periodicals, but does not include newspapers. The term "paperback" means paperback books, which are characterized by a flexible outer cover to which the pages of the book are directly affixed. This method of binding distinguishes paperbacks from hardback books, which usually have stiff front and back covers enclosing pages which are bound to a separate spine. (If an item satisfies the definitions both of magazines and of paperbacks, it is to be treated as a paperback for purposes of the Act.) The term "record" means a disc, tape, or similar object on which musical, spoken, or other sounds are recorded; however, the election does not apply to blank records, tapes. etc., on which it is expected the purchaser will make his or her own recordings.

An election applies with respect to the trade or business in connection with which the magazines, paperbacks, or records are sold. If two or more such categories of merchandise are sold in connection with the same trade or business, each category is treated as a separate trade or business. For example, if a taxpayer sells both magazines and paperbacks in connection with a single trade or business, then solely for purposes of the merchandise-return election the sale of magazines will be considered one trade or business, and the sale of paperbacks will be considered a separate trade or business. With respect to any such separate trade or business, an election applies to all sales of merchandise items in that trade or business (e.g., to all sales of all magazines by an electing taxpayer who publishes several magazines within the same trade or business).

Requirements for application

The method of accounting provided for under the election differs from that used for financial reporting purposes, in that the amount of reduction in gross income pursuant to the election is limited by actual returns during the merchandise return period, while under financial accounting rules, the reduction may be based on an estimate of future returns. Accordingly, several requirements are established to define those returns which may be used to reduce gross income if a timely election is made.

Rather than requiring return of the entire magazine for an adjustment to the sales price, some publishers and distributors require only that the cover be cut off and returned, and that the rest of the magazine be disposed of. In these instances, the regulations could provide that certification from the purchaser that such magazines have not been resold and will not be resold constitutes evidence in lieu of physical return. Any permitted certification or other evidence must be acceptable to the Treasury Department as satisfactory proof of the quantity and time of returns. Either the physically returned merchandise or the allowable substituted evidence must be in the possession of the taxpayer at the close of the merchandise return period.

Amount to be excluded

The amount to be excluded from gross income on account of otherwise qualifying returns is limited to the lesser of (1) the amount covered by the acknowledged legal obligation with respect to such returns or (2) the amount of adjustment to the sales price agreed to by the taxpayer before the close of the merchandise return period. An agreement to adjust the sales price may be evidenced by the taxpayer's making an actual refund or credit to the account of the purchaser, or by the taxpayer's issuing credit memorandum or other document stating such amount credited to the purchaser.

If the amount of legal obligation with respect to such returns is in dispute at the close of the merchandise return period, the amount in dispute cannot be excluded from gross income. For this purpose, the amount in dispute is the difference between the merchandise return amount asserted to be due from the taxpayer and the lesser of the amount covered by the acknowledged legal obligation with respect to such returns or the amount of adjustment to the sales price agreed to by the taxpayer before the close of the merchandise return period.

Method of making election

A merchandise-return election does not require consent of the Treasury Department, but must be made in such manner as the Department may prescribe by regulations. The election for a particular taxable year must be made not later than the time prescribed by law for filing the return for such taxable year (including extensions thereof); the election cannot be made on an amended return filed after the due date (including extensions thereof) for filing the return for such taxable year. Once made, an election is binding for future years with respect to the particular trade or business to which the election applies (e.g., sales of magazines) unless the taxpayer secures consent of the Treasury Department to revoke it.

Election as a method of accounting; transitional adjustments

The computation of income under the merchandise-return election constitutes a method of accounting.³ In the absence of a specific statutory rule to the contrary, an adjustment to income attributable to a change in method of accounting (called the "transitional adjustment") is amortized over a set period of time prescribed by the Internal Revenue Service, usually 10 years (sec. 481(c)). However, this provision sets forth specific rules for the transitional adjustments arising out of merchandise-return elections.

In the case of an election to account for magazine returns under this provision, a special 5-year amortization of the transitional adjustment is provided in place of the normal 10-year amortization. In the case of an election to account for paperback or record returns under this provision, the provision establishes a "suspense account" to hold the transitional adjustment. The operative effect of the suspense account (described in detail below) is to defer deduction of the transitional adjustment until the taxpayer is no longer engaged in the trade or ness of selling the items which were the subject of an election.

To the extent that this provision of the Act sets forth special applicable to computation of income under a merchandise-return election (such as the transitional adjustment rules) which are inconsistent with the rules generally applicable to changes in method of accounting, the special rules of this provision override. For example, the provision authorizes an initial merchandise-return election to be made without consent of the Treasury Department, which also is inconsistent with the general rule on changes in method of accounting. However, other rules under present law relating to accounting changes will continue to apply, such as the requirement of recognizing the balance of a deferred adjustment if the taxpayer ceases to be engaged in the trade or business to which it relates.

Suspense account for paperbacks and records

A separate suspense account is to be established for each trade or business (or category which is treated as a trade or business under this provision) with respect to which an election is made. As long as merchandise returns during the merchandise return period remain at or below the level of the initial opening balance in the account, taxable income under the merchandise-return method is the same as it would have been absent an election. However, an increase in returns over the initial opening balance is recognized one year earlier under the elected method.

For example, assume that a paperback distributor made a timely merchandise-return election effective for its taxable year ending December 31, 1980, and did not select a merchandise return period shorter than the statutory period. If the taxpayer's merchandise returns in the first 4 months and 15 days of 1978, 1979, and 1980 were $5, $8, and $6 respectively, then the initial opening balance in the suspense account on January 1, 1980 would be $8 (the largest dollar amount of merchandise returns in the pertinent years).⁴ Since the initial opening balance exceeds the actual returns in the first 4 months and 15 days of the taxable year for which the election is first effective ($6 in 1980), the excess of $2 is added to gross income for such taxable year (1980).

Assume, in addition to the facts of the example given above, that qualifying returns in the first 4 months and 15 days of 1981, 1982, and 1983 are $5, $7, and $10 respectively. Under these facts, the opening balance for 1981 would be $5. This equals the $8 initial opening balance for 1980 reduced by $3, which is the excess of the initial opening balance ($8) over merchandise returns in the first 4 months and 15 days of 1981 ($5).

The amount excludable from gross income under the election for 1981 is $7, i.e., the amount of qualifying returns in the first 4 months and 15 days of 1982. Since the excludable amount ($7) exceeds the opening balance for 1981 ($5), the account is increased by $2 to $7, and $2 is added to gross income for the year. Thus the net amount excludable from income in 1981 after these adjustments is $5-the $7 exclusion netted against the $2 addition to gross income.

The amount excludable under the election for 1982 is $10, which is $3 more than the $7 opening balance in the suspense account for 1979. However, the suspense account is increased only by $1 to $8, the initial opening balance (and ceiling on the suspense account). The $1 also is added to gross income for the year. The net amount excludable from income in 1982 after all adjustments in $9.

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13. Tax Treatment of Redemptions of Discount Coupons

(sec. 373 of the Act and new sec. 466 of the Code)

The Internal Revenue Service has ruled that two types of "cents-off" or "discount" coupons do not qualify under the regulation for the estimated deduction.¹ The two types are called "media coupons" and "in pak/on pak coupons". Media coupons are issued gratuitously through the mail or by newspaper, etc., while in pak/on pak coupons are included with merchandise purchased by the consumer. Both types allow the consumer "cents off" (or other discount) on the purchase price of specified merchandise.

Another income tax regulation (sec. 1.461-1 (a)(2)) provides that an accrual-basis taxpayer may accrue and deduct an expense in the taxable year in which all the events have occurred that fix the fact of the liability and the amount can be determined with reasonable accuracy. This is called the "all events" test. Under this rule, an accrual method taxpayer generally can accrue and deduct the cost of redeeming discount coupons tendered for redemption by the close of the taxable year. Further, it could be argued that a deduction may be claimed under this rule when the coupon is tendered for redemption to a person authorized to redeem it from the consumer.

The regulation presently governing the tax accounting treatment for trading stamps and premium coupons does not specifically address the method of accounting for discount coupons. It is argued by some that no real distinction can be drawn between premium coupons and discount coupons, and that the principles of the regulation apply equally to both types.

Industries that rely heavily on discount coupons for product promotion have testified before the Congress that they consistently have been using the accounting treatment provided in the trading stamp and premium coupon regulation for discount coupons. Accordingly, the IRS rulings that deny to certain types of discount coupons the accounting treatment provided in the regulation for trading stamps and premium coupons have caused contusion and uncertainty in industries that rely heavily on discount coupon promotions.

The Congress concluded that it is appropriate to allow a limited deduction for discount coupons estimated to have been turned in by consumers by the close of the issuer's taxable year, but which have not been received by the issuer by that time. This treatment is essentially in accord with the rule that allows a deduction under the "all events" test of present law, if the amount of deduction can be determined with reasonable accuracy. The Act resolves the reasonable accuracy issue and the certainty needed for administration by providing, generally, that a deduction will be allowed for coupons outstanding at the close of the taxable year that are received by the issuer within six months after the close of the taxable year.

For taxpayers who use an accrual method of accounting, the Act provides an election to deduct the cost of redeeming qualified discount coupons outstanding at the close of the taxable year and received by the taxpayer within the "redemption period," which generally is the six-month period following the close of the taxable year³ (new sec. 466 of the Internal Revenue Code).⁴

Coupons for which election may be made

The election applies only with respect to qualified discount coupons. The income tax accounting treatment of trading stamps and premium coupons presently provided in Treasury regulation sec. 1.451-4 is not changed by this provision of the Act, and the enactment of this provision does not imply that the tax accounting treatment accorded trading stamps and premium coupons under regulation sec. 1.451-4 is improper.

To the extent (if any) that regulation sec. 1.451-4 applies to qualified discount coupons, this provision of the Act supersedes the regulation and provides, as of the effective date of this provision, the sole accrual accounting method of deducting the cost of redeeming qualified discount coupons outstanding at the close of the taxable year. Also, discount coupons which are not "qualified discount coupons" under the provision are not accorded the tax accounting treatment provided by the provision, nor are they to be accorded the tax accounting treatment provided by the trading stamp and premium coupon regulation. The proper taxable year in which to deduct the cost of redeeming discount coupons which are not "qualified discount coupons" under the provision is to be determined generally under the normal tax accounting rules provided in section 461 of the Code and the regulations thereunder.

The determination of whether a coupon is a premium coupon or discount coupon is to be made by taking into account all the facts and circumstances involving its issuance and redemption. The method of issuance may be one of the facts and circumstances taken into account to determine whether a coupon is a discount coupon or premium coupon (but not to determine whether a discount coupon is a qualified discount coupon).

A premium coupon generally is issued in connection with the sale of some item and entitles the holder to tender it (or, more usually, a large number of such coupons) in exchange for a product, often selected from a catalog, of the consumer's choosing. These coupons are used to promote the sale of the product with which the coupon is issued by allowing the consumer to collect coupons in order to acquire a different product of his or her own choosing.⁵

A discount coupon, on the other hand, usually is designed to encourage the purchase of a specific product by allowing a discount on its purchase price. Discount coupons may be issued in a number of ways, including through newspapers or other printed media, by mail, and printed on or included in the package of another product. The discount may be stated in terms of a cash amount, a percentage of the purchase price, or as a "two for the price of one" coupon. Ordinarily, a discount coupon is individually redeemable, while the premium coupon is intended to be collected and redeemed in large numbers for a single product.

To qualify under the provision, a discount coupon must be (1) issued by the taxpayer, (2) redeemable by the taxpayer, and (3) allow a discount on the purchase price of merchandise or other tangible personal property. Coupons redeemable for a discount on the price of services or real property do not qualify under the provision. A coupon need not be printed on paper in the form usually associated with coupons; it may be a token or other object, so long as it functions as a coupon. A coupon is not a qualified discount coupon if the face amount (including the effective discount of the coupon if it is a "two for the price of one" or "percentage off" coupon) is more than $5, or if it may be used in connection with other coupons to bring about a price reduction of more than $5 with respect to any item.

A coupon is not a qualified discount coupon if it is redeemed by the issuer directly from the person using the coupon to obtain a price discount.⁶ For purposes of this rule, corporations which are members of the same controlled group of corporations (as defined in section 1563(a) of the Code) as the issuer are treated as the issuer. Thus, a coupon redeemed by a wholly owned subsidiary of the issuer is not a qualified discount coupon if it is redeemed directly by such subsidiary from the user.

Method of making election and scope of election

A discount coupon election does not require consent of the Secretary of the Treasury, but must be made in such manner as the Secretary may prescribe by regulations. The election for a particular taxable year must be made not later than the time prescribed by law for filing the return for such taxable year (including extensions thereof); the election cannot be made on an amended return filed after the due date (including extensions thereof) for filing the return for such taxable year. Once made, an election is binding for future years with respect to the particular trade or business to which the election applies unless the taxpayer secures consent of the Secretary to revoke it.

The election is made with respect to the trade or business in connection with which the coupons are issued. An election applies to all qualified discount coupons issued by that trade or business.

Election as method of accounting

The computation of income under a discount coupon election constitutes a method of accounting. Thus, the election of this method or a change to another method of accounting for discount coupons will be a change in method of accounting subject to the applicable rules governing accounting changes. However, to the extent that this provision sets forth special rules that are inconsistent with the rules generally applicable to changes in method of accounting, the special rules of this provision are to take precedence.

Thus, although an election made under this provision constitutes a change in method of accounting, the special rules of the provision relating to the treatment of the adjustment to taxable income resulting from the election are to take precedence over the general rules. Generally, under these special rules, net decreases in taxable income are deferred from recognition by being placed in a suspense account, and net increases in taxable income are taken into income over a 10-year period. Section 481(b)(2), relating to the computation of tax if there is a substantial increase in taxable income because of an accounting method change, does not apply to an election under this provision.

The method of accounting provided by this provision generally is expected to clearly reflect income. However, if (for example) a taxpayer manipulates the issuance of coupons in such a manner that the rules set forth in this provision of the Act do not result in a clear reflection of income, it is anticipated that the Secretary, within his general authority under section 446 of the Code, may modify the method so that it does clearly reflect income.

Amount of deduction

Under the election, a taxpayer is allowed a deduction for the cost of redeeming qualified discount coupons outstanding at the close of the taxable year that are received within the "redemption period", which generally is the six-month period following the close of the taxable year. In addition, a deduction is allowed for the cost of redeeming qualified discount coupons received during the taxable year for which a deduction has not been allowed with respect to a redemption period of a previous year. Coupons received by an agent of the taxpayer (other than an agent who accepted the coupon from the person who used it to receive a price discount) before the close of the redemption period qualify as having been received by the taxpayer before the close of such period.

The cost of redeeming a coupon is the amount of discount stated on the coupon or, if less, the amount incurred by the taxpayer for paying the discount, plus an amount payable to the retailer (or other person redeeming the coupon from the person receiving the price discount) for services in redeeming the coupon. The amount payable to the retailer or other person for services in redeeming the coupon is allowed only if the amount payable is stated on the coupon. The amount incurred by the taxpayer in paying the discount does not include incidental costs such as a redemption center service fee.

Suspense account

In the absence of a specific statutory rule to the contrary, an adjustment to income attributable to a change in method of accounting (called the "transitional adjustment") is amortized over a set period of time prescribed by the Internal Revenue Service, usually 10 years (sec. 481(c)). Instead of using this general rule, the Act provides two special rules for the treatment of the transitional adjustment. If the adjustment is a net decrease in taxable income, it is to be placed in a suspense account. If it is a net increase in taxable income, it is to be taken into income ratably over a 10-year period beginning with the year of change.

The effect of the suspense account, which is described in detail below, is to defer the deduction of the transitional adjustment until the taxpayer is no longer engaged in the trade or business in connection with which the discount coupons are issued. A separate suspense account is to be established for each trade or business with respect to which an election is made.

For example, assume that an issuer of qualified discount coupons makes a timely election under new section 466 for its taxable year ending December 31, 1979, and does not select a coupon redemption period shorter than the statutory period of 6 months. If the taxpayer's qualified coupon redemptions in the first 6 months of 1977, 1978, and 1979 were $7, $13, and $8, respectively (and the accounting change adjustments that increase income for 1979 are $2), then the initial opening balance in the suspense account on January 1, 1979 would be $11 (that is, the largest dollar amount of qualified coupon redemptions in the pertinent years ($13)⁷, reduced by the sum of the accounting change adjustments that increase income in the year of change ($2)). Since the coupon redemptions taken into account in determining the initial opening balance ($13 in 1978) exceed the actual redemptions in the first 6 months of the taxable year for which the election is first effective ($8 in 1979), the excess of $5 is added to gross income for the year of election (1979).

If this amount is less than the opening balance in the suspense account for the taxable year, the account is reduced by the difference. Conversely, if such amount is greater than the opening balance in the suspense account for the taxable year, the account is increased by the difference (but not to an amount in excess of the initial opening balance). Adjustments that reduce the suspense account are a deduction for the taxable year; adjustments that increase the suspense accounts increase gross income for the taxable year.

