Economic Recovery Tax Act of 1981 (P.L. 97-34)

II. General Reasons for the Bill

III. Revenue Effects of the Bill

IV. Explanation of the Bill

VII. Changes in Existing Law Made by the Bill, as Reported

VIII. Additional Views of the Hon. James R. Jones

IX. Additional Views of the Hon. Don J. Pease

X. Minority Views

XI. Additional Views of the Hon. Bill Frenzel

XII. Additional Dissenting Views of the Hon. W. Henson Moore

The principal provisions of the bill are as follows:

• A 2-year sequential reduction in individual income taxes, with most of the tax relief targeted to middle-income taxpayers.

• A third year of targeted tax reduction for 1984, contingent on achieving the Reagan Administration's forecasts of inflation rates, interest rates and the federal budget deficit in 1983.

• An increase in the top income tax rate to 60 percent in 1982 and 50 percent in 1983, providing a top capital gains rate of 20 percent after 1982.

• An increase in the zero bracket amount (formerly the standard deduction) from $2,300 to $2,500 for single persons and from $3,400 to $3,800 for married couples.

• An increase in the rate of the earned income tax credit from 10 percent to 11 percent (providing an increase in the maximum credit from $500 to $550), and an increase in the income range over which that credit phases out from $6,000-$10,000 to $8,000-$12,000.

• Further increases in the zero bracket amount and the earned income credit if the third-year tax cuts are triggered.

• A deduction for married couples, designed to reduce the marriage tax penalty, equal to 10 percent of the first $50,000 of earnings of the spouse with the lesser amount of earnings.

• An increase in the 20-percent rate of the child and dependent care tax credit for taxpayers whose income is less than $30,000, and an increase in the maximum credit for all taxpayers.

• Replacement of the existing system of depreciation of personal property and the investment tax credit with a new "expensing" system under which the costs of most personal property (including machinery and equipment) will be deducted in the year the property is placed in service.

• Accelerated cost recovery for structures over a 15-year period.

• A new system of declining balance capital cost recovery for long-lived public utility property and certain other real and personal property.

• A reduction of the top corporate income tax rate from 46 percent to 34 percent, phased in by 1987.

• Reductions in the graduated corporate tax rates designed to provide relief to small corporations and immediate expensing of up to $25,000 of investment each year.

• Replacement of the existing 10-percent investment credit for rehabilitating industrial or commercial structures with a new credit of 15 percent for industrial or commercial structures 30 to 39 years old, 20 percent for such structures more than 39 years old, and 25 percent for certified historic structures.

• An extension of the investment credit carryback period to aid six distressed industries.

• A series of tax changes designed to aid small businesses, including an increase in the maximum number of shareholders for a subchapter S corporation, eligibility of preferred stock of small business corporations for ordinary loss treatment, and an increase in the credit against the accumulated earnings tax from $150,000 to $250,000.

• An increase in the maximum deduction for contributions to an individual retirement account (IRA) from the lesser of 15 percent of compensation or $1,500 to the lesser of 100 percent of compensation or $2,000.

• Extension of eligibility for IRA's to active participants in tax-qualified pension plans.

• An increase in the annual limit on deductible contributions to H.R. 10 (Keogh) plans from $7,500 to $15,000.

• Repeal of the $200 interest and dividend exclusion ($400 for a joint return) after 1981, when the law will revert to the prior exclusion for up to $100 of dividends per taxpayer.

• Exclusion of up to $1,000 of interest ($2,000 for joint returns) on qualified savings certificates issued by depository institutions investing in residential financing.

• An exclusion for up to $1,500 ($3,000 for a joint return) of dividends from public utilities if they are reinvested in the stock of the same utility, in which case the dividends will be treated as stock dividends and will reduce the taxpayer's basis in the stock, thereby increasing his capital gain when he sells the stock.

• A 25-percent tax credit for incremental expenditures for research and experimentation.

• Allocation, for one year, pending a study, of research and experimental expenditures made in the U.S. entirely to U.S.-source income.

• An increased charitable deduction for new scientific equipment donated by the manufacturer to colleges or universities for research purposes.

• A $95,000 exclusion for income earned abroad by U.S. citizens and residents, and an additional exclusion for excess housing costs.

• An increase in the unified credit against the estate and gift taxes which, when fully effective, will increase the level of taxable transfers at which the estate and gift tax rates begin from $175,625 to $600,000.

• A reduction in the top estate tax rate from 70 percent to 50 percent.

• Removal of the existing limits on the marital deduction, so that no transfer tax will be imposed on gifts and bequests between spouses.

• An increase in the annual exclusion for gifts to any one donee from $3,000 to $10,000, as well as an unlimited gift tax exclusion for gifts made to pay medical expenses and school tuition.

