Taxpayer Relief Act of 1997 (P.L. 105-34)

IV. BUDGET EFFECTS OF THE BILL

• Child tax credit for children under the age of 17--The bill allows taxpayers a maximum nonrefundable tax credit of $500 ($400 for taxable year 1998) for each qualifying child under the age of 17. For taxpayers with modified AGI in excess of certain thresholds, the sum of the otherwise allowable child credit and the otherwise allowable dependent care credit is phased out. Beginning after 2001, the otherwise allowable child credit is reduced by one-half of the amount of the taxpayer's dependent care credit. Generally, the child tax credit is effective for taxable years beginning after December 31, 1997.

• Dependent care credit--The present-law credit is indexed for inflation. The credit is also phased out in conjunction with the child tax credit for high-income taxpayers. The provision is effective for taxable years beginning after December 31, 1997.

• Expand definition of high-risk individuals with respect to tax-exempt State-sponsored organizations providing health coverage--The bill expands the definition of high-risk individuals to include a child of an individual who meets the present-law definition of a high-risk individual, subject to certain requirements. The provision is effective for taxable years beginning after December 31, 1997.

• HOPE credit for higher education tuition expenses--Individual taxpayers are allowed to claim a nonrefundable HOPE credit against Federal income taxes up to $1,500 per student for 50 percent of qualified tuition and related expenses (i.e., tuition, fees, and books but not room and board) paid for the first two years of post-secondary education for the taxpayer, the taxpayer's spouse, or a dependent. The credit is phased out for taxpayers with modified AGI between $40,000 and $50,000 ($80,000 and $100,000 for joint returns). Eligible students must be enrolled on at least a half-time basis at a college, university, or certain vocational schools, but need not maintain any specific grade point average. The credit is not available with respect to a student if a taxpayer elects to claim the proposed deduction for qualified higher education expenses (described below) with respect to that student for the taxable year. The provision is effective for expenses paid after December 31, 1997, for education furnished in academic periods beginning after such date.

• Deduction for qualified higher education expenses and tax treatment of qualified tuition programs and education investment accounts--Individual taxpayers are allowed a deduction of up to $10,000 per student per year for qualified higher education expenses (i.e., tuition, fees, books, supplies, and room and board) paid by the taxpayer during the taxable year for education furnished to the taxpayer, the taxpayer's spouse, or a dependent. The deduction is allowed only to the extent that the taxpayer is required to include in gross income for the taxable year earnings distributed from a qualified tuition program (which is a tax-exempt prepaid tuition program maintained by a State or one or more private colleges) or an education investment account (which is a tax-exempt trust established exclusively for the purpose of paying qualified higher education expenses of the account holder). The deduction is allowed regardless of whether or not the taxpayer otherwise itemizes deductions or claims the standard deduction. The deduction is not available, however, with respect to a student if the proposed HOPE credit (described above) is claimed with respect to that student for the taxable year. Aggregate deductions allowed for a student for all taxable years are limited to $40,000. The deduction is not available for graduate-level courses. Contributions to education investment accounts and qualified tuition programs not operated by a State may not exceed $5,000 per beneficiary per year (with an aggregate contribution limit of $50,000 per beneficiary for all years). The deduction is available for qualified higher education expenses paid after December 31, 1997, for education furnished in academic periods beginning after such date.

• Phase out qualified tuition reduction exclusion--The bill phases out the special rule in section 117(d) that excludes a qualified tuition reduction provided to an employee of an educational organization from gross income. The excludable percentage is 80 percent in 1998 and is reduced by 20 percent each year thereafter; no exclusion is permitted after 2001.

• Penalty free IRA withdrawals for education expenses--The bill provides that individuals may make penalty-free withdrawals from their IRAs to pay for the undergraduate and graduate higher education expenses of themselves, their spouses, their children and grandchildren or the children or grandchildren of their spouses.

• Tax credit for certain tutoring expenses--The bill provides a nonrefundable tax credit equal to the lesser of (1) $150 or (2) 50 percent of the costs of supplementary educational assistance provided to elementary or secondary school students. The credit is phased out for taxpayers with adjusted gross income in excess of certain limits. The credit is available for taxable years beginning after December 31, 1997.

• Exclusion for employer-provided educational assistance--The bill extends the exclusion for employer-provided educational assistance to courses beginning before January 1, 1998.

• Modification of $150 million limit on qualified 510(c)(3)non-hospital bonds--The $150 million limit is increased annually in $10 million increments until it reaches $200 million.

• Enhanced deduction for corporate contributions of computer technology and equipment--The bill provides that corporate contributions of computer technology and equipment to be used for educational purposes in any of grades K-12 qualifies for the augmented contribution deduction currently available under Code sections 170(e)(3) and 170(e)(4). The provision is effective for contributions made in taxable years beginning after 1997.

• Treatment of cancellation of certain student loans--The bill expands present-law section 108(f) so that an individual's gross income does not include forgiveness of loans made by tax-exempt charitable organizations provided the loan recipient's work satisfies a community benefit requirement. Section 108(f) also is expanded to cover forgiveness of certain Federal direct student loans for which an income-contingent repayment option has been selected.

• American Dream IRAs--The bill replaces present-law nondeductible IRAs with new American Dream IRAs ("AD IRAs") to which all individuals may make nondeductible contributions of up to $2,000 annually. Contributions to an AD IRA are in addition to any contributions that can be made to a deductible IRA under the present-law rules. No income limitations apply to AD IRAs. Withdrawals from an AD IRA are not includible in income if the withdrawal (1) is made after the 5-taxable year period beginning with the first taxable year in which the individual made a contribution to an AD IRA, and (2) is (a) made on or after the date on which the individual attains age 59-1/2, (b) made to a beneficiary (or to the individual's estate) on or after the death of the individual, (c) attributable to the individual's being disabled, or (d) for first-time homebuyer expenses.

• Capital gains provisions--The bill reduces the maximum rate of capital gains of individuals from 28 percent to 20 percent (10 percent for gains otherwise taxed at the 15-percent rate), effective May 7, 1997. This maximum rate applies both for the regular tax and the alternative minimum tax. A 26-percent maximum rate is provided for gain attributable to real estate depreciation. The maximum rate for gain attributable to collectibles remains at 28 percent. For certain assets acquired after December 31, 2000, and held 3 years or more, the cost basis may be indexed for inflation. The bill generally provides that $250,000 ($500,000 in the case of a married couple) of gain from the sale of a principal residence is exempt from tax, for sales after May 6, 1997. The bill reduces the corporate capital gains tax on assets held more than 8 years to 30 percent (32 percent in 1998 and 31 percent in 1999). The bill modifies the "110 percent of last year's liability" safe harbor of the individual estimated tax to a "109 percent of last year's liability" safe harbor for 1997 estimated tax payments.

• Modifications to the alternative minimum tax ("AMT")--The bill (1) increases and indexes (after 2007) the AMT exemption amounts applicable to individuals, (2) repeals the depreciation adjustment for property placed in service after 1998, and (3) repeals the corporate AMT for small business for taxable years beginning after 1997.

• Minimum tax installment sales of farmers--The bill repeals the minimum tax on installment sales of farmers, effective for dispositions after 1987.

• The bill provide employers a credit on the first $20,000 of eligible wages paid to qualified long-term family assistance recipients. Qualified long-term family assistance recipients include members of a family receiving family assistance for specified periods of time and members of family no longer on family assistance because of either Federal or State time limits. The maximum credit is $8,500 per employee. The provision is effective for wages paid or incurred to qualified individuals who begin work for an employer on or after January 1, 1998 and before May 1, 1999.

• Repeal excise tax on diesel fuel used in recreational boats--The bill repeals the tax on diesel fuel used in recreational boats.

• Modify excise tax on ozone-depleting chemicals--The bill repeals the present-law exemption for imported recycled halon-1211.

• Modify rate structure of vaccine excise tax--The bill modifies the excise tax on vaccines to provide a uniform rate of tax of $0.84 per dose for all vaccines. In addition, the bill adds the HIB (hemophilus influenza type B) vaccine, the Hepatitis B vaccine, and the varicella (chickenpox) vaccine to the list of taxable vaccines.

• Treat certain "chain retailers" as wholesale distributors under the gasoline tax refund rules--Chain retailers, defined as owner-operators having 10 or more retail outlets, are permitted to claim gasoline tax refunds for fuel sold to States and local governments and certain others under the provisions that currently apply to wholesale distributors.

• Application of luxury excise tax to clean fuel vehicles--The bill increases the threshold at which the luxury excise tax on automobiles applies in the case of clean-burning fuel vehicles and electric cars.

• Provisions relating to pensions and other benefits--The bill (1) provides that certain irrigation or ditch companies or districts may maintain cash or deferred arrangements ("section 401(k) plans"); (2) provides that the current moratorium on the application of certain discrimination rules to State and local government plans is permanent; (3) provides that certain disability payments made on behalf of full-time employees of a police or fire department are excludable from income; (4) provides that contributions made by government employees to purchase certain permissive service credit under a governmental pension plan are not be taken into account in determining annual additions; (5) provides a deduction from the taxable estate for the value of certain stock transferred to an employee stock ownership plan; (6) increases the maximum benefit that can be distributed from a qualified pension plan without the participant's consent from $3,500 to $5,000 (indexed); (7) clarifies certain rules relating to employee stock ownership plans of S corporations; and (8) provides that the value of certain air transportation on employer-provided noncommercial flights is excludable from income.

• Disaster relief provisions--The bill provides the Secretary of the Treasury with the authority to extend additional taxpayer deadlines for up to 90 days for certain taxpayers affected by Presidentially declared disasters. The bill also contains a provision relating to the use of certain appraisals to establish the amount of a disaster loss. In addition, the bill extends the deferral provisions of present law applicable to livestock sold on account of drought to livestock sold on account of floods and other weather-related conditions. Finally, the bill modifies the mortgage revenue bond rules to extend them to Presidentially declared disaster areas. Specifically, the bill waives the first-time homebuyer requirement, the income limits and the purchase price limits during the one-year period following the date of the disaster declaration. The provision is effective for loans financed with bonds issued after December 31, 1996, and before January 1, 2000.

• Provisions relating to employment taxes--The bill (1) provides a safe harbor under which, if certain requirements are satisfied, a worker is classified as an independent contractor for Federal tax purposes; (2) removes the statutory rule treating bakery drivers as employees, so that the generally applicable rules for determining worker status apply to bakery drivers; (3) provides that certain instructions of a service recipient provided pursuant to Federal or State law are not taken into account in determining whether a retail securities broker is an employee or independent contractor; and (4) provides that certain termination payments received by former insurance salesmen are not subject to self-employment taxes.

• Provisions relating to small businesses--The bill provides for an 18-month delay in the imposition of penalties for specified failures to make payments electronically through EFPTS. In addition, the bill provides that a home office qualifies as the "principal place of business"--such that certain expenses with respect to such office may be deductible as a trade or business expense--if (1) the office is used by the taxpayer to conduct administrative or management activities of a trade or business and (2) there is no other fixed location of the trade or business where the taxpayer conducts substantial administrative or management activities of the trade or business. As under present law, deductions are allowed for a home office meeting this two-part test only if the office is exclusively used on a regular basis as a place of business by the taxpayer and, in the case of an employee, only if such exclusive use is for the convenience of the employer. The provision applies to taxable years beginning after December 31, 1997.

• Other provisions--

• Inventory shrinkage--The bill provides that a method of keeping inventories will not be considered unsound, or to fail to clearly reflect income, solely because it includes an adjustment for the shrinkage estimated to occur through year-end, based on inventories taken other than at year-end.

• Treatment of workmen's compensation liability under rules for certain personal injury liability assignments--The provision extends the exclusion for qualified assignments under section 130 to amounts assigned for assuming a liability to pay compensation under any workmen's compensation act, effective for workmen's compensation claims filed after the date of enactment.

• Treatment of State workmen's compensation funds--The provision clarifies the tax-exempt status of any organization that is created by State law, and organized and operated exclusively to provide workmen's compensation insurance and related coverage that is incidental to workmen's compensation insurance, and that meets certain additional requirements. The provision is effective for taxable years beginning after December 31, 1997. No inference is intended as to the status of such organizations under present law.

• Treatment of certain publicly traded partnerships--In the case of an existing publicly traded partnership that elects under the provision to be subject to a tax on gross income from the active conduct of a trade or business, the rule of present law treating a publicly traded partnership as a corporation does not apply. The provision is effective for taxable years beginning after December 31, 1997.

• Exclusion from UBIT for certain corporate sponsorship payments--The bill provides that "qualified sponsorship payments" received by tax-exempt organizations are exempt from taxation under the unrelated business income tax ("UBIT"). "Qualified sponsorship payments" are defined as any payment made by a person engaged in a trade or business with respect to which that person receives from the tax-exempt organization no substantial return benefit other than the use or acknowledgment of the name or logo (or product lines) of the person's trade or business in connection with the organization's activities. The provision applies to qualified sponsorship payments solicited or received after December 31, 1997.

• Timeshare associations--The bill generally extends the rules for taxation of homeowners associations to timeshare associations. However, the rate of tax applicable to timeshare associations is 32 percent, rather than 30 percent. The provision is effective for taxable years beginning after December 31, 1996.

• Modification of advance refunding rules for certain tax-exempt bonds issued by the Virgin Islands--One additional advance refunding is allowed for governmental bonds issued by the Virgin Islands that were advance refunded before June 9, 1997, if the Virgin Islands debt provisions are changed to modify their lien requirement.

• Farm co-ops--The bill provides that gain may be deferred on the sale of refiners and processors to a farm cooperative.

• Information reporting on sales of principal residences--Reports to the IRS are not be required for most sales of primary residences with a sales price of $500,000 or less ($250,000 or less if the seller is not married), provided the person settling the sale obtains representations that any gain on the sale is eligible to be excluded.

• Increased deduction for certain business meals--The deductible percentage of the cost of food and beverages consumed while away from home by an individual during, or incident to, a period of duty subject to the hours of service limitations of the Department of Transportation is increased from 50 percent to 80 percent in stages, over an eleven year period beginning in 1998.

• Treatment of construction allowances provided to lessees with respect to short-term leases--The bill provides an exclusion from income for a retail tenant that receives construction allowances from a landlord to the extent the tenant uses the allowances to construct or improve nonresidential real property that reverts to the landlord at the end of a short-term lease.

• Mutual savings banks--The provision provides that the consolidation of two or more life insurance departments of mutual savings banks into a single life insurance company by requirement of State law is treated as a recapitalization. Any payments required to be made to policyholders in connection with the consolidation are treated as policyholder dividends deductible by the company under section 808, provided that certain requirements are met. The provision takes effect on December 31, 1991.

• Allow refunds to be offset for State tax obligations--Subject to certain limitations, an overpayment of Federal tax could be offset by the amount of any past-due, legally enforceable State tax obligation of a resident of the State seeking the offset.,

• Clean fuel vehicles--The bill increases the limitation on depreciation permitted to be claimed by the taxpayer on automobiles in the case of clean-burning fuel vehicles and electric cars.

• Tax benefits for law enforcement officers killed in the line of duty--The bill provides that certain death benefits received with respect to a police officer killed in the line of duty are excludable from income.

• Two-year suspension of oil and gas income net income limit for production from marginal wells--The bill suspends the 65-percent-of-net-income limitation on percentage depletion deductions for domestic oil and gas production from marginal properties for taxable years beginning in 1998 and 1999.

• Extension of duty-free treatment under Generalized System of Preferences; Tariff treatment of certain equipment and repair of vehicles

• Generalized System of Preferences--The bill reauthorizes Title V of the Trade Act of 1974, (the Generalized System of Preferences), as amended, for two years through May 31, 1999. Refunds would be authorized, upon request of the importer, for any duty paid between May 31, 1997 and the date of enactment.

• Temporary suspension of vessel repair duty (shipbuilding)--The bill suspends, for a one-year period beginning on date of enactment, the current 50-percent duty, established under section 466 of the Tariff Act of 1930, on repairs to U.S. flag vessels made in countries that are signatories to the OECD Shipbuilding Agreement.

• United States-Caribbean Basin Trade Partnership Program

• The bill amends section 213(b) of the Caribbean Basin Economic Recovery Act to provide tariff and quota treatment on imports from CBI beneficiary countries of currently excluded articles (such as textiles, apparel, tuna, petroleum and petroleum products, and footwear) that is similar to tariff and quota treatment accorded to like articles imported from Mexico under the NAFTA, during a temporary period of one year.

• Require recognition of gain on certain appreciated positions in financial property--The bill requires a taxpayer with an appreciated position in stock, a partnership interest or certain trust interests or debt instruments to recognize gain as if the taxpayer had sold the position if the taxpayer enters into one of several transactions. The transactions covered are a "short sale against the box", a forward or futures contract to deliver the same property, an offsetting notional principal contract, and, as provided in Treasury regulations, other transactions with substantially the same effect. An exception is provided for certain transactions that are closed prior to the end of the taxable year in which they are entered into, or within 30 days thereafter. The bill also extends the present law "mark-to-market" regime for securities dealers to securities traders and commodities traders and dealers on an elective basis.

• Limitation on exception for investment companies under section 351--The bill expands the definition of an investment company for purposes of the present-law rule that property contributed to a partnership or corporation meeting this definition does not qualify for non-recognition treatment. Under the bill, an investment company generally includes any corporation or partnership if more than 80 percent of its assets (by value) consist of money, financial instruments, foreign currency and certain interests in precious metals and entities that hold passive-type assets.

• Disallowance of interest on indebtedness allocable to tax-exempt obligations--The bill extends to all corporations (other than insurance companies) the rule that applies to financial institutions that disallows interest deductions of a taxpayer (that are not otherwise disallowed as allocable under present law to tax-exempt obligations) in the same proportion as the average basis of its tax-exempt obligations (other than nonsalable tax-exempt debt acquired by a corporation in the ordinary course of business in payment for goods or services sold to a State or local government) bears to the average basis of all of the taxpayer's assets. The bill does not extend the small-issuer exception to taxpayers which are not financial institutions, but does provide a de minimis exception if the average adjusted basis of tax exempt obligation is less than the lesser of $1 million or 2 percent of the basis of all of the corporation's assets.

• Gains and losses from certain terminations with respect to property--The bill extends the rule which treats gain or loss from the cancellation, lapse, expiration, or other termination of a right or obligation which is (or on acquisition would be) a capital asset in the hands of the taxpayer to all types of property. The bill also repeals the provision that exempts debt obligations issued by natural persons from the rule which treats gain realized on retirement of the debt as exchanges.

• Determination of original issue discount where pooled debt obligations subject to acceleration--The bill requires credit card issuers and other holders of pools of debt instruments to accrue interest income on such pools using reasonable prepayment assumptions.

• Deny interest deduction on certain debt instruments--The bill denies interest deductions on corporate instruments where a substantial amount of interest or principal is mandatorily payable in stock of the issuer or a related party, or is so payable at the option of the issuer or a related party. The provision also applies to instruments that are part of an arrangement designed to result in such payment. The provision is effective for instruments issued after June 8, 1997, unless issued pursuant to a binding written agreement in effect on that date or described in an IRS ruling request or a public announcement or SEC filing on or before such date.

• Require gain recognition for certain extraordinary dividends--Under the bill, except as provided in regulations, a corporate shareholder recognizes gain immediately with respect to any redemption treated as a dividend (in whole or in part) where the nontaxed portion of the dividend (under the dividends received deduction) exceeds the basis of the shares surrendered, if the redemption is treated as a dividend due to options being counted as stock ownership. In addition, the bill requires immediate gain recognition whenever the basis of stock with respect to which any extraordinary dividend was received is reduced below zero. The bill is effective for distributions after May 3, 1995, unless made pursuant to the terms of a written binding contract in effect on May 3, 1995 or a tender offer outstanding on that date. In applying the new gain rules to any distribution that is not a partial liquidation, a non pro rata redemption, or a redemption that is treated as a dividend by reason of options, September 13, 1995, is substituted for May 3, 1995.

• Require gain recognition on certain distributions of controlled corporation stock--If, pursuant to an plan or arrangement is existence on the date of distribution, either the controlled or distributing corporation in a section 355 distribution is acquired, gain is recognized by the other corporation as of the date of the distribution. An acquisition occurs if a person or persons acquire 50 percent or more of the vote or value of the stock of the controlled or distributing corporation pursuant to a plan. Except as provided in regulations, in the case of distributions within an affiliated group of corporations filing a consolidated return, section 355 would not apply to any distribution from one member of the group to another. The bill also modifies certain rules for determining control immediately after a distribution in the case of certain divisive transactions, reducing the present-law test from 80 percent of vote and of all other classes of stock to a 50 percent of vote and value test. This part of the provision is generally effective for distributions after the date of enactment. The rest of the provision generally is effective for distributions after April 16, 1997. No part of the bill applies to a distribution that is pursuant to a written binding contract, IRS ruling request, or an SEC filing or a public announcement on or before April 16, 1997, in which the unrelated acquiror is identified.

• Reform tax treatment of certain corporate stock transfers--Purchases of stock between related corporations that are treated as dividends under section 304 is treated as if the transferor had acquired the stock in exchange for stock of the acquiror and that stock deemed issued had then been redeemed. Basis reduction rules apply. The bill also limits the earnings and profits of an acquiring foreign corporation that would be taken into account in applying section 304. The provision is effective for distributions or acquisitions after June 8, 1997 except that it will not apply to any such distribution made pursuant to a written agreement that was binding on that date, or that was described in an IRS ruling request or SEC filing or public announcement on of before that date.

• Modify holding period for dividends-received deduction--A corporation will not be eligible for the dividends received deduction unless is satisfies a holding period requirement with respect to each dividend. The provision is effective for dividends paid or accrued after the 30th day after the date of enactment.

• Registration of confidential tax shelters and substantial understatement penalty--The bill requires the registration with the Treasury Department of certain confidential tax shelters and modifies the substantial understatement penalty.

• Treat certain preferred stock as "boot"--Certain preferred stock is treated as taxable consideration if received in an otherwise tax-free reorganization or contribution to a corporation. This is preferred stock that does not participate in corporate growth and that includes certain rights to put or redeem the stock within 20 years. Also, stock the dividend rate on which varies with reference to interest rates or certain other indices is within the provision. The provision applies to transactions after June 8, 1997, unless pursuant to a binding written contract in effect on that date or described in an IRS ruling request, SEC filing, or public announcement on or before that date.

• Administrative Provisions--The bill provides for information reporting of certain payments made to attorneys, a decrease in the threshold for reporting payments to corporations performing services for Federal agencies, permanently extends the rules relating to disclosure of return information for administration of certain veterans programs, provides for modifications of the lien and levy rules (including the extension of the continuous levy rules to additional types of payments).

• Consistency rule for beneficiaries of trusts and estates--The bill requires a beneficiary of an estate or trust to file its return in a manner that is consistent with the information received from the estate or trust, unless the beneficiary identifies the inconsistency.

• Extension and modification of aviation excise taxes--The bill extends the Airport and Airway Trust Fund excise taxes in passenger and freight transportation for ten years, through September 30, 2007. The bill also modifies the structure of the commercial air passenger tax from 10 percent of the amount paid to a tax equal to the aggregate of 7.5 percent plus $2 per flight segment (phasing up until the pre flight segment reaches $3.00 in 2002). The international departure tax is increased to $15.50 per passenger, and the tax is extended to internationally arriving passengers. The 7.5 percent tax is extended to amounts paid by credit card companies and other companies under marketing arrangements whereby they offer frequent flyer or other reduced airfare provisions to customers and others. The 4.3-cents-per-gallon deficit reduction tax imposed on aviation fuel is transferred to the Airport and Airway Trust Fund, and modifications are made in certain tax deposits. The modifications generally apply to transportation beginning after September 30, 1997.

• Extend diesel fuel excise tax rules to kerosene--The bill extends the current diesel fuel excise tax rules to kerosene, subject to limited modifications allowing non-tax-paid sales to registered aviation dealers and certain industrial feedstock users.

• Modify tax benefits for ethanol and renewable source methanol--The bill provides for the phase-out of the current tax benefits for ethanol and renewable source methanol through the currently scheduled expiration dates. The phase-out is accomplished through a restriction on production from new facilities, production caps (enforced by an excess production penalty equal to the tax benefits), a reduction in the general 54-cents-per-gallon tax benefit level, and reversal of the Treasury Department regulation providing that ETBE and similar ethers qualify for the tax benefits.

• Reinstate Leaking Underground Storage Tank Trust Fund excise tax--The bill extends the pre-1996 excise tax of 0.1 cent per gallon on gasoline, diesel fuel, special motor fuels, aviation fuels, and inland waterway fuels for five years from the date of enactment. Revenues from the reinstated tax will go to the Leaking Underground Storage Tank Trust Fund as under prior law.

• Application of communications tax to long-distance prepaid telephone cards--The bill clarifies that payments from persons to communications companies for prepaid telephone cards which are subsequently distributed or resold to the ultimate user of the prepaid telephone card constitute payments for communication services that are subject to the 3-percent communications excise tax.

• Extend UBIT rules to second-tier subsidiaries and amend control test--The bill modifies the test for determining control for purposes of the unrelated business income tax rules contained section 512(b)(13). Generally, "control" means ownership by vote or value of more than 50 percent of the ownership interests. In addition, the bill applies the constructive ownership rules of section 318 for purposes of section 512(b)(13). The provision generally applies to taxable years beginning after the date of enactment.

• Limit increase in basis of property on sale by tax-exempt entity to related person--The bill requires a carryover basis in property transferred by a tax exempt entity to a related party in a sale or exchange, except to the extent of any gain recognized to the seller as unrelated business taxable income. The provision is effective for sales or exchanges after June 8, 1997, unless pursuant to a binding written contract in effect on that date.

• Reporting and proxy tax requirements for political and lobbying expenditures--The bill provides that an exemption from the general disclosure requirements and proxy tax of section 6033(e) is available to a tax-exempt organization if more than 90 percent of the amount of aggregate annual dues (or similar payments) received by the organization are paid by (1) individuals or families whose annual dues (or similar amounts) are less than $100, or (2) tax-exempt entities. The provision is effective for taxable years beginning after December 31, 1997.

• Repeal grandfather rule with respect to pension business of certain insurers--The provision repeals the grandfather rules applicable to that portion of the business of the Teachers Insurance Annuity Association-College Retirement Equities Fund which is attributable to pension business and to that portion of the business of Mutual of America which is attributable to pension business. The provision is effective for taxable years beginning after December 31, 1997.

• Phase-out suspense accounts for certain large farm corporations--The bill (1) repeals the ability of family farm corporations with average gross receipts over $25 million to defer income from the required switch from the cash method to an accrual method of accounting by establishing suspense accounts and (2) requires previously-created suspense accounts generally to be restored to income over a period of 20 years.

• Modify net operating loss carryback and carryforward rules--The bill reduces the carryback period for net operating losses from three to two years and extends the carryforward period from 15 to 20 years.

• Expand the limitations on deductibility of interest and premiums with respect to life insurance, endowment, and annuity contracts--The present-law premium deduction limitation is modified to provide that no deduction is permitted for premiums paid on any life insurance, annuity or endowment contract covering the life of any individual, when the taxpayer is directly or indirectly a beneficiary under the contract. Also, no deduction is allowed for any amount paid or accrued on debt incurred or continued to purchase or carry a life insurance, endowment, or annuity contract covering the life of any individual. In addition, in the case of a taxpayer other than a natural person, no deduction is allowed for the portion of the taxpayer's interest expense that is allocable to unborrowed policy cash surrender values with respect to any life insurance policy or annuity or endowment contract issued after June 8, 1997. The provisions apply generally with respect to contracts issued after June 8, 1997.

• Allocation of basis of properties distributed to a partner by a partnership--The provision modifies the basis allocation rules for distributee partners, generally requiring allocation of basis increases in accordance with the fair market value of the distributed properties rather than in accordance with their basis to the partnership, effective for partnership distributions after the date of enactment.

• Treatment of inventory items of a partnership--The provision eliminates the requirement that inventory be substantially appreciated in order to give rise to ordinary income under the rules relating to sales and exchanges of partnership interests and certain partnership distributions. The provision is effective for sales, exchanges, and distributions after the date of enactment.

• Treatment of appreciated property contributed to a partnership--The provision extends the 5-year limit on taxation of partners' pre-contribution gain to 10 years, effective for property contributed to a partnership after June 8, 1997.

• Earned income credit ("EIC") compliance provisions--In addition to the establishment of IRS continuous levy and the modifications of levy exemptions (described elsewhere) which also apply to the EIC, the bill provides three compliance measures to address the EIC compliance problem. First, taxpayers who fraudulently claim the EIC are made EIC ineligible for 10 years thereafter. Taxpayers who erroneously claim the EIC due to reckless or intentional disregard of rules or regulations are ineligible to claim the EIC for two years thereafter. Second, taxpayers who are denied the EIC as a result of deficiency procedures are ineligible in subsequent years to claim the EIC unless they provide evidence of eligibility as required by the Secretary of the Treasury. Finally, return preparers are subject to a $100 penalty for each return claiming an EIC with respect to which certain due diligence requirements are not satisfied. These provisions are effective for taxable years beginning after December 31, 1996.

• Restrict eligibility for income forecast method--The bill limits the availability of the income forecast method of depreciation to movies, sound recordings, videotapes, books, patents, copyrights, and other similar items. The bill also provides a 3-year recovery period for consumer durable goods leased by rent-to-own businesses.

• Require taxpayers to include the rental value of residence in income without regard to period of rental--Gross income for income tax purposes generally includes all income including rents. However, gross income does not include rental income where a dwelling unit is used by the taxpayer as a residence and is actually rented for less than 15 days during the taxable year. Also, no deductions relating to such rental are allowed. The bill repeals the 15-day rules.

• Modify the exception to the related party rule of section 1033 for individuals to only provide an exception for de minimis amounts--The bill provides that in order for the nonrecognition rules of section 1033 (relating to involuntary conversions) to apply, an individual must acquire replacement property from a unrelated party, subject to a $100,000 de minimis rule.

• Repeal of exception for certain sales by manufacturers to dealer--The bill repeals the exception that permits the use of the installment method of accounting for certain sales by manufacturers to dealers.

• Eligibility of licenses of computer software for foreign sales corporation benefits--The bill provides that computer software licensed for reproduction abroad is not excluded from the definition of export property for purposes of the foreign sales corporation provisions. Accordingly, computer software that is exported with a right to reproduce is eligible for the benefits of the foreign sales corporation provisions.

• Increase dollar limitation on section 911 exclusion--Under the bill, the $70,000 limitation on the exclusion for foreign earned income is increased to $80,000, in increments of $2,000 each year beginning in 1998, and is indexed for inflation beginning in 2008.

• Simplify foreign tax credit limitation for individuals--The bill exempts individuals with no more than $300 ($600 in the case of married persons filing jointly) of creditable foreign taxes, and no foreign source income other than passive income, from the foreign tax credit limitation rules.

• Simplify translation of foreign taxes--The bill generally provides for accrual-basis taxpayers to translate foreign taxes at the average exchange rate for the taxable year to which such taxes relate. The bill also generally provides that, in cases where the foreign taxes actually are paid more than two years after such accrual, such taxes are to be taken into account for the year to which they relate, but are to be translated at the exchange rate for the time of payment.

• Election to use simplified foreign tax credit limitation for alternative minimum tax purposes--The bill permits taxpayers to elect to use as their AMT foreign tax credit limitation fraction the ratio of foreign source regular taxable income to entire alternative minimum taxable income, rather than the ratio of foreign source alternative minimum taxable income to entire alternative minimum taxable income.

• Simplify treatment of personal transactions in foreign currency--The bill applies nonrecognition treatment to any exchange gain that results from an individual's acquisition of foreign currency and disposition of it in a personal transaction, provided that such gain does not exceed $200.

• Simplify foreign tax credit limitation for dividends from 10/50 companies--Under the bill, a single foreign tax credit limitation generally applies to dividends received by the taxpayer from all so-called 10/50 companies (other than any 10/50 company that qualifies as a passive foreign investment company).

• The bill makes several modifications to the treatment of controlled foreign corporations and lower-tier controlled foreign corporations. In addition, the bill extends the application of the indirect foreign tax credit to taxes paid or accrued by fourth- through sixth-tier controlled foreign corporations.

• Under the bill, a shareholder that is subject to the subpart F rules with respect to stock of a passive foreign investment company that is also a controlled foreign corporation is not subject also to the passive foreign investment company provisions with respect to the same stock. The bill also allows a shareholder of a passive foreign investment company to make a mark-to-market election with respect to the stock of the passive foreign investment company, provided that such stock is marketable.

• The bill repeals the excise tax that applies to transfers of appreciated property by U.S. persons to certain foreign entities. The bill requires enhanced information reporting by U.S. persons with respect to their interests in foreign partnerships.

• The bill increases the stock ownership threshold that results in an information reporting obligation with respect to a foreign corporation from 5 percent to 10 percent.

• Transition rule for certain trusts--The bill grants regulatory authority to allow nongrantor trusts that had been treated as U.S. trusts prior to the enactment of the Small Business Job Protection Act of 1996 to elect to continue to be treated as U.S. trusts.

• Repeal of stock and securities safe harbor requirement that principal office be outside the United States--The bill modifies the present-law safe harbor that treats foreign persons that trade stock or securities for their own accounts as not engaged in a U.S. trade or business. For purposes of the safe harbor, the bill eliminates the present-law requirement that the principal office not be within the United States.

• Inclusion of income from notional principal contracts and stock lending transactions under subpart F--The bill adds to the definition of foreign personal holding company income for subpart F purposes net income from all types of notional principal contracts and payments in lieu of dividends derived from equity securities lending transactions. The bill provides an expanded dealer exception from the definition of foreign personal holding company income.

• Restrict like-kind exchange rules for certain property--The bill provides that for the nonrecognition rules of section 1031 (relating to like-kind exchanges) to apply, the property surrendered in the exchange and the party received in the exchange must be both predominantly used either in (or outside) the United States.

• Holding period requirement for certain foreign taxes--The bill denies a shareholder the foreign tax credits normally available with respect to a dividend on stock of a foreign corporation or regulated investment company if the shareholder has not held the stock for 16 days, in the case of common stock, or 46 days in the case of preferred stock. An exception is provided for dividends on certain stock held by a foreign securities dealer.

• Penalties for failure to file disclosure of exemption for income from the international operation of ships or aircraft by foreign persons--The bill imposes penalties on foreign persons that do not satisfy the filing requirements for claiming exemption from U.S. tax for income from the international operation of ships or aircraft.

• Limitation on treaty benefits for payments to hybrid entities--The bill limits the availability of a reduced rate of withholding tax under an income tax treaty in the case of income derived through a hybrid entity, in order to prevent tax avoidance.

• Clarification of determination of foreign taxes deemed paid--The bill clarifies that, for purposes of the indirect foreign tax credit, a foreign corporation's foreign tax pool does not include any taxes that are attributable to dividends distributed by the foreign corporation in prior taxable years.

• Clarification of foreign tax credit limitation for financial services income--The bill clarifies that the exclusion from passive income for income that is treated as high-taxed income does not apply for purposes of the separate foreign tax credit limitation applicable to financial services income.

• Interest on underpayment reduced by foreign tax credit carryback--The bill provides that, if an underpayment for a taxable year is reduced or eliminated by a foreign tax credit carryback from a subsequent taxable year, such carryback does not affect the computation of interest on the underpayment for the period ending with the filing date for such subsequent taxable year in which the foreign taxes were paid or accrued.