To continue the example above, assume that coupon redemptions in the first 6 months of 1980, 1981, and 1982 are $7, $10, and $12, respectively. Given these facts, and applying the rules relating to annual adjustments to the suspense account described above, the annual adjustments to the account for 1979, 1980, and 1981 are a reduction of $4, increase of $3, and increase of $l,⁸ respectively. The computation of these adjustments, as well as the net effect of all these adjustments on income for each year, are set out in the following table.

Illustration

This table illustrates the establishment of the suspense account and its operation for the years 1979 through 1981.

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² The largest dollar amount of deduction that would have been allowed with respect to coupons redeemed within any redemption period of the three years immediately preceding the year of election ($13), reduced by the accounting change adjustments that increase income in the year of change ($2).

³ Applies when coupons redeemed during the redemption period for the taxable year exceed the opening balance; the addition is not to cause the suspense account to exceed the initial opening balance.

⁴ Applies when coupons redeemed during the redemption period for the taxable year are less than the opening balance.

⁵ The initial year adjustment applies when the initial opening balance is computed with respect to actual coupon redemptions in the first six months of either of the two years preceding the year of change. If the adjustment applies, the amount of adjustment is the excess of the coupons redeemed in the first six months of the applicable year over the coupons redeemed in the first six months of the year of change.

The provision is effective for taxable years ending after December 31, 1978.

Special rules for certain prior years

Under the provision, certain accounting methods for discount coupons used in taxable years ending before January 1, 1979 are to be treated as proper for Federal tax purposes if the taxpayer elects under new Code section 466 for his first taxable year ending after December 31, 1978. To qualify for the benefit of this "protective" election, the taxpayer (1) for a continuous period of one or more prior taxable years (each of which ends before January 1, 1979) must have used a method of accounting for discount coupons that is reasonably similar to the method provided in the trading stamp and premium coupon regulation (sec. 1.451-4 or its predecessors under the Internal Revenue Code of 1954) and (2) must elect the provisions of new Code section 466 for the taxpayer's first taxable year ending after December 31, 1978. If a reasonably similar method was used in two or more separate continuous periods, the election may be made only with respect to one such period.

If a taxpayer timely makes such a protective election, then the method of accounting used for such continuous period is to be treated as a valid method of accounting with respect to such discount coupons for the continuous period of one or more taxable years each of which ends before January 1, 1979. The protective election must be made in such manner and form as the Secretary of Treasury prescribes by regulations. Such an election shall be treated for Federal tax purposes as a method of accounting, but does not require consent of the Secretary of the Treasury.

An otherwise qualifying protective election may apply, with respect to the continuous period of taxable years each of which ends before January 1, 1979, to coupons which are discount coupons but which would not be treated as qualified discount coupons under new Code section 466. Also, the cost of redemption center service fees, and amounts which are payable to the retailer (or other person redeeming the coupon from the person receiving the price discount) for services in redeeming the coupons but which are not stated on the coupons, are deductible for prior years covered by a protective election (if treated as deductible under the accounting method for such years), even though such cost and amounts would not be deductible under new Code section 466.

If a taxpayer makes a timely election under these rules to "protect" prior years, and, in addition, the method of accounting used in those years was used for all discount coupons issued by the taxpayer in those years, then the taxpayer need not establish the suspense account normally required by new Code section 466.⁹ Instead, the taxpayer will treat the election of the method under new Code section 466 as a change in method of accounting to which the normal rules for accounting for transitional adjustments apply.

This protective election may be made at any time before the expiration of the period for making the election under new Code section 466 for the taxpayer's first taxable year ending after December 31, 1978.

The Congress recognizes that, due to the Internal Revenue Service interpretation of the trading stamp and premium coupon regulation, some taxpayers may have agreed in a prior year or years to discontinue the use of the regulation to account for discount coupons. If any such year is not closed under the statute of limitations, or by reason of a closing agreement with the Internal Revenue Service, the taxpayer may file a claim for the refund if any, which would be due based on the use of the "protected" method of accounting (assuming he makes the protective election) if he used that method in his original return filed for that taxable year. This is not to be construed, however, to abrogate in any way the rules regarding the closing of taxable years due to the statute of limitations or a binding agreement between the Internal Revenue Service and the taxpayer.

(sec. 401 of the Act and sec. 1201(b) of the Code)

In lieu of taxing 50 percent of net capital gains at the regular rates, a partial alternative tax of 25 percent on the first $50,000 of net capital gains was applicable if it resulted in a lower tax rate than that produced by the regular method.

2. Increased Capital Gains Deduction for Individuals

(sec. 402 of the Act and sec. 1202 of the Code)

The Congress believed that lower capital gains taxes will markedly increase sales of appreciated assets, which will offset much of the revenue loss from the tax cut, and potentially lead to an actual increase in revenues. In addition, the improved mobility of capital will stimulate investment, thereby generating more economic activity and more tax revenue.

In addition, the Congress believed that an increased capital deduction would tend to offset the effect of inflation by reducing the amount of gain which is subject to tax. However, since the deduction is constant, unlike the adjustments generally provided for in various indexation proposals, it is much simpler and should not tend to exacerbate inflation.

The Congress believed that the increased deduction, in conjunction with the Act's other capital gains tax changes and its reformulation of the minimum tax, should contribute significantly to a more favorable economic climate by increasing the mobility of capital, and by providing an incentive for taxpayers to both realize gains and to increase savings. In addition, the provisions relating to the alternative minimum tax (see below) should assure that every individual realizing capital gains pays at least a minimum amount of tax.

The Act does not change the present law treatment of a noncorporate taxpayer's capital losses.

The Act coordinates the increased capital gains deduction with the rules applicable to charitable contributions of appreciated property. It provides that the amount of certain charitable contributions of capital gains property is to be reduced by 40, rather than 50, percent of the gain which would have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market value.

Generally, the increased capital gains deduction is applicable in the case of taxable transactions occurring, and installment payments received, after October 31, 1978. These installment payments generally will qualify for the increased deduction even though they relate to pre-November 1, 1978, transactions.

The Act contains a special transitional rule for sales or exchanges occurring, and installment payments received, in November or December 1978. Under this rule, the allowable deduction with respect to the taxable year which began prior to November 1, 1978, and which ends after October 31, 1978, is the sum of: (1) 60 percent of the lesser of the net capital gain for the taxable year, or the net capital gain taking into account only post-October 31, 1978 sales, exchanges, and installment payments, and (2) 50 percent of the excess of the net capital gain for the taxable year, over the amount of the net capital gain taken into account under (1).

In the case of long-term capital gains from sales or exchanges by certain conduit or conduit-type entities (partnerships, subchapter S corporations, mutual funds, real estate investment trusts, etc.) before November 1978, it is anticipated that legislation will be considered in the 96th Congress to clarify that such gains are not eligible for the 60 percent deduction although they are includible in income, by individuals for 1979 because the entities have fiscal years ending in 1979.

3. Reduction of Corporate Alternative Tax for Capital Gains Tax

(sec. 403 of the Act and sec. 1201 of the Code)

A transitional rule is provided for fiscal year taxpayers with respect to sales or exchanges occurring after December 31, 1978 in the fiscal year ending in 1979. Under this rule the corporate alternative tax is the sum of: (1) 28 percent of the lesser of the net capital gain for the year, or the net capital gain from post-December 31, 1978 sales and exchanges, and (2) 30 percent of the excess of the net capital gain for the year over the amount of gain taken into account under (1).

4. Exclusion of Gain on Sale of Residence

(sec. 404 of the Act and sec. 121 of the Code)

Generally, the entire amount of gain or loss realized on the sale or exchange of property is recognized. However, under a "rollover" provision of the Code, gain is not recognized on the sale or exchange of a taxpayer's principal residence if a new principal residence, at least equal in cost to the adjusted sales price of the old residence, is purchased and used by the tax payer as his or her principal residence within a period beginning 18 months before, and ending 18 months after, the date of the sale of the old residence. The basis of the new residence then is reduced by the amount of the gain not recognized on the sale of the old residence. When the purchase price of the new residence is less than the adjusted sales price of the old residence, gain is recognized only to the extent that the adjusted sales price of the old residence exceeds the taxpayer's cost of purchasing the new residence.

If, however, an individual realizes gain on the sale or exchange of a residence and fails to satisfy the rollover requirements, then the gain generally is taxable pursuant to the usual rules of the Code.

Individuals age 65 and over

Under prior law (sec. 121), an individual who attained the age of 65 could elect to exclude from gross income, on a one-time basis, the entire gain realized on the sale of his or her principal residence, if the adjusted sales price was $35,000 or less. If the adjusted sales exceeded $35,000, the amount excludible was that portion of the gain which was determined by multiplying the total gain by a fraction, the numerator of which was $35,000, and the denominator of which was the adjusted sales price of the residence. The exclusion was not available unless the property was owned and used by the taxpayer as his or her principal residence for a period aggregating 5 years or more during the 8-year period preceding the sale. Due to this actual use and occupancy requirement, the holding period of a condemned or involuntarily converted residence was not added to that of a replacement residence for purposes of having gain on the sale of the latter property qualify for the exclusion.

A taxpayer who attained the age of 65 could utilize the special exclusion and then use the generally available rollover provision (sec. 1034) with respect to the balance of any gain.

The exclusion applies only in the case of gain from the sale of a principal residence which the individual has owned and occupied as his or her principal residence for a period aggregating 3 out of 5 years immediately preceding the sale. This ownership and occupancy rule may be satisfied only by the taxpayer, or by the taxpayer's spouse in the case of married individuals. However, the Act provides two exceptions to the generally applicable ownership and occupancy rule. The first exception is a limited transition rule which provides that an individual who satisfies the age, ownership and use requirements of the provisions of prior law relating to sales by taxpayers who attained the age of 65 (5 years or more out of the 8-year period which preceded the sale) will have until July 26, 1981, to qualify for the exclusion either under the new ownership and occupancy test or that of the prior law. The second exception provides that the use and holding period of a condemned or involuntarily converted residence may be tacked to that of a replacement residence for purposes of having gain on the sale of the latter property qualify for the exclusion. In other cases, the holding period for an old residence will not be taken into account even if gain on that residence's sale had been rolled over into the new principal residence which is being sold.

For purposes of the exclusion contained in the Act, the definition of a taxpayer's principal residence is that presently utilized in section 1034 (relating to rollovers). Therefore, whether property qualifies as an individual's principal residence, or what portion of a property qualifies, will depend upon the facts and circumstances in each case. Similarly, the facts and circumstances test is to apply to determine which residence is a taxpayer's principal residence where ho or she has owned and occupied more than one residence during the 5-year period preceding the sale in question.

Of course, if an individual realizes gain in excess of the amount excluded under the Act, the taxpayer's remaining gain is to be subject to the regular income tax in the same manner as other capital gains. Therefore, only 40 percent of the individual's long-term capital gain in excess of the amount excluded under the Act would be includible in the taxpayer's taxable income.

As under prior law, both the exclusion and the nonrecognition provisions of sections 1033 and 1034 may be used with respect to gain realized on the sale of a principal residence. Thus, the amount that would have to be reinvested in a new principal residence is reduced by the amount excluded from income, and the amount of any gain excluded on the prior sale will not reduce his or her basis for the new residence.

A taxpayer who previously elected to use the one-time $35,000 exclusion ratio provision available to individuals 65 or over also may qualify to use the new election without reduction of the excludable amount.

As under prior law, each taxpayer is allowed to elect the exclusion only once in his or her lifetime. Thus, the rules under prior law will continue to apply to determine when an individual is ineligible to make the election in the case of single taxpayers becoming married and married taxpayers becoming divorced. Under these rules, if spouses make an election during marriage, and subsequently become divorced, no further elections are available to either of them or to their spouses should they marry. Also, if a single taxpayer makes the election and subsequently marries, no further election is allowed to the married individuals. If, however, each of two parties made an election independently prior to becoming married, there is to be no recapture of the tax which is attributable to the gain excluded with respect to the sale of either of the residences.

(Under section 421 of the Act, no amount of any gain realized on the sale of an individual's principal residence, whether or not excludable under the Act, is a tax preference subject to the minimum tax.)

5. Rollover of Gain on Sale of Residence

(sec. 405 of the Act and sec. 1034 of the Code)

This nonrecognition treatment was available, however, only once during any 12-month period. Thus, where the nonrecognition treatment applied to the sale of a taxpayer's residence, it would not apply again for a period ending one year from the date of the sale of the old residence.

The 1975 Act extended the replacement time period for the purchase of a new residence to the period beginning 18 months before the sale of the old residence and ending 18 months after such sale. The 1975 Act also applied the 18-month period in determining which residence was the replacement residence where more than one residence was used by the taxpayer as a principal residence after the sale of the old residence, i.e., the last principal residence so used during the old period was the "new residence." Under the 1975 Act, nonrecognition treatment was available only once during any 18-month period.²

Thus, where the taxpayer is entitled to deduct moving expenses with respect to a relocation falling within the 18-month period, the 18-month limitation of present law generally would not apply. In such a situation, the multiple rollover provision would be available so as to allow the nonrecognition of gain on the sale of a principal residence even though there had been nonrecognition of gain on the sale of another principal residence within the preceding 18 months. However, in order to qualify for such treatment, a sale must be in connection with the commencement of work by the taxpayer as an employee or as a self-employed individual at a new principal place of works, and the taxpayer must satisfy both the geographic and length of employment requirements for deductibility of moving expenses (secs. 217(c) and 217(d)).³ In applying the moving expenses test to a residence sold within the 18-month limitation period, the residence sold is treated as the "former residence."

To qualify for the multiple rollover provision it is not necessary for an individual to remain with the same employer, nor actually to satisfy the time test of section 217. Instead, the taxpayer only has to have a reasonable expectation at the time of the move, that he or she would satisfy the time condition. Thus, the provision would not be available if the taxpayer reasonably could have been expected to know that the time test of section 217 could not be satisfied.

In addition, a sale which meets the requirements of the Act will be treated as terminating the 18-month period and starting another 18-month period. Thus, the principal residence receiving rollover treatment under the Act will constitute a new residence with respect to the prior rollover sale and an old residence for purposes of its sale.

Where the multiple rollover provision applies, the basis of each succeeding principal residence is to be reduced by the amount of gain not recognized on the sale of the prior residence.

(sec. 421 of the Act and secs. 55-58 of the Code)

The tax preference items included in this base of the minimum tax for individuals were:

While the Congress believes that it is appropriate to substitute an alternative minimum tax for the present minimum tax in the case of capital gains and adjusted itemized deductions, it also believes that the present minimum tax should be retained in the case of the other items of tax preference.

For these reasons, the Congress agreed to an alternative minimum tax, which is to be paid only to the extent that the tax exceeds a taxpayer's regular tax liability including a revised add-on minimum tax. The alternative minimum tax rates rise to a maximum of 25 percent for those persons with incomes (including certain preferences) exceeding $100,000. Thus, taxpayers paying high regular taxes (i.e., approaching, or in excess of, 25 percent of very large incomes) generally will not be subject to any alternative minimum tax, and they thus will have no disincentive, attributable to the minimum tax, for making capital gain investments. However, the provision will insure that those high income individuals currently paying low regular taxes and realizing large capital gains will pay substantially more tax in the future.

The Act generally retains the prior law minimum tax with respect to all preference items except the deducted amount of net capital gain and adjusted itemized deductions. The Act also establishes an alternative minimum tax which is payable by noncorporate taxpayers to the extent that it exceeds the regular tax paid as increased by the revised add-on minimum tax. Thus, although the tax is in effect a true alternative tax, in the sense that it is paid only when it exceeds regular tax (including any add-on minimum tax liability), technically the taxpayer's regular and add-on minimum taxes continue to be imposed and the amount of alternative minimum tax is the excess of the amount computed under the alternative minimum tax rate table over the amount of the regular and add-on minimum taxes.

Computation

The alternative minimum tax is based on the sum of a noncorporate taxpayer's gross income reduced by deductions allowed for the year (including deductions in excess of gross income, if any), and by amounts included in income under section 667 (relating to accumulation distributions from trusts) and increased by the amount of the taxpayer's adjusted itemized deductions, and capital gains deduction. This amount then is subject to the following alternative minimum tax rates:

 Alternative minimum

Treatment of credits

The foreign tax credit and refundable credits are the only tax credits which are allowed against any alternative minimum tax liability. Thus, taxpayers paying the alternative minimum tax do not obtain the benefit of nonrefundable credits, other than the foreign tax credit, to the extent of the minimum tax. However, in the case of the investment tax credit, the jobs credit, and the WIN credit, the Act provides that any credit carryover or carryback from a year in which the taxpayer is liable for some amount of alternative minimum tax, is not to be reduced to the extent of the taxpayer's alternative minimum tax liability. For example, assume a taxpayer has a regular tax liability before credits of $10,000, investment tax credits of $5 000 and alternative minimum tax before regular tax offset of $8,000 (consisting of regular tax of $5,000 and alternative minimum tax of $3,000). In this case, the taxpayer has used up all $5,000 of investment tax credits against regular tax but has received a benefit only from $2,000 of credits. Thus, the remaining $3,000 of credit for which no tax reduction was obtained is to be available as an additional carryover to the next year to which the credit would be otherwise carried over under the usual rules if the credit did not otherwise expire.³

Preferences for the alternative minimum tax

For purposes of the alternative minimum tax there are two preferences. The capital gains preference is the amount of a taxpayer's section 1202 capital gains deduction, but does not include any deduction which is attributable to the gain from sale of a taxpayer's principal residence.