• Determination of period of limitations relating to foreign tax credits--The bill provides that, in the case of a claim relating to an overpayment attributable to foreign tax credits, the limitations period is determined by reference to the year in which the foreign taxes were paid or accrued.

• Modifications to standard deduction of dependents; AMT treatment of certain minor children--The bill increases the standard deduction for a taxpayer with respect to whom a dependency exemption is allowed on another taxpayer's return to the lesser of (1) the standard deduction for individual taxpayers or (2) the greater of: (a) $500 (indexed for inflation as under present law), or (b) the individual's earned income plus $250. The bill increases the AMT exemption amount for a child under age 14 to the lesser of (1) $33,750 or (2) the sum of the child's earned income plus $5,000.

• Increase estimated tax de minimis threshold--The bill increases the individual estimated tax de minimis threshold from $500 to $1,000.

• Optional methods for computing SECA tax combined--The bill simplifies the reporting of self-employment income by combining the optional methods for reporting farm and non farm self-employment income. The provision also ensures that persons reporting self-employment income by the optional method have enough self-employment income to provide four quarters of coverage under the Social Security Act.

• Treatment of certain reimbursed expenses of rural mail carriers--The bill simplifies the treatment of certain reimbursed expenses of rural mail carriers.

• Travel expenses of Federal criminal investigators--The bill provides for special rules relating to the travel expenses of certain Federal criminal investigators.

• Payment of taxes by commercially acceptable means--The bill generally provides for the payment of taxes by any commercially acceptable means.

• Simplification to the look-back method applicable to long-term contracts--The bill simplifies the look-back method applicable to long-term contracts by providing that the method need not be applied to de minimis changes to estimated income and by stream lining the calculation of applicable interest rates used in the look-back calculation.

• Minimum tax treatment of certain property and casualty insurance companies--The bill provides that a property and casualty insurance company that elects for regular tax purposes to be taxed only on taxable investment income determines its adjusted current earnings under the alternative minimum tax without regard to any amount not taken into account in determining its gross investment income.

• The bill makes simplifying changes to reporting and audit rules in the case of electing large partnerships, which are generally those that elect to come within the provisions and that have 100 or more partners for the partnership's preceding taxable year. The bill also provides that electing large partnerships must report to partners by March 15 following the close of the partnership's taxable year. The bill also provides for reporting on magnetic media to the IRS for all partnerships, and modifies the filing threshold for an IRA with an interest in an electing large partnership. In addition, the bill provides modifications and clarifications to the present-law rules governing partnership proceedings that were enacted in 1982 as part of TEFRA.

• Clarification of limitation on maximum number of shareholders--The bill replaces the rule that disqualifies a REIT for any year in which the REIT failed to comply with Treasury regulations to ascertain its ownership, with an intermediate penalty of $25,000 ($50,000 for intentional violations) for failing to do so. In addition, a REIT that complied with the Treasury regulations for ascertaining its ownership, and which did not know, or have reason to know, that it was so closely held as to be classified as a personal holding company, is treated as meeting the requirement that it not be a personal holding company.

• De minimis rule for tenant service income--The bill permits a REIT to render a de minimis amount (one percent of rents) of impermissible services to tenants, or in connection with the management of property, and still treat amounts received with respect to that property as rent.

• Attribution rules applicable to tenant ownership--The bill modifies the application of section 318(a)(3)(A) (attribution to partnerships) for purposes of defining rent in section 856(d)(2), so that attribution occurs only when a partner owns a 25 percent or greater interest in the partnership.

• Credit for tax paid by REIT on retained capital gains--The bill permits a REIT to elect to retain and pay income tax on net long-term capital gains it received during the tax year, just as a RIC is permitted under present law.

• Repeal of 30-percent gross income requirement--The bill repeals the rule that requires less than 30 percent of a REIT's gross income be derived from gain from the sale or other disposition of stock or securities held for less than one year, certain real property held less than four years, and property that is sold or disposed of in a prohibited transaction.

• Modification of earnings and profits for determining whether REIT has earnings and profits from non-REIT year--The bill changes the ordering rule for purposes of the requirement that newly-electing REITs distribute earnings and profits that were accumulated in non-REIT years such that distributions of accumulated earnings and profits generally are treated as made from the entity's earliest accumulated earnings and profits, rather than the most recently accumulated earnings and profits.

• Treatment of foreclosure property--The bill lengthens the original grace period for foreclosure property until the last day of the third full taxable year following the election. Under the bill, the grace period could be extended for an additional three years by filing a request to the IRS and a REIT could revoke an election to treat property as foreclosure property for any taxable year.

• Payments under hedging instruments--The bill treats income from all hedges (such as an interest rate swap, cap agreement, option, futures contract, forward rate agreement or any similar financial instrument) that reduce the interest rate risk of REIT liabilities, not just from interest rate swaps and caps, as qualifying income under the 95-percent test.

• Excess noncash income--The bill (1) expands the class of excess noncash items that are not subject to the distribution requirement to include income from the cancellation of indebtedness and (2) extends the treatment of original issue discount and coupon interest as excess noncash items to REITs that use an accrual method of taxation.

• Prohibited transaction safe harbor--The bill excludes from the prohibited sales rules property that was involuntarily converted.

• Shared appreciation mortgages--The bill provides that interest received on a shared appreciation mortgage is not subject to the tax on prohibited transactions where the property subject to the mortgage is sold within 4 years of the REIT's acquisition of the mortgage pursuant to a bankruptcy plan of the mortgagor unless the REIT acquired the mortgage knew or had reason to know that the property subject to the mortgage would be sold in a bankruptcy proceeding.

• Wholly-owned REIT subsidiaries--The bill permits any corporation wholly-owned by a REIT to be treated as a qualified subsidiary, regardless of whether the corporation had always been owned by the REIT.

• The bill repeals the requirement of a regulated investment company (RIC) that it derive less than 30 percent of its gross income from the sale or other disposition of stock or securities held for less than 3 months (the "30-percent test" or "short-short rule").

• The bill provides a reasonable cause exception for certain additional penalties where one does not now exist, clarifies the period for filing claims for refunds, repeals the authority to disclose otherwise confidential information regarding whether a prospective juror has been audited, clarifies the statute of limitations, clarifies the rules regarding the awarding of administrative costs, and provides a criminal penalty and civil damages for unauthorized inspection of tax returns and return information ("browsing").

• The bill contains a number of simplification provisions relating to Federal estate, gift and trust taxes that are intended to simplify administration of the Internal Revenue Code.

• Excise tax simplification--The bill simplifies taxpayer compliance with numerous excise tax provisions: accessories installed after purchasing heavy trucks and certain automobiles, the treatment of tires under the heavy vehicle retail tax, and expanded exemptions from IRS registration requirements in certain cases. Additionally, the bill includes a number of provisions related to the taxes on distilled spirits, wine, and beer designed to conform the administration of those taxes (1) across beverage types, and (2) to current industry and Bureau of Alcohol, Tobacco, and Firearms preferred practices.

• Tax-exempt bond provisions--The bill (1) repeals the $100,000 limitation on unspent proceeds under the 1-year exception from rebate, (2) exempts earnings on bond proceeds invested in a bona fide debt service fund from the arbitrage rebate requirement and the penalty requirement (under the construction bond exception from rebate) if the spending requirements are otherwise satisfied, (3) repeals the 150-percent of debt service yield restriction, and (4) repeals certain student loan bond provisions as deadwood.

• Tax Court procedures--The bill provides rules relating to overpayment determinations, to the redetermination of interest pursuant to a motion, and to the application of net worth limitations for awards of litigation costs. The bill also generally provides for Tax Court jurisdiction for the determination of employment status.

• Other provisions--The bill provides that the due date of a private foundation's first-quarter estimated tax payment is the same date for filing the foundation's annual return for the preceding year. The bill clarifies the authority to withhold Puerto Rico (and other Commonwealth) income taxes from the salaries of Federal employees. The bill also provides that notices of less than $100,000 are disregarded for purposes of triggering the increased interest rate on certain large corporate underpayments.

• The bill includes a number of technical corrections to previously enacted legislation, including the Small Business Job Protection Act of 1996, Health Insurance Portability and Accountability Act of 1996, Taxpayer Bill of Rights 2, and other recent tax acts.

• The bill provides for a permanent increase in the public debt limit to $5.95 trillion.

• Solvency of the Airport and Airway Trust Fund (February 5, 1997)

• oPresident's Fiscal Year 1998 Budget (February 11-12, 1997)

• Education and Training Tax Provisions of the Administration Fiscal Year 1998 Budget Proposal (March 5, 1997)

• Revenue Raising Provisions in the Administration's Fiscal Year 1998 Budget Proposal (March 12, 1997)

• Savings and Investment Provisions in the Administration's Fiscal Year 1998 Budget Proposal (March 19, 1997)

• Internal Revenue Service's 1995 Earned Income Tax Credit Compliance Study (May 8, 1997).

• Annual Report of the Internal Revenue Service Taxpayer Advocate (February 25, 1997)

• "High-Risk" Programs Within the Jurisdiction of the Committee on Ways and Means (March 4, 1997)

• IRS Budget for Fiscal 1998 and the 1997 Tax Return Filing Season (March 18, 1997)

• Electronic Federal Tax Payment System (April 16, 1997).

Present law does not provide tax credits based solely on the taxpayer's number of dependent children. Taxpayers with dependent children, however, generally are able to claim a personal exemption for each of these dependents. The total amount of personal exemptions is subtracted (along with certain other items) from adjusted gross income ("AGI") in arriving at taxable income. The amount of each personal exemption is $2,650 for 1997, and is adjusted annually for inflation. In 1997, the amount of the personal exemption is phased out for taxpayers with AGI in excess of $121,200 for single taxpayers, $151,500 for heads of household, and $181,800 for married couples filing joint returns. These phaseout thresholds are adjusted annually for inflation.

Dependent care credit

A nonrefundable credit against income tax liability is available for up to 30 percent (phased down to 20 percent for individuals with AGI above $28,000) of a limited dollar amount of employment-related child and dependent care expenses. Eligible employment-related expenses are limited to $2,400 if there is one qualifying individual and $4,800 if there are two or more qualifying individuals. Employment-related expenses are expenses for household services and the care of a qualifying individual, if incurred to enable the taxpayer to be gainfully employed. Employment-related expenses are reduced to the extent the taxpayer has employer-provided dependent care assistance that is excludable from gross income.

For taxpayers with modified AGI in excess of certain thresholds, the sum of the otherwise allowable child credit and the otherwise allowable dependent care credit is phased out. Specifically, the sum of the otherwise allowable child credit and then the otherwise allowable dependent care credit is reduced by $25 for each $1,000 of modified AGI (or fraction thereof) in excess of the threshold ("the modified AGI phase-out"). For these purposes modified AGI is computed by increasing the taxpayer's AGI by the amount otherwise excluded from gross income under Code sections 911, 931, or 933 (relating to the exclusion of income of U.S. citizens or residents living abroad; residents of Guam, American Samoa, and the Northern Marian Islands; and residents of Puerto Rico, respectively). The reduction is applied first to the child credit and then to the dependent care credit. For married taxpayers filing joint returns, the threshold is $110,000. For taxpayers filing single or head of household returns, the threshold is $75,000. For married taxpayers filing separate returns, the threshold is $55,000. These thresholds are not indexed for inflation.

Beginning after 2001, the otherwise allowable child credit would be reduced by one-half of the amount of the taxpayer's otherwise allowable dependent care credit. This reduction to the otherwise allowable child credit would be applied after the application of the modified AGI phase-out to the child and dependent care credits (if applicable). The maximum amount of the child credit for each taxable year (after the reduction, if any, for the dependent care credit after 2001) could not exceed an amount equal to the excess of: (1) the taxpayer's regular income tax liability (net of applicable credits) over (2) the sum of the taxpayer's tentative minimum tax liability (determined without regard to the alternative minimum foreign tax credit) and the earned income credit allowed.

High-risk individuals eligible to receive medical care coverage from the organization must be residents of the State who, due to a pre-existing medical condition, are unable to obtain health coverage for such condition through insurance or an HMO, or are able to acquire such coverage only at a rate that is substantially higher than the rate charged for such coverage by the organization. The State must determine the composition of membership in the organization. For example, a State could mandate that all organizations that are subject to insurance regulation by the State must be members of the organization.

Present law further requires the State or members of the organization to fund the liabilities of the organization to the extent that premiums charged to eligible individuals are insufficient to cover such liabilities. Finally, no part of the net earnings of the organization can inure to the benefit of any private shareholder or individual.

Employment-related expenses are expenses for household services and the care of a qualifying individual, if incurred to enable the taxpayer to be gainfully employed. The amount of employment-related expenses that may be taken into account in computing the credit generally may not exceed an individual's earned income or, in the case of married taxpayers, the earned income of the spouse with the lesser earnings. Thus, if one spouse is not employed, no credit is generally allowed. Eligible employment-related expenses are limited to $2,400 if there is one qualifying individual, and $4,800 if there are two or more qualifying individuals. The amount of employment-related expenses is reduced by the aggregate amount of employer-provided dependent care assistance excluded from the taxpayer's income.²

^{The 30-percent credit rate is reduced by one percentage point for each $2,000 (or fraction thereof) of adjusted gross income ("AGI") above $10,000. A married couple's combined AGI is used for purposes of this computation. Individuals with more than $28,000 of AGI are entitled to a credit equal to 20 percent of allowable employment-related expenses.}

The sum of the otherwise allowable dependent care credit and the otherwise allowable child credit is phased out for taxpayers with modified AGI in excess of certain thresholds. Specifically, the sum of the otherwise allowable child credit and then the otherwise allowable dependent care credit is reduced by $25 for each $1,000 of modified AGI (or fraction thereof) in excess of the threshold. For these purposes modified AGI is computed by increasing the taxpayer's AGI by the amount otherwise excluded from gross income under Code sections 911, 931, or 933 (relating to the exclusion of income of U.S. citizens or residents living abroad; residents of Guam, American Samoa, and the Northern Mariana Islands; and residents of Puerto Rico, respectively). The reduction is applied first to the child credit and then to the dependent care credit. For married taxpayers filing joint returns, the threshold is $110,000. For taxpayers filing single or head of household returns, the threshold is $75,000. These thresholds are not indexed for inflation.

(sec. 201 of the bill and new sec. 25A of the Code)

Taxpayers generally may not deduct education and training expenses. However, a deduction for education expenses generally is allowed under section 162 if the education or training (1) maintains or improves a skill required in a trade or business currently engaged in by the taxpayer, or (2) meets the express requirements of the taxpayer's employer, or requirements of applicable law or regulations, imposed as a condition of continued employment (Treas. Reg. sec. 1.162-5). However, education expenses are not deductible if they relate to certain minimum educational requirements or to education or training that enables a taxpayer to begin working in a new trade or business. In the case of an employee, education expenses (if not reimbursed by the employer) may be claimed as an itemized deduction only if such expenses meet the above-described criteria for deductibility under section 162 and only to the extent that the expenses, along with other miscellaneous deductions, exceed 2 percent of the taxpayer's adjusted gross income (AGI).

Exclusion for employer-provided educational assistance

A special rule allows an employee to exclude from gross income for income tax purposes and from wages for employment tax purposes up to $5,250 annually paid by his or her employer for educational assistance (sec. 127). In order for the exclusion to apply certain requirements must be satisfied, including a requirement that not more than 5 percent of the amounts paid or incurred by the employer during the year for educational assistance under a qualified educational assistance program can be provided for the class of individuals consisting of more than 5-percent owners of the employer and the spouses or dependents of such more than 5-percent owners. This special rule for employer-provided educational assistance expires with respect to courses beginning after June 30, 1997 (and does not apply to graduate level courses beginning after June 30, 1996).

For purposes of the special exclusion, educational assistance means the payment by an employer of expenses incurred by or on behalf of the employee for education of the employee including, but not limited to, tuition, fees, and similar payments, books, supplies, and equipment. Educational assistance also includes the provision by the employer of courses of instruction for the employee (including books, supplies, and equipment). Educational assistance does not include tools or supplies which may be retained by the employee after completion of a course or meals, lodging, or transportation. The exclusion does not apply to any education involving sports, games, or hobbies.

In the absence of the special exclusion, employer-provided educational assistance is excludable from gross income and wages as a working condition fringe benefit (sec. 132(d)) only to the extent the education expenses would be deductible under section 162.

Exclusion for interest earned on savings bonds

Another special rule (sec. 135) provides that interest earned on a qualified U.S. Series EE savings bond issued after 1989 is excludable from gross income if the proceeds of the bond upon redemption do not exceed qualified higher education expenses paid by the taxpayer during the taxable year.³ "Qualified higher education expenses" include tuition and fees (but not room and board expenses) required for the enrollment or attendance of the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer at certain colleges, universities, or vocational schools. The exclusion provided by section 135 is phased out for certain higher-income taxpayers, determined by the taxpayer's modified AGI during the year the bond is redeemed. For 1996, the exclusion was phased out for taxpayers with modified AGI between $49,450 and $64,450 ($74,200 and $104,200 for joint returns). To prevent taxpayers from effectively avoiding the income phaseout limitation through issuance of bonds directly in the child's name, section 135(c)(1)(B) provides that the interest exclusion is available only with respect to U.S. Series EE savings bonds issued to taxpayers who are at least 24 years old.

Qualified scholarships

Section 117 excludes from gross income amounts received as a qualified scholarship by an individual who is a candidate for a degree and used for tuition and fees required for the enrollment or attendance (or for fees, books, supplies, and equipment required for courses of instruction) at a primary, secondary, or post-secondary educational institution. The tax-free treatment provided by section 117 does not extend to scholarship amounts covering regular living expenses, such as room and board. There is, however, no dollar limitation for the section 117 exclusion, provided that the scholarship funds are used to pay for tuition and required fees. In addition to the exclusion for qualified scholarships, section 117 provides an exclusion from gross income for qualified tuition reductions for education below the graduate level provided to employees of certain educational organizations. Section 117(c) specifically provides that the exclusion for qualified scholarships does not apply to any amount received by a student that represents payment for teaching, research, or other services by the student required as a condition for receiving the scholarship.

Student loan forgiveness

In the case of an individual, section 108(f) provides that gross income subject to Federal income tax does not include any amount from the forgiveness (in whole or in part) of certain student loans, provided that the forgiveness is contingent on the student's working for a certain period of time in certain professions for any of a broad class of employers (e.g., providing health care services to a nonprofit organization). Student loans eligible for this special rule must be made to an individual to assist the individual in attending an education institution that normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of students in attendance at the place where its education activities are regularly carried on. Loan proceeds may be used not only for tuition and required fees, but also to cover room and board expenses (in contrast to tax-free scholarships under section 117, which are limited to tuition and required fees). In addition, the loan must be made by (1) the United States (or an instrumentality or agency thereof), (2) a State (or any political subdivision thereof), (3) certain tax-exempt public benefit corporations that control a State, county, or municipal hospital and whose employees have been deemed to be public employees under State law, or (4) an educational organization that originally received the funds from which the loan was made from the United States, a State, or a tax-exempt public benefit corporation. Thus, loans made with private, nongovernmental funds are not qualifying student loans for purposes of the section 108(f) exclusion. As with section 117, there is no dollar limitation for the section 108(f) exclusion.

Qualified State prepaid tuition programs

Section 529 (enacted as part of the Small Business Job Protection Act of 1996) provides tax-exempt status to "qualified State tuition programs," meaning certain programs established and maintained by a State (or agency or instrumentality thereof) under which persons may (1) purchase tuition credits or certificates on behalf of a designated beneficiary that entitle the beneficiary to a waiver or payment of qualified higher education expenses of the beneficiary, or (2) make contributions to an account that is established for the purpose of meeting qualified higher education expenses of the designated beneficiary of the account. "Qualified higher education expenses" are defined as tuition, fees, books, supplies, and equipment required for the enrollment or attendance at a college or university (or certain vocational schools). Qualified higher education expenses do not include room and board expenses. Section 529 also provides that no amount shall be included in the gross income of a contributor to, or beneficiary of, a qualified State tuition program with respect to any distribution from, or earnings under, such program, except that (1) amounts distributed or educational benefits provided to a beneficiary (e.g., when the beneficiary attends college) will be included in the beneficiary's gross income (unless excludable under another Code section) to the extent such amounts or the value of the educational benefits exceed contributions made on behalf of the beneficiary, and (2) amounts distributed to a contributor (e.g., when a parent receives a refund) will be included in the contributor's gross income to the extent such amounts exceed contributions made by that person.⁴

Individual taxpayers are allowed to claim a non-refundable HOPE credit against Federal income taxes up to $1,500 per student per year for 50 percent of qualified tuition and related expenses (but not room and board expenses) paid for the first two years of the student's post-secondary education in a degree or certificate program. The qualified tuition and related expenses must be incurred on behalf of the taxpayer, the taxpayer's spouse, or a dependent. The HOPE credit is available with respect to an individual student for two taxable years, provided that the student has not completed the first two years of post-secondary education. Beginning in 1998, the maximum credit amount of $1,500 will be indexed for inflation, rounded down to the closest multiple of $50.⁵

^{The HOPE credit amount that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified AGI between $40,000 and $50,000 ($80,000 and $100,000 for joint returns). Modified AGI includes amounts otherwise excluded with respect to income earned abroad (or income from Puerto Rico or U.S. possessions). Beginning in 2001, the income phase-out ranges will be indexed for inflation, rounded down to the closest multiple of $5,000.}

^{The HOPE credit is available in the taxable year the expenses are paid, subject to the requirement that the education commence or continue during that year or during the first three months of the next year. Qualified tuition expenses paid with the proceeds of a loan generally are eligible for the HOPE credit (rather than repayment of the loan itself).6}

^{Dependent students}

^{A taxpayer may claim the HOPE credit with respect to an eligible student who is not the taxpayer or the taxpayer's spouse (e.g., in cases where the student is the taxpayer's child) only if the taxpayer claims the student as a dependent for the taxable year for which the credit is claimed. If a student is claimed as a dependent by the parent or other taxpayer, the eligible student him- or herself is not entitled to claim a HOPE credit for that taxable year on the student's own tax return. If a parent (or other taxpayer) claims a student as a dependent, any qualified tuition and related expenses paid by the student are treated as paid by the parent (or other taxpayer) for purposes of the provision.}

^{Election of HOPE credit or proposed deduction for qualified higher education expenses}

^{For each taxable year, a taxpayer may elect with respect to an eligible student either the HOPE credit or the proposed deduction for qualified higher education expenses (described below). Thus, for example, if a parent claims a child as a dependent for a taxable year, then all qualified tuition expenses paid by both the parent and child are deemed paid by the parent, and the parent may claim the HOPE credit (assuming that the AGI phaseout does not apply) on the parent's return. As an alternative, the parent may elect for that taxable year the deduction for qualified higher education expenses with respect to the dependent child (as described below).7} On the other hand, if a child is not claimed as a dependent by the parent (or by any other taxpayer) for the taxable year, then the child him- or herself has the option of electing either the HOPE credit or deduction for qualified higher education expenses paid during that year.

Qualified tuition and related expenses

The HOPE credit is available for "qualified tuition and related expenses," meaning tuition, fees, and books required for the enrollment or attendance of an eligible student at an eligible educational institution. Charges and fees associated with meals, lodging, student activities, athletics, insurance, transportation, and similar personal, living or family expenses are not included. The expenses of education involving sports, games, or hobbies are not qualified tuition expenses unless this education is part of the student's degree program.

Qualified tuition and related expenses generally include only out-of-pocket expenses. Qualified tuition and related expenses do not include expenses covered by educational assistance that is not required to be included in the gross income of either the student or the taxpayer claiming the credit. Thus, total qualified tuition and related expenses are reduced by any scholarship or fellowship grants excludable from gross income under present-law section 117 and any other tax-free educational benefits received by the student during the taxable year. No reduction of qualified tuition and related expenses is required for a gift, bequest, devise, or inheritance within the meaning of section 102(a). Under the provision, a HOPE credit is not allowed with respect to any education expense for which a deduction is claimed under section 162 or any other section of the Code.⁸

^{Eligible student}

^{An eligible student for purposes of the HOPE credit is an individual who is enrolled in a degree, certificate, or other program (including a program of study abroad approved for credit by the institution at which such student is enrolled) leading to a recognized educational credential at an eligible educational institution. The student must pursue a course of study on at least a half-time basis. (In other words, for at least one academic period which begins during the taxable year, the student must carry at least one-half the normal full-time work load for the course of study the student is pursuing.) An eligible student may not have been convicted of a Federal or State felony consisting of the possession or distribution of a controlled substance.}

^{Eligible educational institution}

^{Eligible educational institutions are defined by reference to section 481 of the Higher Education Act of 1965. Such institutions generally are accredited post-secondary educational institutions offering credit toward a bachelor's degree, an associate's degree, or another recognized post-secondary credential. Certain proprietary institutions and post-secondary vocational institutions also are eligible educational institutions. The institution must be eligible to participate in Department of Education student aid programs.}

^Regulations

^{The Secretary of the Treasury (in consultation with the Secretary of Education) is granted authority to issue regulations to implement the proposal, including regulations providing appropriate rules for recordkeeping and information reporting. These regulations may address the information reports that eligible educational institutions will be required to file to assist students and the IRS in calculating the amount of the HOPE credit potentially available. Where certain terms are defined by reference to the Higher Education Act of 1965, the Secretary of Education has authority to issue regulations, as well as authority to define other education terms as necessary.}

2. Deduction for qualified higher education expenses and tax treatment of qualified tuition programs and education investment accounts

(secs. 202, 211, and 212 of the bill and sec. 529 and new secs. 222 and 530 of the Code)

Taxpayers generally may not deduct education and training expenses. However, a deduction for education expenses generally is allowed under section 162 if the education or training (1) maintains or improves a skill required in a trade or business currently engaged in by the taxpayer, or (2) meets the express requirements of the taxpayer's employer, or requirements of applicable law or regulations, imposed as a condition of continued employment (Treas. Reg. sec. 1.162-5). However, education expenses are not deductible if they relate to certain minimum educational requirements or to education or training that enables a taxpayer to begin working in a new trade or business. In the case of an employee, education expenses (if not reimbursed by the employer) may be claimed as an itemized deduction only if such expenses meet the above-described criteria for deductibility under section 162 and only to the extent that the expenses, along with other miscellaneous deductions, exceed 2 percent of the taxpayer's adjusted gross income (AGI).

Exclusion for employer-provided educational assistance

A special rule allows an employee to exclude from gross income for income tax purposes and from wages for employment tax purposes up to $5,250 annually paid by his or her employer for educational assistance (sec. 127). In order for the exclusion to apply certain requirements must be satisfied, including a requirement that not more than 5 percent of the amounts paid or incurred by the employer during the year for educational assistance under a qualified educational assistance program can be provided for the class of individuals consisting of more than 5-percent owners of the employer and the spouses or dependents of such more than 5-percent owners. This special rule for employer-provided educational assistance expires with respect to courses beginning after June 30, 1997 (and does not apply to graduate level courses beginning after June 30, 1996).

For purposes of the special exclusion, educational assistance means the payment by an employer of expenses incurred by or on behalf of the employee for education of the employee including, but not limited to, tuition, fees, and similar payments, books, supplies, and equipment. Educational assistance also includes the provision by the employer of courses of instruction for the employee (including books, supplies, and equipment). Educational assistance does not include tools or supplies which may be retained by the employee after completion of a course or meals, lodging, or transportation. The exclusion does not apply to any education involving sports, games, or hobbies.

In the absence of the special exclusion, employer-provided educational assistance is excludable from gross income and wages as a working condition fringe benefit (sec. 132(d)) only to the extent the education expenses would be deductible under section 162.

Exclusion for interest earned on savings bonds

Another special rule (sec. 135) provides that interest earned on a qualified U.S. Series EE savings bond issued after 1989 is excludable from gross income if the proceeds of the bond upon redemption do not exceed qualified higher education expenses paid by the taxpayer during the taxable year.⁹ "Qualified higher education expenses" include tuition and fees (but not room and board expenses) required for the enrollment or attendance of the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer at certain colleges, universities, or vocational schools. The exclusion provided by section 135 is phased out for certain higher-income taxpayers, determined by the taxpayer's modified AGI during the year the bond is redeemed. For 1996, the exclusion was phased out for taxpayers with modified AGI between $49,450 and $64,450 ($74,200 and $104,200 for joint returns). To prevent taxpayers from effectively avoiding the income phaseout limitation through issuance of bonds directly in the child's name, section 135(c)(1)(B) provides that the interest exclusion is available only with respect to U.S. Series EE savings bonds issued to taxpayers who are at least 24 years old.

Qualified scholarships

Section 117 excludes from gross income amounts received as a qualified scholarship by an individual who is a candidate for a degree and used for tuition and fees required for the enrollment or attendance (or for fees, books, supplies, and equipment required for courses of instruction) at a primary, secondary, or post-secondary educational institution. The tax-free treatment provided by section 117 does not extend to scholarship amounts covering regular living expenses, such as room and board. There is, however, no dollar limitation for the section 117 exclusion, provided that the scholarship funds are used to pay for tuition and required fees. In addition to the exclusion for qualified scholarships, section 117 provides an exclusion from gross income for qualified tuition reductions for education below the graduate level provided to employees of certain educational organizations. Section 117(c) specifically provides that the exclusion for qualified scholarships does not apply to any amount received by a student that represents payment for teaching, research, or other services by the student required as a condition for receiving the scholarship.

Student loan forgiveness

In the case of an individual, section 108(f) provides that gross income subject to Federal income tax does not include any amount from the forgiveness (in whole or in part) of certain student loans, provided that the forgiveness is contingent on the student's working for a certain period of time in certain professions for any of a broad class of employers (e.g., providing health care services to a nonprofit organization). Student loans eligible for this special rule must be made to an individual to assist the individual in attending an education institution that normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of students in attendance at the place where its education activities are regularly carried on. Loan proceeds may be used not only for tuition and required fees, but also to cover room and board expenses (in contrast to tax-free scholarships under section 117, which are limited to tuition and required fees). In addition, the loan must be made by (1) the United States (or an instrumentality or agency thereof), (2) a State (or any political subdivision thereof), (3) certain tax-exempt public benefit corporations that control a State, county, or municipal hospital and whose employees have been deemed to be public employees under State law, or (4) an educational organization that originally received the funds from which the loan was made from the United States, a State, or a tax-exempt public benefit corporation. Thus, loans made with private, nongovernmental funds are not qualifying student loans for purposes of the section 108(f) exclusion. As with section 117, there is no dollar limitation for the section 108(f) exclusion.

Qualified State prepaid tuition programs

Section 529 (enacted as part of the Small Business Job Protection Act of 1996) provides tax-exempt status to "qualified State tuition programs," meaning certain programs established and maintained by a State (or agency or instrumentality thereof) under which persons may (1) purchase tuition credits or certificates on behalf of a designated beneficiary that entitle the beneficiary to a waiver or payment of qualified higher education expenses of the beneficiary, or (2) make contributions to an account that is established for the purpose of meeting qualified higher education expenses of the designated beneficiary of the account. "Qualified higher education expenses" are defined as tuition, fees, books, supplies, and equipment required for the enrollment or attendance at a college or university (or certain vocational schools). Qualified higher education expenses do not include room and board expenses. Section 529 also provides that no amount shall be included in the gross income of a contributor to, or beneficiary of, a qualified State tuition program with respect to any distribution from, or earnings under, such program, except that (1) amounts distributed or educational benefits provided to a beneficiary (e.g., when the beneficiary attends college) will be included in the beneficiary's gross income (unless excludable under another Code section) to the extent such amounts or the value of the educational benefits exceed contributions made on behalf of the beneficiary, and (2) amounts distributed to a contributor (e.g., when a parent receives a refund) will be included in the contributor's gross income to the extent such amounts exceed contributions made by that person.¹⁰

^{Contributions made to a qualified State tuition program are treated as incomplete gifts for Federal gift tax purposes (sec. 529(c)(2)). Thus, any Federal gift tax consequences are determined at the time that a distribution is made from an account under the program. The waiver (or payment) of qualified higher education expenses of a designated beneficiary by (or to) an educational institution under a qualified State tuition program is treated as a qualified transfer for purposes of present-law section 2503(e). Amounts contributed to a qualified State tuition program (and earnings thereon) are includible in the contributor's estate for Federal estate tax purposes in the event that the contributor dies before such amounts are distributed under the program (sec. 529(c)(4)).}

^{Individual retirement arrangements ("IRAs")}

^{An individual may make deductible contributions to an individual retirement arrangement ("IRA") for each taxable year up to the lesser of $2,000 or the amount of the individual's compensation for the year if the individual is not an active participant in an employer-sponsored qualified retirement plan (and, if married, the individual's spouse also is not an active participant). Contributions may be made to an IRA for a taxable year up to April 15th of the following year. An individual who makes excess contributions to an IRA, i.e., contributions in excess of $2,000, is subject to an excise tax on such excess contributions unless they are distributed from the IRA before the due date for filing the individual's tax return for the year (including extensions). If the individual (or his or her spouse, if married) is an active participant, the $2,000 limit is phased out between $40,000 and $50,000 of adjusted gross income ("AGI") for married couples and between $25,000 and $35,000 of AGI for single individuals.}

^{Present law permits individuals to make nondeductible contributions (up to $2,000 per year) to an IRA to the extent an individual is not permitted to (or does not) make deductible contributions. Earnings on such contributions are includible in gross income when withdrawn.}

^{An individual generally is not subject to income tax on amounts held in an IRA, including earnings on contributions, until the amounts are withdrawn from the IRA. Amounts withdrawn from an IRA are includible in gross income (except to the extent of nondeductible contributions). In addition, a 10-percent additional tax generally applies to distributions from IRAs made before age 59-1/2, unless the distribution is made (1) on account of death or disability, (2) in the form of annuity payments, (3) for medical expenses of the individual and his or her spouse and dependents that exceed 7.5 percent of AGI, or (4) for medical insurance of the individual and his or her spouse and dependents (without regard to the 7.5 percent of AGI floor) if the individual has received unemployment compensation for at least 12 weeks, and the withdrawal is made in the year such unemployment compensation is received or the following year.}

Individual taxpayers are allowed a deduction of up to $10,000 per student per year for qualified higher education expenses paid by the taxpayer during the taxable year for education furnished to the taxpayer, the taxpayer's spouse, or a dependent. The deduction is allowed regardless of whether the taxpayer otherwise itemizes deductions or claims the standard deduction.¹¹ A deduction is not be allowed under the bill with respect to an otherwise eligible student if the HOPE credit (as described previously) is claimed with respect to that student for the same taxable year.¹²

^{The deduction is allowed only to the extent that the taxpayer is required to include in gross income for the taxable year amounts distributed from a "qualified tuition program" or "education investment account." In other words, amounts distributed from a qualified tuition program or education investment account that are includible in the taxpayer's gross income (i.e., earnings) and that are used to pay for qualified higher education expenses during the taxable year will be deductible under the bill (subject to a $10,000 annual limit per student). Amounts distributed from qualified tuition programs or education investment accounts generally will be includible in the gross income of the distributee in the same manner as provided under present-law section 72 (to the extent not excluded under any other section, such as section 117).}

^{Under the bill, the deduction is limited to $10,000 per student for each taxable year. Aggregate deductions under the bill with respect to any one student may not exceed $40,000 for all taxable years. A deduction is not permitted with respect to a student after he or she completes the equivalent of the first four years of post-secondary education at an eligible educational institution.}

^{Dependent students}

^{If a parent (or other taxpayer) claims a student as a dependent for a taxable year, then only the parent (or other taxpayer)--and not the student--may claim the deduction for qualified higher education expenses for that taxable year. In such a case where the parent claims the proposed deduction for qualified higher education expenses, amounts includible in gross income by reason of a distribution from a qualified tuition program or education investment account will be includible in the parent's (or other taxpayer's) gross income for that taxable year.13} If a parent (or other taxpayer) claims a student as a dependent for a taxable year, then all qualified higher education expenses paid that year by both the parent (or other taxpayer) and the student are deemed to be paid by the parent (or other taxpayer). If the student is not claimed as a dependent by another taxpayer, then only the student him- or herself may claim the deduction provided for by the bill (or, as an alternative, the HOPE credit described above) on the student's own tax return for the taxable year.¹⁴

^{Qualified higher education expenses}

^{Under the bill, the term "qualified higher education expenses" means tuition, fees, books, supplies, and equipment required for the enrollment or attendance of a student at an eligible education institution, as well as room and board expenses (meaning the minimum room and board allowance applicable to the student as determined by the institution in calculating costs of attendance for Federal financial aid programs under sec. 472 of the Higher Education Act of 1965). Qualified higher education expenses do not include expenses for any graduate level course of a kind normally taken by an individual pursuing a program leading to a law, business, medical, or other advanced academic or professional degree.}

^{Qualified higher education expenses generally include only out-of-pocket expenses. Qualified higher education expenses do not include expenses covered by educational assistance that is not required to be included in the gross income of either the student or the taxpayer claiming the credit. Thus, total qualified higher education expenses are reduced by any scholarship or fellowship grants excludable from gross income under present-law section 117 and any other tax-free educational benefits received by the student during the taxable year. In addition, no deduction is allowed under the bill for expenses paid with amounts that are excludible under section 135. No reduction of qualified tuition expenses is required for a gift, bequest, devise, or inheritance within the meaning of section 102(a). If a student's education expenses for a taxable year are deducted under section 162 or any other section of the Code, then no deduction is available for such expenses under the bill.}

^{Eligible students}

^{To be eligible for the deduction provided for by the bill, a student must be at least a half-time student in a degree or certificate program at an eligible educational institution. For this purpose, a student is at least a half-time student if, during at least one academic period which begins during the taxable year, he or she is carrying at least one-half the normal full-time work load for the course of study the student is pursuing. A student will no longer be an eligible student once he or she has completed the equivalent of the first four years of post-secondary education at an eligible educational institution. An eligible student may not have been convicted of a Federal or State felony consisting of the possession or distribution of a controlled substance.}

^{Eligible educational institution}

^{Eligible educational institutions are defined by reference to section 481 of the Higher Education Act of 1965. Such institutions generally are accredited post-secondary educational institutions offering credit toward a bachelor's degree, an associate's degree, or another recognized post-secondary credential. Certain proprietary institutions and post-secondary vocational institutions also are eligible educational institutions. The institution must be eligible to participate in Department of Education student aid programs.}

^{Qualified tuition programs and education investments accounts}

^{Under the bill, a "qualified tuition program" means any qualified State tuition program, generally as defined under present-law section 529, as well as any program established and maintained by one or more eligible educational institutions (which may be private institutions that are not State-owned) that satisfy the requirements under section 529 (other than present-law, State ownership rule). An "education investment account" means a trust which is created or organized in the United States exclusively for the purpose of paying the qualified higher education expenses of the account holder and which satisfies certain other requirements.}

^{Contributions to qualified tuition programs or education investment accounts may be made only in cash.15} Such contributions may not be made after the designated beneficiary or account holder reaches age 18. Any balance remaining in a qualified tuition program or education investment account must be distributed within 30 days after the earlier of the date that the beneficiary or account holder becomes 30 years old (or dies) or the date that the beneficiary or account holder completes the equivalent of the first four years of post-secondary education at one or more eligible institutions. Transfers or rollovers of credits or account balances from one account benefiting one beneficiary to another account benefiting another beneficiary will not be considered a distribution from a qualified tuition program or education investment account (nor will a change in the designated beneficiary or account holder) if the new beneficiary is a member of the family of the old beneficiary.¹⁶ In the case of an education investment account or qualified tuition program maintained by one or more private educational institutions, contributions to an account established on behalf of a particular beneficiary (or to a program on behalf of a named beneficiary) may not exceed $5,000 per year, with an aggregate limit of $50,000 for contributions on behalf of that beneficiary for all years. The $50,000 aggregate contribution limit per beneficiary is applied by taking into account all amounts contributed to all education investment accounts for the beneficiary for the current taxable year and all prior taxable years, as well as all amounts contributed to all qualified tuition programs on behalf of such beneficiary for the current taxable year and all prior taxable years.¹⁷

^{Qualified tuition programs and education investment accounts (as separate legal entities) will be exempt from Federal income tax, other than taxes imposed under the present-law unrelated business income tax (UBIT) rules.18}

^{Under the bill, an additional tax of 10 percent will be imposed on distributions from qualified tuition programs or education investment account to the extent the distribution exceeds qualified higher education expenses paid by the taxpayer (and is not made on account of the death, disability, or scholarship received by the designated beneficiary or account holder).}

^{Estate and gift tax treatment}

^{For Federal estate and gift tax purposes, any contribution to a qualified tuition program or education investment account will be treated as a completed gift of a present interest from the contributor to the beneficiary at the time of the contribution. Thus, annual contributions--which cannot exceed $5,000 per year in the case of an education investment account or qualified tuition program maintained by one or more private education institutions--will be eligible for the present-law gift tax exclusion provided by Code section 2503(b) and also will be excludable for purposes of the generation-skipping transfer tax (provided that the contribution, when combined with any other contributions made by the donor to that same beneficiary, does not exceed the annual $10,000 gift-tax exclusion limit). Similar gift tax and generation-skipping tax treatment will apply to contributions of up to $10,000 per donor per beneficiary made to a State-sponsored qualified tuition program. Contributions to a qualified tuition program (either a State-sponsored program or one maintained by a private education institution) or to an education investment account will not, however, be eligible for the educational expense exclusion provided by Code section 2503(e). In no event will a distribution from a qualified tuition program or education investment account be treated as a taxable gift.}

^{Transfers or rollovers of credits or account balances from an account benefiting one beneficiary to an account benefiting another beneficiary (or a change in the designated beneficiary) will not be treated as a taxable gift to the extent that the new beneficiary is: (1) a member of the family of the old beneficiary (as defined above), and (2) assigned to the same generation as the old beneficiary (within the meaning of Code section 2651). In all other cases, a transfer from one beneficiary to another beneficiary (or a change in the designated beneficiary) will be treated as a taxable gift from the old beneficiary to the new beneficiary to the extent it exceeds the $10,000 present-law gift tax exclusion. Thus, a transfer of an account from a brother to his sister will not be treated as a taxable gift, whereas a transfer from a father to his son will be treated as a taxable gift (to the extent it exceeds the $10,000 present-law gift tax exclusion).}

^{For estate tax purposes, the value of any interest in a qualified tuition program or education investment account will be includible in the estate of the designated beneficiary. In no event will such interests be includible in the estate of the contributor.}

3. Phase out qualified tuition reduction exclusion

(sec. 202(c) of the bill and sec. 117(d) of the Code)

Educational benefits provided that are not excludable under the bill may be eligible for the proposed HOPE credit, or may be eligible for the deduction for qualified higher education expenses (described above) to the extent that earnings are distributed from an education investment account on behalf of the student during the year that the education benefits are provided.

4. Penalty-free withdrawals from IRAs for higher education expenses

(sec. 203 of the bill and sec. 72(t) of the Code)

If the individual (or the individual's spouse) is an active participant in an employer-sponsored retirement plan, the $2,000 deduction limit is phased out over certain adjusted gross income ("AGI") levels. The limit is phased out between $40,000 and $50,000 of AGI for married taxpayers, and between $25,000 and $35,000 of AGI for single taxpayers. An individual may make nondeductible IRA contributions to the extent the individual is not permitted to make deductible IRA contributions. Contributions cannot be made to an IRA after age 70-1/2.

Amounts held in an IRA are includible in income when withdrawn (except to the extent the withdrawal is a return of nondeductible contributions). Amounts withdrawn prior to attainment of age 59-1/2 are subject to an additional 10-percent early withdrawal tax, unless the withdrawal is due to death or disability, is made in the form of certain periodic payments, is used to pay medical expenses in excess of 7.5 percent of AGI, or is used to purchase health insurance of an unemployed individual.

The penalty-free withdrawal is available for "qualified higher education expenses," meaning tuition, fees, books, supplies, equipment required for enrollment or attendance, and room and board at a post-secondary educational institution (defined by reference to sec 481 of the Higher Education Act of 1965). Qualified higher education expenses are reduced by any amount excludable from gross income under section 135 relating to the redemption of a qualified U.S. savings bond and certain scholarships and veterans benefits.

5. Tax credit for expenses for education which supplements elementary and secondary education

(sec. 204 of the bill and new sec. 25B of the Code)

Eligible students are children under age 18 enrolled full-time in elementary or secondary school. Qualified educational assistance expenses are costs of supplementary education (e.g., tutoring). Such supplementary education must be provided with respect to a student's current classes by a supplementary education service provider that is accredited by an accreditation organization recognized by the Secretary of Education. Qualified expenses do not include the cost of courses that prepare students for college entrance exams.

The credit is phased out for taxpayers with adjusted gross income between $80,000-$92,000 for joint filers and between $50,000-$62,000 for individual filers.

(sec. 221 of the bill and sec. 127 of the Code)

2. Modification of $150 million limit on qualified 501(c)(3) bonds other than hospital bonds

(sec. 222 of the bill and sec. 145 of the Code)

Present law treats section 501(c)(3) organizations as private persons; thus, bonds for their use may only be issued as private activity "qualified 501(1)(3) bonds," subject to the restrictions of Code section 145. The most significant of these restrictions limits the amount of outstanding bonds from which a section 501(c)(3) organization may benefit to $150 million. In applying this "$150 million limit," all section 501(c)(3) organizations under common management or control are treated as a single organization. The limit does not apply to bonds for hospital facilities, defined to include only acute care, primarily inpatient, organizations.

3. Enhanced deduction for corporate contributions of computer technology and equipment

(sec. 223 of the bill and new section 170(e)(6) of the Code)

Special rules in the Code provide augmented deductions for certain corporate²¹ contributions of inventory property for the care of the ill, the needy, or infants (sec. 170(e)(3)) and certain corporate contributions of scientific equipment constructed by the taxpayer, provided the original use of such donated equipment is by the donee for research or research training in the United States in physical or biological sciences (sec. 170(e)(4)).²² Under these special rules, the amount of the augmented deduction available to a corporation making a qualified contribution is equal to its basis in the donated property plus one-half of the amount of ordinary income that would have been realized if the property had been sold. However, the augmented deduction cannot exceed twice the basis of the donated property.

Eligible donees are (1) any educational organization that normally maintains a regular faculty and curriculum and has a regularly enrolled body of pupils in attendance at the place where its educational activities are regularly carried on; and (2) Code section 501(c)(3) entities that are organized primarily for purposes of supporting elementary and secondary education. A private foundation also is an eligible donee, provided that, within 30 days after receipt of the contribution, the private foundation contributes the property to an eligible donee described above.

Qualified contributions are limited to gifts made no later than two years after the date the taxpayer acquired or substantially completed the construction of the donated property. Such donated property could be computer technology or equipment that is inventory or depreciable trade or business property in the hands of the donor. The bill permits payment by the donee organization of shipping, transfer, and installation costs.²³ The special treatment applies only to donations made by C corporations; as under present law section 170(e)(4), S corporations, personal holding companies, and service organizations are not eligible donors.

4. Treatment of cancellation of certain student loans

(sec. 224 of the bill and section 108(f) of the Code)

Student loans eligible for this special rule must be made to an individual to assist the individual in attending an educational institution that normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of students in attendance at the place where its education activities are regularly carried on. Loan proceeds may be used not only for tuition and required fees, but also to cover room and board expenses (in contrast to tax free scholarships under section 117, which are limited to tuition and required fees). In addition, the loan must be made by (1) the United States (or an instrumentality or agency thereof), (2) a State (or any political subdivision thereof), (3) certain tax-exempt public benefit corporations that control a State, county, or municipal hospital and whose employees have been deemed to be public employees under State law, or (4) an educational organization that originally received the funds from which the loan was made from the United States, a State, or a tax-exempt public benefit corporation. Thus, loans made with private, nongovernmental funds are not qualifying student loans for purposes of the section 108(f) exclusion.

The exclusion also is expanded to cover forgiveness of direct student loans made through the William D. Ford Federal Direct Loan Program where loan repayment and forgiveness are contingent on the borrower's income level and any unpaid amounts are forgiven in full by the Secretary of Education at the end of a 25-year period. Thus, Federal Direct Loan borrowers who have elected the income-contingent repayment option and who have not repaid their loans in full at the end of a 25-year period would not be required to include the outstanding loan balance in income as a result of the forgiveness of the loan.

If the individual (or the individual's spouse) is an active participant in an employer-sponsored retirement plan, the $2,000 deduction limit is phased out over certain adjusted gross income ("AGI") levels. The limit is phased out between $40,000 and $50,000 of AGI for married taxpayers, and between $25,000 and $35,000 of AGI for single taxpayers. An individual may make nondeductible IRA contributions to the extent the individual is not permitted to make deductible IRA contributions. Contributions cannot be made to an IRA after age 70-1/2.

Amounts held in an IRA are includible in income when withdrawn (except to the extent the withdrawal is a return of nondeductible contributions). Amounts withdrawn prior to attainment of age 59-1/2 are subject to an additional 10-percent early withdrawal tax, unless the withdrawal is due to death or disability, is made in the form of certain periodic payments, is used to pay medical expenses in excess of 7.5 percent of AGI, or is used to purchase health insurance of an unemployed individual.

In general, distributions from an IRA are required to begin at age 70-1/2. An excise tax is imposed if the minimum required distributions are not made. Distributions to the beneficiary of an IRA are generally required to begin within 5 years of the death of the IRA owner, unless the beneficiary is the surviving spouse.

A 15-percent excise tax is imposed on excess distributions with respect to an individual during any calendar year from qualified retirement plans, tax-sheltered annuities, and IRAs. In general, excess distributions are defined as the aggregate amount of retirement distributions (i.e., payments from applicable retirement plans) made with respect to an individual during any calendar year to the extent such amounts exceed $160,000 (for 1997) or 5 times that amount in the case of a lump-sum distribution. The dollar limit is indexed for inflation. A similar 15-percent additional estate tax applies to excess retirement accumulations upon the death of the individual. The 15-percent tax on excess distributions (but not the 15-percent additional estate tax) does not apply to distributions in 1997, 1998, or 1999.

In addition, the Committee believes that some individuals would be more likely to save if funds set aside in a tax-favored account could be withdrawn without tax after a reasonable holding period for retirement or certain special purposes. Some taxpayers may find such a vehicle more suitable for their savings needs.

The Committee believes that providing an incentive to save for certain special purposes is appropriate. The Committee believes that many Americans may have difficulty saving enough to purchase a home. Home ownership is a fundamental part of the American dream.

The bill replaces present-law nondeductible IRAs with new American Dream IRAs ("AD IRAs") to which all individuals may make nondeductible contributions of up to $2,000 annually. Contributions to an AD IRA are in addition to any contributions that can be made to a deductible IRA under the present-law rules. No income limitations apply to AD IRAs. An AD IRA is an IRA which is designated at the time of establishment as an AD IRA in the manner prescribed by the Secretary. Qualified distributions from an AD IRA are not includible in income.

Contributions to AD IRAs

The maximum annual contribution that may be made to an AD IRA is the lesser of $2,000 or the individual's compensation for the year. As under the present-law rules relating to deductible IRAs, a contribution of up to $2,000 for each spouse may be made to an AD IRA provided the combined compensation of the spouses is at least equal to the contributed amount. The $2,000 contribution limit is adjusted annually for inflation beginning after 1998 (in $50 increments).

Contributions to an AD IRA may be made even after the individual for whom the account is maintained has attained age 70-1/2.

Taxation of distributions

Qualified distributions from an AD IRA are not includible in gross income, nor subject to the additional 10-percent tax on early withdrawals. A qualified distribution is a distribution that (1) is made after the 5-taxable year period beginning with the first taxable year in which the individual made a contribution to an AD IRA²⁴, and (2) which is (a) made on or after the date on which the individual attains age 59-1/2, (b) made to a beneficiary (or to the individual's estate) on or after the death of the individual, (c) attributable to the individual's being disabled, or (d) for first-time homebuyer expenses.

Distributions from an AD IRA that are not qualified distributions are includible in income to the extent attributable to earnings, and subject to the 10-percent early withdrawal tax (unless an exception applies). The same exceptions to the early withdrawal tax that apply to IRAs apply to AD IRAs. Thus, the following distributions from an AD IRA are not subject to the 10-percent early withdrawal tax: (1) distributions after age 59-1/2; (2) distributions after death or disability of the AD IRA owner; (3) certain periodic distributions; (4) distributions for medical expenses in excess of 7.5 percent of adjusted gross income; (5) distributions for medical insurance of unemployed individuals; and (6) distributions for higher education expenses.²⁵ In addition, the 10-percent early withdrawal tax does not apply to amounts withdrawn from an AD IRA used to pay first-time homebuyer expenses.²⁶

^{Under the bill, qualified first-time homebuyer distributions are withdrawals of up to $10,000 during the individual's lifetime that are used within 60 days to pay costs (including reasonable settlement, financing, or other closing costs) of acquiring, constructing, or reconstructing the principal residence of a first-time homebuyer who is the individual, the individual's spouse, or a child, grandchild, or ancestor of the individual or individual's spouse. A first-time homebuyer is an individual who has not had an ownership interest in a principal residence during the 2-year period ending on the date of acquisition of the principal residence to which the withdrawal relates. The bill requires that the spouse of the individual also meet this requirement as of the date the contract is entered into or construction commences. The date of acquisition is the date the individual enters into a binding contract to purchase a principal residence or begins construction or reconstruction of such a residence. Principal residence is defined as under the provisions relating to the rollover of gain on the sale of a principal residence.}

^{Under the bill, any amount withdrawn for the purchase of a principal residence is required to be used within 60 days of the date of withdrawal. The 10-percent additional income tax on early withdrawals is imposed with respect to any amount not so used. If the 60-day rule cannot be satisfied due to a delay in the acquisition of the residence, the taxpayer may recontribute all or part of the amount withdrawn to the AD IRA prior to the end of the 60-day period without adverse tax consequences.}

^{An ordering will applies for purposes of determining what portion of a distribution that is not a qualified distribution is includible in income. Under the ordering rule, distributions from an AD IRA are treated as made from contributions first, and all an individual's AD IRAs are treated as a single AD IRA. Thus, no portion of a distribution from an AD IRA is treated as attributable to earnings (and therefore includible in gross income) until the total of all distributions from all the individual's AD IRAs exceeds the amount of contributions.}

^{The pre-death minimum distribution rules that apply to IRAs do not apply to AD IRAs, and amounts in AD IRAs are not taken into account for purposes of the excise tax on excess distributions or the additional estate tax on excess accumulations.}

^{Distributions from an AD IRA may be rolled over tax free to another AD IRA.}

^{Conversions of IRAs to AD IRAs}

^{All or any part of amounts in a present-law deductible or nondeductible IRA may be converted into an AD IRA after December 31, 1997, and before January 1, 1999. The amount that would have been includible in gross income if the individual had withdrawn the converted amounts are included in gross income ratably over the 4-taxable year period beginning with the taxable year in which the conversion is made. The early withdrawal tax does not apply to such conversions.27}

^{A conversion of an IRA into an AD IRA may be made in a variety of different ways and with or without taking a distribution. For example, a conversion could be made by taking a distribution from an IRA and rolling it over within 60 days to an AD IRA. Or, an individual may make a conversion simply by notifying the IRA trustee. An individual also may make the conversion in connection with a change in IRA trustees through a rollover or a trustee-to-trustee transfer. If a part of an IRA balance is converted into an AD IRA, the AD IRA amounts have to be held separately.}

(sec. 311 of the bill and sec. 1(h) of the Code)

A capital asset generally means any property except (1) inventory, stock in trade, or property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business, (2) depreciable or real property used in the taxpayer's trade or business, (3) specified literary or artistic property, (4) business accounts or notes receivable, or (5) certain U.S. publications. In addition, the net gain from the disposition of certain property used in the taxpayer's trade or business is treated as long-term capital gain. Gain from the disposition of depreciable personal property is not treated as capital gain to the extent of all previous depreciation allowances. Gain from the disposition of depreciable real property is generally not treated as capital gain to the extent of the depreciation allowances in excess of the allowances that would have been available under the straight-line method of depreciation.

The net personal saving rate in the United States has averaged less than 5 percent of gross domestic product (GDP) for the past 15 years. The Committee believes such saving is inadequate to finance the investment that is needed to equip the country's businesses with the equipment and research dollars necessary to create the higher productivity that results in higher real wages for working Americans. A reduction in the taxation of capital gains increases the rate of return on household saving. Testimony by many economists before the Committee generally concluded that increasing the after-tax return to saving should increase the saving rate of American households.

American technological leadership has been enhanced by the willingness of individuals to take the risk of pursuing new businesses exploiting new technologies. Risk taking is stifled if the taxation of any resulting gain is high and the ability to claim losses is limited. The Committee believes it is important to encourage risk taking and believes a reduction in the taxation of capital gains will have that effect.

Reduction in the taxation of capital gains also should improve the efficiency of the capital markets. The taxation of capital gains upon realization encourages investors who have accrued past gains to keep their monies "locked in" to such investments even when better investment opportunities present themselves. All economists that testified before the Committee agreed that reducing the rate of taxation of capital gains would encourage investors to unlock many of these gains. This unlocking will permit more monies to flow to new, highly valued uses in the economy. When monies flow freely, the efficiency of the capital market is improved.

The unlocking effect also has the short-term and long-term effect of increasing revenues to the Federal Government. The current revenue estimating methods employed by the Congress account for this long-term behavioral response. Nevertheless, current Congressional estimates project that revenue losses to the Federal Government will arise from the reduction in the tax rate on capital gains. The Committee observes, however, that the conservative approach embodied in such estimates does not attempt to account for the potential for increased growth in GDP that can result from increased saving and risk taking. Many macroeconomists have concluded that reductions in the taxation of capital gains may increase GDP and wage growth sufficiently that future tax revenues from the taxation of wages and business profits will offset the losses forecast from the sale of capital assets. The potential for future growth and its benefits both for all United States citizens and for future Federal revenues were important considerations for the Committee.

The Committee rejects the narrow view that reductions in the taxation of capital gains benefit primarily higher-income Americans. Taking a longer view, the Committee sees a reduction in the taxation of capital gains as providing potential benefits to all individuals. Most importantly, the Committee stresses that economic growth benefits all Americans. Increased investment leads to greater productivity and leads to higher wages. Traditional attempts to measure the benefit or burden of a tax change do not account for this critical outcome.

The tax on the net capital gain attributable to any long-term capital gain from the sale or exchange of collectibles will remain at a maximum rate of 28 percent; any long-term capital gain from the sale or exchange of section 1250 property (i.e., depreciable real estate) to the extent the gain would have been treated as ordinary income if the property had been section 1245 property will be taxed at a maximum rate of 26 percent; and the tax treatment of small business stock (as defined in section 1202(c)) will remain unchanged. Gain from the disposition of a collectible which is an indexed asset (described below) will not be eligible for the 28-percent rate unless the taxpayer elects to forego indexing.

For a taxpayer's year that includes May 7, 1997, the lower rates will not apply to an amount equal the net capital gain determined by including only gain or loss properly taken into account for the portion of the taxable year before May 7, 1997. Any net capital gain not eligible for the lower rates will be subject to the present-law maximum rate of 28 percent. This generally has the effect of applying the lower rates to capital assets sold or exchanged (or installment payments received) on or after May 7, 1997, and subjecting the remaining portion of the net capital gain to a maximum rate of 28 percent.

In the case of gain taken into account by a pass-through entity (i.e., a RIC, a REIT, a partnership, an estate or trust, or a common trust fund), the date taken into account by the entity is the appropriate date for applying the rule in the preceding paragraph. Thus, gain taken into account by a pass-through entity before May 7, 1997 is not eligible for the lower rates.

The provision also changes the 110-percent-of-last-year-liability estimated tax safe harbor to a 109-percent-of-last-year-liability safe harbor for 1997.

2. Indexing of basis of certain assets for purposes of determining gain

(sec. 312 of the bill and new sec. 1022 of the Code)

The bill generally provides for an inflation adjustment to (i.e., indexing of) the adjusted basis of certain assets (called "indexed assets") held more than 3 years for purposes of determining gain (but not loss) upon a sale or other disposition of such assets by a taxpayer other than a C corporation. Assets held by trusts, estates, S corporations, regulated investment companies ("RICs"), real estate investment trusts ("REITs"), and partnerships are eligible for indexing, to the extent gain on such assets is taken into account by taxpayers other than C corporations.

The bill applies to assets acquired on or after January 1, 2001.

Indexed assets

Assets eligible for the inflation adjustment generally include common (but not preferred) stock of C corporations and tangible property that are capital assets or property used in a trade or business. A personal residence is not eligible for indexing. To be eligible for indexing, an asset must be held by the taxpayer for more than three years.

The adjusted basis of debt is not indexed. The proposal also excludes from indexing intangible assets, such as options, futures, and other derivatives.

Computation of inflation adjustment

The inflation adjustment under the provision is computed by multiplying the taxpayer's adjusted basis in the indexed asset by an inflation adjustment percentage. The inflation adjustment percentage is the percentage by which the chain-type price index for GDP (as reported by the Commerce Department's Bureau of Economic Analysis) for the last calendar quarter ending before the disposition exceeds the chain-type price index for GDP for the last calendar quarter ending before the asset was acquired by the taxpayer. The inflation adjustment percentage is rounded to the nearest one-tenth of a percent. No adjustment is made if the inflation adjustment is one or less.

Indexing with respect to any asset ends at the time the asset is treated as disposed of for tax purposes. Thus, with respect to installment sales, the inflation adjustment to the seller does not take into account any periods after the sale is made. The purchaser generally is entitled to inflation adjustments beginning with the date of purchase, even though the purchase price is not paid until a later date.

In computing the inflation ratio, periods of time for which an asset is not an indexed asset are not taken into account. For example, if convertible debt is converted into common stock, the period prior to conversion is disregarded in determining the inflation ratio applicable to the disposition of the common stock.

Special entities

In order to deny the benefit of indexing to corporate shareholders of the RIC or REIT, the bill provides that, under regulations, (1) the determination of whether a distribution to a corporate shareholder is a dividend is made without regard to this provision, (2) the amount treated as a capital gain dividend is increased to take into account that the amount distributed was reduced by reason of the indexing adjustment, and (3) such other adjustments as are necessary shall be made to ensure that the benefits of indexing are not allowed to corporate shareholders.

In the case of shares held in a RIC or REIT, partial indexing generally is provided by the provision based on the ratio of the value of indexed assets held by the entity to the value of all its assets. The ratio of indexed assets to total as-month average). If the ratio of indexed assets to total assets exceeds 80 percent in any quarter, full indexing of the shares is allowed for that quarter. If less than 20 percent of the assets are indexed assets in any quarter, no indexing is allowed for that quarter for the shares. Partnership interests held by a RIC or REIT are subject to a look-through test for purposes of determining whether, and to what degree, the shares in the RIC or REIT are indexed.

A return of capital distribution by a RIC or REIT generally is treated by a shareholder as allocable to stock acquired by the shareholder in the order in which the stock was acquired.

The indexing adjustment is disregarded in determining any loss on the sale of an interest in a partnership, S corporation or common trust fund.

Other rules

A taxpayer holding any indexed asset on January 1, 2001, may elect to treat the indexed asset as having been sold on such date for an amount equal to its fair market value, and as having been reacquired for an amount equal to such value. If the election is made, the asset would be eligible for indexing under the provision. Any gain resulting from the election would be treated as received on the date of the deemed sale, and would not be treated as gain from the sale or exchange of property between related persons under Code section 1239. Any loss would not be allowed (and the disallowed loss would not be added to the basis of the indexed asset). For readily traded securities, fair market value is the closing market price on the business day following January 1, 2001. For this purpose, "readily traded" means readily tradable on an established securities market or otherwise.

A taxpayer may make the above election with respect to some indexed assets and not with respect to others.

3. Exclusion of gain on sale of principal residence

(sec. 313 of the bill and secs. 121 and 1034 of the Code)

No gain is recognized on the sale of a principal residence if a new residence at least equal in cost to the sales price of the old residence is purchased and used by the taxpayer as his or her principal residence within a specified period of time (sec. 1034). This replacement period generally begins two years before and ends two years after the date of sale of the old residence. The basis of the replacement residence is reduced by the amount of any gain not recognized on the sale of the old residence by reason of this gain rollover rule.

One-time exclusion

In general, an individual, on a one-time basis, may exclude from gross income up to $125,000 of gain from the sale or exchange of a principal residence if the taxpayer (1) has attained age 55 before the sale, and (2) has owned the property and used it as a principal residence for three or more of the five years preceding the sale (sec. 121).

To postpone the entire capital gain from the sale of a principal residence, the purchase price of a new home must be greater than the sales price of the old home. This provision of present law encourages some taxpayers to purchase larger and more expensive houses than they otherwise would in order to avoid a tax liability, particularly those who move from areas where housing costs are high to lower-cost areas. This promotes an inefficient use of taxpayer's financial resources.

Present law also may discourage some older taxpayers from selling their homes. Taxpayers who would realize a capital gain in excess of $125,000 if they sold their home and taxpayers who have already used the exclusion may choose to stay in their homes even though the home no longer suits their needs. By raising the $125,000 limit and by allowing multiple exclusions, this constraint to the mobility of the elderly would be removed.

While most homeowners do not pay capital gains tax when selling their homes, current law creates certain tax traps for the unwary that can result in significant capital gains taxes or loss of the benefits of the current exclusion. For example, an individual is not eligible for the one-time capital gains exclusion if the exclusion was previously utilized by the individual's spouse. This restriction has the unintended effect of penalizing individuals who marry someone who has already taken the exclusion. Households that move from a high housing-cost area to a low housing-cost area may incur an unexpected capital gains tax liability. Divorcing couples may incur substantial capital gains taxes if they do not carefully plan their house ownership and sale decisions.

To be eligible for the exclusion, a taxpayer must have owned the residence and occupied it as a principal residence for at least two of the five years prior to the sale or exchange. A taxpayer who fails to meet these requirements by reason of a change of place of employment, health, or other unforeseen circumstances is able to exclude the fraction of the $250,000 ($500,000 if married filing a joint return) equal to the fraction of two years that these requirements are met.

In the case of joint filers not sharing a principal residence, an exclusion of $250,000 is available on a qualifying sale or exchange of the principal residence of one of the spouses. Similarly, if a single taxpayer who is otherwise eligible for an exclusion marries someone who has used the exclusion within the two years prior to the marriage, the bill would allow the newly married taxpayer a maximum exclusion of $250,000. Once both spouses satisfy the eligibility rules and two years have passed since the last exclusion was allowed to either of them, the taxpayers may exclude $500,000 of gain on their joint return.

Under the proposal, the gain from the sale or exchange of the remainder interest in the taxpayer's principal residence may qualify for the otherwise allowable exclusion.

A taxpayer could elect to apply present law (rather than the new exclusion) to a sale or exchange (1) made before the date of enactment of the Act, (2) made after the date of enactment pursuant to a binding contract in effect on the date or (3) where the replacement residence was acquired on or before the date of enactment (or pursuant to a binding contract in effect of the date of enactment) and the rollover provision would apply. If a taxpayer acquired his or her current residence in a rollover transaction, periods of ownership and use of the prior residence would be taken into account in determining ownership and use of the current residence.

4. 30-percent corporate alternative tax for certain capital gains

(sec. 321 of the bill and sec. 1201 of the Code)

The Committee observes that net business saving has not increased significantly from its levels of a decade ago. The Committee believes that a lower rate of tax on capital gains will encourage investment, saving, and risk-taking, create new jobs, and promote economic growth.

In the case of gain taken into account by a corporation from a pass-through entity (i.e., a RIC, a REIT, an S corporation, a partnership, an estate or trust, or a common trust fund), the date taken into account by the entity is the appropriate date for applying the rule in the preceding paragraph.

Present law imposes a minimum tax on an individual or a corporation to the extent the taxpayer's minimum tax liability exceeds its regular tax liability. The individual minimum tax is imposed at rates of 26 and 28 percent on alternative minimum taxable income in excess of a phased-out exemption amount; the corporate minimum tax is imposed at a rate of 20 percent on alternative minimum taxable income in excess of a phased-out $40,000 exemption amount. Alternative minimum taxable income ("AMTI") is the taxpayer's taxable income increased by certain preference items and adjusted by determining the tax treatment of certain items in a manner that negates the deferral of income resulting from the regular tax treatment of those items. In the case of a corporation, in addition to the regular set of adjustments and preferences, there is a second set of adjustments known as the "adjusted current earnings" adjustment.

The most significant alternative minimum tax adjustment relates to depreciation. In computing AMTI, depreciation on property placed in service after 1986 must be computed by using the class lives prescribed by the alternative depreciation system of section 168(g) and either (1) the straight-line method in the case of property subject to the straight-line method under the regular tax or (2) the 150-percent declining balance method in the case of other property. For regular tax purposes, depreciation on tangible personal property generally is computed using shorter recovery periods and more accelerated methods than are allowed for alternative minimum tax purposes.

If a taxpayer is subject to alternative minimum tax in one year, such amount of tax is allowed as a credit in a subsequent taxable year to the extent the taxpayer's regular tax liability exceeds its tentative minimum tax in such subsequent year. If the taxpayer is an individual, this credit is allowed to the extent the taxpayer's alternative minimum tax liability is a result of adjustments that are timing in nature.

The corporate alternative minimum tax is repealed for small business corporations for taxable years beginning after December 31, 1997. A corporation that had average gross receipts of less than $5 million for the three-year period beginning after December 31, 1994, is a small business corporation for any taxable year beginning after December 31, 1997. A corporation that meets the $5 million gross receipts test will continue to be treated as small business corporation exempt from the alternative minimum tax so long as its average gross receipts do not exceed $7.5 million. A corporation that fails to meet the $7.5 million gross receipts test will become subject to corporate alternative minimum tax only with respect to preferences and adjustments that relate to transactions and investments entered into after the corporation loses its status as a small business corporation.

In addition, the alternative minimum tax credit allowable to a small business corporation may not exceed the corporation's regular tax liability (reduced by other credits) over 25 percent of the corporation's regular tax (reduced by foreign tax credits) in excess of $25,000.

Repeal of the depreciation adjustment

The alternative minimum tax adjustment relating to depreciation is repealed for all taxpayers for property placed in service after December 31, 1998.

(sec. 501(a) of the bill and sec. 2010 of the Code)

Conforming amendments to reflect the increased unified credit are made (1) to the 5-percent surtax to conform the phase out of the increased unified credit and graduated rates, (2) to the general filing requirements for an estate tax return under section 6018(a), and (3) to the amount of the unified credit allowed under section 2102(c)(3) with respect to nonresident aliens with U.S. situs property who are residents of certain treaty countries.