The other alternative minimum tax preference is adjusted itemized deductions. This preference excludes medical and casualty deductions, State and local tax deductions and, in the case of income in respect of a decedent, amounts deducted (under sec. 691(c)) for estate taxes. (However, income in respect of a decedent which is capital gain continues to be a tax preference.) The remaining itemized deductions are preferences only to the extent they exceed 60 percent of adjusted gross income minus the medical and casualty deductions, State and local tax deductions, and the deduction for estate taxes attributable to the inclusion of income in respect of a decedent in a decedent's gross estate. Thus, for example, a taxpayer with AGI of $50,000 and total itemized deductions of $45,000 (including $10,000 State and local taxes and no medical or casualty expenses) would have $35,000 of deductions subject to the preference computation. The amount of the preference would equal the excess of these deductions over 60 percent of $40,000 ($50,000 AGI less $10,000 State and local taxes), or $24,000. Thus, the preference is $35,000 minus $24,000, or $11,000.

Foreign tax credit

The foreign tax credit is to be allowed separately against the alternative minimum tax, and, in general, the regular foreign tax credit rules apply. However, in determining the allowable credit, the tax credit limitation is to be computed separately on the basis of alternative minimum taxable income. In addition, a number of adjustments are made to the credit rules to take into account the interactions between the alternative minimum tax and the regular tax.

Although the alternative minimum tax is structured as an additional tax equal to the excess of the gross alternative minimum tax over regular tax liability, it is conceptually an alternative to the regular tax. Accordingly, the rules applicable in computing the foreign tax credit against the alternative minimum tax are designed to reach the same results that would obtain if the tax were structured as an alternative to the regular tax (under which the taxpayer's pre-credit liability for the year would be the greater of his pre-credit regular tax or his pre-credit "gross" alternative minimum tax (the alternative minimum tax before the regular tax offset)). However, since the credit limitations applicable to the regular tax and to the alternative minimum tax are computed with reference to different taxable income bases, it would be possible under certain circumstances for a taxpayer's pre-credit gross alternative minimum tax to exceed his pre-credit regular tax while his after-credit alternative minimum tax is less than his after-credit regular tax. Therefore, in order to prevent the alternative minimum tax from in effect reducing his U.S. taxes actually paid for the year, the taxpayer is required to pay an amount equal to the greater of the after-credit regular tax or the after-credit alternative minimum tax. This is accomplished by limiting the alternative minimum tax foreign tax credit to the net alternative minimum tax (the excess of the gross alternative minimum tax over the after-credit regular tax).

As in the case of the regular tax, the credit taken against the alternative minimum tax cannot exceed the portion of that tax attributable to foreign source income. In keeping with the underlying concept of the alternative minimum tax as an alternative to the regular tax, the foreign tax credit limitation is generally based on the gross alternative minimum tax. The limitation is computed with reference to alternative minimum taxable income by modifying the limiting fraction applicable in determining the regular tax credit limitation to include the preference items (the capital gains deduction and adjusted itemized deductions) which are added back to taxable income in computing the income subject to the alternative minimum tax. Thus, the credit is limited to the same proportion of the gross alternative tax which the taxpayer's alternative minimum taxable income from sources without the United States (but not in excess of the taxpayer's alternative minimum taxable income) bears to his entire alternative minimum taxable income the same proportion of the gross alternative tax which the taxpayer's alternative minimum taxable income from sources without the United States (but not in excess of the taxpayer's alternative minimum taxable income) bears to his entire alternative minimum taxable income. (While the limitation, since it is computed with reference to the gross alternative minimum tax, may exceed the taxpayer's net alternative minimum tax (i.e., the tax after the regular tax offset), the credit taken can not exceed that amount.)

The foreign tax credit allowed against the regular tax reduces that tax and may, to the same extent, increase the taxpayer's net alternative minimum tax liability. This in effect would cause the loss of the tax benefit of the foreign tax credit against the regular tax since credits are treated as used under existing law. They are not available as carryovers or carrybacks (or for use against the alternative minimum tax). To preserve the value of these credits, an adjustment is made under which the taxpayer is deemed to have paid additional creditable foreign taxes in an amount equal to the amount by which the tax credit taken against the regular tax reduces the regular tax offset and thus increases the taxpayer's pre-credit alternative minimum tax (that is, the lesser of (i) the foreign tax credit taken against the regular tax or (ii) the pre-credit net alternative minimum tax.) In determining the amount of excess credits available for carryover or carryback after taking the credit against the alternative minimum tax the taxpayer is treated as having been allowed a foreign tax credit equal to the difference between (i) the greater of the gross regular tax and the gross alternative minimum tax (conceptually, the initial measure of tax liability) and (ii) the combined total of the regular and alternative minimum taxes actually paid after the foreign tax credit.

These rules may be illustrated by the following example of a taxpayer with $200,000 of net capital gains, half from U.S. sources and half from foreign sources, and an ordinary loss allocable to U.S. sources of $30,000. After the 60 percent capital gains deduction his taxable income is $50,000, and his regular U.S. tax before the foreign tax credit is $15,000. He pays creditable foreign income taxes of $20,000, his foreign tax credit limitation is $12,000 ($15,000 times $40,000/$50,000), and, therefore, his regular U.S. tax after the foreign tax credit is $3,000. The taxpayer's gross alternative minimum tax (i.e., the tax before the regular tax offset) is $29,500 on alternative taxable income of $170,000. After the regular tax offset of $3,000, the alternative minimum tax (before foreign tax credits) is $26,500.

The taxpayer's alternative minimum tax foreign tax credit limitation is $17,353 ($29,500 times $100,000/$170,000). The taxpayer used $12,000 of his $20,000 of creditable foreign income taxes against his regular tax liability, leaving $8,000, but he is deemed to have paid an additional $12,000 (the lesser of his $26,500 alternative minimum tax and the $12,000 in foreign taxes used against the regular tax) in foreign taxes available to credit against the alternative minimum tax or to carry to other years. His alternative minimum tax net of the foreign tax credit is $9,147 ($26,500 less $17,353). The taxpayer will therefore pay a net basic income tax of $3,000 and a net alternative minimum tax of $9,147 for a total of $12,147. The excess credits that may be carried to another year would be $2,647-the amount by which the sum of the $20,000 foreign taxes actually paid during the year and the $12,000 additional foreign taxes deemed paid under this section exceeds the sum of the regular tax foreign tax credit limitation of $12,000 and the alternative minimum tax foreign tax credit limitation (to the extent it does not exceed the alternative minimum tax) of $17,353. (In this example, the amount of foreign taxes available to be carried to another year is equal to the difference between the $20,000 foreign taxes paid (without regard to the additional foreign taxes deemed paid under this section) and the $17,353 foreign tax credit taken against the alternative minimum tax. However, this would not be the case where the taxpayer's pre-credit regular tax is greater than his pro-credit gross alternative minimum tax.)

Certain additional modifications are necessary if the taxpayer is also liable for the add-on minimum tax imposed under section 56. The foreign tax credit is not allowed against the add-on minimum tax, and, therefore, the multiplicand of the alternative minimum tax foreign tax credit limitation formula is reduced by the amount of the add-on minimum tax.⁴

Special rules

The provision also includes special rules for the application of the alternative minimum tax in the case of estates and trusts. The rate schedule applicable to estates and trusts is the same as the rates applicable to married individuals filing a separate return. Also, accumulation distributions from a trust included in income under section 667 are not to be included in the alternative minimum tax base and the partial tax under section 667(b) is not treated as tax paid for purposes of determining the regular tax. Generally, tax preferences of an estate or trust are to be apportioned between it and its beneficiaries on the basis of estate or trust income allocable to each.

Finally, in the case of accumulation distributions from a trust, the amount of taxes deemed imposed on the trust is not to be increased by any alternative minimum tax in excess of the trust's regular tax liability. Thus, no credit is available to any beneficiary of an accumulation distribution for any minimum tax paid by the trust with respect to that distribution; however, under the normal trust rules, no amount received by that beneficiary is treated as an item of tax preference to the beneficiary. (Other special rules, under section 701(q) of the Act, apply in the case of foreign taxes and accumulation distributions.)

Personal holding companies are treated the same as other corporations and will be subject to the add-on minimum tax but not to the alternative minimum tax. However, the preference for accelerated depreciation on leased personal property (sec. 57(a)(3)) and for intangible drilling costs (sec. 57(a)(11)) will apply to these corporations.

2. Treatment of Intangible Drilling Costs for Purposes of the Minimum Tax

(sec. 422 of the Act and sec. 57 of the Code)

In the Tax Reduction and Simplification Act of 1977, the Congress provided that for taxable years beginning only in 1977 intangible drilling and development costs (over the amount which would have been allowable under either 10-year amortization or cost depletion) in excess of oil and gas production income would constitute a tax preference item. However, this rule would not apply for future years unless there was further Congressional action.

The Congress believed that by applying the preference only where intangible drilling costs exceed oil and gas production income the preference will not constitute a major disincentive to those individuals in the oil and gas business, but will continue to limit the ability of outside investors to reduce the income tax otherwise payable on their dividend or salary income through the use of the intangible drilling cost deduction.

3. Amendment to Definition of Foreign Source Capital Gain Tax Preference

(sec. 423 of the Act and sec. 58 of the Code)

For purposes of computing the minimum tax which may be payable on any subsequent transaction involving property received in an exchange of stock qualifying under this provision, the property received is to be treated as having the same basis in the taxpayer's hands immediately after the exchange that the exchanged stock had immediately before the exchange.

(sec. 441 of the Act and sec. 1348 of the Code)

In the case of a taxable year which begins before November 1, 1978, and ends after October 31, 1978, the provision applies only with respect to post-October 31, 1978 transactions. Thus, only the section 1202 deduction based on the lesser of the net capital gain for the taxable year or such gain on transactions occurring before November 1, 1978, will reduce personal service income.

2. Maximum Tax on Personal Service Income

(sec. 442 of the Act and sec. 1348 of the Code)

Under prior law, if an individual was engaged in an unincorporated trade or business in which both personal services and capital were material income-producing factors, a reasonable allowance as compensation for the personal services actually rendered by the taxpayer could be treated as earned income. However, the total amount which could be treated as the taxpayer's earned income from the trade or business could not exceed 30 percent of the taxpayer's share of the net profits from that trade or business. (An analogous, but more flexible, restriction applies in the case of personal service income derived from a corporate trade or business, i.e., earned income does not include compensation which represents a distribution of corporate earnings or profits rather than a reasonable allowance as compensation for personal services actually rendered.)

To eliminate the potential disparity between the tax treatment of personal service compensation from incorporated and unincorporated trades and businesses, the Congress decided to eliminate the 30-percent limit.

(sec. 501 of the Act and secs. 6041 and 6001 of the Code)

Section 6051(a) requires employers to report on IRS Forms W-2, subject to income tax withholding and Federal Insurance Contributions Act (social security) withholding, only the tips actually reported to them by their employees pursuant to section 6053(a).¹ However, certain additional informational reporting is required of employers. Section 6041 (a) requires every employer of an employee earning $600 or more yearly to report the total of that employee's earnings to the IRS. In interpreting this additional requirement, the regulations (Treas. Reg. sec. l.6041-2(a)(1)) specify that any employee's earnings which are not required to be reported as subject to withholding nonetheless are required to be reported to the IRS by the employer; this additional amount is to be reported separately on the Form W-2 for the employee. Thus in the case of tip income, the IRS has ruled (Rev. Ruls. 75-400 and 76-231, supra) that any charge account tips actually paid over by the employer to the employee must be reported to the IRS by the employer (assuming the aggregate $600 test is met) whether or net the tips were reported to the employer by the employee.²

Under the cited rulings, the IRS did not apply its new employer reporting requirements with respect to charge tips unreported by employees prior to 1977. The Congress, in section 2111 of the Tax Reform Act of 1976 (P.L. 94-455), provided that the IRS was not to follow Revenue Rulings 75-400 and 76-231 until January 1, 1979, and that, until then, the IRS requirements with regard to reporting charge account tips were to be made in accordance with IRS practice prior to the issuance of those rulings.

The provision also states that, with respect to the amount of tips paid to a particular employee, the only records of charged tips which an employer will be required to keep under section 6001 of the Code are charge receipts and copies of statements furnished by employees under section 6053(a). Accordingly, an employer will be required to keep charge receipts (which receipts reflect the amount of tips included by the customer in the charged amount), but may not be required to record on such charge receipts, or otherwise keep records of (except copies of sec. 6053(a) statements), the name of any particular employee to whom the charge tip amount is paid over by the employer.

The limitation added by the Act to the recordkeeping requirements which may be imposed on an employer with respect to charged employee tips relates to records of amounts of such tips paid over to a particular employee and does not affect any other recordkeeping requirements which may be applicable to the employer under section 6001 of the Code (e.g., any applicable requirements, for purposes of determining the employer's own income tax liabilities, to maintain charge receipts, records of amounts received by the employer from credit card companies, and records of aggregate payments to employees of charge account tips). Also, the Act does not affect any recordkeeping, reporting, or return requirements imposed on employers pursuant to section 6051 with respect to tips included in statements furnished by employees to the employer pursuant to section 6053(a).

This provision of the Act does not affect the present-law authority and power of the IRS to audit individuals with respect to their income from tips.

2. Tax Court Small Tax Case Procedures and Authority of Commissioners

(sec. 502 of the Act and secs. 7456 and 7463 of the Code)

Typically, small tax cases are heard by commissioners appointed by the chief judge of the Tax Court (sec. 7456(c)). However, the law which provides for the appointment of commissioners does not specifically authorize them to administer oaths, issue subpoenas or examine witnesses. Under prior law, judges and certain other employees were authorized to administer oaths and issue subpoenas, but only judges were authorized to examine witnesses (sec. 7456(a)).

Following the hearing in small tax cases, the commissioners file reports which, upon review by the chief judge, may be adopted as reports of the Court. After a report is filed by the Court, a decision will be entered. The decision is based on the report and is comprised of a computational determination of the deficiency or overpayment.

Under prior law, the decision in a small tax case had to be entered by a judge, rather than by a commissioner, in accordance with the report of the Tax Court (sec. 7459(a)).

Use of this procedure would continue to be optional with the taxpayer unless the Tax Court decided before the hearing that the case should be heard under normal procedures and should be subject to appeal. Presently, the Tax Court rules provide that the Commissioner of Internal Revenue may file a motion requesting that a small tax case be removed from that category. In view of the increase in the small case jurisdictional amount to $5,000, it is contemplated that the Tax Court will give careful consideration to a request by the Commissioner of Internal Revenue to remove a case from the small case procedures when the orderly conduct of the work of the Court or the administration of the tax laws would be better served by a regular trial of the case. Thus, in some situations, proper Court management may require the removal of a case from the small case procedures so that it can be consolidated with a regular case involving common facts or a common issue of law. Similarly, removal of the case from the small case category may be appropriate where a decision in the case will provide a precedent for the disposition of a substantial number of other cases or where an appellate court. decision is needed on a significant issue.

Most of the small tax cases are handled by commissioners. It is contemplated that such cases will, in general, continue to be tried before the commissioners, with the Court continuing to have the power to authorize the commissioners to hear other cases (e.g., small tax cases where the taxpayers have not elected the simplified procedures), as was the situation after the enactment of the Tax Reform Act of 1969.

In order to alleviate any uncertainty which existed under prior law as to the authority of commissioners to administer oaths, issue subpoenas, and to prepare reports of small tax cases proceedings that they conduct, the Act expressly authorizes commissioners to perform such functions and duties. In addition, in order to further clarify the law with respect to the authority of commissioners, the Act authorizes commissioners to examine witnesses. Finally, under the, Act, the Tax Court may authorize a commissioner to enter a decision in a small tax case proceeding subject to such conditions of review as the Court may impose by an appropriate rule, directive or order, whether or not published.

3. Disclosure of Tax Return Information to the Department of Justice in Tax Administration Matters

(sec. 503 of the Act and sec. 6103(h) of the Code)

4. Refund Adjustments for Amounts Held Under Claim of Right

(sec. 504 of the Act and sec. 6411 of the Code)

If a taxpayer incurs a net operating loss which he carries back to an earlier taxable year, the taxpayer may apply under section 6411 of the Code for a tentative refund of the tax paid for the earlier year. The Internal Revenue Service generally must make the refund after a limited examination of the application and within 90 days after the application is filed. Under prior law, this procedure was not available for refunds of overpayments of tax which resulted from recomputing a prior year's tax under a claim of right adjustment.