2. Indexing of certain other estate and gift tax provisions

(sec. 501(b)-(e) of the bill and secs. 2032A, 2503, 2631, and 6601(J) of the Code)

A taxpayer may exclude $10,000 of gifts of present interests in property made by an individual ($20,000 per married couple) to each donee during a calendar year (sec. 2503).

Special use valuation

An executor may elect for estate tax purposes to value certain qualified real property used in farming or a closely-held trade or business at its current use value, rather than its "highest and best use" value (sec. 2032A). The maximum reduction in value under such an election is $750,000.

Generation-skipping transfer ("GST") tax

An individual is allowed an exemption from the GST tax of up to $1,000,000 for generation-skipping transfers made during life or at death (sec. 2631).

Installment payment of estate tax

An executor may elect to pay the Federal estate tax attributable to an interest in a closely held business in installments over, at most, a 14-year period (sec. 6166). The tax on the first $1,000,000 in value of a closely-held business is eligible for a special 4-percent interest rate (sec. 6601(j)).

3. Installment payments of estate tax attributable to closely held businesses

(secs. 502 and 503 of the bill and secs. 6601(j) and 6166 of the Code)

To qualify for the installment payment election, the business must be an active trade or business and the value of the decedent's interest in the closely held business must exceed 35 percent of the decedent's adjusted gross estate. An interest in a closely held business includes: (1) any interest as a proprietor in a business carried on as a proprietorship; (2) any interest in a partnership carrying on a trade or business if the partnership has 15 or fewer partners, or if at least 20 percent of the partnership's assets are included in determining the decedent's gross estate; or (3) stock in a corporation if the corporation has 15 or fewer shareholders, or if at least 20 percent of the value of the voting stock is included in determining the decedent's gross estate.

In addition, by eliminating the deductibility of interest paid on estate taxes deferred under section 6166 (and reducing the interest rate accordingly), the bill eliminates the need to file annual supplemental estate tax returns and make complex iterative computations to claim an estate tax deduction for interest paid.

In addition, the bill provides that no interest is imposed on the amount of deferred estate tax attributable to the first $1,000,000 in taxable value of the closely held business (i.e., the first $1,000,000 in value in excess of the effective exemption provided by the unified credit). Thus, for example, in 1998, when the unified credit is increased to provide an effective exemption of $650,000 (as described above), the amount of estate tax attributable to the value of the closely held business between $650,000 and $1,650,000 is eligible for the zero-percent interest rate.

The interest rate imposed on the amount of deferred estate tax attributable to the taxable value of the closely held business in excess of $1,000,000 is reduced to an amount equal to 45 percent of the rate applicable to underpayments of tax. The interest paid on estate taxes deferred under section 6166 is not deductible for estate or income tax purposes.

4. Estate tax recapture from cash leases of specially-valued property

(sec. 504 of the bill and sec. 2032A of the Code)

Some courts have held that cash rental of specially-valued property after the death of the decedent is not a qualified use under section 2032A because the heirs no longer bear the financial risk of working the property, and, therefore, results in the imposition of the additional estate tax under section 2032A(c). See Martin v. Commissioner, 783 F.2d 81 (7th Cir. 1986) (cash lease to unrelated party not qualified use); Williamson v. Commissioner, 93 T.C. 242 (1989), aff'd, 974 F.2d 1525 (9th Cir. 1992) (cash lease to family member not a qualified use); Fisher v. Commissioner, 65 T.C.M. 2284 (1993) (cash lease to family member not a qualified use); cf. Minter v. U.S., 19 F.3d 426 (8th Cir. 1994) (cash lease to family's farming corporation is qualified use); Estate of Gavin v. U.S., 1997 U.S. App. Lexis 10383 (8th Cir. 1997) (heir's option to pay cash rent or 50 percent crop share is qualified use).

With respect to a decedent's surviving spouse, a special rule provides that the surviving spouse will not be treated as failing to use the property in a qualified use solely because the spouse rents the property to a member of the spouse's family on a net cash basis. (sec. 2032A(b)(5)). Under section 2032A, members of an individual's family include (1) the individual's spouse, (2) the individual's ancestors, (3) lineal descendants of the individual, of the individual's spouse, or of the individual's parents, and (4) the spouses of any such lineal descendants.

5. Clarify eligibility for extension of time for payment of estate tax

(sec. 505 of the bill and new sec. 7479 of the Code)

Under present law, there is limited access to judicial review of disputes regarding initial or continuing eligibility for the deferral and installment election under section 6166. If the Commissioner determines that an estate was not initially eligible for deferral under section 6166, or has lost its eligibility for such deferral, the estate is required to pay the full amount of estate taxes asserted by the Commissioner as being owed in order to obtain judicial review of the Commissioner's determination.

6. Gifts may not be revalued for estate tax purposes after expiration of statute of limitations

(sec. 506 of the bill and secs. 2001, 6501(c)(9) and 7477 of the Code)

Generally, any estate or gift tax must be assessed within three years after the filing of the return. No proceeding in a court for the collection of an estate or gift tax can be begun without an assessment within the three-year period. If no return is filed, the tax may be assessed, or a suit commenced to collect the tax without assessment, at any time. If an estate or gift tax return is filed, and the amount of unreported items exceeds 25 percent of the amount of the reported items, the tax may be assessed or a suit commenced to collect the tax without assessment, within six years after the return was filed (sec. 6501).

Commencement of the statute of limitations generally does not require that a particular gift be disclosed. A special rule, however, applies to certain gifts that are valued under the special valuation rules of Chapter 14. The gift tax statute of limitations runs for such a gift only if it is disclosed on a gift tax return in a manner adequate to apprise the Secretary of the Treasury of the nature of the item.

Most courts have permitted the Commissioner to redetermine the value of a gift for which the statute of limitations period for the gift tax has expired in order to determine the appropriate tax rate bracket and unified credit for the estate tax. See, e.g., Evanson v. United States, 30 F.3d 960 (9th Cir. 1994); Stalcup v. United States, 946 F. 2d 1125 (5th Cir. 1991); Estate of Levin, 1991 T.C. Memo 1991-208, aff'd 986 F. 2d 91 (4th Cir. 1993); Estate of Smith v. Commissioner, 94 T.C. 872 (1990). But see Boatman's First National Bank v. United States, 705 F. Supp. 1407 (W.D. Mo. 1988) (Commissioner not permitted to revalue gifts).

It is intended that, in order to revalue a gift that has been adequately disclosed on a gift tax return, the IRS must issue a final notice of redetermination of value (a "final notice") within the statute of limitations applicable to the gift for gift tax purposes (generally, three years). This rule is applicable even where the value of the gift as shown on the return does not result in any gift tax being owed (e.g., through use of the unified credit). It is also anticipated that the IRS will develop an administrative appeals process whereby a taxpayer can challenge a redetermination of value by the IRS prior to issuance of a final notice.

A taxpayer who is mailed a final notice may challenge the redetermined value of the gift (as contained in the final notice) by filing a motion for a declaratory judgment with the Tax Court. The motion must be filed on or before 90 days from the date that the final notice was mailed. The statute of limitations is tolled during the pendency of the Tax Court proceeding.

7. Repeal of throwback rules applicable to domestic trusts

(sec. 507 of the bill and secs. 644(e) and 665 of the Code)

The Internal Revenue Code has several rules intended to limit the benefit that would otherwise occur from using the lower rates applicable to one or more trusts. Under the so-called "throwback" rules, the distribution of previously accumulated trust income to a beneficiary will be subject to tax (in addition to any tax paid by the trust on that income) where the beneficiary's average top marginal rate in the previous five years is higher than those of the trust.

Under section 643(f), two or more trusts are treated as one trust if (1) the trusts have substantially the same grantor or grantors and substantially the same primary beneficiary or beneficiaries, and (2) a principal purpose for the existence of the trusts is to avoid Federal income tax. For trusts that were irrevocable as of March 1, 1984, section 643(f) applies only to contributions to corpus after that date.

Under section 644, if property is sold within two years of its contribution to a trust, the gain that would have been recognized had the contributor sold the property is taxed at the contributor's marginal tax rates. In effect, section 644 treats such gains as if the contributor had realized the gain and then transferred the net after-tax proceeds from the sale to the trust as corpus.

Sections 665 through 668 apply different rules to accumulation distributions from a foreign trust than to accumulation distributions from domestic trusts. If a foreign trust accumulates income, changes its situs so as to become a domestic trust, and then makes a distribution that is deemed to have been made in a year in which the trust was a foreign trust, the distribution is treated as a distribution from a foreign trust for purposes of the accumulation distribution rules. Rev. Rul. 91-6, 1991-1 C.B. 89.

The treatment of foreign trusts, including the treatment of foreign trusts that become domestic trusts,³³ remains unchanged.

8. Unified credit of decedent increased by unified credit of spouse used on split gift included in decedent's gross estate

(sec. 508 of the bill and sec. 2010 of the Code)

The amount of estate tax payable generally is determined by multiplying the applicable tax rate (from the unified rate schedule) by the cumulative post-1976 taxable transfers made by the taxpayer and then subtracting any transfer taxes payable for prior taxable periods. This amount is reduced by any remaining available unified credit (and other applicable credits) to determine the estate tax liability. The estate tax is imposed on all of the assets held by the decedent at his death, including the value of certain property previously transferred by the decedent in which the decedent had certain retained powers or interests. In such circumstances, property that has been treated as a gift made one-half by each spouse may be includible in both spouses' estates.

9. Reformation of defective bequests to spouse of decedent

(sec. 509 of the bill and secs. 2056(b) and 2523 of the Code)

The determination of whether a marital deduction should be allowed (i.e., the reformation has cured the defects to qualification and otherwise qualifies under this provision) is made either as of the due date for filing the estate or gift tax return (including any extensions) or the time that changes are completed pursuant to a reformation proceeding. The statute of limitations is extended with respect to the estate or gift tax attributable to the trust property until one year after the date the Treasury Department is notified that a qualified reformation has been completed or that the reformation proceeding has otherwise terminated.

(sec. 511 of the bill and sec. 2642(a) of the Code)

If the value of the transferred property exceeds the amount of the GST exemption allocated to that property, the GST tax generally is determined by multiplying a flat tax rate equal to the highest estate tax rate (i.e., currently 55 percent) by the "inclusion percentage" and the value of the taxable property at the time of the taxable event. The "inclusion percentage" is the number one minus the "exclusion percentage". The exclusion percentage generally is calculated by dividing the amount of the GST exemption allocated to the property by the value of the property.

Under Treasury regulations, trusts that are included in the transferor's gross estate or created under the transferor's will may be validly severed only if (1) the trust is severed according to a direction in the governing instrument; or (2) the trust is severed pursuant to the trustee's discretionary powers, but only if certain other conditions are satisfied (e.g., the severance occurs or a reformation proceeding begins before the estate tax return is due). Treas. Reg. 26.2654-1(b).

2. Modification of generation-skipping transfer tax for transfers to individuals with deceased parents

(sec. 512 of the bill and sec. 2651 of the Code)

In addition, the bill extends the predeceased parent exception (as modified by the change in the preceding paragraph) to taxable terminations and taxable distributions, provided that the parent of the relevant beneficiary was dead at the earliest time that the transfer (from which the beneficiary's interest in the property was established) was subject to estate or gift tax. For example, where a trust was established to pay an annuity to a charity for a term for years with a remainder interest granted to a grandson, the termination of the term for years would not be a taxable termination subject to the GST tax if the grandson's parent (who is the son or daughter of the transferor) is deceased at the time the trust was created and the transfer creating the trust was subject to estate or gift tax.

Section 41 provides for a research tax credit equal to 20 percent of the amount by which a taxpayer's qualified research expenditures for a taxable year exceeded its base amount for that year. The research tax credit expired and generally will not apply to amounts paid or incurred after May 31, 1997.³⁴

^{A 20-percent research tax credit also applied to the excess of (1) 100 percent of corporate cash expenditures (including grants or contributions) paid for basic research conducted by universities (and certain nonprofit scientific research organizations) over (2) the sum of (a) the greater of two minimum basic research floors plus (b) an amount reflecting any decrease in nonresearch giving to universities by the corporation as compared to such giving during a fixed-base period, as adjusted for inflation. This separate credit computation is commonly referred to as the "university basic research credit" (see sec. 41(e)).}

^{Computation of allowable credit}

^{Except for certain university basic research payments made by corporations, the research tax credit applies only to the extent that the taxpayer's qualified research expenditures for the current taxable year exceed its base amount. The base amount for the current year generally is computed by multiplying the taxpayer's "fixed-base percentage" by the average amount of the taxpayer's gross receipts for the four preceding years. If a taxpayer both incurred qualified research expenditures and had gross receipts during each of at least three years from 1984 through 1988, then its "fixed-base percentage" is the ratio that its total qualified research expenditures for the 1984-1988 period bears to its total gross receipts for that period (subject to a maximum ratio of .16). All other taxpayers (so-called "start-up firms") are assigned a fixed-base percentage of 3 percent.35}

^{In computing the credit, a taxpayer's base amount may not be less than 50 percent of its current-year qualified research expenditures.}

^{To prevent artificial increases in research expenditures by shifting expenditures among commonly controlled or otherwise related entities, research expenditures and gross receipts of the taxpayer are aggregated with research expenditures and gross receipts of certain related persons for purposes of computing any allowable credit (sec. 41(f)(1)). Special rules apply for computing the credit when a major portion of a business changes hands, under which qualified research expenditures and gross receipts for periods prior to the change of ownership of a trade or business are treated as transferred with the trade or business that gave rise to those expenditures and receipts for purposes of recomputing a taxpayer's fixed-base percentage (sec. 41(f)(3)).}

^{Alternative incremental research credit regime}

^{As part of the Small Business Job Protection Act of 1996, taxpayers are allowed to elect an alternative incremental research credit regime. If a taxpayer elects to be subject to this alternative regime, the taxpayer is assigned a three-tiered fixed-base percentage (that is lower than the fixed-base percentage otherwise applicable under present law) and the credit rate likewise is reduced. Under the alternative credit regime, a credit rate of 1.65 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of 1 percent (i.e., the base amount equals 1 percent of the taxpayer's average gross receipts for the four preceding years) but do not exceed a base amount computed by using a fixed-base percentage of 1.5 percent. A credit rate of 2.2 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of 1.5 percent but do not exceed a base amount computed by using a fixed-base percentage of 2 percent. A credit rate of 2.75 percent applies to the extent that a taxpayer's current-year research expenses exceed a base amount computed by using a fixed-base percentage of 2 percent. An election to be subject to this alternative incremental credit regime may be made only for a taxpayer's first taxable year beginning after June 30, 1996, and before July 1, 1997, and such an election applies to that taxable year and all subsequent years (in the event that the credit subsequently is extended by Congress) unless revoked with the consent of the Secretary of the Treasury. If a taxpayer elects the alternative incremental research credit regime for its first taxable year beginning after June 30, 1996, and before July 1, 1997, then all qualified research expenses paid or incurred during the first 11 months of such taxable year are treated as qualified research expenses for purposes of computing the taxpayer's credit.}

^{Eligible expenditures}

^{Qualified research expenditures eligible for the research tax credit consist of: (1) "in-house" expenses of the taxpayer for wages and supplies attributable to qualified research; (2) certain time-sharing costs for computer use in qualified research; and (3) 65 percent of amounts paid by the taxpayer for qualified research conducted on the taxpayer's behalf (so-called "contract research expenses").36}

^{To be eligible for the credit, the research must not only satisfy the requirements of present-law section 174 (described below) but must be undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and must pertain to functional aspects, performance, reliability, or quality of a business component. Research does not qualify for the credit if substantially all of the activities relate to style, taste, cosmetic, or seasonal design factors (sec. 41(d)(3)). In addition, research does not qualify for the credit if conducted after the beginning of commercial production of the business component, if related to the adaptation of an existing business component to a particular customer's requirements, if related to the duplication of an existing business component from a physical examination of the component itself or certain other information, or if related to certain efficiency surveys, market research or development, or routine quality control (sec. 41(d)(4)).}

^{Expenditures attributable to research that is conducted outside the United States do not enter into the credit computation. In addition, the credit is not available for research in the social sciences, arts, or humanities, nor is it available for research to the extent funded by any grant, contract, or otherwise by another person (or governmental entity).}

^{Relation to deduction}

^{Under section 174, taxpayers may elect to deduct currently the amount of certain research or experimental expenditures incurred in connection with a trade or business, notwithstanding the general rule that business expenses to develop or create an asset that has a useful life extending beyond the current year must be capitalized. However, deductions allowed to a taxpayer under section 174 (or any other section) are reduced by an amount equal to 100 percent of the taxpayer's research tax credit determined for the taxable year. Taxpayers may alternatively elect to claim a reduced 41 in lieu of reducing deductions otherwise allowed (sec. 280C(c)(3)).}

Under the provision, taxpayers are permitted to elect the alternative incremental research credit regime under section 41(c)(4) for any taxable year beginning after June 30, 1996, and such election will apply to that taxable year and all subsequent taxable years unless revoked with the consent of the Secretary of the Treasury.

A special rule provides that, notwithstanding the general termination date for the research credit of December 31, 1998, if a taxpayer elects to be subject to the alternative incremental research credit regime for its first taxable year beginning after June 30, 1996, and before July 1, 1997, the alternative incremental research credit will be available during the entire 30-month period beginning with the first month of such taxable year--i.e., the equivalent of the 11-month extension provided for by the Small Business Job Protection Act of 1996 plus an additional 19-month extension provided for by this bill. However, to prevent taxpayers from effectively obtaining more than 30-months of research credits from the Small Business Job Protection Act of 1996 and this bill, the 30-month period for taxpayers electing the alternative incremental research credit regime is reduced by the number of months (if any) after June 1996 with respect to which the taxpayer claimed research credit amounts under the regular, 20-percent research credit rules.

^{In cases involving contributions to a private foundation (other than certain private operating foundations), the amount of the deduction is limited to the taxpayer's basis in the property. However, under a special rule contained in section 170(e)(5), taxpayers are allowed a deduction equal to the fair market value of "qualified appreciated stock" contributed to a private foundation prior to May 31, 1997.39} Qualified appreciated stock is defined as publicly traded stock which is capital gain property. The fair-market-value deduction for qualified appreciated stock donations applies only to the extent that total donations made by the donor to private foundations of stock in a particular corporation did not exceed 10 percent of the outstanding stock of that corporation. For this purpose, an individual is treated as making all contributions that were made by any member of the individual's family.

The work opportunity tax credit is available on an elective basis for employers hiring individuals from one or more of seven targeted groups. The credit generally is equal to 35 percent of qualified wages. Qualified wages consist of wages attributable to service rendered by a member of a targeted group during the one-year period beginning with the day the individual begins work for the employer. For a vocational rehabilitation referral, however, the period will begin on the day the individual begins work for the employer on or after the beginning of the individual's vocational rehabilitation plan as under prior law.

Generally, no more than $6,000 of wages during the first year of employment is permitted to be taken into account with respect to any individual. Thus, the maximum credit per individual is $2,100. With respect to qualified summer youth employees, the maximum credit is 35 percent of up to $3,000 of qualified first-year wages, for a maximum credit of $1,050.

The deduction for wages is reduced by the amount of the credit. Also, the credit does not reduce alternative minimum tax (AMT) liability.

Targeted groups eligible for the credit

Further, a qualified veteran is an individual who has served on active duty (other than for training) in the Armed Forces for more than 180 days or who has been discharged or released from active duty in the Armed Forces for a service-connected disability. However, any individual who has served for a period of more than 90 days during which the individual was on active duty (other than for training) is not an eligible employee if any of this active duty occurred during the 60-day period ending on the date the individual was hired by the employer. This latter rule is intended to prevent employers who hire current members of the armed services (or those departed from service within the last 60 days) from receiving the credit.

Minimum employment period

No credit is allowed for wages paid unless the eligible individual is employed by the employer for at least 180 days (20 days in the case of a qualified summer youth employee) or 400 hours (120 hours in the case of a qualified summer youth employee).

Expiration date

The credit is effective for wages paid or incurred to a qualified individual who begins work for an employer after September 30, 1996, and before October 1, 1997.

As with other general business credits (sec. 38), taxpayers are allowed to carry back unused credits to three years preceding the year the credit is earned (but not to a taxable year ending before July 1, 1996) and to carry forward unused credits to 15 years following the year the credit is earned. The credit cannot be used to offset a taxpayer's alternative minimum tax liability.

The orphan drug tax credit expired and does not apply to expenses paid or incurred after May 31, 1997.⁴⁰

The following tax incentives are available for certain businesses located in empowerment zones: (1) an annual 20-percent wage credit for the first $15,000 of wages paid to a zone resident who works in the zone; (2) an additional $20,000 of expensing under Code section 179 for "qualified zone property" placed in service by an "enterprise zone business" (accordingly, certain businesses operating in empowerment zones are allowed up to $38,000 of expensing for 1997; the allowable amount will increase to $38,500 for 1998); and (3) special tax-exempt financing for certain zone facilities (described in more detail below).

The 95 enterprise communities are eligible for the special tax-exempt financing benefits but not the other tax incentives available in the nine empowerment zones. In addition to these tax incentives, OBRA 1993 provided that Federal grants would be made to designated empowerment zones and enterprise communities.

The tax incentives for empowerment zones and enterprise communities generally will be available during the period that the designation remains in effect, i.e., a 10-year period.

A "qualified business" is defined as any trade or business other than a trade or business that consists predominantly of the development or holding of intangibles for sale or license.⁴² In addition, the leasing of real property that is located within the empowerment zone or community to others is treated as a qualified business only if (1) the leased property is not residential property, and (2) at least 50 percent of the gross rental income from the real property is from enterprise zone businesses. The rental of tangible personal property to others is not a qualified business unless substantially all of the rental of such property is by enterprise zone businesses or by residents of an empowerment zone or enterprise community.

Tax-exempt financing rules

Tax-exempt private activity bonds may be issued to finance certain facilities in empowerment zones and enterprise communities. These bonds, along with most private activity bonds, are subject to an annual private activity bond State volume cap equal to $50 per resident of each State, or (if greater) $150 million per State.

Qualified enterprise zone facility bonds are bonds 95 percent or more of the net proceeds of which are used to finance (1) "qualified zone property" (as defined above) the principal user of which is an "enterprise zone business" (also defined above⁴³), or (2) functionally related and subordinate land located in the empowerment zone or enterprise community. These bonds may only be issued while an empowerment zone or enterprise community designation is in effect.

The aggregate face amount of all qualified enterprise zone bonds for each qualified enterprise zone business may not exceed $3 million per zone or community. In addition, total qualified enterprise zone bond financing for each principal user of these bonds may not exceed $20 million for all zones and communities.

Taxation of capital gains

In general, gain or loss reflected in the value of an asset is not recognized for income tax purposes until a taxpayer disposes of the asset. On the sale or exchange of capital assets, the net capital gain generally is taxed at the same rate as ordinary income, except that the maximum rate of tax is limited to 28 percent of the net capital gain.⁴⁴ Net capital gain is the excess of the net long-term capital gain for the taxable year over the net short-term capital loss for the year. Gain or loss is treated as long-term if the asset is held for more than one year.

Capital losses generally are deductible in full against capital gains. In addition, individual taxpayers may deduct capital losses against up to $3,000 of ordinary income in each year. Any remaining unused capital losses may be carried forward indefinitely to another taxable year.

A capital asset generally means any property except (1) inventory, stock in trade, or property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business, (2) depreciable or real property used in the taxpayer's trade or business, (3) specified literary or artistic property, (4) business accounts or notes receivable, and (5) certain publications of the Federal Government.

In addition, the net gain from the disposition of certain property used in the taxpayer's trade or business is treated as long-term capital gain. Gain from the disposition of depreciable personal property is not treated as capital gain to the extent of all previous depreciation allowances. Gain from the disposition of depreciable real property generally is not treated as capital gain to the extent of the depreciation allowances in excess of the allowances that would have been available under the straight-line method.

Individual tax rates

To determine tax liability, an individual taxpayer generally must apply the tax rate schedules (or the tax tables) to his or her taxable income. The rate schedules are broken into several ranges of income, known as income brackets, and the marginal tax rate increases as a taxpayer's income increases. Separate rate schedules apply based on an individual's filing status. For 1997, the individual income tax rate schedules are as follows:

 _____________________________________________________________________

Certain economically depressed census tracts within the District of Columbia are designated as the "D.C. Enterprise Zone," within which businesses and individual residents are eligible for special tax incentives. The census tracts that compose the D.C. Enterprise Zone are (1) all census tracts that presently are part of the D.C. enterprise community designated under section 1391 (i.e., portions of Anacostia, Mt. Pleasant, Chinatown, and the easternmost part of the District) and (2) all additional census tracts within the District of Columbia where the poverty rate is at least 35 percent. The D.C. Enterprise Zone designation generally will remain in effect for five years for the period from January 1, 1998, through December 31, 2002.⁴⁵

^{The following tax incentives will take effect only if, prior to January 1, 1998, a Federal law is enacted creating a District of Columbia economic development corporation that is an instrumentality of the District of Columbia government.46}

^{Business development incentives}

In general, the wage credit for certain D.C. Enterprise Zone residents who work in the D.C. Enterprise Zone is the same as is available in empowerment zones under present law. However, the wage credit rate remains at 20 percent for the D.C. Enterprise Zone for the period 1998 through 2002 (and does not phase down to 15 percent in the year 2002 as under present-law section 1396). The wage credit is effective for wages paid (or incurred) to a qualified individual after December 31, 1997, and before January 1, 2003.

The increased expensing under Code section 179 is effective for property placed in service in taxable years beginning after December 31, 1997, and before January 1, 2003. Thus, qualified D.C. Zone property placed in service in taxable years beginning in 1998 is eligible for up to $38,500 of expensing.

A qualified D.C. Zone business (defined as under present law section 1394(b)(3)) is permitted to borrow proceeds from the issuance of qualified enterprise zone facility bonds. Such bonds can be issued only by a newly created economic development corporation and are subject to the requirements applicable under present law to enterprise zone facility bonds, except that the amount of outstanding bond proceeds that can be borrowed by any qualified District business cannot exceed $15 million (rather than $3 million). The special tax-exempt bond provisions apply to bonds issued after December 31, 1997, and prior to January 1, 2003.

Under the bill, the amount of credit cannot exceed 25 percent of the amount invested (or loaned) by the taxpayer. Thus, the economic development corporation may allocate the full $75 million in tax credits to no less than $300 million in equity investments in, or loans, to eligible businesses.

Under the bill, credits may be allocated to loans made to an eligible business only if the business uses the loan proceeds to purchase depreciable tangible property and any functionally related and subordinate land. Credits may be allocated to equity investments only if the equity interest was acquired for cash. Any credits allocated to a taxpayer making an equity investment are subject to recapture if the equity interest is disposed of by the taxpayer within five years. A taxpayer's basis in an equity investment is reduced by the amount of the credit.

The bill applies to credit amounts allocated for taxable years beginning after December 31, 1997, and before January 1, 2003.⁴⁷

"D.C. Zone business stock" is stock in a domestic corporation originally issued after December 31, 1997, that, at the time of issuance⁴⁸ and during substantially all of the taxpayer's holding period, was a D.C. Zone business, provided that such stock was acquired by the taxpayer on original issue from the corporation solely in exchange for cash.⁴⁹ A "D.C. Zone partnership interest" is a domestic partnership interest originally issued after December 31, 1997, that is acquired by the taxpayer from the partnership solely in exchange for cash before January 1, 2003, provided that, at the time such interest was acquired⁵⁰ and during substantially all of the taxpayer's holding period, the partnership was a D.C. Zone business. Finally, "D.C. Zone business property" is tangible property acquired by the taxpayer by purchase (within the meaning of present law section 179(d)(2)) after December 31, 1997, and before January 1, 2003, provided that the original use of such property in the D.C. Enterprise Zone commences with the taxpayer and substantially all of the use of such property during substantially all of the taxpayer's holding period was in a D.C. Zone business of the taxpayer.

A special rule provides that, in the case of business property that is "substantially renovated," such property need not be acquired by the taxpayer after December 31, 1997, nor need the original use of such property in the D.C. Enterprise Zone commence with the taxpayer. For these purposes, property is treated as "substantially renovated" if, prior to January 1, 2003, additions to basis with respect to such property in the hands of the taxpayer during any 24-month period beginning after December 31, 1997, exceed the greater of (1) an amount equal to the adjusted basis at the beginning of such 24-month period in the hands of the taxpayer, or (2) $5,000. Thus, substantially renovated real estate located in the D.C. Enterprise Zone may constitute D.C. Zone business property. However, the bill specifically excludes land that is not an integral part of a D.C. Zone business from the definition of D.C. Zone business property.

In addition, qualified D.C. Zone assets include property that was a qualified D.C. Zone asset in the hands of a prior owner, provided that at the time of acquisition, and during substantially all of the subsequent purchaser's holding period, either (1) substantially all of the use of the property is in a D.C. Zone business, or (2) the property is an ownership interest in a D.C. Zone business.⁵¹

^{In general, gain eligible for the zero percent tax rate means gain from the sale or exchange of a qualified D.C. Zone asset that is (1) a capital asset or (2) property used in the trade or business as defined in section 1231(b). Gain attributable to periods before December 31, 1997, and after December 31, 2007, is not qualified capital gain. No gain attributable to real property, or an intangible asset, which is not an integral part of a D.C. Zone business qualifies for the zero percent rate.}

^{The bill provides that property that ceases to be a qualified D.C. Zone asset because the property is no longer used in (or no longer represents an ownership interest in) a D.C. Zone business after the five-year period beginning on the date the taxpayer acquired such property would continue to be treated as a D.C. Zone asset. Under this rule, the amount of gain eligible for the zero percent capital gains rate cannot exceed the amount which would be qualified capital gain had the property been sold on the date of such cessation.}

^{Special rules are provided for pass-through entities (i.e., partnerships, S corporations, regulated investment companies, and common trust funds). In the case of a sale or exchange of an interest in a pass-through entity that was not a D.C. Zone business during substantially all of the period that the taxpayer held the interest, the zero percent capital gains rate applies to the extent that the gain is attributable to amounts that would have been qualified capital gain had the assets been sold for their fair market value on the date of the sale or exchange of the interest in the pass-through entity. This rule applies only if the interest in the pass-through entity were held by the taxpayer for more than five years. In addition, the rule applies only to qualified D.C. Zone assets that were held by the pass-through entity for more than five years, and throughout the period that the taxpayer held the interest in the pass-through entity.}

^{The bill also provides that in the case of a transfer of a qualified D.C. Zone asset by gift, at death, or from a partnership to a partner that held an interest in the partnership at the time that the qualified D.C. Zone asset was acquired, (1) the transferee is to be treated as having acquired the asset in the same manner as the transferor, and (2) the transferee's holding period includes that of the transferor. In addition, rules similar to those contained in section 1202(i)(2) regarding treatment of contributions to capital after the original issuance date and section 1202(j) regarding treatment of certain short positions apply.}

^{Individual resident tax rate reduction}

^{Individuals who have their principal place of abode in any census tract that is part of the D.C. Enterprise Zone are entitled to a 10-percent tax rate on all taxable income that currently is subject to a 15-percent Federal income tax rate. Thus, using the 1997 tax rate schedule, a single taxpayer who resides in the D.C. Enterprise Zone with $24,650 or more of taxable income will receive a Federal income tax reduction of $1,233 under the bill. Married taxpayers who reside in the D.C. Enterprise Zone and file a joint return with taxable income of $41,200 or more of taxable income will receive a Federal income tax reduction of $2,060 under the bill.}

^{The special 10-percent rate provision is in effect for the period 1998-2007.}

For purposes of the work opportunity tax credit, the targeted groups for which the credit is available include (1) families receiving Aid to Families with Dependent Children (AFDC), (2) qualified ex-felons, (3) high-risk youth, (4) vocational rehabilitation referrals, (5) qualified summer youth employees, (6) qualified veterans, and (7) families receiving food stamps.

Generally, no more than $6,000 of wages during the first year of employment is permitted to be taken into account with respect to any individual. Thus, the maximum credit per individual is $2,100. With respect to qualified summer youth employees, the maximum credit is 35 percent of up to $3,000 of qualified first-year wages, for a maximum credit of $1,050.

The deduction for wages is reduced by the amount of the credit.

The work opportunity tax credit is effective for wages paid or incurred to a qualified individual who begins work for an employer after September 30, 1996, and before October 1, 1997.

Qualified long-term family assistance recipients are: (1) members of a family that has received family assistance for at least 18 consecutive months ending on the hiring date; (2) members of a family that has received family assistance for a total of at least 18 months (whether or not consecutive) after the date of enactment of this credit if they are hired within 2 years after the date that the 18-month total is reached; and (3) members of a family who are no longer eligible for family assistance because of either Federal or State time limits, if they are hired within 2 years after the Federal or State time limits made the family ineligible for family assistance.

Eligible wages are amounts paid by the employer for the following: (1) educational assistance excludable under a section 127 program (or that would be excludable but for the expiration of section 127); (2) health plan coverage for the employee, but not more than the applicable premium defined under section 4980B(f)(4); and (3) dependent care assistance excludable under section 129.

(sec. 901 of the bill and secs. 4041 and 6427 of the Code)

2. Continued application of tax on imported recycled halon-1211

(sec. 902 of the bill and sec. 4682 of the Code)

Taxable chemicals that are recovered and recycled within the United States are exempt from tax. In addition, exemption is provided for imported recycled halon-1301 and halon-2402 if such chemicals are imported from countries that are signatories to the Montreal Protocol on Substances that Deplete the Ozone Layer. Present law further provides that exemption is to be provided for imported recycled halon-1211, for such chemicals imported from countries that are signatories to the Montreal Protocol on Substances that Deplete the Ozone Layer after December 31, 1997.

3. Uniform rate of excise tax on vaccines

(sec. 903 of the bill and secs. 4131 and 4132 of the Code)

Amounts equal to net revenues from this excise tax are deposited in the Vaccine Injury Compensation Trust Fund to finance compensation awards under the Federal Vaccine Injury Compensation Program for individuals who suffer certain injuries following administration of the taxable vaccines. This program provides a substitute Federal, "no fault" insurance system for the State-law tort and private liability insurance systems otherwise applicable to vaccine manufacturers. All persons immunized after September 30, 1998, with covered vaccines must pursue compensation under this Federal program before bringing civil tort actions under State law.

The Committee further believes it is appropriate to review the list of taxable vaccines from time to time as medical science advances. The Center for Disease Control has recommended that the vaccines for HIB (hemophilus influenza type B), Hepatitis B, and varicella (chickenpox) be widely administered among the nation's children. In light of the growing number of immunizations using these vaccines, the Committee adds these vaccines to the list of taxable vaccines.

In addition, the provision adds three new taxable vaccines to the present-law taxable vaccines: (1) HIB (hemophilus influenza type B); (2) Hepatitis B; and (3) varicella (chickenpox). The three newly listed vaccines also are subject to the 84-cents per dose excise tax.

4. Treat certain gasoline "chain retailers" as wholesale distributors under the gasoline excise tax refund rules

(sec. 904 of the bill and sec. 6416 of the Code)

5. Exemption of electric and other clean-fuel motor vehicles from luxury automobile classification

(sec. 905 of the bill and secs. 4001 and 4003 of the Code)

The tax generally applies only to the first retail sale after manufacture, production, or importation of an automobile. It does not apply to subsequent sales of taxable automobiles. A 10-percent tax is imposed on the separate purchase of vehicle and parts and accessories therefor when the sum of the separate purchases exceeds the luxury tax threshold (sec. 4003).⁵²

^{The tax under section 4001 applies to sales before January 1, 2003. The tax under section 4003 has no termination date.53}

In the case of a passenger vehicle designed to be propelled primarily by electricity and built by an original equipment manufacturer, the threshold applicable for any year is modified to equal 150 percent of $30,000 with the result increased for inflation occurring after 1990 and rounded to next lowest multiple of $2,000.

For all other vehicles, the threshold remains equal to that provided under present law.

(sec. 911 of the bill and sec. 401(k) of the Code)

Mutual irrigation or ditch companies are exempt from tax if at least 85 percent of the income of the company consists of amounts collected from members for the sole purpose of meeting losses and expenses.

2. Permanent moratorium on application of nondiscrimination rules to governmental plans

(sec. 912 of the bill)

For purposes of satisfying the nondiscrimination rules, the Internal Revenue Service has issued several Notices which extended the effective date for compliance for governmental plans. Governmental plans will be required to comply with the nondiscrimination rules beginning with plan years beginning on or after the later of January 1, 1999, or 90 days after the opening of the first legislative session beginning on or after January 1, 1999, of the governing body with authority to amend the plan, if that body does not meet continuously. For plan years beginning before the extended effective date, governmental plans are deemed to satisfy the nondiscrimination requirements.

3. Treatment of certain disability payments to public safety employees

(sec. 913 of the bill and sec. 104 of the Code)

The bill provides that claims for refund or credit for overpayment of tax resulting from the provision could be filed up to 1 year after the date of enactment, without regard to the otherwise applicable statute of limitations.

4. Portability of permissive service credit under governmental pension plans

(sec. 914 of the bill and sec. 415 of the Code)

In the case of a defined contribution plan, the limit on annual additions is the lesser of $30,000 or 25 percent of compensation. Annual additions include employer contributions, as well as after-tax employee contributions. In the case of a defined benefit pension plan, the limit on the annual retirement benefit is the lesser of (1) 100 percent of compensation or (2) $120,000 (indexed for inflation). The 100 percent of compensation limitation does not apply in the case of State and local governmental pension plans.

Amounts contributed by employees to a State or local governmental plan are treated as made by the employer if the employer "picks up" the contribution.

Permissive service credit means credit for a period of service recognized by the governmental plan if the employee contributes to the plan an amount (as determined by the plan) which does not exceed the amount necessary to fund the accrued benefit attributable to such period of service.

The bill does not affect the treatment of "pick up" contributions.

5. Gratuitous transfers for the benefit of employees

(sec. 915 of the bill and sec. 664 of the Code)

An employee stock ownership plan ("ESOP") is a qualified stock bonus plan or a combination stock bonus and money purchase pension plan under which employer securities are held for the benefit of employees. The securities, which are held by one or more tax-exempt trusts under the plan, may be acquired through direct employer contributions or with the proceeds of a loan to the trust (or trusts).

Charitable remainder trusts

A deduction is allowed for Federal estate tax purposes for transfers by a decedent to charitable, religious, scientific, etc. organizations (Code sec. 2055(a)). In the case of a transfer of a remainder interest to a charity, the remainder interest must be in a charitable remainder trust (Code sec. 2055(e)). A charitable remainder trust generally is a trust that is required to pay, no less often than annually, a fixed dollar amount (charitable remainder annuity trust) or a fixed percentage of the fair market value of the trust's assets determined at least annually (charitable remainder unitrust) to noncharitable beneficiaries, and the remainder of the trust (i.e., after termination of the annuity or unitrust amounts) to a charitable, religious, scientific, etc. organization (Code sec. 664).

The bill permits certain limited transfers of qualified employer securities by charitable remainder trusts to ESOPs without adversely affecting the status of the charitable remainder trusts under Code section 664. As a result, the bill provides that a qualified gratuitous transfer of employer securities to an ESOP is deductible from the gross estate of a decedent under Code section 2055 to the extent of the present value of the remainder interest. In addition, an ESOP will not fail to be a qualified plan because it complies with the requirements with respect to a qualified gratuitous transfer.

Qualified gratuitous transfer

In order for a transfer of securities to be a "qualified gratuitous transfer," the following requirements must be satisfied: (1) the securities transferred must previously have passed from the decedent to a charitable remainder trust; (2) at the time of the transfer to the ESOP, family members of the decedent own (directly or indirectly) no more than 10 percent of the value of the outstanding stock of the company; (3) immediately after the transfer to the ESOP, the ESOP owns at least 60 percent⁵⁴ of the value of outstanding stock of the company; and (4) the plan meets certain requirements. In order to prevent erosion of the 60-percent ownership requirements, an excise tax is imposed on the employer maintaining the ESOP with respect to certain dispositions of the transferred stock within 3 years of the transfer.

The provision applies in cases in which the ESOP was in existence on August 1, 1996, and the decedent dies on or before December 31, 1998. The provision does not fail to apply merely because the ESOP is amended after August 1, 1996, for example, in order to conform to the requirements of the provision.

Plan requirements

In order for a transfer to qualify as a gratuitous transfer, the ESOP must contain certain provisions. First, the plan must provide that plan participants are entitled to direct the manner in which stock transferred are to be voted (with respect to all matters). Transferred securities that have not yet been allocated to participants must be voted by a trustee that is not a 5-percent owner of the company or a family member of the decedent.

Second, the plan must provide that participants have the right to receive distributions in the form of stock and that the participant can require the employer to repurchase any shares distributed under a fair valuation formula. For this purpose, a valuation formula is not considered fair if it takes into account a discount for minority interests.

Finally, the plan must provide that, if the plan is terminated before all the transferred stock has been allocated, the remaining stock is to be transferred to one or more charitable organizations. The employer is subject to an excise tax designed to recapture the estate taxes that would have been due had the transfer to the ESOP not occurred if the plan is terminated and any unallocated shares are not transferred to charitable organizations.

Treatment of transferred stock and allocation rules

No deduction is permitted under section 404 of the Code with respect to securities transferred from the charitable remainder trust. The nondiscrimination requirements (sec. 401(a)(4)) normally applicable to qualified plans must be satisfied with respect to the securities transferred. The ESOP is required to treat the securities transferred as employer securities, except for purposes of determining the amount of deductible contributions to the plan otherwise permitted by the employer. The ESOP is required to allocate the transferred securities up to the limit on contributions and benefits (sec. 415) after allocating any other employer contributions for the year; any transferred securities that can not be allocated because of the section 415 limits would be held in a suspense account and allocated in the same manner in subsequent years. Transferred securities are not taken into account in determining whether any other contributions satisfy the section 415 limit. Further, securities transferred to an ESOP by a charitable remainder trust cannot be allocated to the account of (1) any family member of the decedent, or (2) any employee owning more than 5 percent of any class of outstanding stock of the corporation issuing the securities (or a member of a controlled group of corporations) or the total value of any class of outstanding stock of any such corporation. The employer is subject to an excise tax if impermissible allocations are made.

Definition of qualified employer securities

Qualified employer securities include only employer securities (within the meaning of sec. 409(l) of the Code), which are issued by a domestic corporation that has no outstanding stock that is readily tradable on an established securities market and that has only one class of stock.

6. Treatment of certain transportation on noncommercially operated aircraft as a fringe benefit

(sec. 916 of the bill and sec. 132 of the Code)

7. Cash out of certain accrued benefits

(sec. 917 of the bill and secs. 411 and 417 of the Code)

Generally, a cash-out distribution from a qualified plan to a plan participant can be rolled over, tax free, to an IRA or to another qualified plan.

8. ESOPs maintained by S corporations

(sec. 918 of the bill and secs. 409 and 4975 of the Code)

ESOPs are generally required to make distributions in the form of employer securities.

ESOPs are subject to certain prohibited transaction rules designed to prohibit certain transactions between the plan and certain persons close to the plan. A number of statutory exceptions are provided to the prohibited transaction rules, including exceptions for loans between the plan and plan participants and certain sales of stock to the ESOP. These statutory exceptions do not apply to shareholder-employees of S corporations. However, such individuals can obtain an administrative exception from such rules from the Department of Labor.

(sec. 921 of the bill and new sec. 7508A of the Code)

2. Use of certain appraisals to establish amount of disaster loss

(sec. 922 of the bill and sec. 165 of the Code)

3. Treatment of livestock sold on account of weather-related conditions

(sec. 923 of the bill and secs. 451 and 1033 of the Code)

In addition, the sale of livestock (other than poultry) that is held for draft, breeding, or dairy purposes in excess of the number of livestock that would have been sold but for drought conditions is treated as an involuntary conversion under section 1033(e). Consequently, gain from the sale of such livestock could be deferred by reinvesting the proceeds of the sale in similar property within a two-year period.

In addition, the bill amends Code section 1033(e) to provide that the sale of livestock (other than poultry) that are held for draft, breeding, or dairy purposes in excess of the number of livestock that would have been sold but for drought (as under present law), flood or other weather-related conditions is treated as an involuntary conversion.

4. Mortgage bond financing for residences located in Presidentially-declared disaster areas

(sec. 924 of the bill and sec. 143 of the Code)

Present law waives the three buyer targeting requirements for a portion of the loans made with proceeds of a qualified mortgage bond issue if the loans are made to finance homes in statutorily prescribed economically distressed areas.

(sec. 931 of the bill and sec. 3121 of the Code)

Under a special statutory rule, bakery distributors are treated as employees for Social Security payroll tax purposes (even if they are independent contractors for income tax purposes) if: (1) their services are part of a continuing relationship with the person for whom they are performed; (2) the distributor's service contract contemplates that he or she will perform substantially all of the services personally; and (3) the distributor does not have a substantial investment in facilities used in the performance of services, excluding facilities used for transportation. This provision also applies to distributors of meat, vegetable, fruit, and beverage (other than milk) products, as well as to distributors of laundry and dry cleaning services.

Bakery drivers generally take the position that they are not employees under the statutory rule because they have a substantial investment in facilities and their contract of service doe snot contemplate that substantially all services are to be performed personally by them.

2. Clarification of standard to be used in determining tax status of retail securities brokers

(sec. 932 of the bill)

3. Clarification of exemption from self-employment tax for certain termination payments received by former insurance salesmen

(sec. 933 of the bill and sec. 1402 of the Code)

Similarly, under the self-employment contributions act ("SECA"), taxes are imposed on an individual's net earnings from self employment. In general, net earnings from self employment means the gross income derived by an individual from any trade or business carried on by such individual, less the deductions allowed which are attributable to such trade or business. The SECA tax rate is the same as the combined employer and employee FICA rates (i.e., 12.4 percent for OASDI and 2.9 percent for HI) and the maximum amount of earnings subject to the OASDI portion of SECA taxes is coordinated with and is set at the same level as the maximum level of wages and salaries subject to the OASDI portion of FICA taxes. There is no limit on the amount of self-employment income subject to the HI portion of the tax.

Certain insurance salesmen are independent contractors and therefore subject to tax under SECA.

Under case law, certain payments received by a former insurance salesmen who had sold insurance as an independent contractor are not net earnings from self employment and therefore are not subject to SECA. See, e.g., Jackson v. Comm'r, 108 TC __ No. 10 (1997); Gump v. U.S., 86 F. 3d 1126 (CA FC 1996); Milligan v. Comm'r, 38 F. 3d 1094 (9th Cir. 1994).

The bill will also amend the Social Security Act to provide that such termination payments are not treated as earnings for purposes of determining social security benefits.

No inference is intended with respect to the SECA tax treatment of payments that are not described in the proposal.

4. Safe harbor for independent contractors

(sec. 934 of the bill and new sec. 3511 of the Code)

Under a special safe harbor rule (section 530 of the Revenue Act of 1978), a service recipient may treat a worker as an independent contractor for employment tax purposes even though the worker is in fact an employee if the service recipient has a reasonable basis for treating the worker as an independent contractor and certain other requirements are met. Section 530 does not apply to the worker and does not apply for income tax purposes. Section 530 does not apply to technical services personnel.

The bill provides a statutory safe harbor for determining worker classification for Federal tax purposes. If the standards set forth in the bill are met, the worker is not treated as an employee and the service recipient (or payor) is not treated as an employer. If the safe harbor is not satisfied, the determination of the worker's status is made under the present-law rules.

Standards for determining whether individuals are not employees

Under the bill, the following three sets of requirements have to be satisfied in order for a worker not to be treated as an employee: (1) worker requirements regarding the service recipient; (2) worker requirements regarding others; and (3) documentation requirements. The requirements regarding the worker are satisfied if, in connection with performing the services, the worker: (1) has a significant investment in assets and/or training; (2) incurs significant unreimbursed expenses; (3) agrees to perform the services for a particular amount of time or to complete a specific result and is liable for damages for early termination without cause; (4) is paid primarily on a commissioned basis; or (5) purchases products for resale.

The requirements regarding others are satisfied if one of the following two requirements is met: (1) a place of business requirement; or (2) a services available to the public requirement. The place of business requirement is satisfied if the worker: (1) has a principal place of business; (2) does not primarily perform services in the service recipient's place of business; or (3) pays a fair market rent for use of the service recipient's place of business. The services available to the public requirement is satisfied if the worker is not required to perform services exclusively for the service recipient, and during the year (or the preceding or subsequent year) the worker (1) has performed a significant amount of services for other persons; (2) has offered to perform services for other persons through advertising, individual written or oral solicitations, listings with agencies, brokers, or other organizations that provide referrals, or other similar activities; or (3) provides service under a business name that is registered with (or licensed by) a State or a political subdivision (or an agency or instrumentality of a State or political subdivision).

The services performed by the worker are performed pursuant to a written contract between the worker and the service recipient (or payor) and the contract provides that the worker will not be treated as an employee.

If the service recipient (or payor) fails to file the appropriate Federal tax returns (including information returns) with respect to a worker for a taxable year, the safe harbor is not available for such year. Thus, the classification of the worker for the year is determined under the present-law rules.

If the worker performs services through an entity owned in whole or in part by the worker, then the standards under the bill may be applied to include the entity as the worker. The term service recipient (and payor) does not include any entity which is owned in whole or in part by the worker. Thus, the new standards do not apply to the relationship between the worker and an entity if the worker has any ownership interest in the service recipient (or payor) (e.g., if the worker provides services through a personal service corporation, the bill does not apply with respect to the relationship between the worker and the personal service corporation).

(sec. 941 of the bill and sec. 6302 of the Code)

The Code requires the development and implementation of an electronic fund transfer system to remit these taxes and convey deposit information directly to the Treasury (Code sec. 6302(h)⁵⁵). The Electronic Federal Tax Payment System ("EFTPS") was developed by Treasury in response to this requirement.⁵⁶ Employers must enroll with one of two private contractors hired by the Treasury. After enrollment, employers generally initiate deposits either by telephone or by computer.

The new system is phased in over a period of years by increasing each year the percentage of total taxes subject to the new EFTPS system. For fiscal year 1994, 3 percent of the total taxes are required to be made by electronic fund transfer. These percentages increased gradually for fiscal years 1995 and 1996. For fiscal year 1996, the percentage was 20.1 percent (30 percent for excise taxes and corporate estimated tax payments). For fiscal year 1997, these percentages increased significantly, to 58.3 percent (60 percent for excise taxes and corporate estimated tax payments). The specific implementation method required to achieve the target percentages is set forth in Treasury regulations. Implementation began with the largest depositors.

Treasury had originally implemented the 1997 percentages by requiring that all employers who deposit more than $50,000 in 1995 must begin using EFTPS by January 1, 1997. The Small Business Job Protection Act of 1996 provided that the increase in the required percentages for fiscal year 1997 (which, pursuant to Treasury regulations, was to take effect on January 1, 1997) will not take effect until July 1, 1997.⁵⁷ This was done to provide additional time prior to implementation of the 1997 requirements so that employers could be better informed about their responsibilities.

On June 2, 1997, the IRS announced⁵⁸ that it will not impose penalties through December 31, 1997, on businesses that make timely deposits using paper federal tax deposit coupons while converting to the EFTPS system.

2. Home office deduction: clarification of definition of principal place of business

(sec. 942 of the bill and sec. 280A of the Code)

Prior to 1976, expenses attributable to the business use of a residence were deductible whenever they were "appropriate and helpful" to the taxpayer's business. In 1976, Congress adopted section 280A, in order to provide a narrower scope for the home office deduction, but did not define the term "principal place of business." In Commissioner v. Soliman, 113 S.Ct. 701 (1993), the Supreme Court reversed lower court rulings and upheld an IRS interpretation of section 280A that disallowed a home office deduction for a self-employed anesthesiologist who practiced at several hospitals but was not provided office space at the hospitals. Although the anesthesiologist used a room in his home exclusively to perform administrative and management activities for his profession (i.e., he spent two or three hours a day in his home office on bookkeeping, correspondence, reading medical journals, and communicating with surgeons, patients, and insurance companies), the Supreme Court upheld the IRS position that the "principal place of business" for the taxpayer was not the home office, because the taxpayer performed the "essence of the professional service" at the hospitals.⁶⁰ Because the taxpayer did not meet with patients at his home office and the room was not a separate structure, a deduction was not available under the second or third exception under section 280A(c)(1) (described above).

Section 280A(c)(2) contains a special rule that allows a home office deduction for business expenses related to a space within a home that is used on a regular (even if not exclusive) basis as a storage unit for the inventory or product samples of the taxpayer's trade or business of selling products at retail or wholesale, but only if the home is the sole fixed location of such trade or business.

Home office deductions may not be claimed if they create (or increase) a net loss from a business activity, although such deductions may be carried over to subsequent taxable years (sec. 280A(c)(5)).

Thus, under the bill, a home office deduction is allowed (subject to the present-law "convenience of the employer" rule governing employees) if a portion of a taxpayer's home is exclusively and regularly used to conduct administrative or management activities for a trade or business of the taxpayer, who does not conduct substantial administrative or management activities at any other fixed location of the trade or business, regardless of whether administrative or management activities connected with his trade or business (e.g., billing activities) are performed by others at other locations. The fact that a taxpayer also carries out administrative or management activities at sites that are not fixed locations of the business, such as a car or hotel room, will not affect the taxpayer's ability to claim a home office deduction under the bill. Moreover, if a taxpayer conducts some administrative or management activities at a fixed location of the business outside the home, the taxpayer still will be eligible to claim a deduction so long as the administrative or management activities conducted at any fixed location of the business outside the home are not substantial (e.g., the taxpayer occasionally does minimal paperwork at another fixed location of the business). In addition, a taxpayer's eligibility to claim a home office deduction under the bill will not be affected by the fact that the taxpayer conducts substantial non-administrative or non-management business activities at a fixed location of the business outside the home (e.g., meeting with, or providing services to, customers, clients, or patients at a fixed location of the business away from home).

If a taxpayer in fact does not perform substantial administrative or management activities at any fixed location of the business away from home, then the second part of the test will be satisfied, regardless of whether or not the taxpayer opted not to use an office away from home that was available for the conduct of such activities. However, in the case of an employee, the question whether an employee chose not to use suitable space made available by the employer for administrative activities is relevant to determining whether the present-law "convenience of the employer" test is satisfied. In cases where a taxpayer's use of a home office does not satisfy the provision's two-part test, the taxpayer nonetheless may be able to claim a home office deduction under the present-law "principal place of business" exception or any other provision of section 280A.

(sec. 951 of the bill and sec. 471 of the Code)

Some taxpayers verify and adjust their book inventories by a physical count taken on the last day of the taxable year. Other taxpayers may verify and adjust their inventories by physical counts taken at other times during the year. Still other taxpayers take physical counts at different locations at different times during the taxable year (cycle counting).

If a physical inventory is taken at year-end, the amount of shrinkage for the year is known. If a physical inventory is not taken at year-end, shrinkage through year-end will have to be based on an estimate, or not taken into account until the following year. In the first decision in Dayton Hudson v. Commissioner⁶², the U.S. Tax Court held that a taxpayer's method of accounting may include the use of an estimate of shrinkage occurring through year-end, provided the method is sound and clearly reflects income. In the second decision in Dayton Hudson v. Commissioner⁶³, the U.S. Tax Court adhered to this holding. However, the U.S. Tax Court in the second decision determined that this taxpayer had not established that its method of accounting clearly reflected income. Other cases decided by the U.S. Tax Court⁶⁴ have held that taxpayers' methods of accounting that included shrinkage estimates do clearly reflect income.

The U.S. Tax Court in the second Dayton Hudson opinion noted that "(i)n most cases, generally accepted accounting principles (GAAP), consistently applied, will pass muster for tax purposes. The Supreme Court has made clear, however, that GAAP does not enjoy a presumption of accuracy that must be rebutted by the Commissioner."

The Committee believes that a taxpayer should have the opportunity to change its method of accounting to a method that keeps inventories using shrinkage estimates, so long as such method is sound and clearly reflects income. The Committee does not believe that it is appropriate to deny a taxpayer access to such a method solely because its current, acceptable method of accounting does not utilize shrinkage estimates.

A taxpayer is permitted to change its method of accounting by this section if the taxpayer is currently using a method that does not utilize estimates of inventory shrinkage and wishes to change to a method for inventories that includes shrinkage estimates based on physical inventories taken other than at year-end. Such a change is treated as a voluntary change in method of accounting, initiated by the taxpayer with the consent of the Secretary of the Treasury, provided the taxpayer changes to a permissible method of accounting. The period for taking into account any adjustment required under section 481 as a result of such a change in method is 4 years.

No inference is intended by the Committee by the adoption of this provision with regard to the validity of any method of accounting for inventories under present law.

2. Treatment of workmen's compensation liability under rules for certain personal injury liability assignments

(sec. 952 of the bill and sec. 130 of the Code)

3. Tax-exempt status for certain state workmen's compensation act companies

(sec. 953 of the bill and sec. 501(c)(27) of the Code)

Certain insurance risk pools have qualified for tax exemption under Code section 501(c)(6). In general, these organizations (1) assign any insurance policies and administrative functions to their member organizations (although they may reimburse their members for amounts paid and expenses); (2) serve an important common business interest of their members; and (3) must be membership organizations financed, at least in part, by membership dues.

State insurance risk pools may also qualify for tax exempt status under section 501(c)(4) as a social welfare organizations or under section 115 as serving an essential governmental function of a State. In seeking qualification under section 501(c)(4), insurance organizations generally are constrained by the restrictions on the provision of "commercial-type insurance" contained in section 501(m). Section 115 generally provides that gross income does not include income derived from the exercise of any essential governmental function and accruing to a State or any political subdivision thereof. However, the IRS may be reluctant to rule that particular State risk-pooling entities satisfy the section 501(c)(4) or 115 requirements for tax-exempt status.

4. Treatment of certain publicly traded partnerships

(sec. 954 of the bill and sec. 7704 of the Code)

A publicly traded partnership generally is treated as a corporation for Federal tax purposes (sec. 7704). An exception to the rule treating the partnership as a corporation applies if 90 percent of the partnership's gross income consists of "passive-type income," which includes (1) interest (other than interest derived in a financial or insurance business, or certain amounts determined on the basis of income or profits), (2) dividends, (3) real property rents (as defined for purposes of the provision), (4) gain from the sale or other disposition of real property, (5) income and gains relating to minerals and natural resources (as defined for purposes of the provision), and (6) gain from the sale or disposition of a capital asset (or certain trade or business property) held for the production of income of the foregoing types (subject to an exception for certain commodities income).

The exception for publicly traded partnerships with "passive-type income" does not apply to any partnership that would be described in section 851(a) of the Code (relating to regulated investment companies, or "RICs"), if that partnership were a domestic corporation. Thus, a publicly traded partnership that is registered under the Investment Company Act of 1940 generally is treated as a corporation under the provision. Nevertheless, if a principal activity of the partnership consists of buying and selling of commodities (other than inventory or property held primarily for sale to customers) or futures, forwards and options with respect to commodities, and 90 percent of the partnership's income is such income, then the partnership is not treated as a corporation.

A publicly traded partnership is a partnership whose interests are (1) traded on an established securities market, or (2) readily tradable on a secondary market (or the substantial equivalent thereof).

Treasury regulations provide detailed guidance as to when an interest is treated as readily tradable on a secondary market or the substantial equivalent. Generally, an interest is so treated "if, taking into account all of the facts and circumstances, the partners are readily able to buy, sell, or exchange their partnership interests in a manner that is comparable, economically, to trading on an established securities market" (Treas. Reg. sec. 1.7704-1(c)(1)).

When the publicly traded partnership rules were enacted in 1987, a 10-year grandfather rule provided that the provisions apply to certain existing partnerships only for taxable years beginning after December 31, 1997.⁶⁶ An existing publicly traded partnership is any partnership, if (1) it was a publicly traded partnership on December 17, 1987, (2) a registration statement indicating that the partnership was to be a publicly traded partnership was filed with the Securities and Exchange Commission with respect to the partnership on or before December 17, 1987, or (3) with respect to the partnership, an application was filed with a State regulatory commission on or before December 31, 1987, seeking permission to restructure a portion of a corporation as a publicly traded partnership. A partnership that otherwise would be treated as an existing publicly traded partnership ceases to be so treated as of the first day after December 17, 1987, on which there has been an addition of a substantial new line of business with respect to such partnership. A rule is provided to coordinate this grandfather rule with the exception to the rule treating the partnership as a corporation applies if 90 percent of the partnership's gross income consists of passive-type income. The coordination rule provides that passive-type income exception applies only after the grandfather rule ceases to apply (whether by passage of time or because the partnership ceases to qualify for the grandfather rule).

The tax is 15 percent of the partnership's gross income from the active conduct of a trade or business. The partnership's gross trade or business income includes its share of gross trade or business income of any lower-tier partnership. The tax imposed under the provision may not be offset by tax credits.

5. Exclusion from UBIT for certain corporate sponsorship payments

(sec. 955 of the bill and sec. 513 of the Code)

"Qualified sponsorship payments" are defined as any payment made by a person engaged in a trade or business with respect to which the person will receive no substantial return benefit other than the use or acknowledgment of the name or logo (or product lines) of the person's trade or business in connection with the organization's activities.⁶⁹ Such a use or acknowledgment does not include advertising of such person's products or services -- meaning qualitative or comparative language, price information or other indications of savings or value, or an endorsement or other inducement to purchase, sell, or use such products or services. Thus, for example, if, in return for receiving a sponsorship payment, an organization promises to use the sponsor's name or logo in acknowledging the sponsor's support for an educational or fundraising event conducted by the organization, such payment will not be subject to the UBIT. In contrast, if the organization provides advertising of a sponsor's products, the payment made to the organization by the sponsor in order to receive such advertising will be subject to the UBIT (provided that the other, present-law requirements for UBIT liability are satisfied).

The bill specifically provides that a qualified sponsorship payment does not include any payment where the amount of such payment is contingent, by contract or otherwise, upon the level of attendance at an event, broadcast ratings, or other factors indicating the degree of public exposure to an activity. However, the fact that a sponsorship payment is contingent upon an event actually taking place or being broadcast, in and of itself, will not cause the payment to fail to be a qualified sponsorship payment. Moreover, mere distribution or display of a sponsor's products by the sponsor or the tax-exempt organization to the general public at a sponsored event, whether for free or for remuneration, will be considered to be "use or acknowledgment" of the sponsor's product lines (as opposed to advertising), and thus will not affect the determination of whether a payment made by the sponsor is a qualified sponsorship payment.

The provision does not apply to the sale of advertising or acknowledgments in tax-exempt organization periodicals. For this purpose, the term "periodical" means regularly scheduled and printed material published by (or on behalf of) the payee organization that is not related to and primarily distributed in connection with a specific event conducted by the payee organization. For example, the provision will not apply to payments that lead to acknowledgments in a monthly journal, but will apply if a sponsor receives an acknowledgment in a program or brochure distributed at a sponsored event.

The provision specifically provides that, to the extent that a portion of a payment would (if made as a separate payment) be a qualified sponsorship payment, such portion of the payment will be treated as a separate payment. Thus, if a sponsorship payment made to a tax-exempt organization entitles the sponsor to both product advertising and use or acknowledgment of the sponsor's name or logo by the organization, then the UBIT will not apply to the amount of such payment that exceeds the fair market value of the product advertising provided to the sponsor. Moreover, the provision of facilities, services or other privileges by an exempt organization to a sponsor or the sponsor's designees (e.g., complimentary tickets, pro-am playing spots in golf tournaments, or receptions for major donors) in connection with a sponsorship payment will not affect the determination of whether the payment is a qualified sponsorship payment. Rather, the provision of such goods or services will be evaluated as a separate transaction in determining whether the organization has unrelated business taxable income from the event. In general, if such services or facilities do not constitute a substantial return benefit or if the provision of such services or facilities is a related business activity, then the payments attributable to such services or facilities will not be subject to the UBIT. Moreover, just as the provision of facilities, services or other privileges by a tax-exempt organization to a sponsor or the sponsor's designees (complimentary tickets, pro-am playing spots in golf tournaments, or receptions for major donors) will be treated as a separate transaction that does not affect the determination of whether a sponsorship payment is a qualified sponsorship payment, a sponsor's receipt of a license to use an intangible asset (e.g., trademark, logo, or designation) of the tax-exempt organization likewise will be treated as separate from the qualified sponsorship transaction in determining whether the organization has unrelated business taxable income.

The exemption provided by the provision will be in addition to other present-law exceptions from the UBIT (e.g., the exceptions for activities substantially all the work for which is performed by volunteers and for activities not regularly carried on). No inference is intended as to whether any sponsorship payment received prior to 1998 was subject to the UBIT.

6. Timeshare associations

(sec. 956 of the bill and sec. 528 of the Code)

Under present law (sec. 528), condominium management associations and residential real estate management associations may elect to be taxable at a 30 percent rate on their "homeowners association income" if they meet certain income, expenditure, and organizational requirements.

"Homeowners association income" is the excess of the association's gross income, excluding "exempt function income," over allowable deductions directly connected with non-exempt function gross income. "Exempt function income" includes membership dues, fees, and assessments for a common activity undertaken by association members or owners of residential units in the condominium or subdivision. Homeowners association income includes passive income (e.g., interest and dividends) earned on reserves and fees for use of association property (e.g., swimming pools, meeting rooms, etc.).

For an association to qualify for this treatment, (1) at least 60 percent of the association's gross income must consist of membership dues, fees, or assessments on owners, (2) at least 90 percent of its expenditures must be for the acquisition, management, maintenance, or care of "association property," and (3) no part of its net earnings can inure to the benefit of any private shareholder. "Association property" means: (1) property held by the association; (2) property commonly held by association members; (3) property within the association privately held by association members; and (4) property held by a governmental unit for the benefit of association members. In addition to these statutory requirements, Treasury regulations require that the units of the association be used for residential purposes. Use is not a residential use if the unit is occupied by a person or series of persons less than 30 days for more than half of the association's taxable year. Treas. reg. sec. 1.528-4(d).

Taxation of homeowners associations not making the section 528 election

Homeowners associations that do not (or cannot) make the section 528 election are taxed either as a tax-exempt social welfare organization under section 501(c)(4) or as a regular C corporation. In order for an organization to qualify as a tax-exempt social welfare organization, the organization must meet the following three requirements: (1) the association must serve a "community" which bears a reasonable, recognizable relationship to an area ordinarily identified as a governmental subdivision or unit; (2) the association may not conduct activities directed to exterior maintenance of any private residence, and (3) common areas of association facilities must be for the use and enjoyment of the general public (Rev. Rul. 74-99, 1974-1 C.B. 131).

Non-exempt homeowners associations are taxed as C corporations, except that (1) the association may exclude excess assessments that it refunds to its members or applies to the subsequent year's assessments (Rev. Rul. 70-604, 1970-2 C.B. 9); (2) gross income does not include special assessments held in a special bank account (Rev. Rul. 75-370, 75-2 C.B. 25), and (3) assessments for capital improvements are treated as non-taxable contributions to capital (Rev. Rul. 75-370, 1975-2 C.B. 25).

Taxation of timeshare associations

Under present law, timeshare associations are taxed as regular C corporations because (1) they cannot meet the requirement of the Treasury regulations for the section 528 election that the units be used for residential purposes (i.e., the 30-day rule) and they have relatively large amount of services performed for its owners (e.g., maid and janitorial services) and (2) they cannot meet any of requirements of Rev. Rul. 74-99 for tax-exempt status under section 501(c)(4).

7. Modification of advance refunding rules for certain tax-exempt bonds issued by the Virgin Islands

(sec. 957 of the bill and sec. 149 of the Code)

Generally a governmental bond originally issued after December 31, 1985, may be advance refunded one time. An advance refunding is any refunding where all of the refunded bonds are not redeemed within 90 days after the refunding bonds are issued.

Virgin Island bonds

Under present law, the Virgin Islands is required to secure its bonds with a priority first lien claim on specified revenue streams rather than being permitted to issue multiple bond issues secured on a parity basis by a common pool of revenues. Under a proposed non-tax law change, the priority lien requirement would be repealed.

8. Deferral of gain on certain sales of farm product refiners and processors

(sec. 958 of the bill and sec. 1042 of the Code)

The deferral of gain is available only if, immediately after the sale, the eligible farmers' cooperative owns 100 percent of the qualified refiner or processor. The provision applies even if the stock of the qualified refiner or processor is publicly traded. In addition, the bill applies to gain on the sale of stock by a C corporation.

9. Information returns on real estate transactions

(sec. 959 of the bill and sec. 6045(e) of the Code)

10. Increased deduction for business meals while operating under Department of Transportation hours of service limitations

(sec. 960 of the bill and sec. 274(n) of the Code)

 _____________________________________________________________________

11. Treatment of construction allowances provided to lessees

(sec. 961 of the bill and new sec. 110 of the Code)

The gross income of a lessor of real property does not include any amount attributable to the value of buildings erected, or other improvements made by, a lessee that revert to the lessor at the termination of a lease (sec. 109).

Issues have arisen as to the proper treatment of amounts provided to a lessee by a lessor for property to be constructed and used by the lessee pursuant to the lease ("construction allowances"). Incentive payments have been includible in income as accessions to wealth.⁷² However, a coordinated issue paper issued by the Internal Revenue Service on October 8, 1996, provides that amounts received by a lessee from a lessor and expended by the lessee on assets owned by the lessor were not includible in the lessee's income. The issue paper provides that tax ownership is determined by applying a "benefits and burdens of ownership" test and includes an examination of the following factors: (1) whether legal title passes; (2) how the parties treat the transaction; (3) whether an equity interest was acquired in the property; (4) whether the contract creates present obligations on the seller to execute and deliver a deed and on the buyer to make payments; (5) whether the right of possession is vested; (6) who pays property taxes; (7) who bears the risk of loss or damage to the property; (8) who receives the profits from the operation and sale of the property; (9) who carries insurance with respect to the property; (9) who is responsible for replacing the property the property; and (10) who has the benefits of any remainder interests in the property.

The bill provides that lessor will treat the amounts expended on the construction allowance as nonresidential real property. However, the lessee's exclusion is not dependent upon the lessor's treatment of the property as nonresidential real property.

The bill contains reporting requirements to ensure that both the lessor and lessee treat such amounts as nonresidential real property. Under regulations. the lessor and the lessee, shall, at such times and in such manner as provided by the regulations, furnish to the Secretary of the Treasury information concerning the amounts received (or treated as a rent reduction), the amounts expended on qualified long-term real property, and such other information as the Secretary deems necessary to carry out the provisions of the bill. It is expected that the Secretary, in promulgating such regulations, will attempt to minimize the administrative burdens of taxpayers while ensuring compliance with the bill.