Within 90 days after the application is filed (or, if later, within 90 days after the last day of the month in which the tax return for the year with respect to which the overpayment occurs must be filed, including extensions), the Secretary of the Treasury must review the application, determine the amount of the overpayment and apply, credit, or refund the overpayment to the taxpayer (unless the application contains errors in computation or material omissions).

This application for tentative refund will be administered in a manner similar to the manner prescribed under present law for tentative refunds due to carryback of net operating losses, investment tax credit, etc. Thus, special rules may need to be prescribed by the Secretary of the Treasury to take into account special problems involving consolidated returns.

(sec. 511 of the Act and sec. 2040 of the Code)

In the case of certain trade or business activities conducted in the form of a family partnership, the partnership interest the surviving spouse will not be included in the deceased spouse's gross estate. In this situation, because the husband and the to operate the business as a partnership, the effect is that the services performed by the surviving spouse in connection with the family owned business are taken into account, by reason of the profit-sharing ratio, as consideration furnished for the purchase of jointly owned property used in the trade or business if a partnership is used to conduct business.

Under the Tax Reform Act of 1976. one-half of the value of a qualified joint interest is included in the gross estate of a decedent regardless of which joint tenant furnished the consideration for acquisition of the property. An interest is treated as a qualified joint interest only if the following requirements are satisfied: (1) the interest must have been created by the decedent, the decedent's spouse, or both; (2) in the case of personal property, the creation of the joint interest must be a completed gift for gift tax purposes: (3) in the case of real property, the donor must have elected to treat the creation of the joint tenancy as a taxable event for gift tax purposes; and (4) the joint tenants cannot be persons other than the decedent and the decedent's spouse.

The amount excludable is equal to the sum of the amount determined by applying a percentage rate of 2 percent for each year the surviving spouse materially participated in the business (not to exceed 50 percent) to the excess of the value of the joint, interest (as determined for estate tax purposes) over the amount attributable to the original consideration furnished by both spouses and the amount attributable to the original consideration furnished by the surviving spouse. For this purpose, the amount attributable to the original consideration consists of the amount of that consideration plus assumed appreciation at the rate of 6 percent simple interest for the period of investment of the consideration.

The aggregate amount by which the value of the decedent's gross estate may be reduced by exclusions under this provision is $50O,000, and the provision may not result in the inclusion in the decedent's gross estate of less than 50 percent of the value of the eligible joint interest.

The provision applies if elected by the executor of the estate not later than the time for filing the estate tax return (including extensions) and in the manner prescribed under Treasury regulations.

2. Treatment of Certain Interests Held by Decedent's Family for Purposes of Extension of Time for Payment of Estate Tax

(sec. 512 of the Act and sec. 6166 of the Code)

In order to qualify for this deferral and installment payment treatment, the value of the closely held business (or businesses) included in the decedent's estate must exceed 65 percent of time value of the gross estate reduced by allowable expenses, indebtedness, and losses. For this purpose, the term "interest in a closely held business" means an interest as sole proprietor in a trade or business; an interest as a partner in a partnership having not more than 15 partners, or in which the decedent owned 20 percent or more of the capital; or ownership of stock in a corporation having not more than 15 shareholders, or in which the decedent owned 20 percent or more in value of the voting stock. In determining the number of shareholders or partners each individual is generally counted once without regard to any attribution rules (such as attribution between father and son). Certain interests held by a husband and wife are treated as held by one shareholder or partner.

If a decedent's gross estate inc1udes more than 20 percent of the value of each of two or more closely held businesses, the businesses can be treated as a single closely held business in determining whether the 65 percent test is satisfied.

A 10-year extended payment provision is also provided for estate tax attributable to a closely held business where a lesser proportion of the estate is represented by its value (sec. 616A ). Under this 10-year extension, the value of the business must be in excess of either 35 percent of the value of the gross estate or 50 percent of the taxable estate. In addition, the Internal Revenue Service is authorized to permit discretionary annual extensions of up to 10 years to pay estate tax where reasonable cause for an extension exists (sec. 6161(a)(2)). Prior to the Tax Reform Act of 1976, the 10-year discretionary extension was available only in the case of "undue hardship." Under both of these extensions, interest is payable at the regular rate rather than the special 4-percent rate.

In addition, the Act allows an executor to elect to apply the same attribution rules in order to determine whether at least 20 percent of the capital interest or value of voting stock in a business is included in the decedent's gross estate. However, in the case of stock, this attribution provision may elected only if, at the time of the decedent's death, there was no market on a stock exchange or in an over-the-counter market for the stock. If an executor makes an election under this provision, then the extended payment period for the estate tax due cannot exceed 10 years, and the special 4 percent interest rate will not apply.

3. Subordination of Special Liens for Estate Tax Attributable to Special Valuation Property

(sec. 513 of the Act and sec. 6325 of the Code)

Also, under present law the Internal Revenue Service may agree to the subordination of a prior tax lien to a subsequent security interest if certain conditions are satisfied (i.e., an amount equal to the security interest is paid over or the Service believes that subordination of the tax lien would increase the amount ultimately realizable).

Under prior law, the subordination of lien provision did not specifically deal with the circumstances under which the special lien for estate taxes attributable to special valuation property could be subordinated.

4. Time To Amend Governing Instruments of Charitable Split Interest Trusts

(sec. 514 of the Act and secs. 170, 2055, and 2522 of the Code)

Many persons created instruments which did not comply with these new requirements. As a result, Congress provided, as early as 1974, that the governing instruments of charitable remainder trusts could be amended to meet the new rules within certain time limitations for estate tax purposes. The latest extension of these time limitations was made by the Tax Reform Act of 1976 which permitted amendment of charitable remainder trusts until December 31, 1977, in order to qualify the trust for the charitable estate tax deduction. However, it provided this relief only in the case of the charitable deduction for estate tax purposes and only for remainder interests passing to charity. No relief was provided for the charitable deduction for income or gift tax purposes or for "income" interests passing to charity for income, gift or estate tax purposes.

5. Deferral of Carryover Basis Rules

(sec. 515 of the Act and secs. 691 and 1023 of the Code)

The Act also postpones the changes made by the 1976 Act with respect to the computation of the section 691(c) deduction for estate taxes attributable to the inclusion of items of income in respect of a decedent in a decedent's gross estate. As a result, the section 691(c) deduction is determined, for the three year postponement period, only with regard to Federal estate tax, and is based on the highest marginal, rather than the average rate of tax.

(sec. 520 of the Act and sec. 4940 of the Code)

Because of the operation of the private foundation charitable distribution provisions (sec. 4942(d)), this tax reduces the minimum amount that private foundations are required to spend or grant for charitable purposes. In many cases, the tax actually has reduced charitable expenditures.

This experience with the tax and its impact on charitable expenditures has led the Congress to conclude that it is appropriate to cut the tax rate in half.

The Congress also is concerned that the Internal Revenue Service devote adequate resources to the administration of the provisions of the tax law relating to tax-exempt organizations. The excise was instituted in the Tax Reform Act of 1969 in order to assure availability of such resources. In section 1052 of the Employee Retirement Income Security Act of 1974, the Congress established a separate office in the IRS to effectively deal with this area and made permanent authorization of appropriations to assure further the availability of sufficient resources to administer these provisions. The change in tax rate made by this Act does not reduce the amount of that permanent authorization.

The Congress expects and intends that the Internal Revenue Service report annually to the tax-writing committees on the extent to which audits are conducted as to the tax liabilities of exempt organizations, the extent to which examinations are made as to the continued qualification of such organizations for exempt status, the extent to which IRS personnel are given initial and refresher instruction in the relevant portions of the law and administrative procedures, the extent to which the IRS cooperates with, and receives cooperation from State officials with regard to supervision of charities and other tax-exempt organizations, the costs of maintaining such programs at levels which would produce proper compliance with the laws, the amounts requested by the Executive Branch for the maintenance of those programs, and the reasons for any difference between the needed funds and the requested amounts. Also, the Internal Revenue Service is to notify the tax-writing committees of any administrative problems that the IRS experiences in the course of its enforcement of the internal revenue laws with respect to exempt organizations.

2. Excise Tax on Certain Gaming Devices

(sec. 521 of the Act, and secs. 4461 and 4464 of the Code)

The availability of the State tax credit facilitates the raising of State revenues through State taxes on slot machines. Under State law in Nevada, an amount equal to the State tax credit is used for educational purposes.

For these reasons, the Congress believes that the State credit should be increased to 95 percent of the Federal tax for two years, and that the Federal tax should be repealed as of July 1, 1980.

3. Exemption From Private Foundation Excise Tax for Failure to Distribute Income

(sec. 522 of the Act and sec. 4942 of the Code)

In addition to other restrictions on private foundations, a private foundation is required to make annual expenditures or distributions for exempt purposes generally equal to the net income of the private foundation. However, an exception to this rule is provided for certain private foundations known as "operating foundations." A private foundation may qualify as an "operating" foundation if it spends directly for the active conduct of its exempt-purpose activities amounts which are at least equal to 85 percent of its adjusted net income, and which are at least equal to 3-1/3 percent of its net endowment assets, or if the foundation meets certain other tests (sec. 4942(j)(3)).

In general, the rules relating to income tax deductions by individuals for contributions to public charities or to private operating foundations are more favorable to the donor than the rules relating to the deductibility of contributions to private non-operating foundations (sec. 170).

(sec. 530 of the Act)

Generally, the basis for determining whether a particular worker is an employee or independent contractor is the common control. Under Treasury regulations, if a person engaging the services of another has "the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work, but also as to the details and means by which the result is accomplished," the relationship of employer and employee is deemed to exist. On the other hand, the absence of a right to control generally indicates that the person performing the services is an independent contractor. In interpreting the Treasury regulations, twenty factors are used in determining whether workers are employees or independent contractors.

In some cases, the assessments were for liabilities already satisfied directly by workers, who paid their own income and self-employment taxes. The IRS has agreed to allow taxpayers certain income tax and FICA-SECA offsets, if they provide the Service with their workers' names and social security numbers. However, many taxpayers lack such information about their workers and cannot benefit from this procedure.

Many taxpayers have complained that proposed reclassifications involve a change of position by the Internal Revenue Service in interpreting how the common law rules apply to their workers or industry. Some taxpayers have prior private letter rulings or technical advice memoranda from the Service in which the Service said that the workers were independent contractors. Other taxpayers have pointed to prior audits in which their treatment of workers as independent contractors was not challenged. Before the 1970s, however, most audits did not focus on employment tax status determinations; so most taxpayers relied on their own judgment, industry practice, or in a few industries, published Revenue Rulings.

During the 1976 Tax Reform Act conference, House and Senate conferees included in the Statement of Managers a request that the IRS "not apply any changed position or any newly stated position in this general subject area to past, as opposed to future taxable years" until the completion of a study by the staff of the Joint Committee on Taxation on the problems of classifying persons as employees or independent contractors.

The Congress believes that it is appropriate to provide interim relief for taxpayers who are involved in employment tax status controversies with the Internal Revenue Service, and who potentially face large assessments, as a result of the Service's proposed reclassifications of workers, until the Congress has adequate time to resolve the many complex issues involved in this area.

The Act provides an interim solution for controversies between the Internal Revenue Service and taxpayers involving whether certain individuals are employees by--

The Act provides relief from employment tax liability to certain taxpayers involved in employment tax status controversies with the Internal Revenue Service as a result of Service's proposed reclassifications of workers, whom taxpayers have considered as having independent contractor status or some other status (e.g., customer), as employee. For purposes of determining such taxpayers' employment tax liabilities, the Act provides that workers shall be deemed not to be the taxpayers' employees, unless the taxpayers had no reasonable basis for not treating the workers as employees.

Liabilities terminated under the Act are those for Federal income tax withholding, Social Security (FICA), and unemployment (FUTA) taxes for any period ending before January 1, 1979, during which the taxpayers did not treat the workers as employees. It is not necessary that a taxpayer have treated workers other than as employees for all pre-1979 periods in order to qualify for relief. A taxpayer who treated workers as employees for some pre-1979 periods, may obtain relief for other pre-1979 periods when they were treated other than as employees, provided there was a reasonable basis for such treatment. (However, an anti-abuse rule, discussed later, denies relief for 1979 periods, if the taxpayers' treatment of workers other than as employees is inconsistent with the treatment of such workers for any period beginning after December 31, 1977.)

Generally, the Act terminates pre-1979 employment tax liabilities of taxpayers who had a reasonable basis for treating workers other than as employees. The Congress intends that this reasonable basis requirement be construed liberally in favor of taxpayers. In addition, the Act establishes several alternative statutory standards which constitute "safe havens," and which, when met, qualify a taxpayer for the termination of employment, tax liability.

The first statutory reasonable basis standard is met if a taxpayer's treatment of an individual as not being an employee for a period was due to reasonable reliance on judicial precedent, published rulings, technical advice with respect to the taxpayer, or a ruling, for example, a "letter rulings" or a "determination letter," issued to the taxpayer. Under this test, the judicial precedent or published ruling upon which a taxpayer reasonably relied does not have to relate, necessarily, to the particular industry or business in which the taxpayer is engaged.

Under the second statutory "safe haven" standard, taxpayer is treated as satisfying the reasonable basis test for the treatment of individual as other than an employee for employment tax purposes, by showing reasonable reliance on a past Internal Revenue Service audit of the taxpayer. Such an audit need not have been for employment tax purposes. However, a prior audit would qualify as a "safe haven" basis for a taxpayer's reliance only if the audit entailed no assessment attributable to the taxpayer's treatment (for employment tax purposes) of individuals holding positions substantially similar to the position held by the individual whose treatment is at issue. A taxpayer does not meet this second test if in the conduct of prior audit an assessment attributable to the taxpayer's treatment of an individual was offset by other claims asserted by the taxpayer.

The third statutory method for a taxpayer to establish a reasonable basis for the treatment of an individual as other than an employee is to show that such treatment coincided with a long-standing, recognized practice of a significant segment of the industry in which the individual whose status is at issue was engaged. This test does not require that a practice be uniform throughout an entire industry.

The three statutory methods for fulfilling the requirement that a taxpayer had a reasonable basis for the treatment of an individual as other than an employee are not the exclusive ways of meeting the Act's reasonable basis requirement. A taxpayer who can demonstrate a reasonable basis for the treatment of an individual as other than an employee in some other manner also is entitled to termination of employment tax liabilities.

Termination of employment tax liabilities under the Act is made available to taxpayers who are under audit by the Internal Revenue Service or who are involved in administrative or judicial proceedings with respect to assessments based on employment status reclassifications. Relief also is extended to any claim for a refund or for a credit of any overpayment of an employment tax resulting from the Act's termination of liability, provided the claim is not barred on the Act's date of enactment by any law or rule of law.

Taxpayers who have entered into final closing agreements under section 7121 or compromises under section 7122 with respect to employment status controversies are ineligible for relief under the Act, unless they have not completely paid their liability. Thus, for example, a taxpayer who has agreed or compromised a liability for an amount which is to be paid in installments, but who still has one or more installment to pay, is relieved of 1iability for such outstanding installments. Taxpayers who settled employment status controversies administratively with the Internal Revenue Service or who unsuccessfully litigated such cases are eligible for relief, provided their claims are not barred by the statute of limitations or by the application of the doctrine of res judicata. However, an unsuccessful litigant in an employment status case who fulfills the Act's requirements, can avoid collection of any unpaid employment tax liabilities, regardless of the doctrine of res judicata.

Eligibility for relief for pre-1979 periods is to be determined independently of a taxpayer's eligibility for relief for any periods in 1979. With respect to pre-1979 periods, there is no requirement that the taxpayer file all Federal tax returns (including information returns), required to be filed with respect to an individual whose status is at issue on a basis, consistent with the taxpayer's treatment of such individual as not being an employee.

Employment tax liability for 1979

Until the Congress enacts legislation clarifying the employment tax status of individuals, taxpayers will remain uncertain about the proper treatment of many workers. Therefore, the Act allows taxpayers to continue to treat workers as other than employees through 1979, unless the taxpayers have no reasonable basis for not treating the workers as employees. However, in order to qualify for relief for 1979, the Act also provides that taxpayers must file all Federal tax returns (including information returns) required to be filed for periods after December 31, 1978, with respect to workers whose status is at issue, on a basis consistent with the taxpayers' treatment of the workers other than as employees. Thus, the Act prospectively relieves taxpayers of liabilities with they might incur during 1979. The Congress believes that work on formulating comprehensive legislation on the employment tax status controversy should be undertaken during this period.

Except for the filing requirement, taxpayers' eligibility for the prospective relief from potential 1979 liabilities is to be determined under the same tests and the same liberal interpretations of the tests which determine eligibility for pre-1979 relief.

It is expected that legislation developed during 1979 to clarify the employment tax status of individuals would become effective January 1, 1980, or the date of enactment of clarifying legislation, whichever is earlier, and would replace present law for all periods thereafter.

Anti-abuse provision

To prevent taxpayers from changing the way they treat workers for employment tax purposes solely to take advantage of the relief provisions, the Act denies relief in such circumstances. The Act prohibits the termination of any potential employment tax liability with respect to the treatment of any individual for employment tax purposes for any period ending after December 31, 1978, and before January 1, 1980, if the taxpayer (or predecessor taxpayer) has treated an individual holding a substantially similar position as an employee for any period beginning after December 31, 1977. The application of this provision to taxpayers and their predecessors is intended to prevent avoidance of this rule, for example, by reincorporations.

Refunds or credits of overpayments

The Act allows taxpayers at least a one-year period for filing claims for refunds or credits attributable to the relief provided in the Act. If a taxpayer's claim for refund or credit is not barred on the Act's date of enactment by any law or rule of law, the taxpayer will have at least until the date one year after the Act's date of enactment for filing a claim. If the taxpayer is entitled to a longer period under the general statute of limitations for filing such claims, the longer period applies.

Generally, taxpayers should file refund or credit claims asserting grounds for relief under the Act with the Internal Revenue Service. If the taxpayer already has an open claim filed with the Service, or is involved in litigation over such a claim with the Department of Justice, the original claim qualifies as a claim for relief under this provision, provided the taxpayer notifies either the Service or the Department of Justice, whichever is appropriate, within the proper time period, of the taxpayer's basis for relying on the Act for relief.

Penalties and interest

If a taxpayer is relieved of 1iability for any tax under this provision, any liability for interest or penalties attributable to such tax liability is forgiven automatically. This relief applies to all such interest and penalties for both pre-1979 and 1979 liabilities, whether charged directly against the taxpayer or personally against the taxpayer's officers.

Status, liabilities and rights of individual employees and independent contractors

The Act does not change in any way the status, liabilities and rights of an individual whose employment status is at issue.

Prohibition against IRS Revenue Rulings and Regulations

The Act prohibits the Department of the Treasury (including the Internal Revenue Service) from publishing any regulation or Revenue Ruling classifying individuals for purposes of employment taxes under interpretations of the common law. This prohibition becomes effective on the date of enactment of the Act and will remain in effect until January 1, 1980, or, if earlier, the effective date of any law subsequently enacted to clarify the employment Status of individuals for purposes of employment taxes.

The prohibition applies to Revenue Ruling having precedential status but does not apply to the issuance of private letter rulings requested by taxpayers. Moreover, the prohibition does not extend to regulations or Revenue Rulings based on statutory provisions dealing with the employment tax status of particular workers, such as certain fishermen, which do not involve the application of common law standards; nor does the prohibition apply to the determination of matters such as effective dates, which do not entail issues of common law employment status for purposes of employment taxes.

2. Tax Treatment of Cooperative Housing Corporations

(sec. 531 of the Act and sec. 216 of the Code)

In general, for an organization to qualify to pass through these deductions to tenant-stockholders, 30 percent or more of the gross income of the cooperative housing corporation must have been derived from individual tenant-stockholders. However, for purposes of determining whether the 80 percent test has been satisfied, stock owned and dwelling units leased by governmental entities for the purpose of providing housing facilities are not taken into account. Further, banks and other lending institutions which obtain stock in a cooperative housing corporation through foreclosure are treated as tenant-stockholders for up to three years after the date of acquisition.

Consequently, Congress believed that there should be a relaxation of the rule that 80 percent or more of the income of the cooperative must come from individual tenant-stockholders in situations where buildings are being converted into housing cooperatives (or being constructed for use as housing cooperatives) by non-individual sponsors.

3. Deposits in Certain Branches of Puerto Rican Savings and Loan Associations

(sec. 540 of the Act and sec. 861 of the Code)

As a general rule, interest received from a U.S. corporation is treated as U.S. source income (sec. 861(a)(1)) and thus does not qualify for the special treatment provided for Puerto Rican source income of Puerto Rican residents (sec. 933) and possessions corporations (sec. 936) described above. However, interest paid by a domestic corporation is considered to be foreign source if less than 20 percent of the corporation's gross income is from sources within the United States (sec. 861(a)(1)(B)). If this requirement is met and 50 percent or more of the corporation's gross income is from Puerto Rican sources, then interest paid by the corporation is treated as from Puerto Rican sources in the same proportion as the corporation's gross income is from Puerto Rican source. (Cf. Rev. Rul. 76-535, 1976-2 C.B. 219.)

As an exception to these rules, interest on deposits with a foreign branch of a U.S. commercial bank, including a brunch located in Puerto Rico or another U.S. possession, is treated as income from sources within the foreign country or possession in which the branch is located (sec. 861(a)(1)(F); Treas. Reg. sec. 1.861-2(b)(5)). Consequently, interest, paid by Puerto Rican branches of U.S. commercial banks generally qualifies for the special treatment afforded Puerto Rican residents and possessions corporations (provided, of course, it meets the other applicable conditions for such treatment).

However, this exception for foreign branches of U.S. commercial banks did not, under prior law, extend to foreign or possessions branches of U.S. savings and loan associations. Since this exception did not apply to Puerto Rican branches of U.S. savings and loan institutions, interest paid by those branches generally was treated as U.S. source income or, if less than 20 percent of the gross income of the savings and loan was from U.S. sources, the interest income, could be treated as partially from sources within and without Puerto Rico in accordance with the proportion of the gross income of the savings and loan institution from sources within and without Puerto Rico. It was unclear under prior law whether these same source rules were to be applied for purposes of the special treatment provided Puerto Rican residents and possessions corporations. As a result, unless all the income of the savings and loan association was from Puerto Rican sources, interest income received from the Puerto Rican branch of the savings and loan association (or, where applicable, a pro rata portion of the interest) might not have been from Puerto Rican sources for purposes of the exclusion for residents of Puerto Rico under section 933, and also might not have qualified for the possessions tax credit under section 936.

4. Taxation of Alaska Native Claims Settlement Act Corporations

(sec. 541 of the Act and sec. 21 of the Alaska Native Claims Settlement Act)

In many instances, a large part of the value of the land the corporations may select is in its potential for mineral exploitation. A number of regional corporations are understood to have entered into agreements with oil companies under which the companies agreed to explore the land and to provide information to the regional and village corporations to assist them in selecting the land with the greatest potential. The oil companies might then drill on the selected lands and receive a share of the oil extracted. The regional and village corporations have also incurred expenses in organizing, selecting land, and commencing business operations.

Section 21 of ANCSA provides a number of rules for the tax treatment of various aspects of the transactions contemplated by ANCSA. However, under prior law, the proper rules for the treatment of certain transactions were unclear. Questions were raised as to whether, when an oil company provided services, equipment and information to a regional corporation, the regional corporation realized income to the extent of the fair market value of those goods or services. It was also not clear whether the expenses of the regional and village corporations for exploring land were deductible, or were to be added to the basis of land which was selected. Finally, questions were raised as to whether or not the expenses incurred by the regional and village corporations in the early stages of their operations were nondeductible "start-up" or "pre-opening" expenses. This depended on whether or not the corporations were engaged in a trade or business at the time the expenses were incurred.

ANCSA provides that village corporations may be organized in certain villages with a population of as few as 25 Natives. In some instances, the Native shareholders may be closely related to one another and, if the corporation has sufficient passive income, it may meet the definitional requirements for a personal holding company (sec. 542) by operation of the tock attribution rules (sec. 44).

In addition, income of these corporations generally does not include the value derived from the expenditure of funds, incurring of costs, or the use of any equipment or supplies by any person or any Federal, State, or local government agency, or any promise, agreement, or other arrangement by the person or agency to expend funds or use any equipment or supplies for the purpose of developing the information or performing the services described above. As an exception to this general rule, any funds paid for these purposes to an ANCSA corporation or to any subsidiary of such a corporation are not excludable under this provision.

The Act also provides that each ANCSA corporation is deemed to have become engaged in carrying on a trade or business as of the date it was incorporated for purposes of any form of Federal, State, or local taxation. Thus, a deduction for the ordinary and necessary business expenses of such a corporation will not be denied solely on the ground that they are "pre-opening" or "start-up" costs.

The Act provides that all expenses paid or incurred by an ANCSA corporation in connection with the selection or conveyance of lands pursuant to ANCSA, or in assisting another ANCSA corporation within or for the same region in the selection or conveyance of lands under ANCSA, are deemed to be ordinary and necessary expenses of the corporation, paid or incurred in carrying on a trade or business, for purposes of any form of Federal, State, or local taxation. As a result, these expenses generally will be deductible, whether they relate to land which is selected or land which is not selected.

Finally, the Act provides that no ANCSA corporation is to be considered to be a personal holding company.

5. Replacement of Livestock With Other Farm Property Where There Has Been Environmental Contamination

(sec. 542 of the Act and sec. 1033 of the Code)

If livestock is involuntarily converted,¹ the "similar or related in service or use" requirement for nonrecognition can be satisfied only if the replacement property is livestock which is functionally the same as that converted.

6. Exclusion for Certain Cost-Sharing Payments

(sec. 543 of the Act and new secs. 126 and 1255 of the Code)

For these reasons, Congress believes that it is appropriate to exclude these payments from income and to provide for their inclusion only at the time the underlying property is disposed of.

Neither a current deduction, depreciation, amortization, depletion, nor the investment credit may be claimed with respect to amounts excluded under this provision. The basis of any property acquired or improved with such payments would not reflect the amount of such payments. Recapture (that is, ordinary income treatment) is provided to the extent of the lesser of the income recognized or the excluded payments if the property or improvements purchased with such payments are disposed of before the expiration of 20 years. The amount recaptured is reduced 10 percent per year after the first ten years.

(sec. 551 of the Act)

The Secretary is to establish a task force to assist him in the study, which must report from time to time on its progress directly to the Secretary. The Secretary may appoint up to 10 employees to carry out the function of the task force.

The Secretary, after studying the reports and recommendations of the task force, must submit to the Senate Finance Committee and House Ways and Means Committee a final report on the study, together with such recommendations for legislation as he finds necessary, no later than November 6, 1980.

2. Study of the Tax Treatment of Certain Government-Mandated Expenditures

(sec. 532 of the Act)

The Treasury Department is to report to the Congress before April 1, 1979.

3. Study of Taxation of Nonresident Alien Real Estate Transactions in the United States

(sec. 553 of the Act)

Foreign investors can generally avoid most or all U.S. taxes on U.S. real estate by utilizing U.S. tax treaties. If, for example, a foreign investor makes a U.S. real estate investment using a Netherlands Antilles holding company, the election to be taxed on a net basis can be made annually under the tax treaty applicable to the Netherlands Antilles. Particularly in situations where the real estate investment is financed in part with debt, it is generally possible to structure the investment so that it does not yield taxable income on a current basis. (The funds may even be lent to the holding company by the foreign investors themselves, and the interest payments would be deductible for U.S. tax purposes by the holding company but the foreign investors may be exempt from U.S. tax under the treaty on the interest they receive. Cf. Rev. Rul. 75-23, 1975-1 C.B. 290) In the year the U.S. real estate is sold, the foreign investor does not make the annual election and the gain on the sale is exempt from U.S. tax under the normal Code rule for foreign investors.

4. Report on Effectiveness of Jobs Credit

(sec. 554 of the Act)

In addition, the report is to include an evaluation of the probable effectiveness and feasibility of any alternatives to jobs credit. This portion of the report is to include an evaluation of the probable economic effect and feasibility of a tax credit based on increases in worker opportunity. The evaluation should include consideration of a credit of up to 10 percent of certain wage levels with a provision for disqualification or credit phase-out if the worker is employed by a company which raises its prices above certain levels during a year.

This report is due no later than June 30, 1981.

5. Study of Effects of Capital Gains Tax Changes

(sec. 555 of the Act)

(sec. 601 of the Act and secs. 1391-1397, 172(b), 3402(r), 1016(a), and 6039B of the Code)

The Act authorizes a State to establish a General Stock Ownership Corporation (GSOC) for the benefit of all its citizens. It anticipated that the GSOC will be permitted to borrow money to invest in business enterprises. The cash flow from the operation of the business would be used to service and repay the loan, and the remaining cash would be distributed to the GSOC shareholder (i.e., all the citizens of the State).

Definition of GSOC

The Act provides that a corporation must meet certain statutory tests in order be treaded as a GSOC. First, the corporation must be chartered by an official act of the State legislature or by a State-wide referendum. Second, the GSOC's corporate charter must provide for the issuance of only one class of stock, the issuance of shares only to eligible individuals and issuance of at least one share to each eligible individual if such eligible individual does not elect within one year after the date of issuance not to receive such share. The Act also requires the charter to provide for certain restrictions on the transferability of the GSOC shares. The transfer restriction must provide that the share cannot he transferred until the earliest to occur of (1) the expiration of 5 years from issuance, (2) death, or (3) failure to meet the State's residency requirements. In no event may shares of stock of a GSOC be transferred to nonresidents. Also, no person may acquire more than 10 shares of the GSOC's stock. Third, the GSOC must not be empowered to invest in properties acquired by it or for its benefit through the right of eminent domain. Fourth, the GSOC may not be affiliated with any other corporation. For this purpose, a 20 percent ownership test will apply to determine affiliated status rather than the customary 80 percent test. Fifth, the GSOC must be organized after December 31, 1978, and before January 1, 1984.

An eligible individual is any individual who is a resident of the chartering State as of the date specified in the enabling legislation and who remains a resident between that date and the date of issuance of the stock. A State may define a resident for purposes of its GSOC so long as such definition is consistent with constitutional principles.

Election by GSOC

A GSOC must make an election to obtain the special statutory Treatment provided for by the amendment. The election is effective for the taxable year for which it is made. The manner in which the election is to be made is to determined by regulations promulgated by the Department of the Treasury. The election once made is irrevocable unless terminated with the consent of the Secretary of the Treasury. In addition, the election is terminated if the corporation ceases to qualify as a GSOC.

The effect of the election is to exempt the corporation from Federal income taxation. Instead, the shareholders of the GSOC would report their proportionate part of the GSOC's taxable income on their Federal individual income tax returns.

Other rules for GSOC

Taxation of GSOC shareholders

Under the Act, each shareholder includes in his gross income his daily pro rata portion of the GSOC's taxable income. Such income is included in the shareholder's gross income for the taxable year in which or with which the GSOC's taxable year ends. The income in the hands of the shareholder is treated as ordinary income end is not eligible for the partial dividend exclusion (sec. 116).

Shareholders will increase the tax basis of shares of stock in the GSOC by the amount of the (GSOC taxable income which is taxed to the shareholders. This basis adjustment is made by a shareholder only to the extent an amount is actually included in gross income in his or her income tax return (unless under section 6012(a)(1), the shareholder is not required to file a return). Distribution from the GSOC out of such previously taxed income decreases the tax basis of such shares.

Studies

The Act also requires the staff of the Joint Committee on Taxation to prepare a report on the operation and effect of any electing GSOCs. An interim report is to be filed within two years after the first GSOC is formed and a final report is due by September 30, 1983.

[Editor's Note: This table of contents has been moved to its place in the table of contents at the beginning of this document.]

(sec. 701(a) of the Act and sec. 37 of the Code)

The 1976 Act increased the maximum credit base to $2,500 ($3,750 for joint returns if each spouse is eligible for the credit), renamed the general provision the credit for the elderly, simplified the qualification requirements, and broadened the category of eligible individual age 65 and over. Although the credit for public retirees under age 65 was also simplified and increased, most of the prior law provisions for public retirees under age 65 were retained. However, the requirement that an individual have earnings of at least $600 for 10 years was eliminated.

In addition, the credit has been claimed by married couples with one spouse a public retiree age 65 or older and the other spouse a nonpublic retiree under age 65. This unintended situation resulted by oversight from the lack of an explicit statutory requirement that the spouse who is under age 65 be the one receiving the public retirement system income.

Furthermore, because the Tax Reform Act of 1976 eliminated the 10-years' earnings test and because "retirement income" eligible for the credit continued to be defined as income from public retirement system pensions and annuities received by an individual under age 65, the credit has been claimed by taxpayers who receive such income but who are neither public retirees nor spouses of public retirees and who were not intended to qualify for the credit. For example, some public retirees' children who receive public retirement system income because of their parents' death have claimed the credit.

The Congress believes that the situations described above are inconsistent with the Congressional intent regarding the revisions of the retirement income credit rules in the Tax Reform Act of 1976. The Congress therefore has decided to eliminate the difference in the tax treatment of married public retirees in community property and common law States who file joint returns, to clarify the special rules for married public retirees with one spouse under age 65 and the other spouse age 65 or over, and to limit the credit explicitly and exclusively to public retirees and their spouses.