12. Treatment of consolidation of certain mutual savings bank life insurance departments

(sec. 962 of the bill and sec. 594 of the Code)

Present law provides for special treatment of a mutual savings bank conducting a life insurance business in a separate life insurance department (Code sec. 594). Under the special rule, the insurance and noninsurance businesses of such banks are bifurcated, and the tax imposed is the sum of the partial taxes computed on (a) the taxable income of the mutual savings bank determined without regard to items properly allocable to the life insurance business, and (b) the income of the life insurance department, calculated in accordance with the rules applicable to life insurance companies (subchapter L of the Code). This special treatment applies so long as the mutual savings bank is authorized under State law to engage in the business of issuing life insurance contracts, the life insurance business is conducted in a separate department the accounts of which are maintained separately from the other accounts of the mutual savings bank, and the life insurance department would qualify as a life insurance company under Code section 816 if it were treated as a separate corporation.

Rules for corporate reorganizations

Present law provides that certain corporate reorganization transactions, including recapitalizations, generally are treated as tax-free transactions (sec. 368(a)(1)(E)). No gain or loss is recognized if stock or securities in a corporation that is a party to a reorganization are (in pursuance of the plan of reorganization) exchanged solely for stock or securities in that corporation or in another corporation that is a party to the reorganization, except that gain (if any) to the recipient is recognized to the extent the principal amount of securities received exceeds the principal amount of the securities surrendered (secs. 354, 356(a)(1)). If such an exchange has the effect of distribution of a dividend, then the portion of the distributee's gain that does not exceed his ratable share of the corporation's earnings and profits is treated as a dividend (sec. 356(a)(2)).

Rules for life insurance companies

A life insurance company generally is permitted to deduct the amount of policyholder dividends paid or accrued during the taxable year (sec. 808). In the case of a mutual life insurance company, the amount of the deduction for policyholder dividends is reduced (but not below zero) by the differential earnings amount (sec. 809). The term policyholder dividend includes (1) any amount paid or credited (including as an increase in benefits) if the amount is not fixed in the contract but depends on the experience of the company or the discretion of the management; (2) excess interest; (3) premium adjustments; and (4) experience-rated refunds.

13. Offset of past-due, legally enforceable state tax obligations against Federal overpayments

(sec. 963 of the bill and sec. 6402 of the Code)

The Secretary of the Treasury will establish regulations prescribing the time and manner in which States may submit notices of past-due, legally enforceable State tax obligations and may require States to pay a fee to reimburse the Secretary for the cost of applying the offset procedure.

The offset for a past-due, legally enforceable state tax obligation of a state resident will apply after the offsets provided in present law for internal revenue tax liabilities, past-due support, and past-due, legally enforceable obligations owed a Federal agency. The Secretary of the Treasury is authorized to issue regulations establishing procedures for the implementation of this proposal.

14. Exemption of the incremental cost of a clean fuel vehicle from the limits on depreciations for vehicles

(sec. 964 of the bill and sec. 280F of the Code)

15. Exemption from tax upon death of a police officer in the line of duty

(sec. 965 of the bill and new sec. 138 of the Code)

Survivor annuity benefits paid under a governmental retirement plan to a survivor of a law enforcement officer killed in the line of duty are generally includible in income. Amounts contributed to the plan by the officer and previously included in the officer's income would not be includible in the survivor's income.

16. Temporary suspension of taxable income limit on percentage depletion for marginal production

(sec. 966 of the bill and sec. 613A of the Code)

Specific percentage depletion rules apply to oil and gas production from "marginal" properties. Marginal production is defined as domestic crude oil and natural gas production from stripper well property or from property substantially all of the production from which during the calendar year is heavy oil. Stripper well property is property from which the average daily production is 15 barrel equivalents or less, determined by dividing the average daily production of domestic crude oil and domestic natural gas from producing wells on the property for the calendar year by the number of wells.

(sec. 971 of the bill)

Section 971 of the bill reauthorizes Title V of the Trade Act of 1974, as amended (Generalized System of Preferences, "GSP") for two years to expire on May 31, 1999.

2. Temporary suspension of vessel repair duty (shipbuilding)

(sec. 972 of the bill and sec. 466 of the Tariff Act of 1930)

The Committee intends that this provision be considered a temporary, one-time measure to aid ship operators while the Congress continues to try to implement the Shipbuilding Agreement. The Committee strongly supports the Shipbuilding Agreement and hopes that it can be implemented so that it may take effect as soon as possible, with the inclusion at that time of a permanent repeal of the vessel repair duty.

Subtitle H of Title IX provides additional trade benefits to Caribbean Basin Initiative (CBI) countries comparable to tariff and quota treatment under the North American Free Trade Agreement (NAFTA) on products not already eligible for CBI treatment subject to certain conditions and limitations.

1. Findings and policy

(sec. 982 of the bill)

2. Temporary duty and quota treatment provided to partnership countries

(sec. 984 of the bill)

Under NAFTA, imports of these products from Mexico (excluded from CBI and listed above) receive either declining tariff or duty-free and quota-free treatment.

The Subcommittee is aware that questions periodically arise regarding beneficiary countries' adherence to the eligibility criteria under section 212 of the CBERA, as amended. As part of the implementation of this legislation, the Subcommittee expects the President to offer adequate opportunities for interested parties to present information concerning CBERA beneficiaries' adherence to the eligibility criteria.

Under NAFTA, the U.S. may invoke a special safeguard provision at any time during the tariff phase-out period if a NAFTA-origin textile or apparel good is being imported in such increased quantities and under such conditions as to cause "serious damage, or actual threat thereof," to a domestic industry producing a like or directly competitive good. The President is authorized to either suspend further duty reductions or increase the rate of duty to the most-favored-nation rate for up to three years. The NAFTA also provides for a "quantitative restriction" safeguard, which the United States or Mexico may invoke against "non-originating" textile or apparel goods, using the standard of "serious damage, or actual threat thereof."

The bill requires that these amounts be allocated among the seven partnership countries which have the largest volume of textile and apparel exports to the United States, based on a pro rata share of the volume of their textile and apparel exports.

5. Treatment of sugar imports

(sec. 985 of the bill)

The quantity of sugar which may be imported duty-free from Mexico is governed by Section A of Annex 703.2 of the NAFTA. Under NAFTA, access grows over time to unlimited duty-free access for exports of sugar from Mexico beginning in the year 2009.

6. Rum imports

(sec. 986 of the bill)

7. Meeting of Caribbean trade ministers and USTR

(sec. 987 of the bill)

(sec. 1001(a) of the bill and new sec. 1259 of the Code)

The recognition of gain or loss is postponed for open transactions. For example, in the case of a "short sale" (i.e., when a taxpayer sells borrowed property such as stock and closes the sale by returning identical property to the lender), no gain or loss on the transaction is recognized until the closing of the borrowing.

Transactions designed to reduce or eliminate risk of loss on financial assets generally do not cause realization. For example, a taxpayer may lock in gain on securities by entering into a "short sale against the box," i.e., when the taxpayer owns securities that are the same as, or substantially identical to, the securities borrowed and sold short. The form of the transaction is respected for income tax purposes and gain on the substantially identical property is not recognized at the time of the short sale. Pursuant to rules that allow specific identification of securities delivered on a sale, the taxpayer can obtain open transaction treatment by identifying the borrowed securities as the securities delivered. When it is time to close out the borrowing, the taxpayer can choose to deliver either the securities held or newly-purchased securities. The Code provides rules only to prevent taxpayers from using short sales against the box to accelerate loss or to convert short-term capital gain into long-term capital gain or long-term capital loss into short-term capital loss (sec. 1233(b)).

Taxpayers also can lock in gain on certain property by entering into offsetting positions in the same or similar property. Under the straddle rules, when a taxpayer realizes a loss on one offsetting position in actively-traded personal property, the taxpayer generally can deduct this loss only to the extent the loss exceeds the unrecognized gain in the other positions in the straddle. In addition, rules similar to the short sale rules prevent taxpayers from changing the tax character of gains and losses recognized on the offsetting positions in a straddle (sec. 1092).

Taxpayers may engage in other arrangements, such as "futures contracts," "forward contracts," "equity swaps" and other "notional principal contracts" where the risk of loss and opportunity for gain with respect to property are shifted to another party (the "counterparty"). These arrangements do not result in the recognition of gain by the taxpayer.

The Code accelerates the recognition of gains and losses in certain cases. For example, taxpayers are required each year to mark-to-market certain regulated futures contracts, foreign currency contracts, non-equity options, and dealer equity options, and to take any capital gain or loss thereon into account as 40 percent short-term gain and 60 percent long-term gain (sec. 1256).

One of these transactions is the "short sale against the box." In such a transaction, a taxpayer borrows and sells shares identical to the shares the taxpayer holds. By holding two precisely offsetting positions, the taxpayer is insulated from economic fluctuations in the value of the stock. While the short against the box is in place, the taxpayer generally can borrow a substantial portion of the value of the appreciated long stock so that, economically, the transaction strongly resembles a sale of the stock held.

Other transactions that have been used by taxpayers to transfer risk of loss (and opportunity for gain) involve entering into notional principal contracts or futures or forward contracts to deliver the same stock. For example, a taxpayer holding appreciated stock may enter into an "equity swap" which requires the taxpayer to make payments equal to the dividends and any increase in the stock's value for a specified period, and entitles the taxpayer to receive payments equal to any depreciation in value. The terms of such swaps also frequently entitle the shareholder to receive payments during the swap period of a market rate of return (e.g., the Treasury-bill rate) on a notional principal amount equal to the value of the shareholder's appreciated stock, making the transaction strongly resemble a taxable exchange of the appreciated stock for an interest-bearing asset.

The bill requires a taxpayer to recognize gain (but not loss) upon entering into a constructive sale of any appreciated position in stock, a partnership interest or certain debt instruments as if such position were sold, assigned or otherwise terminated at its fair market value on the date of the constructive sale.

If the requirements for a constructive sale are met, the taxpayer would recognize gain in a constructive sale as if the position were sold at its fair market value on the date of the sale and immediately repurchased. Except as provided in Treasury regulations, a constructive sale would generally not be treated as a sale for other Code purposes. An appropriate adjustment in the basis of the appreciated financial position would be made in the amount of any gain realized on a constructive sale, and a new holding period of such position would begin as if the taxpayer had acquired the position on the date of the constructive sale.

A taxpayer is treated as making a constructive sale of an appreciated position when the taxpayer (or, in certain circumstances, a person related to the taxpayer) does one of the following: (1) enters into a short sale of the same property, (2) enters into an offsetting notional principal contract with respect to the same property, or (3) enters into a futures or forward contact to deliver the same property. A constructive sale under any part of the definition occurs if the two positions are in property that, although not the same, is substantially identical. In addition, for a taxpayer that has entered into a short sale, a notional principal contract or a futures or forward contract, the taxpayer is treated as making a constructive sale when it acquires the same property as the underlying property for the position. Finally, to the extent provided in Treasury regulations, a taxpayer is treated as making a constructive sale when it enters into one or more other transactions, or acquires one or more other positions, that have substantially the same effect as any of the transactions described.

The positions of two related persons are treated as together resulting in a constructive sale if the relationship is one described in section 267 or section 707(b) and the transaction is entered into with a view toward avoiding the purposes of the provision.

Whether any part of the constructive sale definition is met by one or more appreciated financial positions and offsetting transactions generally will be determined as of the date the last of such positions or transactions is entered into. More than one appreciated financial position or more than one offsetting transaction can be aggregated to determine whether a constructive sale has occurred. For example, it is possible that no constructive sale would result if one appreciated financial position and one offsetting transaction were considered in isolation, but that a constructive sale would result if the appreciated financial position were considered in combination with two transactions. Where the standard for a constructive sale is met with respect to only a pro rata portion of a taxpayer's appreciated financial position (e.g., some, but not all, shares of stock), that portion would be treated as constructively sold under the provision. If there is a constructive sale of less than all of any type of property held by the taxpayer, the specific property deemed sold would be determined under the rules governing actual sales, after adjusting for previous constructive sales under the bill. Under the regulations to be issued by the Treasury, either a taxpayer's appreciated financial position or its offsetting transaction might in some circumstances be disaggregated on a non-pro rata basis for purposes of the constructive sale determination.

The bill provides an exception from constructive sale treatment for any transaction that is closed before the end of the 30th day after the close of the taxable year in which it was entered into. This exception does not apply, however, where a transaction is closed during the last 60 days of the taxable year or within 30 days thereafter unless (1) the taxpayer holds the appreciated financial position to which the transaction relates (e.g., the stock where the offsetting transaction is a short sale) throughout the 60-day period beginning on the date the transaction is closed and (2) at no time during such 60-day period is the taxpayer's risk of loss reduced (under the principles of section 246(c)(4)) by holding positions with respect to substantially similar or related property.

A transaction that has resulted in a constructive sale of an appreciated financial position (e.g., a short sale) is not be treated as resulting in a constructive sale of another appreciated financial position so long as the taxpayer holds the position which was treated as constructively sold. However, when that position is assigned, terminated or disposed of by the taxpayer, the taxpayer immediately thereafter is treated as entering into the transaction that resulted in the constructive sale (e.g., the short sale) if it remains open at that time. Thus, the transaction can cause a constructive sale of another appreciated financial position at any time thereafter. For example, assume a taxpayer holds two stock positions and one offsetting short sale, and the taxpayer identifies the short sale as offsetting one of the stock positions. If the taxpayer then sells the stock position that was identified, the identified short position would cause a constructive sale of the taxpayer's other stock position at that time.

Definitions

An appreciated financial position is defined as any position with respect to any stock, debt instrument, or partnership interest, if there would be gain upon a taxable disposition of the position for its fair market value. A "position" is defined as an interest, including a futures or forward contract, short sale, or option. An exception is provided for debt instruments the interest on which is not contingent on profits, the borrower's discretion, or similar factors and which are not convertible, directly or indirectly, into stock. Other debt instruments, including those identified as part of a hedging or straddle transaction, are appreciated financial positions.

A notional principal contract is treated as an offsetting notional principal contract, and thus, results in a constructive sale of an appreciated financial position, if it requires the holder of the appreciated financial position to pay (or provide a contractual credit for) all or substantially all of the investment yield and appreciation on the position for a specified period and also gives the holder a right to be reimbursed for (or receive credit for) all or substantially all of any decline in value of the position.

A forward contract results in a constructive sale of an appreciated financial position only if the forward contract provides for delivery of a substantially fixed amount of property and a substantially fixed price. Thus, a forward contract providing for delivery of an amount of property, such as shares of stock, that is subject to significant variation under the contract terms does not result in a constructive sale.

A constructive sale does not include a transaction involving an appreciated financial position that is marked to market, including positions governed by section 475 (mark-to-market for securities dealers) or section 1256 (mark-to-market for futures contracts, options and currency contracts). Nor does a constructive sale include any contract for sale of an appreciated financial position which is not a "marketable security" (as defined in section 453(f))) if the contract settles within one year after the date it is entered into.

Treasury guidance

The provision provides regulatory authority to the Treasury to treat as constructive sales certain transactions that have substantially the same effect as those specified (i.e., short sales, offsetting notional principal contracts and futures or forward contracts to deliver the same or substantially similar property). Under section 7805(b)(2), the Treasury generally is prohibited from issuing regulations that are retroactive, unless such regulations are issued within 18 months of the date of enactment of the provision.

It is anticipated that the Treasury will use the provision's authority to treat as constructive sales other financial transactions that, like those specified in the provision, have the effect of eliminating substantially all of the taxpayer's risk of loss and opportunity for income or gain with respect to the appreciated financial position. Because this standard requires reduction of both risk of loss and opportunity for gain, it is intended that transactions that reduce only risk of loss or only opportunity for gain will not be covered. Thus, for example, it is not intended that a taxpayer who holds an appreciated financial position in stock will be treated as having made a constructive sale when the taxpayer enters into a put option with an exercise price equal to the current market price (an "at the money" option). Because such an option reduces only the taxpayer's risk of loss, and not its not be met.

For purposes of the provision, it is not intended that risk of loss and opportunity for gain be considered separately. Thus, if a transaction has the effect of eliminating a portion of the taxpayer's risk of loss and a portion of the taxpayer's opportunity for gain with respect to an appreciated financial position which, taken together, are substantially all of the taxpayer's risk of loss and opportunity for gain, it is intended that Treasury regulations will treat this transaction as a constructive sale of the position.

It is anticipated that the Treasury regulations, when issued, will provide specific standards for determining whether several common transactions will be treated as constructive sales. One such transaction is a "collar". In a collar, a taxpayer commits to an option requiring him to sell a financial position at a fixed price (the "call strike price") and has the right to have his position purchased at a lower fixed price (the "put strike price"). For example, a shareholder may enter into a collar for a stock currently trading at $100 with a put strike price of $95 and a call strike price of $110. The effect of the transaction is that the seller has transferred the rights to all gain above the $110 call strike price and all loss below the $95 put strike price; the seller has retained all risk of loss and opportunity for gain in the range price between $95 and $110. A collar can be a single contract or can be effected by using a combination of put and call options.

In order to determine whether collars have substantially the same effect as the transactions specified in the provision, it is anticipated that Treasury regulations will provide specific standards that take into account various factors with respect to the appreciated financial position, including its volatility. Similarly, it is expected that several aspects of the collar transaction will be relevant, including the spread between the put and call prices, the period of the transaction, and the extent to which the taxpayer retains the right to periodic payments on the appreciated financial position (e.g., the dividends on collared stock).

Another common transaction for which a specific regulatory standard may be appropriate is a so-called "in-the-money" option, i.e., a put option where the strike price is significantly above the current market price or a call option where the strike price is significantly below the current market price. For example, if a shareholder purchases a put option exercisable at a future date (a so-called "European" option) with a strike price of $120 with respect to stock currently trading at $100, the shareholder has eliminated all risk of loss on the position for the option period and assured himself of all yield and gain on the stock for any appreciation up to $120. In determining whether such a transaction will be treated as a constructive sale, it is anticipated that Treasury regulations will provide a specific standard that takes into account many of the factors described above with respect to collars, including the yield and volatility of the stock and the period and other terms of the option.

For collars, options and some other transactions, one approach that Treasury might take in issuing regulations is to rely on option prices and option pricing models. The price of an option represents the payment the market requires to eliminate risk of loss (for a put option) and to purchase the right to receive yield and gain (for a call option). Thus, option pricing offers one model for quantifying both the total risk of loss and opportunity for gain with respect to an appreciated financial position, as well as the proportions of these total amounts that the taxpayer has retained.

In addition to setting specific standards for treatment of these and other transactions, it may be appropriate for Treasury regulations to establish "safe harbor" rules for common financial transactions that do not result in constructive sale treatment. An example might be a collar with a sufficient spread between the put and call prices, a sufficiently limited period and other relevant terms such that, regardless of the particular characteristics of the stock, the collar probably would not transfer substantially all risk of loss and opportunity for gain.

In the case of a decedent dying after June 8, 1997, if (1) a constructive sale of an appreciated financial position (as defined in the proposal) occurred before such date, (2) the transaction remains open for not less than two years, and (3) the transaction is not closed in a taxable transaction within 30 days after the date of enactment, such position (and any property related to it, under principles of the provision) will be treated as property constituting rights to receive income in respect of a decedent under section 691.

2. Election of mark-to-market for securities traders and for traders and dealers in commodities

(sec. 1001(b) of the bill and new sec. 475(d) of the Code)

Traders in securities generally are taxpayers who engage in a trade or business involving active sales or exchanges of securities on the market, rather than to customers. The mark-to-market treatment applicable to securities dealers does not apply to traders in securities or to dealers in other property.

With respect to a commodities dealer, all of the provisions of present law section 475 apply as if commodities were securities. Commodities for purposes of the provision would include only commodities of a kind customarily dealt in on an organized commodities exchange. It is anticipated that Treasury regulations will provide that section 475(c)(4), which prevents a dealer from treating certain notional principal contracts and other derivative financial instruments as held for investment, will apply only to contacts and instruments referenced to commodities in the case of a commodities dealer.

For securities traders, some of the provisions of present law section 475 apply, but others that are specific to dealers do not. For example, because a securities trader does not hold inventory, the mark-to-market rules for inventory are not applicable to traders. In addition, securities that are not held in connection with the trade or business of a securities trader are excluded from mark-to-market treatment if the trader identifies the securities in the trader's records before the close of the day on which they are acquired under rules similar to those of section 475(b)(2) for dealers. The provisions applicable to securities traders apply to commodities traders as if commodities were securities.

The election is to be made separately with respect to the taxpayer's entire business as (1) a securities trader, (2) a commodities trader, or (3) a commodities dealer. Thus, a taxpayer that is both a commodities dealer and a securities trader may make the election with respect to one business, but not the other. The election will be made in the time and manner prescribed by the Secretary of the Treasury and will be effective for the taxable year for which it is made and all subsequent taxable years, unless revoked with the consent of the Secretary.

For elections made for the first taxable year ending after the date of enactment, the taxpayer must identify the securities or commodities to which the election will apply within 30 days of the date of enactment.

3. Limitation on exception for investment companies under section 351

(sec. 1002 of the bill and sec. 351(e) of the Code)

Certain Code sections provide exceptions to the general rule for deferral of pre-contribution gain and loss. Gain or loss is recognized upon a contribution by a shareholder to a corporation that is an investment company (sec. 351(e)(1)). Gain, but not loss, is recognized upon a contribution by a partner to a partnership that would be treated as an investment company if the partnership were a corporation (sec. 721(b)). Under Treasury regulations, a contribution of property by a shareholder to a corporation, or by a partner to a partnership, is treated as a transfer to an investment company only if (1) the contribution results, directly or indirectly, in a diversification of the transferor's interests, and (2) the transferee is (a) a regulated investment company ("RIC"), (b) a real estate investment trust ("REIT"), or (c) a corporation more than 80 percent of the assets of which by value (excluding cash and non-convertible debt instruments) are readily marketable stocks or securities or interests in RICs or REITs that are held for investment (Treas. reg. sec. 1.351-1(c)(1)).

Under the bill, an investment company includes a RIC or REIT as under present law. In addition, under the bill, an investment company includes any corporation or partnership if more than 80 percent of its assets by value consist of money, financial instruments, foreign currency, interests in REITs, RICs, common trust funds and publicly-traded partnerships, and certain interests in precious metals and entities that hold the above-listed items.⁷³ In addition, the bill grants regulatory authority to the Treasury to add other assets to the list set out in the provision.

The bill is intended to change only the types of assets considered in the definition of an investment company in the present Treasury regulations (Treas. reg. sec. 1.351-1(c)(1)(ii)) and not to override the other provisions of those regulations. For example, the bill does not override (1) the requirement that only assets held for investment are considered for purposes of the definition (Treas. reg. sec. 1.351-1(c)(3)), (2) the rule treating the assets of a subsidiary as owned proportionally by a parent owning 50 percent or more of its stock (Treas. reg. sec. 1.351-1(c)(4)), (3) the requirement that the investment company determination consider any plan with regard to an entity's assets in existence at the time of transfer (Treas. reg. sec. 1.351-1(c)(2)), and (4) the requirement that a contribution of property to an investment company result in diversification in order for gain to be recognized (Treas. reg. sec. 1.351-1(c)(1)(i)).

4. Disallowance of interest on indebtedness allocable to tax-exempt obligations

(sec. 1003 of the bill and sec. 265 of the Code)

Present law disallows a deduction for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is not subject to tax (tax-exempt obligations) (sec. 265). This rule applies to tax-exempt obligations held by individual and corporate taxpayers. The rule also applies to certain cases in which a taxpayer incurs or continues indebtedness and a related person acquires or holds tax-exempt obligations.⁷⁴

^{Application to non-financial corporations}

This purpose may be established either by direct or circumstantial evidence. Direct evidence of a purpose to purchase tax-exempt obligations exists when the proceeds of indebtedness are directly traceable to the purchase of tax-exempt obligations or when such obligations are used as collateral for indebtedness. In the absence of direct evidence, a deduction is disallowed only if the totality of facts and circumstances establishes a sufficiently direct relationship between the borrowing and the investment in tax-exempt obligations.

^{Application to financial corporations and dealers in tax-exempt obligations}

^{In the case of a financial institution, the allocation of the interest expense of the financial institution (which is not otherwise allocable to tax-exempt obligations) is based on the ratio of the average adjusted basis of the tax-exempt obligations acquired after August 7, 1987, to the average adjusted basis of all assets of the taxpayer (sec. 265). In the case of an obligation of an issuer which reasonably anticipates to issue not more than $10 million of tax-exempt obligations (other than certain private activity bonds) within a calendar year (the "small issuer exception"), only 20 percent of the interest allocable to such tax-exempt obligations is disallowed (sec. 291(a)(3)). A similar pro rata rule applies to dealers in tax-exempt obligations, but there is no small issuer exception, and the 20-percent disallowance rule does not apply (Rev. Proc. 72-18).}

^{Treatment of insurance companies}

^{Present law provides that a life insurance company's deduction for additions to reserves is reduced by a portion of the company's income that is not subject to tax (generally, tax-exempt interest and deductible intercorporate dividends) (secs. 807 and 812). The portion by which the life insurance company's reserve deduction is reduced is related to its earnings rate. Similarly, in the case of property and casualty insurance companies, the deduction for losses incurred is reduced by a percentage (15 percent) of (1) the insurer's tax-exempt interest and (2) the deductible portion of dividends received (with special rules for dividends from affiliates) (sec. 832(b)(5)(B)). If the amount of this reduction exceeds the amount otherwise deductible as losses incurred, the excess is includible in the property and casualty insurer's income.}

The bill extends to all corporations (other than insurance companies) the rule that applies to financial institutions that disallows interest deductions of a taxpayer (that are not otherwise disallowed as allocable under present law to tax-exempt obligations) in the same proportion as the average basis of its tax-exempt obligations bears to the average basis of all of the taxpayer's assets. However, the bill does not extend the small-issuer exception to taxpayers which are not financial institutions.

Exceptions

The provision does not apply to nonsalable tax-exempt debt acquired by a corporation in the ordinary course of business in payment for goods or services sold to a State or local government. In addition, the bill provides a de minimis exception under which the disallowance rule does not apply to corporations, other than financial institutions and dealers in tax-exempt obligations, if the average adjusted basis of tax exempt obligations acquired after August 7, 1986, is less than the lesser of $1 million or 2 percent of the basis of all of the corporation's assets. Under the bill, insurance companies are not subject to the pro rata rule but would continue to be subject to present law.

Holdings by related persons

The provision applies the interest disallowance provision to all related persons that are members of the same consolidated group as if all the members of the group were a single taxpayer. The consolidated group rule is to be applied without regard to any member that is an insurance company. In the case of affiliated corporations that are not members of the same consolidated group, tracing rules apply as if all of the related persons are a single entity

In the case of a corporation (other than a financial institution) that is a partner in a partnership, the corporate partners are treated as holding their allocable shares of all of the assets of the partnership.

The provision is not intended to affect the application of section 265 to related parties under current law.

5. Gains and losses from certain terminations with respect to property

(sec. 1004 of the bill and sec. 1234A of the Code)

Gain from the "sale or other disposition" is the excess of the amount realized therefrom over its adjusted basis; loss is the excess of adjusted basis over the amount realized. The definition of capital gains and losses in section 1222 requires that there be a "sale or exchange" of a capital asset.⁷⁶ The U.S. Supreme Court has held that the term "sale or exchange" is a narrower term than "sale or other disposition."⁷⁷ Thus, it is possible from there to be a taxable income from the sale or other disposition of an asset without that gain being treated as a capital gain.

Treatment of capital gains and losses

Long-term capital gains of individuals are subject to a maximum rate of tax of 28 percent.⁷⁸ Capital losses of individuals are allowed to the extent of capital gains or the lower of those gains or $3,000.

Long-term capital gains of corporations are subject to the same rate of tax as ordinary income.⁷⁹ Capital losses of corporations are allowed only to the extent of the corporation's capital gains; excess capital losses may be carried back to the 3 preceding years and carried forward for the succeeding years.

In the case of gains and losses from the sale or exchange of property used in a trade or business, net gains generally are treated as capital gain while net losses are treated as ordinary losses (sec. 1231).

Court decisions interpreting the "sale or exchange" requirement

There has been a considerable amount of litigation dealing with whether modifications of legal relationships between taxpayers is be treated as a "sale or exchange." For example, in Douglass Fairbanks v. U.S., 306 U.S. 436 (1939), the U.S. Supreme Court held that gain realized on the redemption of bonds before their maturity is not entitled to capital gain treatment because the redemption was not a "sale or exchange".⁸⁰ Several court decisions interpreted the "sale or exchange" requirement to mean that a disposition, that occurs as a result of a lapse, cancellation, or abandonment, is not a sale or exchange of a capital asset, but produces ordinary income or loss. For example, in Commissioner v. Pittston Co., 252 F. 2d 344 (2d Cir), cert. denied, 357 U.S. 919 (1958), the taxpayer was treated as receiving ordinary income from amounts received for acquisition from the mine owner of a contract that the taxpayer had made with mine owner to buy all of the coal mined at a particular mine for a period of 10 years on the grounds that the payments were in lieu of subsequent profits that would have been taxed as ordinary income. Similarly, Commissioner v. Starr Brothers, 205 F. 2d 673 (1953), the Second Circuit held that a payment that a retail distributor received from a manufacturer in exchange for waiving a contract provision prohibiting the manufacturer from selling to the distributor's competition was not a sale or exchange. Likewise, in General Artists Corp. v Commissioner, 205 F. 2d 360, cert. denied 346 U.S. 866 (1953), the Second Circuit held that amounts received by a booking agent for cancellation of a contract to be the exclusive agent of a singer was not a sale or exchange. In National-Standard Company v. Commissioner, 749 F. 2d 369, the Sixth Circuit held that a loss incurred the transfer of foreign currency to discharge the taxpayer's liability was an ordinary loss, since transfer was not a "sale or exchange" of that currency. More recently, in Stoller v. Commissioner, 994 F. 2d 855, 93-1 U.S.T.C. par. 50349 (1993), the Court of Appeals for the District of Columbia held, in a transaction that preceded the effective date of section 1234A, that losses incurred on the cancellation of forward contracts to buy and sell short-term Government securities that formed a straddle were ordinary because the cancellation of the contracts was not a "sale or exchange."

Extinguishment treated as sale or exchange

The Internal Revenue Code contains provisions that deem certain transactions to be a sale or exchange and, therefore, any resulting gain or loss is to be treated as a capital gain or loss. These rules generally provide for "sale or exchange" treatment as a way of extending capital gain or loss treatment of those transactions. Under one special provision, gains and losses attributable to the cancellation, lapse, expiration, or other termination of a right or obligation with respect to certain personal property are treated as gains or losses from the sale of a capital asset (sec. 1234A). Personal property subject to this rule is (1) personal property of a type which is actively traded⁸¹ and which is, or would be on acquisition, a capital asset in the hands of the taxpayer (other than stock that is not part of straddle or of a corporation that is not formed or availed of to take positions which offset positions in personal property of its shareholders) and (2) a "section 1256 contract"⁸² which is capital asset in the hands of the taxpayer.⁸³ Section 1234A does not apply to the retirement of a debt instrument.

Retirement of debt obligations treated as sale or exchange

Amounts received on the retirement of any debt instrument are treated as amounts received in exchange therefor (sec. 1271(a)(1)). In addition, gain on the sale or exchange of a debt instrument with OID⁸⁴ generally is treated as ordinary income to the extent of its OID if there was an intention at the time of its issuance to call the debt instrument before maturity (sec. 1271(a)(2)). These rules do not apply to (1) debt issued by a natural person or (2) debt issued before July 2, 1982, by a noncorporate or nongovernment issuer. As a result of this exemption, the character of gain or loss realized on retirement of an obligation issued by a natural person under present law is governed by case law.

In general, the Committee believes that present law is deficient since it (1) taxes similar economic transactions differently, (2) effectively provides some, but not all, taxpayers with an election, and (3) its lack of certainty makes the tax laws unnecessarily difficult to administer.

The Committee believes that some transactions, such as settlements of contracts to deliver a capital asset, are economically equivalent to a sale or exchange of such contracts since the value of any asset is the present value of the future income that such asset will produce. In addition, to the extent that present law treats modifications of property rights as not being a sale or exchange, present law effectively provides, in many cases, taxpayers with an election to treat the transaction as giving rise to capital gain, subject to more favorable rates than ordinary income, or an ordinary loss that can offset higher-taxed ordinary income and not be subject to limitations on use of capital losses. The effect of an election can be achieved by selling the property right if the resulting transaction results in a gain or providing for the extinguishment of the property right if the resulting transaction results in a loss.

Courts have given different answers as to whether transactions which terminate contractual interests are treated as a "sale or exchange." This lack of uniformity has caused uncertainty to both taxpayers and the Internal Revenue Service in the administration of the tax laws.

Accordingly, the Committee bill treats the cancellation, lapse, expiration, or other termination of a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer to all types of property as a "sale or exchange." A major effect of the Committee bill would be to remove the effective ability of a taxpayer to elect the character of gains and losses from certain transactions. Another significant effect of the Committee bill would be to reduce the uncertainty concerning the tax treatment of modifications of property rights.

Character of gain on retirement of debt obligations issued by natural persons

Similar objections can be raised about the rule which exempts debt of natural persons from the deemed sale or exchange rule applicable to debt of other taxpayers. The Committee believes that the debt of natural persons and other taxpayers is sufficiently economically similar to be similarly taxed upon their retirement. Accordingly, the Committee believes that the exception to the deemed sale or exchange rule on retirement of debt of a natural person should be repealed.

The bill extends to all types of property the rule which treats gain or loss from the cancellation, lapse, expiration, or other termination of a right or obligation with respect to property which is (or on acquisition would be) a capital asset in the hands of the taxpayer.

By definition, the extension of the "sale or exchange rule" of present law section 1234A to all property will only affect property that is not personal property which is actively traded on an established exchange. Thus, the Committee bill is will apply to (1) interests in real property and (2) non-actively traded personal property. An example of the first type of property interest that will be affected by the Committee bill is the tax treatment of amounts received to release a lessee from a requirement that the premise be restored on termination of the lease.⁸⁵ An example of the second type of property interest that is affected by the Committee bill is the forfeiture of a down payment under a contract to purchase stock.⁸⁶ The Committee bill does not affect whether a right is "property" or whether property is a "capital asset."

Character of gain or loss on retirement of debt obligations issued by natural persons

The Committee bill repeals the provision that exempts debt obligations issued by natural persons from the rule which treats gain or loss realized on retirement of the debt as gain or loss realized on an exchange. Thus, under the bill, gain or loss on the retirement of such debt will be capital gain or loss. The provision retains the present-law exceptions for debt issued before July 2, 1982, by noncorporations or nongovernments.

The extension of the extinguishment rule applies to property acquired or positions established 30 day after the date of enactment of the provision.

Character of gain or loss on retirement of debt obligations issued by natural persons

The repeal of the exception to the character of gain on retirement of debt instruments issued by natural persons or obligations issued before July 2, 1982, applies to purchases and debt issued 30 days after date of enactment of the provision.

6. Determination of original issue discount where pooled debt obligations subject to acceleration

(sec. 1005 of the bill and sec. 1272 of the Code)

A taxpayer generally must include in gross income the amount of interest received or accrued within the taxable year on indebtedness held by the taxpayer. If the principal amount of an indebtedness may be paid without interest by a specified date (as is the case with certain credit card balances), under present law, the holder of the indebtedness is not required to accrue interest until after the specified date has passed.