2. Amendments Relating to the Minimum Tax

Moreover, the charitable deduction, generally, is treated as an itemized deduction even though imposition of the minimum tax may actually reduce the amount passing to charity and even though the trust was not established to avoid the application of the minimum tax to the grantor since it was created prior to the 1976 Act.

Consequently, the Congress believes that the charitable deduction should not be treated as an itemized deduction in the case of deductions attributable to transfers in trust made before the effective date of the adjusted itemized deduction preference. In addition, the Congress believes that the charitable deduction should not be treated as an itemized deduction for minimum tax purposes where the remainder interest has been given to charity.

Finally, the Congress believes that the deduction for estate attributable to income in respect of a decedent should not be treated as an itemized deduction for individuals or for trusts and estates.

Finally, the Act provides that the deduction for estate taxes attributable to income in respect to a decedent is not taken into account in computing the preference for adjusted itemized deductions for individuals or for trusts and estates.

3. Exclusion For Disability Income

(sec. 701(c) of the Act and sec. 105 of the Code)

Because the statute uses the term "taxpayer" to mean the individual taxpayer in one instance and the married couple in another, it is not clear whether the income phaseout is to be made separately on the basis of each spouse's adjusted gross income or on their combined income. Nor is it entirely clear whether, if otherwise eligible, both spouses are entitled to one of two maximum exclusions of $5,200. The Congress believes that the application of these provisions should be clarified.

4. Net Operating Loss Carryback and Carryforward

(sec. 701(d) of the Act and sec. 172 of the Code)

The 1976 Act increased the loss carryforward period by two years for those categories of business taxpayers. The two additional carryforward years were not provided, however, for categories of taxpayers which were already allowed extended loss carryback or carryover periods, such as financial institutions (which have 10-year loss carrybacks and 5-year carryforwards).

5. Construction Period Interest and Taxes

(sec. 701(e) of the Act and sec. 189 of the Code)

6. Tax Treatment of Certified Historic Structures

(sec. 701(f) of the Act and secs. 167, 191, and 280B of the Code)

Under the Act, a certified historic structure is defined as a depreciable structure listed in the National Register, a depreciable structure located in a district listed in the National Register if the Secretary of the Interior certifies that the structure is of historic significance to the district, or a depreciable structure located in a State or locally designated historic district which meets certain tests.

The 1976 Act provides that the full amount of the rapid amortization deductions claimed are to be recaptured on the sale or exchange of an historic structure (i.e., gain on the disposition, to the extent of the rapid amortization claimed, is treated as ordinary income rather than capital gain).

Recapture of the full amount of the rapid amortization deductions claimed with respect to expenditures for rehabilitating historic structures (as required by the 1976 Act) is the recapture rule that generally applies with respect to recapture of depreciation or amortization deductions on dispositions of personal property. In the case of real property, recapture is ordinarily limited to the extent that the depreciation or amortization deductions claimed exceed otherwise allowable straight-line depreciation. The Congress believes it is appropriate to conform the recapture rules applicable to amortization of rehabilitation expenses of historic structures with the rules applicable to real estate generally.

It is the current policy of the Department of the Interior, and the Congress' intent, that buildings within registered historic districts can be certified as significant if they contribute to the significance of the district as a whole even if they do not individually qualify for listing in the National Register. For example, a turn of the century warehouse in a district identified for its significance in the commercial development of a city might be certified as contributing to the significance of the district based on the history of architecture of the structure and the area in which it is located.

The 1976 Act contains a special rule under which deductions are not allowed with respect to the demolition of a structure located in a registered historic district unless the Secretary of Interior certifies that the building is not of historic significance. The 1978 Act applies this special rule to structures located in State or locally designated districts. The Act also provides that, in order to obtain accelerated depreciation on a structure replacing a demolished structure which was located in a Federal, State, or locally designated historic district, certification that the structure to be demolished is not historically significant must be obtained prior to its demolition unless the taxpayer, in good faith, was not aware of the certification requirement at the beginning of the demolition.

The 1978 Act applies the real property recapture rules to rapid amortization deductions claimed with respect to rehabilitation of certified historic structures. Thus, recapture is limited to the excess of the amortization claimed over the otherwise allowable straight-line depreciation (computed on the basis of the actual useful life). The Act makes it clear that the excess amortization claimed over the otherwise allowable straight-line depreciation is a preference for minimum tax purposes (as is the case with other excess depreciation on real property).

In addition, the 1978 Act clarifies other 1976 Act law provisions dealing with historic structures. Under the 1976 Act, a taxpayer could elect either rapid amortization or accelerated depreciation with respect to the same substantial rehabilitation of a certified historic structure, but he could not elect both (i.e., the taxpayer could not claim rapid amortization with respect to the amounts spent on rehabilitation and claim accelerated depreciation with respect to the remaining basis of the property). The 1978 Act makes it clear that a taxpayer may not elect accelerated depreciation (under sec. 167(o)) on a substantially rehabilitated historic structure if he has previously elected rapid amortization of rehabilitation expenditures with respect to the building. The Act also makes it clear that the required use of straight-line depreciation with respect to a structure which has been substantially altered (other than by a certified rehabilitation) does not apply where there is a subsequent substantial alteration of the structure which is a certified rehabilitation.

The 1978 Act permits lessees of historic structures to claim the rapid amortization deductions with respect to expenditures incurred in rehabilitating certified historic structures in situations where the lessee holds the historic structure under a lease which, at the time the improvements are completed, has a remaining term at least as long as the useful life of the improvements determined without regard to any renewal periods (but in no event less than 30 years). As in the case of dispositions by owners of historic structures claiming the benefit of the 1976 Act provisions, benefits claimed by lessees under this proposal would be subject to recapture if the lease is terminate early.

7. Deduction for Attending Foreign Conventions

(sec. 701(g) of the Act and sec. 274(h) of the Code)

The 1976 Act provided specific rules (sec. 274(h) of the Code) limiting the deduction for expenses of attending conventions, seminars or similar meetings held outside the United States, its possessions, and the Trust Territory of the Pacific. These rules apply not only to the individual attending the convention, but also to his employer, if the employer pays the expenses. The new rules apply to conventions beginning after December 31, 1976. Under the new rules:

The Act provides that the limitations added by the Tax Reform Act of 1976 on the deductibility of attending foreign conventions do not apply to an employer (or other person) paying the expenses of an individual attending a foreign convention (either directly or through reimbursement) where that individual is required to include the expenses in his gross income. This exception would not apply to a payor where the amounts paid are required to be furnished by the payor to the payee on information returns or statements (i.e., Form W-2 or Form 1099) but are not furnished by the payor.

For example, where a manufacturer purchases tickets for the attendance by one or more of the employees of its dealers at a foreign convention as an incentive award and transfers the tickets to its dealers who in turn award them to certain employees, the manufacturer will not be subject to these limitations if the tickets are includible in income of the dealer and the manufacturer complies with any required information reporting. Further, the limitations will not apply to the dealer for any amount if the employee is required to include that amount in his income and the dealer complies with the applicable information reporting requirements. Of course, the rules described above limiting deductions for foreign conventions continue to apply to the individual involved to determine the extent to which he is entitled to deduct the convention expenses.

Business activities allocation rule

The 1976 Act added new provisions limiting the deduction for attendance at a foreign convention. One of the provisions limits the deductibility of the full transportation expenses to and from the site of the convention to situations where "more than one-half" of the total days of the trip (exclusive of days travelling to and from the convention) are devoted to business activities. If "less than one-half" of the total days are devoted to business activities, the transportation expenses are allocated to business activities on the basis of the percentage of days devoted to business. No specific rule is prescribed when exactly one-half of the time is devoted to business.

To correct this situation, the Act makes it clear that a portion of the Transportation expenses will be denied only where less than-half of the total days are devoted to business activities.

Individuals residing in foreign countries

The Act also provides that the attendance by a U.S. citizen who is a bona fide resident of a foreign country at a convention in that foreign country will not be treated as attendance at a foreign convention.

8. Deduction for Expenses Attributable to Rental of Vacation Homes

(sec. 701(h) of the Act and sec. 280A of the Code)

The 1976 Act added a provision which, in general, provides a limitation on the amount allowable to a taxpayer for the deductions attributable to the rental of a dwelling unit if the taxpayer personally uses the unit in excess of specified periods of time during a taxable year. This new limitation applies if the taxpayer's use of the dwelling unit for personal purposes during his taxable year exceeds the greater of 14 days or 10 percent of the number of the days during the year for Which the home is rented. The purpose of this limitation was to prevent the conversion of nondeductible personal living expenses into deductible expenses.

The provision does not apply to the deductions attributable to any period other than the "qualified rental period". In addition, the provision does not affect the allocation of deductions attributable to the rental period.

The determination of whether a unit is a principal residence (within the meaning of section 1034) is to depend on the facts amid circumstances of each particular case.

9. Simultaneous Liquidation of Parent and Subsidiary Corporations

(sec. 701(i) of the Act and sec. 337 of the Code)

Section 337 generally does not apply to a sale of assets by an 80 percent or greater controlled subsidiary which liquidates into its parent corporation. In that case, the parent corporation is not taxable on the liquidation of the subsidiary (sec. 332), and no current tax would be imposed at all if sections 332 and 337 were available at the same time.

As amended by the 1976 Act, the rule for 12-month liquidations under section 337 is available for a sale by a member of an affiliated group of corporations if every other member of the group which receives a liquidating distribution also liquidates completely.

The 1976 amendment to section 337 applied to a sale or exchange by a corporation which is a member of an affiliated group of corporations. However, the language of the amendment did not make completely clear at what point the existence of stock ownership for this purpose is to be determined. The Congress believes that this language should be clarified.

If the corporation which sells property is a second-tier or lower subsidiary in a group of corporations, section 337 also is not to be available if any of the liquidations occurring at a higher point in the chain of ownership (which are otherwise required to occur) are governed by section 333.

In lieu of the reference to an affiliated group of corporations in the 1976 Act, the 1978 Act substitutes references to the selling corporation and to distributee corporations which are members of the chain of includible corporations. The selling corporation and each distributee corporation in the chain of includible corporations are required to liquidate completely within 12 months after the selling company adopts its liquidation plan. A "distributee corporation" is a corporation in the chain to which the selling company makes a liquidating distribution and each other company in the chain which in turn receives a liquidating distribution by reason of the liquidation of its transferor. The term "chain of includible corporations" is intended to have the same meaning as that term has in section 1504(a), which generally defines an affiliated group.² The reference to chains of includible corporations is substituted for the existing reference to an affiliated group in order to make clear that the liquidation requirements of the 1976 amendment apply only to those corporations which directly or indirectly own a stock interest in the selling company (other than through the common parent.)³

The definition of distributee corporation also is intended to make it clear that no corporation in which the selling company owns stock is required to liquidate under this provision. That is, the liquidation requirements apply only to corporations in the chain above the 1evel of the selling company in the direction of the common parent; a subsidiary of the selling company which owns no stock of the selling company would not have to liquidate.

The definition of distributee corporation also makes clear that the companies required to liquidate are determined by reference to the date on which a liquidating distribution is made rather than the date on which the distribution is received (which in some cases might be later than the date on which the transferor transmitted the distribution). The 1976 amendment was subject to a possible interpretation that a corporation in the chain which received a liquidating distribution from another corporation in the same chain might not be required to liquidate if the distributee actually received the distribution beyond the 12-month period.

The definitions in the Act also deal with changes in stock ownership of the selling company (or of another company in the same chain) after the selling company adopts its plan or sells assets and before it begins making distributions in liquidation. If the selling company is a member of a chain of includible corporations at the time the selling company makes a liquidating distribution, each corporate member of the chain receiving a liquidating distribution at that time must itself liquidate completely. Thus, for example, if a corporation is owned by one or more individuals at the time it adopts a section 337 plan and sells its assets, but is 80 percent or more owned by a corporate shareholder at the time it begins making distributions in liquidation, the corporate shareholder must liquidate completely even though that shareholder did not own stock of the selling company at the time the plan was adopted or the assets sold.

Even if a corporation which receives a liquidating distribution was not a member of the chain at the time the selling company liquidated, a "distributee corporation" must also liquidate completely within 12 months after the selling company adopted its plan. For example, assume that several individuals own all the stock of corporation B which in turn owns all the stock of corporation C. C adopts a section 337 plan on January 1, 1978, shortly thereafter sells some or all of its assets, and makes a liquidating distribution to B on June 1 of the same year. On July 1 of the same year, unrelated corporation A purchases all the stock of B. On September 1 of the same year B makes a liquidating distribution to A. Under the Act, section 337 will apply to C's gain on its sale of property only if A also liquidates completely within the 12 month period starting on January 1, 1978. Even though A and C were never in the same affiliated group or chain of includible corporations (because C had liquidated before A acquired B's stock). A must liquidate because within the 12-month period it became a distributee corporation (as described above).

10. Transactions Involving Two or More Investment Companies

(sec. 701(j) of the Act and sec. 368(a)(2)(F) of the Code)

In addition, the Act modifies the definition of an investment company to parallel the percentage requirements for portfolio diversification which are otherwise applicable to reorganizations of two or more investment companies. In addition, the Act adds a specific definition of the term "securities" for purposes of the "Swap fund" provision. Finally, the Act makes several changes in the language of the "reverse acquisition" rules in order to clarify the computation of the amount which shareholders will be deemed to realize in transactions to which this special rule applies.

11. At Risk Provisions

(sec. 701(k) of the Act and sec. 465 of the Code)

In addition, the at risk provision provides generally that the amount of any loss (otherwise allowable for the taxable year) which may be deducted in connection with any one of certain activities (involving farming, oil and gas, motion pictures or video tape, or equipment leasing) cannot exceed the aggregate amount with respect to which the taxpayer is at risk in each such activity at the close of the taxable year. The intent of the provision was to treat amounts disallowed by reason of the at risk provision in the prior taxable year in the same manner as amounts paid or accrued from the activity to which section 465 applies in the current taxable year.

The definition of loss for a taxable year (sec. 465(d)) refers to the excess of the deductions allowable for the taxable year (determined without regard to the at risk provision) over the income received or acquired by the taxpayer during the taxable year from the activity. Thus, the provision is unclear as to whether the deductions entering into the computation of the loss for the current year include losses from prior years which, by virtue of section 465 (a), were disallowed as deductions in those prior years.

The 1978 Act also amends the definition of loss for the taxable year (sec. 465(d)) to clarify that the deductions entering into the computation of loss for the taxable year includes losses from prior years which, by virtue of section 465 (a), are treated as deductions in the current year.

12. Amendments Relating to the Use of Accrual Accounting for Farming

(sec. 701(1) of the Act and secs. 447 and 464 of the Code)

The 1976 Act generally requires that certain farming corporations use an accrual method of accounting and capitalize preproductive period expenses. Exceptions are provided for subchapter S corporations, family corporations, certain small corporations, and taxpayers in the trade or business of operating a nursery. The Act also requires that certain farming partnerships (in which "nonexcepted" corporations are partners) use an accrual method of accounting and capitalize pre-productive period expenses.

A transitional rule (sec. 447(f)) provided that a taxpayer who is required by this section to change its method of accounting can, except as otherwise provided in regulations, take the accounting adjustments required by this change into account over a ten-year period.

The Congress believes that it is equitable to allow a taxpayer who has been in existence for less than 10 taxable years, to be able to spread the adjustments over a period equal to 10 taxable years (or if lesser, its stated future life, if one is specified).

The determination as to the stated future life of an organization is to be made as of the first day of the first taxable year for which an accounting change is required. Thus, for instance, if a partnership agreement contains a provision limiting the future life of the partnership to a stated period and also contains an agreement whereby such partnership agreement may be amended to extend the life of the partnership, the provision to permit an extension is to be disregarded if the partnership agreement has not been amended to provide for such extension as of the first day of the year of change.

The 1976 Act provides limitations on certain types of deductions for farming syndicates. These limitations generally require farming syndicates (1) to defer deducting the cost of prepaid feed, seed, fertilizer, or other supplies until the supplies are used or consumed, (2) to capitalize or inventory certain preproductive period expenses of poultry, and (3) to capitalize preproductive period expenses of orchards and vineyards.

No transitional rules were provided for farming syndicates affected by this provision. Thus, if a farming syndicate wishes to change to an accrual method of accounting with capitalization of preproductive period expenses, it must, under the ordinary rules, obtain the consent of the Internal Revenue Service, and the Internal Revenue Service would have broad discretion to determine the period (if any) over which the farming syndicate would have to spread the adjustments required by the change in accounting method.

This provision is to be available only if the farming syndicate changes to an accrual method of accounting with capitalization of the preproductive period expenses referred to in section 447(b). It is not intended to apply to a taxpayer seeking to change to the "annual accrual method of accounting" under section 447(g).