Original issue discount

The holder of a debt instrument with original issue discount ("OID") generally accrues and includes in gross income, as interest, the OID over the life of the obligation, even though the amount of the interest may not be received until the maturity of the instrument.

The amount of OID with respect to a debt instrument is the excess of the stated redemption price at maturity over the issue price of the debt instrument. The stated redemption price at maturity includes all amounts payable at maturity. The amount of OID in a debt instrument is allocated over the life of the instrument through a series of adjustments to the issue price for each accrual period. The adjustment to the issue price is determined by multiplying the adjusted issue price (i.e., the issue price increased by adjustments prior to the accrual period) by the instrument's yield to maturity, and then subtracting the interest payable during the accrual period. Thus, in order to compute the amount of OID and the portion of OID allocable to a period, the stated redemption price at maturity and the time of maturity must be known. Issuers of OID instruments accrue and deduct the amount of OID as interest expense in the same manner as the holder.

Special rules for determining the amount of OID allocated to a period apply to certain instruments that may be subject to prepayment. First, if a borrower can reduce the yield on a debt by exercising a prepayment option, the OID rules assume that (1) any regular interest in a REMIC, (2) qualified mortgages held by a REMIC, or (3) any other debt instrument if payments under the instrument may be accelerated by reason of prepayments of other obligations securing the instrument, the daily portions of the OID on such debt instruments are determined by taking into account an assumption regarding the prepayment of principal for such instruments.

The bill operates as follows. Assume that a calendar year taxpayer issues credit cards, the terms of which provide that if charges for a calendar month are paid within 30 days after the close of the month, no interest will accrue with respect to such charges. However, if the balances are not paid within this 30-day grace period, interest will accrue from the date of the charge until the balance is paid. Further assume that the taxpayer issues a significant number of such credit cards and the card holders incur charges of $10 million in December 1997. Under present law (depending upon the taxpayer's accounting method), the taxpayer is not required to include any interest income in 1997 with respect to the December charges because it is possible that all the credit card holders will pay off the $10 million cumulative December balance by January 30, 1998, and therefore will not be subject to interest with respect to such charges. If some of the credit card holders do not pay their December charges by January 30, 1998, the balances of those holders will be subject to interest charges under the terms of the credit cards and the taxpayer would accrue such interest in income in 1998. Under the bill, the taxpayer, in computing its 1997 taxable income, would be required to make a reasonable assumption as to what portion of the $10 million balances will not be paid off within the 30-day grace period and would be required to accrue interest income through December 31, 1997, with respect to such portion. The taxpayer would then adjust such accrual in 1998 to reflect the extent to which such prepayment assumption reflected the actual payments received in January.

In addition, the Secretary of the Treasury is authorized to provide appropriate exemptions from the provision, including exemptions for taxpayers that hold a limited amount of debt instruments, such as small retailers.

7. Deny interest deduction on certain debt instruments

(sec. 1006 of the bill and sec. 163 of the Code)

Original issue discount ("OID") on a debt instrument is the excess of the stated redemption price at maturity over the issue price of the instrument. An issuer of a debt instrument with OID generally accrues and deducts the discount as interest over the life of the instrument even though interest may not be paid until the instrument matures. The holder of such a debt instrument also generally includes the OID in income on an accrual basis.

The bill is not intended to affect the characterization of instruments as debt or equity under present law; and no inference is intended as to the treatment of any instrument under present law.

(sec. 1011 of the bill and sec. 1059 of the Code)

Section 1059 of the Code requires a corporate shareholder that receives an "extraordinary dividend" to reduce the basis of the stock with respect to which the dividend was received by the nontaxed portion of the dividend. Whether a dividend is "extraordinary" is determined, among other things, by reference to the size of the dividend in relation to the adjusted basis of the shareholder's stock. Also, a dividend resulting from a non pro rata redemption or a partial liquidation is an extraordinary dividend. If the reduction in basis of stock exceeds the basis in the stock with respect to which an extraordinary dividend is received, the excess is taxed as gain on the sale or disposition of such stock, but not until that time (sec. 1059(a)(2)). The reduction in basis for this purpose occurs immediately before any sale or disposition of the stock (sec. 1059(d)(1)(A)). The Treasury Department has general regulatory authority to carry out the purposes of the section.

Except as provided in regulations, the extraordinary dividend provisions do not apply to result in a double reduction in basis in the case of distributions between members of an affiliated group filing consolidated returns, where the dividend is eliminated or excluded under the consolidated return regulations. Double inclusion of earnings and profits (i.e., from both the dividend and from gain on the disposition of stock with a reduced basis) also should generally be prevented.⁸⁷ Treasury regulations provide for application of the provision when a corporation is a partner in a partnership that receives a distribution.⁸⁸

^{In general, a distribution in redemption of stock is treated as a dividend, rather than as a sale of the stock, if it is essentially equivalent to a dividend (sec. 302). A redemption of the stock of a shareholder generally is essentially equivalent to a dividend if it does not result in a meaningful reduction in the shareholder's proportionate interest in the distributing corporation. Section 302(b) also contains several specific tests (e.g., a substantial reduction computation and a termination test) to identify redemptions that are not essentially equivalent to dividends. The determination whether a redemption is essentially equivalent to a dividend includes reference to the constructive ownership rules of section 318, including the option attribution rules of section 318(a)(4). The rules relating to treatment of cash or other property received in a reorganization contain a similar reference (sec. 356(a)(2)).}

Even in the absence of options, the present law rules dealing with extraordinary dividends may permit inappropriate deferral of gain recognition when the portion of the distribution that is excluded due to the dividends received deduction exceeds the basis of the stock with respect to which the extraordinary dividend is received.

^{In addition, the bill requires immediate gain recognition whenever the basis of stock with respect to which any extraordinary dividend was received is reduced below zero. The reduction in basis of stock would be treated as occurring at the beginning of the ex-dividend date of the extraordinary dividend to which the reduction relates.}

^{Reorganizations or other exchanges involving amounts that are treated as dividends under section 356 of the Code are treated as redemptions for purposes of applying the rules relating to redemptions under section 1059(e). For example, if a recapitalization or other transaction that involves a dividend under section 356 has the effect of a non pro rata redemption or is treated as a dividend due to options being counted as stock, the rules of section 1059 apply. Redemptions of shares, or other extraordinary dividends on shares, held by a partnership will be subject to section 1059 to the extent there are corporate partners (e.g., appropriate adjustments to the basis of the shares held by the partnership and to the basis of the corporate partner's partnership interest will be required).}

^{Under continuing section 1059(g) of present law, the Treasury Department is authorized to issue regulations where necessary to carry out the purposes and prevent the avoidance of the provision.}

No inference is intended regarding the tax treatment under present law of any transaction within the scope of the provision, including transactions utilizing options.

In addition, no inference is intended regarding the rules under present law (or in any case where the treatment is not specified in the provision) for determining the shares of stock with respect to which a dividend is received or that experience a basis reduction.

2. Require gain recognition on certain distributions of controlled corporation stock

(sec. 1012 of the bill and secs. 355, 351(c), and 368(a)(2)(H) of the Code)

In cases where the form of the transaction involves a contribution of assets to the particular controlled corporation that is distributed in connection with the distribution, there are specific Code requirements that distributing corporation's shareholders own "control" of the distributed corporation immediately after the distribution. Control is defined for this purpose as 80 percent of the voting power of all classes of stock entitled to vote and 80 percent of each other class of stock. (Sections 368(a)(1)(D), 368(c), and 351(a) and (c)). In addition, it is a requirement for qualification of any section 355 distribution that the distributing corporation distribute control of the controlled corporation (defined by reference to the same 80-percent test).⁹² Present law has the effect of imposing more restrictive requirements on certain types of acquisitions or other transfers following a distribution if the company involved is the controlled corporation rather than the distributing corporation.

The Committee is also concerned that spin-off transactions within a single corporate group can have the effect of avoiding other present law rules that create or recapture excess loss accounts in affiliated groups filing consolidated returns.⁹³ Such intra-group distributions can also generally have the effect of permitting possibly inappropriate basis increases (or preventing basis decreases) following a distribution, due to the differences between the basis allocation rules that govern spin-offs and those that apply to other distributions.

However, the Committee believes that the difference in treatment of certain transactions following a spin-off, depending upon whether the distributing or controlled corporation engages in the transaction, should be minimized.

Under the bill, if, pursuant to a plan or arrangement in existence on the date of distribution, either the controlled or distributing corporation is acquired, gain is recognized by the other corporation as of the date of the distribution.

In the case of an acquisition of a controlled corporation, the amount of gain recognized by the distributing corporation is the amount of gain that the distributing corporation would have recognized had stock of the controlled corporation been sold for fair market value on the date of distribution. In the case of an acquisition of the distributing corporation, the amount of gain recognized by the controlled corporation is the amount of net gain that the distributing corporation would have recognized had it sold its assets for fair market value immediately after the distribution. This gain is treated as long-term capital gain. No adjustment to the basis of the stock or assets of either corporation is allowed by reason of the recognition of the gain.

Whether a corporation is acquired is determined under rules similar to those of present law section 355(d), except that acquisitions would not be restricted to "purchase" transactions. Thus, an acquisition occurs if one or more persons acquire 50 percent or more of the vote or value of the stock of the controlled or distributing corporation pursuant to a plan or arrangement. For example, assume a corporation ("P") distributes the stock of its wholly owned subsidiary ("S") to its shareholders. If, pursuant to a plan or arrangement, 50 percent or more of the vote or value of either P or S is acquired by one or more persons, the bill proposal requires gain recognition by the corporation not acquired. Except as provided in Treasury regulations, if the assets of the distributing or controlled corporation are acquired by a successor in a merger or other transaction under section 368(a)(1)(A), (C) or (D) of the Code, the shareholders (immediately before the acquisition) of the corporation acquiring such assets are treated as acquiring stock in the corporation from which the assets were acquired. Under Treasury regulations, other asset transfers also could be subject to this rule. However, in any transaction, stock received directly or indirectly by former shareholders of distributing or controlled, in a successor or new controlling corporation of either, is not be treated as acquired stock if it is attributable to such shareholders' stock in distributing or controlled that was not acquired as part of a plan or arrangement to acquire 50 percent or more of such successor or other corporation.

Acquisitions occurring within the four-year period beginning two years before the date of distribution are presumed to have occurred pursuant to a plan or arrangement. Taxpayers can avoid gain recognition by showing that an acquisition occurring during this four-year period was unrelated to the distribution.

The bill does not apply to distributions that would otherwise be subject to section 355(d) of present law, which imposes corporate level tax on certain disqualified distributions.

The bill does not apply to a distribution pursuant to a title 11 or similar case.

The Treasury Department is authorized to prescribe regulations as necessary to carry out the purposes of the proposal, including regulations to provide for the application of the proposal in the case of multiple transactions.

Except as provided in regulations, in the case of distributions of stock within an affiliated group of corporations filing a consolidated return, section 355 does not apply to any distribution of the stock of one member of the group to another member. In the case of such a distribution of stock, the Secretary of the Treasury is to provide appropriate rules for the treatment of the distribution, including rules governing adjustments to the adjusted basis of the stock and the earnings and profits of the members of the group.

The bill also modifies certain rules for determining control immediately after a distribution in the case of certain divisive transactions in which a controlled corporation is distributed and the transaction meets the requirements of section 355. In such cases, under section 351 and modified section 368(a)(2)(H) with respect to certain reorganizations under section 368(a)(1)(D), those shareholders receiving stock in the distributed corporation are treated as in control of the distributed corporation immediately after the distribution if they hold stock representing a 50 percent or greater interest in the vote and value of stock of the distributed corporation.

The bill does not change the present-law requirement under section 355 that the distributing corporation must distribute 80 percent of the voting power and 80 percent of each other class of stock of the controlled corporation. It is expected that this requirement will be applied by the Internal Revenue Service taking account of the provisions of the proposal regarding plans that permit certain types of planned restructuring of the distributing corporation following the distribution, and to treat similar restructurings of the controlled corporation in a similar manner. Thus, the 80-percent control requirement is expected to be administered in a manner that would prevent the tax-free spin-off of a less-than-80-percent controlled subsidiary, but would not generally impose additional restrictions on post-distribution restructurings of the controlled corporation if such restrictions would not apply to the distributing corporation.

No part of the bill will apply to a distribution (or transfer, as the case may be) after April 16, 1997, if such distribution or transfer is (1) made pursuant to a written agreement which was binding on such date and at all times thereafter; (2) described in a ruling request submitted to the Internal Revenue Service on or before such date; or (3) described on or before such date in a public announcement or in a filing with the Securities and Exchange Commission required solely by reason of the distribution. Any written agreement, ruling request, or public announcement is not within the scope of these transition provisions unless it identifies the unrelated acquiror of the distributing corporation or of any controlled corporation, whichever is applicable.

3. Reform tax treatment of certain corporate stock transfers

(sec. 1013 of the bill and secs. 304 and 1059 of the Code)

Section 1059 applies to "extraordinary dividends," including certain redemption transactions treated as dividends qualifying for the dividends received deduction. If a redemption results in an extraordinary dividend, section 1059 generally requires the shareholder to reduce its basis in the stock of the redeeming corporation by the nontaxed portion of such dividend.

Under the bill, a special rule applies to section 304 transactions involving acquisitions by foreign corporations. The bill limits the earnings and profits of the acquiring foreign corporation that are taken into account in applying section 304. The earnings and profits of the acquiring foreign corporation to be taken into account will not exceed the portion of such earnings and profits that (1) is attributable to stock of such acquiring corporation held by a corporation or individual who is the transferor (or a person related thereto) and who is a U.S. shareholder (within the meaning of sec, 951(b)) of such corporation, and (2) was accumulated during periods in which such stock was owned by such person while such acquiring corporation was a controlled foreign corporation. For purposes of this rule, except as otherwise provided by the Secretary of the Treasury, the rules of section 1248(d) (relating to certain exclusions from earnings and profits) would apply. The Secretary of the Treasury is to prescribe regulations as appropriate, including regulations determining the earnings e to particular stock of the acquiring corporation.

No inference is intended as to the treatment of any transaction under present law.

4. Modify holding period for dividends-received deduction

(sec. 1014 of the bill and sec. 246(c) of the Code)

The dividends-received deduction is allowed to a corporate shareholder only if the shareholder satisfies a 46-day holding period for the dividend-paying stock (or a 91-day period for certain dividends on preferred stock). The 46- or 91-day holding period generally does not include any time in which the shareholder is protected from the risk of loss otherwise inherent in the ownership of an equity interest. The holding period must be satisfied only once, rather than with respect to each dividend received.

The Committee believes that no deduction for a distribution on stock should be allowed when the owner of stock does not bear the risk of loss otherwise inherent in the ownership of an equity interest at a time proximate to the time the distribution is made.

(sec. 1021 of the bill and secs. 6111 and 6662 of the Code)

An organizer of a tax shelter is required to register the shelter with the Internal Revenue Service (IRS) (sec. 6111). If the principal organizer does not do so, the duty may fall upon any other participant in the organization of the shelter or any person participating in its sale or management. The shelter's identification number must be furnished to each investor who purchases or acquires an interest in the shelter. Failure to furnish this number to the tax shelter investors will subject the organizer to a $100 penalty for each such failure (sec. 6707(b)).

A penalty may be imposed against an organizer who fails without reasonable cause to timely register the shelter or who provides false or incomplete information with respect to it. The penalty is the greater of one percent of the aggregate amount invested in the shelter or $500. Any person claiming any tax benefit with respect to a shelter must report its registration number on her return. Failure to do so without reasonable cause will subject that person to a $250 penalty (sec. 6707(b)(2)).

A person who organizes or sells an interest in a tax shelter subject to the registration rule or in any other potentially abusive plan or arrangement must maintain a list of the investors (sec. 6112). A $50 penalty may be assessed for each name omitted from the list. The maximum penalty per year is $100,000 (sec. 6708).

For this purpose, a tax shelter is defined as any investment that meets two requirements. First, the investment must be (1) required to be registered under a Federal or state law regulating securities, (2) sold pursuant to an exemption from registration requiring the filing of a notice with a Federal or state agency regulating the offering or sale of securities, or (3) a substantial investment. Second, it must be reasonable to infer that the ratio of deductions and 350 percent of credits to investment for any investor (i.e., the tax shelter ratio) may first five years ending after the date on which the investment is offered for sale. An investment that meets these requirements will be considered a tax shelter regardless of whether it is marketed or customarily designated as a tax shelter (sec. 6111(c)(1)).

Accuracy-related penalty

The accuracy-related penalty, which is imposed at a rate of 20 percent, applies to the portion of any underpayment that is attributable to (1) negligence, (2) any substantial understatement of income tax, (3) any substantial valuation misstatement, (4) any substantial overstatement of pension liabilities, or (5) any substantial estate or gift tax valuation understatement.

The substantial understatement penalty applies in the following manner. If the correct income tax liability of a taxpayer for a taxable year exceeds that reported by the taxpayer by the greater of 10 percent of the correct tax or $5,000 ($10,000 in the case of most corporations), then a substantial understatement exists and a penalty may be imposed equal to 20 percent of the underpayment of tax attributable to the understatement. In determining whether a substantial understatement exists, the amount of the understatement is reduced by any portion attributable to an item if (1) the treatment of the item on the return is or was supported by substantial authority, or (2) facts relevant to the tax treatment of the item were adequately disclosed on the return or on a statement attached to the return and there was a reasonable basis for the tax treatment of the item. Special rules apply to tax shelters.

With respect to tax shelter items of non-corporate taxpayers, the penalty may be avoided only if the taxpayer establishes that, in addition to having substantial authority for his position, he reasonably believed that the treatment claimed was more likely than not the proper treatment of the item. This reduction in the penalty is unavailable to corporate tax shelters. The reduction in the understatement for items disclosed on the return is inapplicable to both corporate and non-corporate tax shelters. For this purpose, a tax shelter is a partnership or other entity, plan, or arrangement the principal purpose of which is the avoidance or evasion of Federal income tax.

The Secretary may waive the penalty with respect to any item if the taxpayer establishes reasonable cause for his treatment of the item and that he acted in good faith.

The provision requires a promoter of a corporate tax shelter to register the shelter with the Secretary. Registration is required not later than the next business day after the day when the tax shelter is first offered to potential users. If the promoter is not a U.S. person, or if a required registration is not otherwise made, then any U.S. participant is required to register the shelter. An exception to this special rule provides that registration would not be required if the U.S. participant notifies the promoter in writing not later than 90 days after discussions began that the U.S. participant will not participate in the shelter and the U.S. person does not in fact participate in the shelter.

A corporate tax shelter is any investment, plan, arrangement or transaction (1) a significant purpose of the structure of which is tax avoidance or evasion by a corporate participant, (2) that is offered to any potential participant under conditions of confidentiality, and (3) for which the tax shelter promoters may receive total fees in excess of $100,000.

A transaction is offered under conditions of confidentiality if: (1) an offeree (or any person acting on its behalf) has an understanding or agreement with or for the benefit of any promoter to restrict or limit its disclosure of the transaction or any significant tax features of the transaction; or (2) the promoter claims, knows or has reason to know (or the promoter causes another person to claim or otherwise knows or has reason to know that a party other than the potential offeree claims) that the transaction (or one or more aspects of its structure) is proprietary to the promoter or any party other than the offeree, or is otherwise protected from disclosure or use. The promoter includes specified related parties.

Registration will require the submission of information identifying and describing the tax shelter and the tax benefits of the tax shelter, as well as such other information as the Treasury Department may require.

Tax shelter promoters are required to maintain lists of those who have signed confidentiality agreements, or otherwise have been subjected to nondisclosure requirements, with respect to particular tax shelters. In addition, promoters must retain lists of those paying fees with respect to plans or arrangements that have previously been registered (even though the particular party may not have been subject to confidentiality restrictions).

All registrations will be treated as taxpayer information under the provisions of section 6103 and will therefore not be subject to any public disclosure.

The penalty for failing to timely register a corporate tax shelter is the greater of $10,000 or 50 percent of the fees payable to any promoter with respect to offerings prior to the date of late registration (i.e., this part of the penalty does not apply to fee payments with respect to offerings after late registration). A similar penalty is applicable to actual participants in any corporate tax shelter who were required to register the tax shelter but did not. With respect to participants, however, the 50-percent penalty is based only on fees paid by that participant. Intentional disregard of the requirement to register by either a promoter or a participant increases the 50-percent penalty to 75 percent of the applicable fees.

Substantial understatement penalty

The provision makes two modifications to the substantial understatement penalty. The first modification affects the reduction in the amount of the understatement which is attributable to an item if there is a reasonable basis for the treatment of the item. The provision provides that in no event would a corporation have a reasonable basis for its tax treatment of an item attributable to a multi-party financing transaction if such treatment does not clearly reflect the income of the corporation. No inference is intended that such a multi-party financing transaction could not also be a tax shelter as defined under the modification described below or under present law.

The second modification affects the special tax shelter rules, which define a tax shelter as an entity the principal purpose of which is the avoidance or evasion of Federal income tax. The provision instead provides that a significant purpose (rather than the principal purpose) of the entity must be the avoidance or evasion of Federal income tax for the entity to be considered a tax shelter. This modification conforms the definition of tax shelter for purposes of the substantial understatement penalty to the definition of tax shelter for purposes of these new confidential corporate tax shelter registration requirements.

Treasury report

The provision also directs the Treasury Department, in consultation with the Department of Justice, to issue a report to the tax-writing committees on the following tax shelter issues: (1) a description of enforcement efforts under section 7408 of the Code (relating to actions to enjoin promoters of abusive tax shelters) with respect to corporate tax shelters and the lawyers, accountants, and others who provide opinions (whether or not directly addressed to the taxpayer) regarding aspects of corporate tax shelters; (2) an evaluation of whether the penalties regarding corporate tax shelters are generally sufficient; and (3) an evaluation of whether confidential tax shelter registration should be extended to transactions where the investor (or potential investor) is not a corporation. The report is due one year after the date of enactment.

2. Treat certain preferred stock as "boot"

(sec. 1022 of the bill and secs. 351, 354, 355, 356 and 1036 of the Code)

The Committee believes that when such preferred stock instruments are received in certain exchange transactions, it is appropriate to view such instruments as taxable consideration since the investor has often obtained a more secure form of investment.

The bill applies to preferred stock (i.e., stock that is limited and preferred as to dividends and does not participate, including through a conversion privilege, in corporate growth to any significant extent), where (1) the holder has the right to require the issuer or a related person (within the meaning of secs. 267(b) and 707(b)) to redeem or purchase the stock, (2) the issuer or a related person is required to redeem or purchase the stock, (3) the issuer (or a related person) has the right to redeem or purchase the stock and, as of the issue date, it is more likely than not that such right will be exercised, or (4) the dividend rate on the stock varies in whole or in part (directly or indirectly) with reference to interest rates, commodity prices, or other similar indices, regardless of whether such varying rate is provided as an express term of the stock (for example, in the case of an adjustable rate stock) or as a practical result of other aspects of the stock (for example, in the case of auction rate stock). For this purpose, the rules of (1), (2), and (3) apply if the right or obligation may be exercised within 20 years of the date the instrument is issued and such right or obligation is not subject to a contingency which, as of the issue date, makes remote the likelihood of the redemption or purchase. In addition, if neither the stock surrendered nor the stock received in the exchange is stock of a corporation any class of stock of which (or of a related corporation) is publicly traded, a right or obligation is disregarded if it may be exercised only upon the death, disability, or mental incompetency of the holder. Also, a right or obligation is disregarded in the case of stock transferred in connection with the performance of services if it may be exercised only upon the holder's separation from service.

The following exchanges are excluded from this gain recognition: (1) certain exchanges of preferred stock for comparable preferred stock of the same or lesser value stock for common stock; (3) certain exchanges of debt securities for preferred stock of the same or lesser value; and (4) exchanges of stock in certain recapitalizations of family-owned corporations. For this purpose, a family-owned corporation is defined as any corporation if at least 50 percent of the total voting power and value of the stock of such corporation is owned by members of the same family for five years preceding the recapitalization. In addition, a recapitalization does not qualify for the exception if the same family does not own 50 percent of the total voting power and value of the stock throughout the three-year period following the recapitalization. Members of the same family are defined by reference to the definition in section 447(e). Thus, a family includes children, parents, brothers, sisters, and spouses, with a limited attribution for directly and indirectly owned stock of the corporation. Shares held by a family member are treated as not held by a family member to the extent a non-family member had a right, option or agreement to acquire the shares (directly or indirectly, for example, through redemptions by the issuer), or with respect to shares as to which a family member has reduced its risk of loss with respect to the share, for example, through an equity swap. Even though the provision excepts certain family recapitalizations, the special valuation rules of section 2701 for estate and gift tax consequences continue to apply.

An exchange of nonqualified preferred stock for nonqualified preferred stock in an acquiring corporation may qualify for tax-free treatment under section 354, but not section 351. In cases in which both sections 354 and 351 may apply to a transaction, section 354 generally will apply for purposes of this proposal. Thus, in that situation, the exchange would be tax free.

The Treasury Secretary has regulatory authority to (1) apply installment sale-type rules to preferred stock that is subject to this proposal in appropriate cases and (2) prescribe treatment of preferred stock subject to this provision under other provisions of the Code (e.g., secs. 304, 306, 318, and 368(c)). Until regulations are issued, preferred stock that is subject to the proposal shall continue to be treated as stock under other provisions of the Code.

(sec. 1031 of the bill and sec. 6045 of the Code)

In addition, the present exception in the regulations exempting from reporting any payments made to corporations will not apply to payments made to attorneys. Treasury regulation section 1.6041-3(c) exempts payments to corporations generally (although payments to most corporations providing medical services must be reported). Reporting will be required under both Code sections 6041 and 6045 (as proposed) for payments to corporations that provide legal services. The exception of Treasury regulation section 1.6041-3(g) exempting from reporting payments of salaries or profits paid or distributed by a partnership to the individual partners would continue to apply to both sections (since these amounts are required to reported on Form K-1).

First, the provision applies to payments made to attorneys regardless of whether the attorney is the exclusive payee. Second, payments to law firms are payments to attorneys, and therefore are subject to this reporting provision. Third, attorneys are required to promptly supply their TINs to persons required to file these information reports, pursuant to section 6109. Failure to do so could result in the attorney being subject to penalty under section 6723 and the payments being subject to backup withholding under section 3406. Fourth, the IRS should administer this provision so that there is no overlap between reporting under section 6041 and reporting under section 6045. For example, if two payments are simultaneously made to an attorney, one of which represents the attorney's fee and the second of which represents the settlement with the attorney's client, the first payment would be reported under section 6041 and the second payment would not be reported under either section 6041 or section 6045, since it is known that the entire payment represents the settlement with the client (and therefore no portion of it represents income to the attorney).

2. Information reporting on persons receiving contract payments from certain Federal agencies

(sec. 1032 of the bill and sec. 6041A of the Code)

The head of each Federal executive agency must file an information return indicating the name, address, and taxpayer identification number (TIN) of each person (including corporations) with which the agency enters into a contract (sec. 6050M). The Secretary of the Treasury has the authority to require that the returns be in such form and be made at such time as is necessary to make the returns useful as a source of information for collection purposes. The Secretary is given the authority both to establish minimum amounts for which no reporting is necessary as well as to extend the reporting requirements to Federal license grantors and subcontractors of Federal contracts. Treasury regulations provide that no reporting is required if the contract is for $25,000 or less (Treas. reg. sec. 1.6050M-1(c)(1)(i)).

3. Disclosure of tax return information for administration of certain veterans programs

(sec. 1033 of the bill and sec. 6103 of the Code)

Among the disclosures permitted under the Code is disclosure to the Department of Veterans Affairs ("DVA") of self-employment tax information and certain tax information supplied to the Internal Revenue Service and Social Security Administration by third parties. Disclosure is permitted to assist DVA in determining eligibility for, and establishing correct benefit amounts under, certain of its needs-based pension, health care, and other programs (sec. 6103(1)(7)(D)(viii)). The income tax returns filed by the veterans themselves are not disclosed to DVA.

The DVA is required to comply with the safeguards currently contained in the Code and in section 1137(c) of the Social Security Act (governing the use of disclosed tax information). These safeguards include independent verification of tax data, notification to the individual concerned, and the opportunity to contest agency findings based on such information.

The DVA disclosure provision is scheduled to expire after September 30, 1998.

4. Establish IRS continuous levy and improve debt collection

(secs. 1034, 1035, and 1036 of the bill and secs. 6331 and 6334 of the Code)

^{In general, a levy does not apply to property acquired after the date of the levy,97} regardless of whether the property is held by the taxpayer or by a third party (such as a bank) on behalf of a taxpayer. Successive seizures may be necessary if the initial seizure is insufficient to satisfy the liability.⁹⁸ The only exception to this rule is for salary and wages.⁹⁹ A levy on salary and wages is continuous from the date it is first made until the date it is fully paid or becomes unenforceable.

A minimum exemption is provided for salary and wages.¹⁰⁰ It is computed on a weekly basis by adding the value of the standard deduction plus the aggregate value of personal exemptions to which the taxpayer is entitled, divided by 52.¹⁰¹ For a family of four for taxable year 1996, the weekly minimum exemption is $325.¹⁰²

In addition, the provision provides that this levy would attach up to 15 percent of any specified payment due the taxpayer. This rule explicitly replaces the other specifically enumerated exemptions from levy in the Code. A continuous levy of up to 15 percent would also apply to unemployment benefits and means-tested public assistance.

The bill also permits the disclosure of otherwise confidential tax return information to the Treasury Department's Financial Management Service only for the purpose of, and to the extent necessary in, implementing these levy provisions.

5. Consistency rule for beneficiaries of trusts and estates

(sec. 1037 of the bill and sec. 6034A of the Code)

The fiduciary of an estate or trust that is required to file a return for any taxable year is required to furnish to beneficiaries certain information shown on such return (generally via a Schedule K-1) (sec. 6034A). In addition, a U.S. person that is treated as the owner of any portion of a foreign trust is required to ensure that the trust files a return for the taxable year and furnishes certain required information to each U.S. person who is treated as an owner of a portion of the trust or who receives any distribution from the trust (sec. 6048(b)). However, rules comparable to the consistency rules that apply to S corporation shareholders and partners in partnerships are not specified in the case of beneficiaries of estates and trusts.

(sec. 1041 of the bill and secs. 4081, 4091, and 4261 of the Code)

Commercial air passenger transportation taxes

Domestic air passenger transportation is subject to an ad valorem excise tax equal to 10 percent of the amount paid for the transportation. Taxable domestic air transportation includes both travel within the United States and certain travel between the United States and points in Canada or Mexico that are within 225 miles of the U.S. border (the "225-mile zone").

International air passenger transportation is subject to a $6 departure excise tax imposed on passengers departing the United States for other countries. No tax is imposed on passengers arriving in the United States from other countries. International transportation is defined to include separate domestic flights that connect to international flights, provided that stopover time at any point within the United States does not exceed 12 hours. Thus, these "domestic legs" associated with international transportation (e.g., a flight from Los Angeles to New York from which the passenger boards a connecting flight to London) are exempt from the 10-percent ad valorem excise tax otherwise imposed on such transportation between two domestic points.

Because both the domestic and international air passenger excise taxes are imposed only on transportation for which an amount is paid, no tax is imposed on "free" travel (e.g., frequent flyer travel and airline industry employee travel for which the passenger is not directly charged) even if third parties (e.g., credit card companies) make cash or in kind payments for the right to award the "free" or reduced-rate travel to their customers.

The air passenger transportation excise taxes are imposed on passengers; transportation providers (generally airlines) are responsible for collecting and remitting the taxes to the Federal Government. In general, both the domestic and international air passenger transportation excise taxes are imposed without regard to whether the transportation is purchased within the United States. An exception provides that travel between the United States and the 225-mile zone is subject to the ad valorem domestic tax only if it is purchased within the United States.

The Code requires all advertising for taxable air passenger transportation either (1) to state the fare on a tax-inclusive basis or (2) if the Federal tax is stated separately, to state the amount of the tax at least as prominently as the underlying airline fare and to identify that amount as "user taxes to pay for airport construction and airway safety and operations" (sec. 7275(b)).

The amount of air passenger transportation excise tax collected from a passenger must be stated separately on the ticket.

Commercial air cargo transportation

Domestic air cargo transportation is subject to a 6.25-percent ad valorem excise tax. This tax, like the air passenger excise taxes, is imposed on the consumer, with the transportation provider being required to collect and remit the tax to the Federal Government. However, there is no requirement that the tax be stated separately on shipping invoices.

Noncommercial aviation

Noncommercial aviation, or transportation on private aircraft which is not "for hire," is subject to excise taxes imposed on fuel in lieu of the commercial air passenger ticket and air cargo excise taxes. The current Airport and Airway Trust Fund tax rates on these fuels are 15 cents per gallon on aviation gasoline and 17.5 cents per gallon on jet fuel.

The aviation gasoline excise tax is imposed on removal of the fuel from a registered terminal facility (the same point as the highway gasoline excise tax). The jet fuel excise tax is imposed on sale of the fuel by a wholesale distributor. Many larger airports have dedicated pipeline facilities that directly service aircraft; in such a case, the tax effectively is imposed at the retail level. The person removing the gasoline from a terminal facility or the wholesale distributor of the jet fuel is liable for these taxes.

General Fund aviation fuels excise tax

Fuels used in air transportation are subject to a 4.3-cents-per-gallon excise tax, receipts from which are retained in the General Fund. This fuels tax is identical to taxes also imposed on motor fuels used in other transportation sectors, including highway, inland waterway, and rail.

Deposit of air transportation excise taxes

Under present law, the air passenger ticket and freight excise taxes are collected from passengers and freight shippers by the commercial air carriers. The air carriers then remit the funds to the Treasury Department; however, the air carriers are not required to remit monies immediately. Excise tax returns are filed quarterly (similar to annual income tax returns) with taxes being deposited on a semi-monthly basis (similar to estimated income taxes). For air transportation sold during a semi-monthly period, air carriers may elect to treat the taxes as collected on the last day of the first week of the second following semi-monthly period. Under these "deemed collected" rules, for example, the taxes on air transportation sold between August 1 and August 15, are treated as collected by the air carriers on or before September 7, with the amounts generally being deposited with the Treasury Department by September 10. A special rule requires certain amounts deemed collected during the second half of September to be deposited by September 29.

Semi-monthly deposits and quarterly excise tax returns also are required with respect to the fuels excise taxes imposed on air transportation.

Overflight user fees

Non-tax user fees are imposed on air transportation (both commercial and noncommercial aviation) that travels through airspace for which the United States provides air traffic control services, but that neither lands in nor takes off from a point in the United States. These fees are imposed and collected by the FAA with respect to mileage actually flown, and apply both to travel within U.S. territorial airspace and to travel within international oceanic airspace for which the United States is responsible for providing air traffic control services.

The Committee determined limited modifications to the current passenger excise tax structure are warranted. First, the structure of the tax is modified to include a reduced ad valorem rate and a fixed dollar amount tax rate applicable to all revenue passengers. In addition, the Committee determined that the perceived fairness of the passenger air transportation excise taxes will be improved if certain currently untaxed payments and passengers were required to contribute to the financing of the FAA programs from which they benefit. In furtherance of this goal, the bill extends the tax to internationally arriving passengers and clarifies that the tax applies to payments to airlines (and related parties) from credit card and other companies in exchange for the right to award frequent flyer or other reduced air travel rights.

The Airport and Airway Trust Fund excise taxes, as modified below, are extended for 10 years, for the period October 1, 1997, through September 30, 2007. The taxes that are extended include the domestic and international air passenger excise taxes, the air cargo excise tax, and the noncommercial aviation fuels taxes. Gross receipts from these taxes will continue to be deposited in the Airport and Airway Trust Fund.

Modification of commercial air passenger transportation taxes

 ______________________________________________

The term "flight segment" is defined as transportation involving a single take-off and a single landing.¹⁰⁷ The bill provides that there is no change in the number of flight segments for which a passenger is charged (increase or decrease) in the case of transportation routing changes initiated by the air carrier, provided there is no change in the fare charged. Generally, this rule applies to flight changes for travel between the same origin and destination as a result of, e.g., aircraft mechanical problems. The rule similarly covers itinerary changes such as a diversion to another intermediate or destination airport as a result of inclement weather conditions.

All transportation between points within the 48 contiguous States (and within Hawaii or Alaska), other than domestic segments associated with international transportation, is subject to tax at the 7.5 percent and $2.00 rates.

The current $6 international departure tax is increased to $15.50 per departure, and an identical $15.50 per passenger tax is imposed on arrivals in the United States from international locations. The international departure and arrival taxes are indexed for inflation occurring after 1997, measured by changes in the CPI rounded to the nearest 10 cents. Inflation adjustments will be effective for transportation provided beginning after December 31, 1998, and each subsequent calendar year.

As under present law, certain air transportation between the United States and points within the 225-mile zone of Canada or Mexico is taxed as domestic transportation subject to the 7.5 percent and $2.00 rates. The present-law rules classifying transportation between the 48 contiguous States and Alaska or Hawaii (or between those States) as part domestic and part international are retained, without change, other than a clarification that a single flight segment between the 48 contiguous States and Alaska or Hawaii (or between those States) is subject to only one $15.50 per passenger international tax despite the fact that the flight both departs into and arrives from international airspace.

Clarification further is provided that any amounts paid to air carriers (in cash or in kind) for the right to award or otherwise distribute free or reduced-rate air transportation are treated as amounts paid for taxable air transportation, subject to the 7.5 percent ad valorem tax rate. Examples of such taxable amounts include (1) payments for frequent flyer miles purchased by credit card companies, telephone companies, rental car companies, television networks, restaurants and hotels, and other businesses for distribution to their customers and others and (2) amounts received by airlines pursuant to joint venture credit card or other marketing arrangements. The Treasury Department is authorized specifically to disregard accounting allocations or other arrangements which have the effect of reducing artificially the base to which the 7.5-percent tax is applied. No inference is intended from this provision as to the proper treatment of these payments under present law.

Transfer of 4.3-cents-per-gallon fuels excise tax to Airport and Airway Trust Fund

The 4.3-cents-per-gallon excise tax on aviation gasoline and jet fuel will be deposited in the Airport and Airway Trust Fund, rather than in the General Fund, beginning with fuels sold or removed after September 30, 1997.

Modify air passenger excise tax deposit rules

The deposit rules with respect to the commercial air passenger excise taxes are modified to permit payment of these taxes that otherwise would have been required to be deposited during the period August 15, 1997 through September 30, 1997, to be deposited on October 10, 1997.

Present law requires transportation providers to continue collecting the commercial aviation excise taxes (at the current rates) on transportation to be provided after September 30, 1997, if the transportation is purchased before October 1, 1997. The bill requires transportation providers to collect the taxes at the modified rates for transportation purchased after the date of enactment for travel beginning after September 30, 1997.

The extension of the general aviation fuels excise taxes is effective for fuels removed or sold after September 30, 1997.

The provision clarifying application of the commercial air passenger excise tax to certain amounts paid for the right to award air transportation is effective for amounts paid (or benefits transferred) after September 30, 1997, except payments (or transfers) between related parties occurring after June 11, 1997 and before October 1, 1997, are subject to tax if the payments relate to rights to transportation to be awarded or otherwise distributed after September 30, 1997.

The provisions transferring certain General Fund fuels tax revenues and modifying the commercial air passenger excise tax deposit rules are effective on the date of enactment.

2. Extend diesel fuel excise tax rules to kerosene

(sec. 1042 of the bill and sec. 4081-4083 of the Code)

Aviation gasoline and jet fuel (both commercial and noncommercial use) currently are subject to a 4.3-cents-per-gallon General Fund tax rate. In addition, through September 30, 1997, gasoline and jet fuel used in noncommercial aviation are subject to an additional 15-cents-per-gallon rate (gasoline) and 17.5-cents-per-gallon rate (jet fuel) for the Airport and Airway Trust Fund. These combined rates produce an aggregate tax of 21.8 cents per gallon on noncommercial aviation jet fuel and 19.3 cents per gallon on noncommercial aviation gasoline. The tax on non-gasoline aviation fuel is imposed on the sale of the fuel by a "producer," typically a wholesale distributor. Thus, this tax is imposed at a point in the fuel distribution chain subsequent to removal from a terminal facility.

Kerosene is used both as a transportation fuel and as an aviation fuel. Kerosene also is blended with diesel fuel destined both for taxable (highway) and nontaxable (heating oil) uses to, among other things, prevent gelling of the diesel fuel in colder temperatures. Under present law, kerosene is not subject to excise tax unless it is blended with taxable diesel fuel or is sold for use as aviation fuel. When kerosene is blended with dyed diesel fuel to be used in a nontaxable use, the dye concentration of the fuel mixture must be adjusted to ensure that it meets Treasury Department requirements for untaxed, dyed diesel fuel.

Clear, low-sulphur kerosene (K-1) also is used in space heaters, and often is sold for this purpose at retail service stations. As with other heating oil uses, kerosene used in space heaters, is not subject to Federal excise tax. Although heating oil often has minor amounts of kerosene blended with it in colder weather, this blending typically occurs before removal of the fuel from the terminal facilities where Federal excise taxes are imposed. However, it may be necessary during periods of extreme or unseasonably cold weather to add kerosene to heating oil after its removal from the terminal. Other nontaxable uses of kerosene include feedstock use in the petrochemical industry.

To accommodate State safety regulations that require the use of clear (K-1) kerosene in certain space heaters, a refund procedure would be provided under which registered ultimate vendors may claim refunds of the tax paid on kerosene sold for that use. In addition, the Internal Revenue Service is given discretion to refund to a registered ultimate vendor the tax paid on kerosene that is blended with heating oil for use during periods of extreme or unseasonable cold.

3. Modify tax benefits for ethanol and renewable source methanol

(sec. 1043 of the bill and secs. 40, 4041, 4081, 4091, and 6427, and new sec. 4476 of the Code)

In addition to these general ethanol benefits, a separate 10-cents-per-gallon credit is provided for small ethanol producers, defined generally as persons whose production does not exceed 15 million gallons per year and whose production capacity does not exceed 30 million gallons per year. No comparable small producer credit is provided for small renewable source methanol producers.

Treasury Department regulations provide that ethyl tertiary butyl ether ("ETBE"), which is made using ethanol, qualifies for the blender income tax credit and the excise tax exemption.

The alcohol fuels tax benefits are scheduled to expire after December 31, 2000. The provision allowing the ethanol blender benefits to be claimed through the motor fuels excise tax system is scheduled to expire after September 30, 2000.

Limit on production eligible for tax benefits

The alcohol fuels income tax credits (other than the small ethanol producer tax credit) and the excise tax exemptions for ethanol and methanol from renewable sources will be available only for alcohol fuels produced by distilling equipment placed in service before June 9, 1997.¹⁰⁸ Additionally, producers other than small producers (defined as under present law) will receive these benefits only to the extent that annual production after December 31, 1997, does not exceed average annual production of fuel alcohol by the equipment during a prescribed three-year period (the "eligible production ceiling"). The eligible production ceiling is determined first by ascertaining annual production during each year of the five-year period ending on May 31, 1997. The year when production was the greatest and the year when production was the lowest are eliminated. The production ceiling equals the average of the annual production during the remaining three years. A safe-harbor production level equal to 50 percent of capacity as of June 8, 1997, is provided.

To ensure that only eligible production continues to receive the blender tax benefits after the date of the bill's enactment, an "excess production penalty" is imposed on all production from equipment placed in service after June 8, 1997, and on production from existing equipment (by producers other than small producers) that exceeds the producer's eligible production ceiling. Beginning on January 1, 2001, all ethanol production will be treated as "excess" production, but the penalty will not apply during any period when no ethanol or renewable source methanol tax benefits are statutorily available. The penalty is non-deductible for Federal income tax purposes. Receipts from the penalty will be deposited in the Highway Trust Fund. The penalty offsets the benefit provided to excess production by the current general income tax and excise tax provisions; therefore, no changes (other than those described herein) are made to those provisions. Thus, blenders will remain eligible to claim the tax benefits in the same manner as provided under present law, through 2000.

Reduce ethanol tax benefits to reflect carbon dioxide by-product value; offset for small producers

Carbon dioxide is a naturally occurring by-product of ethanol production. This carbon dioxide is commercially valuable and currently is being captured and sold by ethanol producers. The 54-cents-per-gallon ethanol income tax credit and the 5.4-cents-per-gallon ethanol excise tax exemptions are reduced to 51 cents per gallon and 5.1 cents per gallon, respectively, to reflect the value of carbon dioxide recovered as a by-product in ethanol production.

The present-law small ethanol producers credit is increased from 10 cents per gallon to 13 cents per gallon to offset the effect of this reduction for small producers.

ETBE and similar ethers not to qualify

Statutory clarification is provided that ETBE and similar ethers (and alcohol used to produce these ethers) are not qualified alcohol fuels for either the ethanol or methanol from renewable sources tax benefits.

The provision limiting production eligible for the alcohol fuels tax benefits to production from facilities placed in service before June 9, 1997, is effective on the date of enactment. The production limits applicable to such grandfathered facilities is effective for production occurring after December 31, 1997.

Reduce ethanol tax benefits to reflect carbon dioxide by-product value

The reduction in the ethanol blenders credit and excise tax exemption to reflect the value of carbon dioxide produced as a by-product and the offsetting increase in the small producer's income tax credit are effective on January 1, 1998.

ETBE and similar ethers not to qualify

The provision reversing the Treasury Department regulations defining ethers as qualified alcohol fuels is effective for ethers produced after December 31, 1997.

4. Reinstate Leaking Underground Storage Tank Trust Fund excise tax

(sec. 1044 of the bill and secs. 4041(d), 4081(a)(2), and 4081(d)(2) of the Code)

5. Application of communications tax to long-distance prepaid telephone cards

(sec. 1045 of the bill and sec. 4251 of the Code)

(sec. 1051 of the bill and sec. 512(b)(13) of the Code)

^{The control test under section 512(b)(13) does not, however, incorporate any indirect ownership rules.112} Consequently, rents, royalties, annuities and interest derived from second-tier subsidiaries generally do not constitute UBTI to the tax-exempt parent organization.¹¹³

In addition, the bill applies the constructive ownership rules of section 318 for purposes of section 512(b)(13). Thus, a parent exempt organization is deemed to control any subsidiary in which it holds more than 50 percent of the voting power or value, directly (as in the case of a first-tier subsidiary) or indirectly (as in the case of a second-tier subsidiary).

The bill also makes technical modifications to the method provided in section 512(b)(13) for determining how much of an interest, rent, annuity, or royalty payment made by a controlled entity to a tax-exempt organization is includible in the latter organization's UBTI. Such payments are subject to the unrelated business income tax to the extent the payment reduces the net unrelated income (or increases any net unrelated loss) of the controlled entity.

2. Limitation on increase in basis of property resulting from sale by tax-exempt entity to related person

(sec. 1052 of the bill and sec. 1061 of the Code)

Other provisions of the Code deny certain tax benefits when a transferor and transferee are related parties. For example, losses on sales between related parties are not recognized (sec. 267).

A related person means any person having a relationship to the tax-exempt entity described in section 267(b) or 707(b)(1) (generally, certain more-than-50-percent relationships, with specified attribution rules). For purposes of applying section 267(b)(2), such an entity is treated as if it were an individual.

3. Reporting and proxy tax requirements for political and lobbying expenditures of certain tax-exempt organizations

(sec. 1053 of the bill and sec. 6033(e) of the Code)

Under section 6033(e), tax-exempt organizations (other than charities described in section 501(c)(3)) that engage in lobbying or political campaign activities must disclose the amount of members' dues allocable to lobbying or political campaign expenditures to their members and to the Internal Revenue Service (IRS), except for certain in-house, de minimis expenses.¹¹⁴ If an organization fails to meet the disclosure requirement under section 6033(e), then the organization generally is subject to a so-called "proxy tax" equal to 35 percent of the amount of members' dues allowable to lobbying or political campaign expenditures. However, under section 6033(e)(3), organizations are exempt from the disclosure requirements and proxy tax if they can establish to the satisfaction of the Secretary of the Treasury that substantially all dues or other similar amounts received by the organization are not deductible without regard to whether or not the organization conducts lobbying or political campaign activities. In Rev. Proc. 95-35, the IRS announced that all tax-exempt organizations--other than (1) organizations described in section 501(c)(4) that are not veterans organizations, (2) agricultural and horticultural organizations described in section 501(c)(5), and (3) trade associations and other organizations described in section 501(c)(6)--are deemed automatically to qualify for the section 6033(e)(3) exemption from the general disclosure requirements and proxy tax. Rev. Proc. 95-35 further provides that an organization described in section 501(c)(4) or an agricultural or horticultural organization described in section 501(c)(5) qualified for the section 6033(e)(3) exemption if the organization receives at least 90 percent of its dues from (a) members with annual dues of less than $50 or (b) other tax-exempt organizations. Under Rev. Proc. 95-35, a trade association or other organization described in section 501(c)(6) qualifies for the section 6033(e)(3) exemption if the organization receives at least 90 percent of its dues from other tax-exempt organizations.¹¹⁵

4. Repeal grandfather rule with respect to pension business of certain insurers

(sec. 1054 of the bill and sec. 1012(c) of the Tax Reform Act of 1986)

The treatment applicable to such organizations, which became taxable organizations under the provision, is as follows. A special deduction applies with respect to health business equal to 25 percent of the claims and expenses incurred during the taxable year less the adjusted surplus at the beginning of the year. An exception is provided for such organizations from the application of the 20-percent reduction in the deduction for increases in unearned premiums that applies generally to property and casualty insurance companies. A fresh start was provided with respect to changes in accounting methods resulting from the change from tax-exempt to taxable status. Thus, no adjustment was made under section 481 on account of an accounting method change. Such an organization was required to compute its ending 1986 loss reserves without artificial changes that would reduce 1987 income. Thus, any reserve weakening after August 16, 1986 was treated as occurring in the organization's first taxable year beginning after December 31, 1986. The basis of such an organization's assets was deemed to be equal to the amount of the assets' fair market value on the first day of the organization's taxable year beginning after December 31, 1986, for purposes of determining gain or loss (but not for determining depreciation or for other purposes).

Grandfather rules were provided in the 1986 Act relating to the provision. It was provided that the provision does not apply to that portion of the business of the Teachers Insurance Annuity Association-College Retirement Equities Fund which is attributable to pension business, nor does the provision apply with respect to that portion of the business of Mutual of America which is attributable to pension business. Pension business means the administration of any plan described in section 401(a) of the Code which includes a trust exempt from tax under section 501(a), and plan under which amounts are contributed by an individual's employer for an annuity contract described in section 403(b) of the Code, any individual retirement plan described in section 408 of the Code, and any eligible deferred compensation plan to which section 457(a) of the Code applies.

A fresh start is provided with respect to changes in accounting methods resulting from the change from tax-exempt to taxable status. Thus, no adjustment is made under section 481 on account of an accounting method change. The Teachers Insurance Annuity Association and College Retirement Equities Fund and Mutual of America are required to compute ending 1997 loss reserves without artificial changes that would reduce 1998 income. Thus, any reserve weakening after June 8, 1997, is treated as occurring in the organization's first taxable year beginning after December 31, 1997. The basis of assets of Teachers Insurance Annuity Association and College Retirement Equities Fund and Mutual of America is deemed to be equal to the amount of the assets' fair market value on the first day of the organization's taxable year beginning after December 31, 1997, for purposes of determining gain or loss (but not for determining depreciation or for other purposes).

(sec. 1061 of the bill and sec. 477 of the Code)

A provision of the Revenue Act of 1987 ("1987 Act") requires a family corporation (or a partnership with a family corporation as a partner) to use an accrual method of accounting for its farming business unless, for each prior taxable year beginning after December 31, 1985, such corporation (and any predecessor corporation) did not have gross receipts exceeding $25 million. A family corporation is one where at 50 percent or more of the stock of the corporation is held by one (or in some limited cases, two or three) families.

A family farm corporation that must change to an accrual method of accounting as a result of the 1987 Act provision is to establish a suspense account in lieu of including the entire amount of the section 481 adjustment in gross income. The initial balance of the suspense account equals the lesser of (1) the section 481 adjustment otherwise required for the year of change, or (2) the section 481 adjustment computed as if the change in method of accounting had occurred as of the beginning of the taxable year preceding the year of change.

The amount of the suspense account is required to be included in gross income if the corporation ceases to be a family corporation. In addition, if the gross receipts of the corporation attributable to farming for any taxable year decline to an amount below the lesser of (1) the gross receipts attributable to farming for the last taxable year for which an accrual method of accounting was not required, or (2) the gross receipts attributable to farming for the most recent taxable year for which a portion of the suspense account was required to be included in income, a portion of the suspense account is required to be included in gross income.

In addition, any taxpayer with an existing suspense account is required to restore the account into income ratably over a 20-year period beginning in the first taxable year beginning after June 8, 1997, subject to the present-law requirements to restore such accounts more rapidly. The amount required to be restored to income for a taxable year pursuant to the 20-year spread period shall not exceed the net operating loss of the corporation for the year (in the case of a corporation with a net operating loss) or 50 percent of the net income of the taxpayer for the year (for corporations with taxable income). For this purpose, a net operating loss or taxable income is determined without regard to the amount restored to income under the bill. Any reduction in the amount required to be restored to income is taken into account ratably over the remaining years in the 20-year period or, if applicable, after the end of the 20-year period. Amounts that extend beyond the 20-year period remain subject to the net operating loss and 50-percent-of-taxable income rules. The net operating loss and 50-percent-of-taxable income rules do not apply to restorations of suspense accounts pursuant to present law.

2. Modify net operating loss carryback and carryforward rules

(sec. 1062 of the bill and sec. 172 of the Code)

3. Expand the limitations on deductibility of premiums and interest with respect to life insurance, endowment and annuity contracts

(sec. 1063 of the bill and sec. 264 of the Code)

No Federal income tax generally is imposed on a policyholder with respect to the earnings under a life insurance contract ("inside buildup").¹¹⁷ Further, an exclusion from Federal income tax is provided for amounts received under a life insurance contract paid by reason of the death of the insured (sec. 101(a)).

Premium deduction limitation

No deduction is permitted for premiums paid on any life insurance policy covering the life of any officer or employee, or of any person financially interested in any trade or business carried on by the taxpayer, when the taxpayer is directly or indirectly a beneficiary under such policy (sec. 264(a)(1)).

Interest deduction disallowance with respect to life insurance

Present law provides generally that no deduction is allowed for interest paid or accrued on any indebtedness with respect to one or more life insurance contracts or annuity or endowment contracts owned by the taxpayer covering any individual who is or was (1) an officer or employee of, or (2) financially interested in, any trade or business currently or formerly carried on by the taxpayer (the "COLI" rules).

This interest deduction disallowance rule generally does not apply to interest on debt with respect to contracts purchased on or before June 20, 1986; rather, an interest deduction limit based on Moody's Corporate Bond Yield Average--Monthly Average Corporates applies in the case of such contracts.¹¹⁸

^{An exception to this interest disallowance rule is provided for interest on indebtedness with respect to life insurance policies covering up to 20 key persons. A key person is an individual who is either an officer or a 20-percent owner of the taxpayer. The number of individuals that can be treated as key persons may not exceed the greater of (1) 5 individuals, or (2) the lesser of 5 percent of the total number of officers and employees of the taxpayer, or 20 individuals. For determining who is a 20-percent owner, all members of a controlled group are treated as one taxpayer. Interest paid or accrued on debt with respect to a contract covering a key person is deductible only to the extent the rate of interest does not exceed Moody's Corporate Bond Yield Average--Monthly Average Corporates for each month beginning after December 31, 1995, that interest is paid or accrued.}

^{The foregoing interest deduction limitation was added in 1996 to existing interest deduction limitations with respect to life insurance and similar contracts.119}

^{Interest deduction limitation with respect to tax-exempt interest income}

^{Present law provides that no deduction is allowed for interest on debt incurred or continued to purchase or carry obligations the interest on which is wholly exempt from Federal income tax (sec. 265(a)(2)). In addition, in the case a financial institution, a proration rule provides that no deduction is allowed for that portion of the taxpayer's interest that is allocable to tax-exempt interest (sec. 265(b)). The portion of the interest deduction that is disallowed under this rule generally is the portion determined by the ratio of the taxpayer's (1) average adjusted bases of tax-exempt obligations acquired after August 7, 1986, to (2) the average adjusted bases for all of the taxpayer's assets (sec. 265(b)(2)).120}

Under the provision, the present-law premium deduction limitation is modified to provide that no deduction is permitted for premiums paid on any life insurance, annuity or endowment contract, if the taxpayer is directly or indirectly a beneficiary under the contract.

Expansion of interest disallowance to individuals in whom taxpayer has insurable interest

Under the provision, no deduction is allowed for interest paid or accrued on any indebtedness with respect to life insurance policy, or endowment or annuity contract, covering the life of any individual. Thus, the provision limits interest deductibility in the case of such a contract covering any individual in whom the taxpayer has an insurable interest when the contract is first issued under applicable State law, except as otherwise provided under present law with respect to key persons and pre-1986 contracts.

Pro rata disallowance of interest on debt to fund life insurance

In the case of a taxpayer other than a natural person, no deduction is allowed for the portion of the taxpayer's interest expense that is allocable to unborrowed policy cash surrender values with respect to any life insurance policy or annuity or endowment contract issued after June 8, 1997. Interest expense is so allocable based on the ratio of (1) the taxpayer's average unborrowed policy cash values of life insurance policies, and annuity and endowment contracts, issued after June 8, 1997, to (2) the average adjusted bases for all assets of the taxpayer. This rule does not apply to any policy or contract owned by an entity engaged in a trade or business, covering any individual who is an employee, officer or director of the trade or business at the time first covered by the policy or contract. Such a policy or contract is not taken into account in determining unborrowed policy cash values.

The unborrowed policy cash values means the cash surrender value of the policy or contract determined without regard to any surrender charge, reduced by the amount of any loan with respect to the policy or contract. The cash surrender value is to be determined without regard to any other contractual or noncontractual arrangement that artificially depresses the cash value of a contract.

If a trade or business (other than a sole proprietorship or a trade or business of performing services as an employee) is directly or indirectly the beneficiary under any policy or contract, then the policy or contract is treated as held by the trade or business. For this purpose, the amount of the unborrowed cash value is treated as not exceeding the amount of the benefit payable to the trade or business. In the case of a partnership or S corporation, the provision applies at the partnership or corporate level. The amount of the benefit is intended to take into account the amount payable to the business under the contract (e.g., as a death benefit) or pursuant to another agreement (e.g., under a split dollar agreement). The amount of the benefit is intended also to include any amount by which liabilities of the business would be reduced by payments under the policy or contract (e.g., when payments under the policy reduce the principal or interest on a liability owed to or by the business).

As provided in regulations, the issuer or policyholder of the life insurance policy or endowment or annuity contract is required to report the amount of the amount of the unborrowed cash value in order to carry out this rule.

If interest expense is disallowed under other provisions of section 264 (limiting interest deductions with respect to life insurance policies or endowment or annuity contracts) or under section 265 (relating to tax-exempt interest), then the disallowed interest expense is not taken into account under this provision, and the average adjusted bases of assets is reduced by the amount of debt, interest on which is so disallowed. The provision is applied before present-law rules relating to capitalization of certain expenses where the taxpayer produces property (sec. 263A).

An aggregation rule is provided, treating related persons as one for purposes of the provision.

The provision does not apply to any insurance company subject to tax under subchapter L of the Code. Rather, the rules reducing certain deductions for losses incurred, in the case of property and casualty companies, and reducing reserve deductions or dividends received deductions of life insurance companies, are modified to take into account the increase in cash values of life insurance policies or annuity or endowment contracts held by insurance companies.

4. Allocation of basis of properties distributed to a partner by a partnership

(sec. 1064 of the bill and sec. 732(c) of the Code)

The partnership provisions of present law generally permit partners to receive distributions of partnership property without recognition of gain or loss (sec. 731).¹²² Rules are provided for determining the basis of the distributed property in the hands of the distributee, and for allocating basis among multiple properties distributed, as well as for determining adjustments to the distributee partner's basis in its partnership interest. Property distributions are tax-free to a partnership. Adjustments to the basis of the partnership's remaining undistributed assets are not required unless the partnership has made an election that requires basis adjustments both upon partnership distributions and upon transfers of partnership interests (sec. 754).

Partner's basis in distributed properties and partnership interest

Present law provides two different rules for determining a partner's basis in distributed property, depending on whether or not the distribution is in liquidation of the partner's interest in the partnership. Generally, a substituted basis rule applies to property distributed to a partner in liquidation. Thus, the basis of property distributed in liquidation of a partner's interest is equal to the partner's adjusted basis in its partnership interest (reduced by any money distributed in the same transaction) (sec. 732(b)).

By contrast, generally, a carryover basis rule applies to property distributed to a partner other than in liquidation of its partnership interest, subject to a cap (sec. 732(a)). Thus, in a non-liquidating distribution, the distributee partner's basis in the property is equal to the partnership's adjusted basis in the property immediately before the distribution, but not to exceed the partner's adjusted basis in its partnership interest (reduced by any money distributed in the same transaction). In a non-liquidating distribution, the partner's basis in its partnership interest is reduced by the amount of the basis to the distributee partner of the property distributed and is reduced by the amount of any money distributed (sec. 733).

Allocating basis among distributed properties

In the event that multiple properties are distributed by a partnership, present law provides allocation rules for determining their bases in the distributee partner's hands. An allocation rule is needed when the substituted basis rule for liquidating distributions applies, in order to assign a portion of the partner's basis in its partnership interest to each distributed asset. An allocation rule is also needed in a non-liquidating distribution of multiple assets when the total carryover basis would exceed the partner's basis in its partnership interest, so a portion of the partner's basis in its partnership interest is assigned to each distributed asset.

Present law provides for allocation in proportion to the partnership's adjusted basis. The rule allocates basis first to unrealized receivables and inventory items in an amount equal to the partnership's adjusted basis (or if the allocated basis is less than partnership basis, then in proportion to the partnership's basis), and then among other properties in proportion to their adjusted bases to the partnership (sec. 732(c)).¹²³ Under this allocation rule, in the case of a liquidating distribution, the distributee partner can have a basis in the distributed property that exceeds the partnership's basis in the property.

Under the provision, basis is allocated first to the extent of each distributed property's adjusted basis to the partnership. Any remaining basis adjustment, if an increase, is allocated among properties with unrealized appreciation in proportion to their respective amounts of unrealized appreciation (to the extent of each property's appreciation), and then in proportion to their respective fair market values. For example, assume that a partnership with two assets, A and B, distributes them both in liquidation to a partner whose basis in its interest is 55. Neither asset consists of inventory or unrealized receivables. Asset A has a basis to the partnership of 5 and a fair market value of 40, and asset B has a basis to the partnership of 10 and a fair market value of 10. Under the provision, basis is first allocated to asset in the amount of 5 and to asset B in the amount of 10 (their adjusted bases to the partnership). The remaining basis adjustment is an increase totaling 40 (the partner's 55 basis minus the partnership's total basis in distributed assets of 15). Basis is then allocated to asset A in the amount of 35, its unrealized appreciation, with no allocation to asset B attributable to unrealized appreciation because its fair market value equals the partnership's adjusted basis. The remaining basis adjustment of 5 is allocated in the ratio of the assets' fair market values, i.e., 4 to asset A (for a total basis of 44) and 1 to asset B (for a total basis of 11).

If the remaining basis adjustment is a decrease, it is allocated among properties with unrealized depreciation in proportion to their respective amounts of unrealized depreciation (to thin proportion to their respective adjusted bases (taking into account the adjustments already made). A remaining basis adjustment that is a decrease arises under the provision when the partnership's total adjusted basis in the distributed properties exceeds the amount of the partner's basis in its partnership interest, and the latter amount is the basis to be allocated among the distributed properties. For example, assume that a partnership with two assets, C and D, distributes them both in liquidation to a partner whose basis in its partnership interest is 20. Neither asset consists of inventory or unrealized receivables. Asset C has a basis to the partnership of 15 and a fair market value of 15, and asset D has a basis to the partnership of 15 and a fair market value of 5. Under the provision, basis is first allocated to the extent of the partnership's basis in each distributed property, or 15 to each distributed property, for a total of 30. Because the partner's basis in its interest is only 20, a downward adjustment of 10 (30 minus 20) is required. The entire amount of the 10 downward adjustment is allocated to the property D, reducing its basis to 5. Thus, the basis of property C is 15 in the hands of the distributee partner, and the basis of property D is 5 in the hands of the distributee partner.

5. Treatment of inventory items of a partnership

(sec. 1065 of the bill and sec. 751 of the Code)

Present law provides a similar rule to the extent that a distribution is treated as a sale or exchange of a partnership interest. A distribution by a partnership in which a partner receives substantially appreciated inventory or unrealized receivables in exchange for its interest in certain other partnership property (or receives certain other property in exchange for its interest in substantially appreciated inventory or unrealized receivables) is treated as a taxable sale or exchange of property, rather than as a nontaxable distribution (sec. 751(b)).

For purposes of these rules, inventory of a partnership generally is treated as substantially appreciated if the fair market value of the inventory exceeds 120 percent of adjusted basis of the inventory to the partnership (sec. 751(d)(1)(A)). In applying this rule, inventory property is excluded from the calculation if a principal purpose for acquiring the inventory property was to avoid the rules relating to inventory (sec. 751(d)(1)(B)).

6. Treatment of appreciated property contributed to a partnership

(sec. 1066 of the bill and secs. 704(c)(1)(B) and 737 of the Code)

If the property is subsequently distributed to another partner within 5 years of the contribution, the contributing partner generally recognizes gain as if the property had been sold for its fair market value at the time of the distribution (sec. 704(c)(1)(B)). Similarly, the contributing partner generally includes pre-contribution gain in income to the extent that the value of other property distributed by the partnership to that partner exceeds its adjusted basis in its partnership interest, if the distribution by the partnership is made within 5 years after the contribution of the appreciated property (sec. 737).

If a partnership distributes property to a partner, the partner does not recognize gain except to the extent any money (including marketable securities) received in the distribution exceeds the partner's basis for its partnership interest (sec. 731(a)). In addition, a partnership does not recognize gain on a distribution to a partner (sec. 731(b)).

7. Earned income credit compliance provisions

(sec. 1067 of the bill and secs. 32, 6213(g) and 6695 of the Code)

The parameters for the credit depend upon the number of qualifying children the individual claims. For 1997, the parameters are given in the following table:

             PRESENT-LAW EARNED INCOME CREDIT PARAMETERS

The fraud penalty, which is imposed at a rate of 75 percent, applies to the portion of any underpayment that is attributable to fraud (sec. 6663).

Neither the accuracy-related penalty nor the fraud penalty is imposed with respect to any portion of an underpayment if it is shown that there was a reasonable cause for that portion and that the taxpayer acted in good faith with respect to that portion.

The IRS must follow deficiency procedures when investigating other types of questionable EIC claims. Under these procedures, contact letters are first sent to the taxpayer. If the necessary information is not provided by the taxpayer, a statutory notice of deficiency is sent by certified mail, notifying the taxpayer that the adjustment will be assessed unless the taxpayer files a petition in Tax Court within 90 days. If a petition is not filed within that time and there is no other response to the statutory notice, the assessment is made and the EIC is denied.

In addition, if any part of an understatement of tax on a return or claim for refund is attributable to a willful attempt by an income tax return preparer to understate the tax liability of another person or to any reckless or intentional disregard of rules or regulations by an income tax return preparer, then the income tax return preparer is subject to a penalty of $1,000 with respect to that return or claim (sec. 6694(b)).

Also, a penalty for aiding and abetting the understatement of tax liability is imposed in cases where any person aids, assists in, procures, or advises with respect to the preparation or presentation of any portion of a return or other document if (1) the person knows or has reason to believe that the return or other document will be used in connection with any material matter arising under the tax laws, and (2) the person knows that if the portion of the return or other document were so used, an understatement of the tax liability of another person would result (sec. 6701).

Additional penalties are imposed on return preparers with respect to each failure to (1) furnish a copy of a return or claim for refund to the taxpayer, (2) sign the return or claim for refund, (3) furnish his list of the returns prepared, and (5) file a correct information return (sec. 6695). The penalty is $50 for each failure and the total penalties imposed for any single type of failure for any calendar year are limited to $25,000.

8. Eligibility for income forecast method

(sec. 1068 of the bill and secs. 167 and 168 of the Code)

MACRS does not apply to certain property, including any motion picture film, video tape, or sound recording or to other any property if the taxpayer elects to exclude such property from MACRS and the taxpayer applies a unit-of-production method or other method of depreciation not expressed in a term of years. Section 197 does not apply to certain intangible property, including property produced by the taxpayer or any interest in a film, sound recording, video tape, book or similar property not acquired in transaction (or a series of related transactions) involving the acquisition of assets constituting a trade or business or substantial portion thereof. Thus, the cost of a film, video tape, or similar property that is produced by the taxpayer or is acquired on a "stand-alone" basis by the taxpayer may not be recovered under either the MACRS depreciation provisions or under the section 197 amortization provisions. The cost of such property may be depreciated under the "income forecast" method.

The income forecast method is considered to be a method of depreciation not expressed in a term of years. Under the income forecast method, the depreciation deduction for a taxable year for a property is determined by multiplying the cost of the property (less estimated salvage value) by a fraction, the numerator of which is the income generated by the property during the year and the denominator of which is the total forecasted or estimated income to be derived from the property during its useful life. The income forecast method is available to any property if (1) the taxpayer elects to exclude such property from MACRS and (2) for the first taxable year for which depreciation is allowable, the property is properly depreciated under such method. The income forecast method has been held to be applicable for computing depreciation deductions for motion picture films, television films and taped shows, books, patents, master sound recordings and video games.¹²⁷ Most recently, the income forecast method has been held applicable to consumer durable property subject to short-term "rent-to-own" leases.¹²⁸

Finally, the Committee provides a MACRS class life for consumer durables subject to rent-to-own contracts, in order to avoid future controversies with respect to the proper treatment of such property.

In addition, consumer durables subject to rent-to-own contracts are provided a three-year recovery period and a four-year class life for MACRS purposes (and would not be eligible for the income forecast method). Such property generally is described in Rev. Proc. 95-38, 1995-34 I.R.B. 25.

9. Require taxpayers to include rental value of residence in income without regard to period of rental

(sec. 1069 of the bill and secs. 280A and 1016 of the Code)

10. Modify the exception to the related party rule of section 1033 for individuals to only provide an exception for de minimis amounts

(sec. 1070 of the bill and sec. 1033 of the Code)