In determining whether a farming syndicate (such as a partnership) has a stated future life of less than 10 years. And in determining the number of years of such stated future life, reference is to be made to the circumstances as of the first day of the year of change of the accounting method. Thus, for instance, if a partnership agreement contains a provision limiting the future life of the partnership to a stated period and also contains an agreement whereby such partnership agreement may be amended to extend the life of the partnership for a further period, the provision to permit an extension will be disregarded if the partnership agreement has not been amended to provide for such extension as of the first day of the year of change.

The 1976 Act provided limitations on certain types of deductions for farming syndicates. These limitations generally require farming syndicates (1) to (defer deducting the cost of prepaid feed, seed, fertilizer or other supplies until the supplies are used or consumed, (2) to capitalize or inventory certain costs of poultry, and (3) to capitalize pre-productive period expenses of orchards and vineyards.

In general, farming syndicates were defined to include (1) any partnership or other noncorporate enterprise engaged in farming if interests in the business were required to be registered with a Federal or State securities agency and (2) any partnership or other noncorporate enterprise engaged in farming if more than 35 percent of the losses during any period are allocable to limited partners or limited entrepreneurs. Generally, limited entrepreneurs and limited partners are individuals who do not actively participate in management of the activity. Certain interests in farming enterprises are not treated as interests held by limited partners or limited entrepreneurs if the interests are attributable to active participation in farm management or certain other qualifications are met by an individual or certain family members of that individual. For purposes of this rule, a family is determined by reference to the grandparent of an individual, and family members are members of the grandparent's family. However, under the language of this provision, the individual's spouse and the spouses of other family members other than the grandparent are not included as family members.

13. Extensions of Certain Provisions to Foreign Personal Holding Companies

(sec. 701(m) of the Act and secs. 189 and 280 of the Code)

In general, these provisions were applied only to situations where the deductions would reduce the taxable income of individuals (or estates and trusts). However, these rules also were made applicable to personal holding companies, which are certain domestic corporations receiving investment income or compensation of its shareholders in order to shield that income from the higher individual tax rates that would apply if the income were received by the shareholders.

14. Definition of Condominium Management Association

(sec. 701(n) of the Act and sec. 528 of the Code)

15. Personal Holding Companies--Definition of "Individual" for Stock Ownership Test

(sec. 701(o) of the Act and sec. 542 of the Code)

Under the law prior to the Tax Reform Act of 1976, an organization or trust organized or created before July 1, 1950, would not be counted as an individual in determining whether a corporation constituted a personal holding company if the organization or trust owned all of the common stock and at least 80 percent of the other stock of the corporation. The 1976 Act deleted this last exception as part of the "deadwood" provisions of that Act.

16. Gain on Sale of Certain Property Transferred in Trust

(sec. 701(p) of the Act and sec. 644 of the Code)

In addition, the application of the new provision is unclear where the transferor has items, such as charitable contributions, net operating losses, and capital losses, that are carried back or over from the transferor's taxable year in which the property was sold by the trust to another year.

Also, where the transferor incurs a net operating loss within three years after the year in which the transferred property was sold, the transferor may be permitted to carry back the net operating loss and thus reduce his taxable income for the year in which the transferred property was sold. In such a case, the trust would apparently be entitled to file a claim for refund since its tax under this new provision is based on the transferor's rate bracket.

Generally, the new provision applies regardless of whether the trust elects to report income under the installment method for reporting gain on a sale or exchange. However, the "includible gain" does not include any portion of an installment received by the trust after the death of the transferor.

In addition, the Congress believes that it should not be possible for both the trust and the transferor to obtain the benefit of an item through the carryover of that item to another year of the transferor.

Moreover, because of the administrative difficulties which would arise if the trust is permitted to take into account a net operating loss carryback of the transferor, the Congress believes that the tax under the new provision should be computed without regard to any net operating loss carryback of the transferor.

Finally, the Congress wishes to clarify that the provision applies where installment reporting of gain on the sale or exchange of property is elected and installment payments with respect to the purchase price are made in two or more years.

In addition, the Act provides that the tax computation under the new provision is to be determined without regard to any loss or deduction which is carried (either back or forward) to another year of the transferor. For example, assume that the transferor had $10,000 of ordinary business income in the year in which the transferred property is sold and that the includible gain on the transferred property was $20,000. If the transferor had a long-term capital loss in 1977 or a long-term capital loss carryover to that year of $5,000, then $1,000 of the loss would be disregarded because it is carried over to the transferor's following taxable year (total long-term capital loss of $5,000 reduced by $4,000 which is the amount considered used to determine to a maximum $2,000 capital loss deductible against ordinary income for 1977 ($3,000 for 1978) at 50 percent of the long-term capital loss.)

In addition, the Act provides that the tax under the new provision is to be computed without regard to any net operating loss carrybacks to the transferor's taxable year which are used to determine the applicable tax rate. However, the tax is computed with regard to net operating loss carryovers from prior years and any net operating loss for the year of sale, to the extent no carryback or carryover arises from that year. For example, assume the same facts above, except that the transferor has a net operating loss carryforward from prior years of $5,000 and no capital losses. In this case, the tax under the new provision is computed by taking the entire amount of the $5,000 net operating loss deduction into account since none of the net operating loss deduction can be carried forward to another year of the transferor. However, if the net operating loss carryforward were $12,000, then the tax under the new provision would be computed by allowing a net operating loss deduction of $10,000 since $2,000 can be carried over to another year of the transferor. Where, however, the year of sale is the last year to which a net operating loss deduction can he carried (generally 7 years), then the tax under the new provision is computed with regard to the full net operating loss deduction since any excess net operating loss deduction of the transferor cannot be carried over to another year of the transferor.

Finally, in the case installment sales, each installment is taxed at the grantor's tax rate if the installment sale occurred within the two year period after the transfer to the trust. In other words, the provision applies where a trust elects to report income under the installment sale method as if each installment were a separate sale or exchange of property to which the provision applied, without regard to the two year rule.

The Act also removes a conforming amendment in the capital gains throw-back rule which was repealed by the 1976 Act since the enactment of the new provision (sec. 644) removed the need for such a conforming amendment.

17. Allowance of Foreign Tax Credit for Accumulation Distributions

(sec. 701(q) of the Act and secs. 665 and 667 of the Code)

With respect to distributions from domestic accumulation trusts, the Act clarifies the operation of the credit mechanism by defining "taxes imposed on the trust" as the gross Federal income tax before credits allocable to the distribution. Thus, the benefit of any foreign tax credit, investment credit, or any other credit allowed under subpart A of part IV of subchapter A of the Code (secs. 31 though 45) claimed by the trust in a prior accumulation year is flowed through to the beneficiary when the accumulated income of such year is distributed. The credits are not passed through as identifiable amounts, but rather comprise a portion of U.S. tax imposed on the trust which may be offset against the partial tax on the distribution. Since any applicable limitations on the credits were computed and applied at the trust level, no further limitations (other than the denial of refund for taxes imposed on the trust in excess of the partial tax) are imposed. There is no requirement under the Act that the beneficiary elect the foreign tax credit for the year of distribution.

A separate rule is provided under which foreign income taxes allocable to accumulation distributions from foreign trusts are allowed as a credit in computing the partial U.S. tax on the distribution.

Under the Act, the definition of "taxes imposed on the trust" (sec. 665 (d)) is amended to include, in the case of foreign trusts, the foreign taxes paid or accrued by the trust that are properly allocable to the accumulation distribution. As a consequence, the amount of such taxes is deemed to have been distributed to the beneficiary and is includible in his gross income along with the actual trust distribution (secs. 666(b) or (c) and 667). As in the case of a domestic trust, a partial tax is computed with respect to the total distribution using the throwback rules (sec. 667(b)). In computing the partial tax in the case of a foreign trust, however, the deemed distributed foreign income taxes included in income in a computation year are allowed, subject to the foreign tax credit limitations, as a credit against the increase in tax for that year. In contrast, U.S. taxes imposed on the trust are allowed as an offset against the partial tax on the distribution in the distribution year (determined on the basis of the average increase in tax for the three computation years).

The foreign tax credit limitations are applied in computing the partial tax in the case of distributions from foreign trusts because, in contrast to domestic trusts, foreign trusts are not generally subject to U.S. tax on the income when accumulated, and thus the foreign tax credit limitations have not been applied at the trust level. Foreign taxes in excess of these limitations are not available for carryover or carryback. (This corresponds to the treatment of U.S. taxes attributable to accumulation distributions; they are allowed as an offset against the partial tax, but no carryovers are allowed for any excess).

The limitations on the foreign tax as a credit against the increase in tax in each of the computation years are applied separately to the accumulation distribution as compared with other items in the beneficiary's return for such year. Further, foreign taxes included in income in the computation year by reason of the accumulation distributions may be claimed only against the increase in tax for the computation year. The separate limitations on the trust distribution are computed in the same manner as the separate limitations on foreign taxes related to foreign source interest and DISC dividends. That is, the numerator of the limiting fraction is the portion of the income added to the beneficiary's taxable income for the computation year which is from foreign sources (or which is foreign oil-related income, interest income, or DISC income); the denominator is the sum of the worldwide taxable income of the beneficiary for the computation year and the income added to his taxable income for purposes of computing the increase in tax; and the tax to which the fraction is applied is the sum of the total U.S. tax of the beneficiary for the computation year and the increase in tax for that year. The items of income, deduction, and credit of the trust retain their character and source to the extent necessary to apply these rules.

If the beneficiary elected the foreign tax credit on his return for a computation year, he must credit the foreign taxes deemed distributed by the trust in computing the increase in tax for that year. If the beneficiary did not elect the foreign tax credit on his return for the computation year, he may either treat the foreign tax imposed on the trust as a deduction or a credit in determining the increase in tax for that computation year. If the beneficiary deducted other foreign taxes in the computation year, he will not merely by reason of the throw-back rules, be required to amend his return for that year and recompute the tax as if the foreign taxes had been claimed as a credit. However, if the beneficiary deducted foreign taxes on his return for the computation year but elects to credit foreign taxes included in the accumulation distribution in computing the increase in tax for that year, the increase in tax is the difference between (i) the tax on the beneficiary's taxable income for that year, computed by deducting foreign taxes and (ii) the tax on the sum of the beneficiary's taxable income, plus the amount added under section 667(b)(1)(C), plus the amount of foreign taxes originally deducted for that year, computed by creating both the foreign taxes imposed on the trust and the foreign taxes paid or accrued by the beneficiary in the computation year.

A special rule is provided for the application of the foreign loss recapture rules (sec. 904(f)) to accumulation distributions from foreign trusts. If the beneficiary sustained an overall foreign loss (or foreign oil-related loss) in a taxable year prior to the distribution year, the portion of the accumulation distribution which is out of foreign source income (or foreign oil-related income) of the trust will be recaptured (i.e., treated as U.S. source income for purposes of computing the credit in the computation year) to the extent that the loss has not been recaptured (i) in intervening years or (ii) against any foreign source taxable income (or foreign oil-related income) of the beneficiary in the distribution year other than the accumulation distribution. The recapture will apply to the entire amount of the foreign source income included in the accumulation distribution (the 50 percent of foreign source taxable income limitation of sec. 904(f)(1)(B) will not apply). By recapturing the unused loss against the accumulation distribution, the trust income added to each of the computation years is treated as income from U.S. sources in the proportion that the loss recaptured against the accumulation distribution bears to the total accumulation distribution (including the foreign taxes deemed distributed).

The application of this rule is illustrated by the following example. A beneficiary of a foreign accumulation trust receives a distribution in 1980 of $20,000 of foreign source income. The foreign tax paid or accrued by the trust that is properly allocable to such income is $4,000. The three computation years chosen after application of section 667(b)(1)(C) are 1975, 1977, and 1978. The beneficiary incurred an overall foreign loss in 1979 of $10,000. He does not have any foreign source income in 1980 other than that from the trust distribution. The amount to be added to taxable income in each computation year is $12,000 (the sum of the actual distribution ($20,000) plus the deemed distributed taxes ($4,000) divided by the number of accumulation years (2)). The foreign loss recapture rules require that 10/24 ($10,000 recaptured loss over the $24,000 total distribution) of the income added to each computation year be treated as U.S. source income. Thus, $5,000 of the income added to each computation year is U.S. source and $7,000 is foreign source for the purposes of computing the foreign tax credit limitation in those years.

18. Source and Character of Accumulation Distributions from Trusts

(sec. 701(r) of the Act and sec. 667 of the Code)

19. Exempt-Interest Dividend of Regulated Investment Companies

(sec. 701(s) of the Act and sec. 851 of the Code)

The 1976 Act contained an amendment to the provisions dealing with regulated investment companies which permits a company to pay exempt-interest dividends to its shareholders if at least 50 percent of its assets are invested in tax-exempt State and local governmental obligations. However, interest on tax-exempt State and local governmental obligations is not included in gross income. Consequently, a regulated investment company investing all or most of its assets in tax-exempt obligations could fail to meet the 90- and 30-percent tests if, for example, it recognizes a relatively small amount of nonqualifying income.

Also, a shareholder may invest in an open end tax-exempt mutual fund shortly before the record date of a future dividend and then tender his share for redemption immediately after the receipt of the tax-exempt interest dividend. Since the fund's assets have been depleted by the amount of the dividend, the shareholder will generally recognize a short-term capital loss on the redemption in the amount of the dividend. The net effect of the two transactions is to create an artificial short-term capital loss which can be used to shelter other capital gains of the shareholder.

20. Real Estate Investment Trusts

(sec. 701(t) of the Act and sec. 859 of the Code)

The 1976 Tax Reform Act made extensive changes to the provisions relating to taxation of REITs and their shareholders. Under prior law, for example, a REIT could elect a fiscal year, and, if its shareholders used the calendar year for tax purposes, the shareholders could obtain a delay of up to two years in reporting income flowed through from the REIT. The 1976 Act provided that a REIT could not in the future adopt or change to any annual accounting period other than the calendar year.

Prior law also prohibited a REIT from holding property, other than property qualifying as foreclosure property, for sale to customers in the ordinary course of business. The 1976 Act permits REITs to hold such property; however, the net income from the sale of the property is taxed at a rate of 100 percent. In addition, gains derived from such property generally do not qualify for purposes of meeting the income source tests.

21. Amendments Relative to the Treatment of Foreign Income

(sec. 701(u) of the Act)

A recent Tax Court case (Kewanee Oil Co., 62 T.C. 728) has held that the sale of substantially all the assets of a trade or business does not, for purposes of the Western Hemisphere trade corporation provisions, constitute income derived from the active conduct of a trade or business. The 1976 Act does not specify the treatment of this type of sale for purposes of the possessions tax credit.

In addition to the tax credit for income earned by possessions corporations, the 1976 Act provides that corporate shareholders are entitled to the dividends-received deduction with respect to dividends from possessions corporations. As a result, Congress decided that it was inappropriate to allow a foreign tax credit for taxes imposed on distributions from possessions corporations to U.S. shareholders which are also partially or fully exempt from U.S. tax because of the dividends-received deduction or other nonrecognition provisions. However, the 1976 Act (sec. 901(g)) disallows the credit even where the distribution was fully subject to U.S. tax. For example, the credit is denied with respect to withholding taxes on dividends from possessions corporations which are receive by individuals although individuals are not entitled to the dividends-received deduction.

In addition, the 1976 Act provision disallowing any foreign tax credit on dividends from possessions corporations was intended to apply only where those dividends are exempt (or substantially exempt) from U.S. tax. The Congress believes it is necessary to make conforming changes to carry out this intention.

The Act also provides that the denial of the foreign tax credit with respect to taxes imposed on distributions from possessions corporation does not apply where the distribution is fully taxable by the U.S. Where the recipient of the distribution (including an indirect recipient such as a corporate partner of a partnership or corporate beneficiary of a trust which directly receives the dividend) is entitled to a dividends-received deduction attributable to the distribution, the credit is denied with respect to the full amount of the taxes imposed on the distribution. Where the distribution is received in connection with a liquidation or other transaction, the credit is denied to the extent that the taxes are imposed on income, gain or loss which is not recognized for U.S. tax purposes by the recipient. The Act also makes it clear that the disallowance of the credit also applies in the case of distribution from corporations described in section 957(c) in situations where income, gain, or loss is not recognized.

To reduce these advantages, the 1976 Act extended the recapture provisions to all foreign losses. The Act requires that, in cases where a loss from foreign operations reduces U.S. tax on U.S. source income, the loss is to be recaptured by the United States if the company subsequently derives income from abroad. In general, the recapture is accomplished by treating a portion of foreign income which is subsequently derived as income from domestic sources.

The loss recapture provisions apply to losses sustained in taxable years beginning after December 31, 1975. An exception to the effective date is provided for cases where a loss sustained in 1976 is from an investment in a corporation which became substantially worthless prior to the effective date. This exception applies where a corporation has suffered an operating loss in three out of the five years preceding the year in which the loss was sustained, the corporation has sustained an overall loss for those five years, and the termination of the investment takes place before January 1, 1977.

An additional exception was provided for cases where an investment is continued beyond 1976 in an attempt to try to make the investment profitable, although the attempt may ultimately fail. The Act provides that if a loss would qualify for the above exception to recapture but for the fact that the investment was not terminated in 1976, and if the investment is terminated before January 1, 1979, there is to be no recapture of the loss to the extent there was on December 31, 1975, a deficit in earnings and profits.

In addition, problems can arise for U.S. taxpayers owning foreign corporations prior to 1962 because, unless dividends are likely to be paid out of pre-1962 earnings, the corporation may not have retained earnings and profits records from pre-1962 years.

The 1976 Act repealed the per country limitation for years beginning with 1976 and, in addition, provided that any foreign losses on an overall basis are to be recaptured out of future foreign income.

However, the Act provided a three-year exception (i.e., up to 1979) to the repeal of the per country limitation for income from sources within a possession of the United States (including Puerto Rico). No similar exception was provided for the loss recapture rule, but any losses reducing U.S. tax under the per country limitation during the 3-year period are only to be recaptured on a per country basis.

The change in the extraction limit in the case of noncorporate taxpayers was accomplished by eliminating the separate limitations for oil related income and the fixed percentage limitation on the extraction taxes of noncorporate taxpayers and by substituting a separate foreign tax credit limitation for foreign oil and gas extraction income. Thus, the limitation on extraction taxes paid by noncorporate taxpayers is an amount equal to the taxpayer's effective U.S. rate of tax (before foreign tax credit) times the taxpayer's foreign extraction income.

Prior to the 1976 Act, there as no recapture of accumulated DISC income (i.e., treatment as a dividend) on the distribution of DISC stock in certain tax-free transactions (sec. 311, 336, or 337) because no gain was recognized on the transfer. The accumulated DISC income would also escape recapture upon a subsequent disposition of the DISC stock by the distributee if the distributee did not carry over the distributing corporation's basis and holding period in the DISC stock (but instead received a stepped-up basis). Therefore, the 1976 Act requires recapture of the accumulated DISC income upon a distribution, sale, or exchange of DISC stock to which section 311, 336, or 337 of the Code applies. (Sec. 995(c)(1)(C))

The amendments by the 1976 Act were effective for sales or other dispositions made after December 31, 1975, in taxable years ending after that date.

In addition, this recapture provision was not contained in the House version of the 1976 Act but was added to the Act as part of the Senate amendment to the DISC provisions, which generally were effective for sales after December 31, 1976. The conference committee adopted the substantive provisions of the Senate amendment, but with the December 31, 1975, effective date of the House bill. The use of the House bill's December 31, 1975, effective date results in the application of the Senate's recapture rule to transactions occurring during 1976 when the taxpayers did not have notice that the recapture provision would apply.

The Act also delays the effective date of the DISC recapture provision of the 1976 Act until December 31, 1976.

The 1976 Act increased the excise tax and expanded the application of the tax to additional types of property. In addition, the Act provided a carryover basis for assets transferred at death. Since assets transferred by estates do not generally receive a step-up in basis, assets transferred by estates to foreign entities can escape both the U.S. capital gains and excise taxes. The 1976 Act also provides that the excise tax imposed on transfers of property to foreign persons to avoid Federal income tax shall not apply to "a transfer to which section 367 applies." In these instances, the taxation of such transfers are governed by section 367.

In addition, the exception created in the 1976 Act for transfers to which section 367 applies produces some possibility that specific transfers to which that section does not apply because the IRS has determined that no tax avoidance is involved will inadvertently be subjected to the excise tax.

In addition, the Act provides that the election to be treated as a resident will apply to any individual who, at the time an election was made, was a nonresident alien individual married to a citizen or resident of the United States. A literal reading of this provision results in a requirement that, at the time the election is made, one of the spouses must be a nonresident alien married to a U.S. citizen or resident.

An additional problem arises because of the possible interpretation that the nonresident alien electing to file a joint return must be a nonresident at the time the election is made (i.e., at the time the return is filed). This requirement appears inappropriate where the nonresident becomes a resident of the United States in the period between the year in question and the time for filing the return for that year.

The Act also deletes the requirement that one spouse be a nonresident alien married to a U.S. citizen or resident at the time of the election and provides instead that it applies to nonresident aliens who, at the close of the taxable year with respect to which an election is made, are married to U.S. citizens or residents.

Apparently the Indonesian taxes affected by the ruling are imposed on an annual basis, and in most situations the entire annual tax liability accrues on December 31 with respect to each year. Consequently, the ruling did not affect the creditability of Indonesian taxes paid and accrued with respect to 1976 by calendar year taxpayers and taxpayers whose fiscal year began before June 30. 1976. With respect to taxpayers whose fiscal year began on or after June 30, the ruling applied to the fiscal year beginning in 1976 and ending in 1977, and therefore disallowed the creditability of Indonesian taxes imposed with respect to 1976.

The 1976 Act provides that Revenue Ruling 76-215 is not to apply to most taxpayers for taxable years ending in 1977 with respect to amounts paid to foreign governments and designated as taxes under production-sharing contracts entered into before April 8, 1976. The 1976 Act generally intended to delay the effect of the ruling for one year so that the companies would have additional time to renegotiate their production-sharing contracts with Indonesia. The Act does result in a one-year delay in the effective date of the ruling for taxpayers on a calendar year basis (for taxes paid with respect to 1977) and for taxpayers with fiscal years beginning on or after June 30 (for Indonesian taxes paid with respect to 1976). In the case of taxpayers with fiscal years beginning before June 30, however, the Act does not delay the date of the ruling (to cover Indonesia taxes paid with respect to 1977).

22. Gain From Sales Between Related Persons

(sec. 701(v) of the Act and sec. 1239(a) of the Code)

In making these changes, the 1976 Act inadvertently changed the description of the property subject to the provision from "property of a character which is subject to the allowance for depreciation pro-vided in section 167" to property which is "subject to the allowance for depreciation provided in section 167." However, no substantive change was intended by this change in language.

23. Recapture of Depreciation on Player Contracts

(sec. 701(w) of the Act and sec. 1245 of the Code)

The special recapture rules provisions apply to transfers of player contracts in connection with any sale or exchange of a franchise after December 31, 1975.

In addition, the special recapture rules for the initial contract recapture pool result in retroactively changing the treatment of depreciation and losses claimed before 1976 if the franchise is sold after December 31, 1975.

The Act also provides that the pool recapture rule for contracts initially acquired with the franchise is to apply with respect to depreciation allowable for periods after December 31, 1975, and losses incurred after December 31, 1975.

24. Treatment of Pensions and Annuities for Purposes of Maximum Tax on Personal Service Income

(sec. 701(x) of the Act and sec. 1348 of the Code)

25. Certain Grantor Trusts Treated as Permitted Shareholders of Subchapter S Corporations

(sec. 701(y) of the Act and sec. 1371 of the Code)

However, where the corpus of the trust is not includible in the estate, only 60 days should be allowed. In addition, the Congress wishes to clarify that the grantor of a grantor trust must himself be an eligible shareholder for the trust to qualify.

The provision also makes it clear that a grantor trust is an ineligible shareholder only if the grantor would be an eligible shareholder, i.e., the grantor is an individual citizen or resident of the United States.

26. Withholding of Federal Taxes on Certain Individuals Engaged in Fishing

(sec. 701(z) of the Act and secs. 1402(c), 3121(b)(20), and 3401(a) of the Code)

Under the 1976 Act, members of a fishing boat crew are to be treated as self-employed persons for Federal withholding and social security tax purposes if their sole remuneration is a share of the boat's catch (or a share of the proceeds of the catch) or, in the case of an operation involving more than one boat, a share of the entire fleet's catch or its proceeds. For this rule to apply, the boats must normally have operating crews of less than 10 members.

Generally, the changes made by the 1976 Act are applicable to services performed after December 31, 1971.

27. Tax on Excess Individual Retirement Plan Contributions

(sec. 701(aa) of the Act and sec. 4973(a) of the Code)

28. Disclosure of Returns and Return Information

(sec. 701(bb) of the Act and secs. 6103, 7213 and 7217 of the Code)

The 1976 Act treats taxpayer return information, including the address supplied by the taxpayer on his or her tax return, as confidential information not subject to disclosure by the IRS, except as specified in the Act. While the Act provides for disclosure of address information in certain situations, no provision was made in the Act to permit the disclosure of the mailing address of persons who have defaulted on student loans made under part E of title 4 of the Higher Education Act of 1965.

Under the 1976 Act, the Justice Department and other Federal agencies are required in nontax criminal cases to obtain court approval in order to receive return information which was filed by or on behalf of a taxpayer with the IRS. The court approval procedure, however, does not apply to return information which is not furnished by or on behalf of the taxpayer. Thus, in nontax criminal cases, the IRS may disclose to the Justice Department or other Federal agency re-turn information, other than that furnished by or on behalf of the taxpayer, including return information which may constitute evidence of a violation of the Federal criminal laws (secs. 6103(i)(2) and (i)(3)). In order for the IRS to transmit this information to the Justice Department or other Federal agency, it is necessary, of course, to provide the name and address of the taxpayer. Because the taxpayer furnishes his name and address on his return, it is arguable that the IRS would not be able to provide this information to the Justice Department or other Federal agency, thus comp1etely negating the purpose and operation of these provisions.

The 1976 Act provided that returns and return information relating to specified Federal taxes could generally be disclosed to State tax officials for the purpose of, but only to the extent necessary in, the administration of State tax laws. However, the 1976 Act omitted taxes imposed by chapter 31 of the Code (i.e., the special fuel excise taxes) from the list of taxes with respect to which information could be disclosed to State tax officials. As a result, the IRS no longer has the authority to provide State tax officials with returns or return information regarding special fuel excise taxes.

The 1976 Act provides that returns or return information may be disclosed to a competent authority of a foreign government which has an income tax treaty with the United States, but only to the extent provided in and subject to the terms and conditions of such treaty. No similar provision is made, however, with respect to estate and gift tax treaties.

Under the 1976 Act, the criminal violation of the disclosure rules is a felony punishable by a fine of up to $5,000, or imprisonment of up to 5 years, or both. It is also a felony, subject to the same penalties, for any person to receive an unauthorized disclosure of returns or return information as a result of an offer by that person to exchange an item of material value for the unauthorized disclosure. The 1976 Act also provides that any person who knowingly or negligently discloses returns or return information in violation of the law is liable to the taxpayer for actual damages sustained plus court costs (but in no event less than $1,O00 liquidated damages with respect to each unauthorized disclosure).

The Congress believes that fuel excise tax returns may be disclosed to State tax authorities and that the IRS should have the authority to make disclosures to the Justice Department and other Federal agencies of information not furnished by the taxpayer where the information involved constitutes evidence of a violation of the Federal criminal laws

Finally, because of the possible criminal or civil liability which Government employees handling returns and return information might face in the event of an unauthorized disclosure, the Congress believes that certain clarifying changes should be made to the civil and criminal penalty provisions in order to eliminate any possible doubt as to their meaning.

(sec. 701(bb)(1) of the Act and sec. 6103(m)(4) of the Code)

Upon the receipt of a written request, the Secretary will be authorized to disclose to the Commissioner of Education the mailing address of any taxpayer who has defaulted on a loan made from a student loan fun established under part E of title IV of the Higher Education Act of 1965 for the use only to locate the taxpayer for purposes of collecting the loan. Any mailing address received by the Commissioner of Education under this provision may, in turn, be disclosed by the Commissioner of Education to any educational institution with which he has an agreement under part E of title IV of the Higher Education Act of 1965. These addresses will only be disclosed to employees and agents of the educational institution whose duties relate to the collection of student loans and only for the purposes of locating and collecting the loans from the individuals who have defaulted on student loans made by the institution pursuant to this agreement.

Disclosure to State tax authorities of reruns and return information regarding special fuel excise taxes

(sec. 701(bb)(2) of the Act and sec. 6103(d) of the Code)

This amendment includes returns and return information regarding the special fuel excise taxes imposed under chapter 31 of the Code among the returns and return information which the IRS is authorized to disclose to State tax official.

Disclosure of name and mailing address to the Justice Department and other Federal agencies

(secs. 701(bb)(2) and (3) of the Act and secs. 6103(i)(2) and (3) of the Code)

These amendments permit the IRS to transmit to the Justice Department and other Federal agencies the name and address of a taxpayer along with return information (including return information indicating the violation of a Federal criminal law) pertaining to, but not furnished by or on behalf of, the taxpayer.

Disclosure under tax conventions

(sec. 701(bb)(5) of the Act and sec. 6103(k)(4) of the Code)

The Act authorizes the Secretary to disclose returns or return information to a competent authority of a foreign government which has an estate and gift tax convention with the United States or other convention relating to the exchange of tax information, but only to the extent provided in and subject to the terms and conditions of such convention.

Criminal penalty for unauthorized disclosure of returns and return information

(secs. 701(bb)(1) and (6) of the Act and sec. 7213 of the Code)

The Code provision imposing criminal penalties for unauthorized disclosures, printings, publications, and solicitations (sec. 7213) is amended in two respects. First, any employee or agent of an educational institution receiving a taxpayer's address in regard to a defaulted student loan, who, in turn, makes a disclosure which is not authorized under section 6103, will be subject to the criminal penalties of section 7213.

Second, the section is clarified by explicitly providing that the criminal penalties of section 7213 are to apply only to willfully made disclosures, printings, publications, or solicitations, as the case may be. The term "willfully" relates to a voluntary, intentional violation of a known legal duty. See, U.S. v. Pomponio, 97 S. Ct. 22 (1976).

Civil penalties for unauthorized disclosures

(sec. 701(bb)(7) of the Act and sec. 7217 of the Code)

The Code provision imposing civil penalties for knowing or negligent unauthorized disclosures of returns and return information (sec. 7217) is amended to provide that no liability for this penalty shall arise in the event of an unauthorized disclosure which results from a good faith, but erroneous, interpretation of section 6103 and the rules and regulations relating thereto.

29. Definition of Income Tax Return Preparer and Negotiation of Taxpayer Refund Check by Banks

(sec. 701(cc) of the Act and secs. 6695 and 7701 of the Code)

The 1976 Act also prohibits any tax return preparer from endorsing a refund check of any taxpayer whose return he prepared (except for subsequent endorsements by banks). A $500 fine was provided for violation of this provision.

All of the requirements of the 1976 Act also apply to banks which are tax return preparers for their customers generally (i.e., in other than a fiduciary capacity). In this case, although the bank should be subject to the basic rules relating to income tax preparers, there is no need to apply the prohibition against check endorsements where the check is deposited by the bank to the taxpayer's own account.

In addition, the Act permits banks (as defined in sec. 581 of the Code) to endorse and deposit a customer's tax refund check in full to the customer's account in any case where the customer's tax return was prepared by that bank without violation of the penalties relating to endorsement of taxpayers' refund checks by tax return preparers.

In addition, the Congress wished to clarify the application of the Return preparer penalty. It is intended that if a preparer in good Faith and with reasonable basis takes the position that a rule or regulation does not accurately reflect the Code and does not follow it, the preparer has not negligently or intentionally disregarded the rule or regulation. This test shall be applied in the same manner as it is applied under section 6653(a) and the regulations thereunder (relating to disregard of rules and regulations by taxpayers). For example, if a preparer reasonably takes the position in good faith that a revenue ruling does not accurately reflect the Code, the preparation of a return or claim for refund by the preparer in conflict with the revenue ruling is not a negligent or intentional disregard of the revenue ruling. For purposes of section 6694(a), the view of the taxpayer concerning a rule or regulation is not material.

The Congress directed that the Internal Revenue Service shall reasonably interpret section 6694(a) according to the standards of section 6653(a) and in light of all the facts and circumstances of each case, taking into account any and all mitigating factors.

30. Declaratory Judgments--Revocation of Prior Determination

(sec. 701(dd) of the Act and secs. 7428 and 7476 of the Code)

The 1976 Act provided for declaratory judgments in a case of an actual controversy involving--(1) a determination by the Secretary--(A) with respect to the initial qualification or continuing qualification of an organization as an organization described in section 501(c)(3) * * *." (Emphasis supplied.) Both the House and Senate committee reports on the 1976 Act stated that this statutory language, in both Acts, is intended to grant jurisdiction in cases where the Internal Revenue Service has concluded that a previously qualified organization has lost its preferred tax status.

On October 6, 1976, the Tax Court published an opinion (Sheppard & Myers, Inc. v. Comm'r, 67 T.C. 26) in which it held that the retirement plans declaratory judgment provisions do not apply to revocations of favorable determination letters. The Tax Court decision made no mention of the 1976 Act or of the committee reports on that Act.

31. Contributions of Certain Government Publications

(sec. 701(ee) of the Act and sec. 1231 of the Code)

32. Procedure for Claiming Exemption from Excise Tax on Certain Light-Duty Truck Parts

(sec. 701(ff) of the Act and sec. 4063 of the Code)