• Liberalization of the rules regarding the current use valuation of farms, small businesses and woodlands and an increase in the maximum allowable reduction in the taxable estate from current use valuation from $500,000 to $1 million.

• Various technical changes to the estate and gift taxes.

• An exemption from the windfall profit tax for the first 500 barrels per day of new, heavy and tertiary oil, and a windfall profit tax exemption for old oil and stripper oil of up to 100 barrels per day in 1982 through 1984, 200 barrels per day in 1985 and 350 barrels per day in 1986, with the aggregate exemption for all tiers of oil limited to 500 barrels per day.

• A $2,500 credit against the windfall profit tax for royalty owners for 1981, and an exemption from that tax for royalty owners for 1 barrel per day in 1982 through 1984, 2 barrels per day in 1985 and 3-1/2 barrels per day thereafter.

• Windfall profit tax exemption for certain front-end tertiary oil for projects certified for subsidization by the Department of Energy on or before decontrol of oil prices on January 28, 1981, and also exemption for oil owned by certain residential child care agencies.

• Treatment of natural gas retailers as independent producers for purposes of the special tax rates under the windfall profit tax.

• Exemption from taxation for foreign oil and gas extraction income, denial of deductions and credits attributable to such income, and current taxation of certain other foreign oil related income.

• A tax credit for builders of passive solar residences of up to $2,000 per home.

• A series of changes in the law designed to curtail the use of commodity straddles to defer taxes on unrelated income and to convert unrelated ordinary income and short-term capital gains into long-term capital gains.

• An increase in the railroad retirement tax rate for employers and a new 2-percent tax on employees.

• More current adjustment of the interest rate on tax deficiencies and tax refunds to the prime interest rate.

• An increase in the exemption from the estimated tax penalty for individuals from $100 to $500.

• A new "no-fault" penalty in cases where underpayments of tax result from overstatements of the value of property.

• Elimination, for large corporations, of the "prior year's tax" exception to the rule that corporations must cover 80 percent of their current year's tax liability with estimated tax payments.

• A 2-year extension of the recently expired moratoriums on the issuance of final regulations on the tax treatment of fringe benefits and the issuance of regulations and rulings changing the tax treatment of commuting expenses.

• Amortization over 60-months of the adjusted basis of motor carriers' operating rights held on July 1, 1980.

• Extension and restructuring of the expiring targeted jobs tax credit.

• Extension of the recently expired rules on the tax treatment of business expenses of State legislators, with some modifications of those rules.

• Capital gains treatment for certain stock options.

• An increase from 18 months to 24 months in the period in which taxpayers must reinvest the proceeds of the sale of a principal residence in a new principal residence in order to avail themselves of the rollover provision in present law.

• An increase from $100,000 to $125,000 in the exclusion for capital gains on sales of principal residences by taxpayers age 55 or over.

• Extension through 1987 of the expiring exemption for investors in low-income housing projects from the requirement that taxpayers capitalize interest and taxes paid during construction period of a building.

• Tax exemption for bonds issued to finance equipment leased to mass transit systems and bonds issued by volunteer fire departments.

• Authorizations of payments to the governments of Guam and the Virgin Islands to compensate them for the revenue loss from the tax cuts in the bill.

• Charging of interest on new Federal unemployment compensation loans to States and, if certain solvency conditions are met, freezing of the net Federal unemployment tax in States with outstanding loans in default.

Marginal tax rates

The bill reduces income tax rates by an average of approximately one percent for calendar year 1981, 10 percent for 1982 and 16 percent for 1983. The top tax rate is reduced from 70 percent to 60 percent in 1982 and to 50 percent in 1983. This reduces the top tax rate on long-term capital gains from 28 percent to 24 percent in 1982 and to 20 percent in 1983. Apart from the reduction in the top tax rate, the rate cuts are specifically targeted to help taxpayers whose income is between $15,000 and $50,000.

Zero bracket amount

The bill raises the zero bracket amount (formerly the standard deduction) from the present level of $2,300 for single persons to $2,350 in 1981 and to $2,500 in 1982 and subsequent years. For married couples, the increase is from $3,400 to $3,500 in 1981 and to $3,800 in 1982 and subsequent years.

Withholding changes

These tax cuts are to be reflected in reductions of taxes withheld from worker's paychecks on October 1, 1981, and July 1, 1982.

Earned income credit

The bill increases the rate of the earned income tax credit from 10 to 11 percent, thereby raising the maximum credit from $500 to $550, and it increases the phaseout of that credit from the income range between $6,000 and $10,000 to the range between $8,000 and $12,000.

Marriage penalty

To reduce the marriage tax penalty, the bill provides a new deduction for two-earner married couples equal to 10 percent of the first $50,000 of earnings of the spouse with the lesser amount of earnings.

Child care credit

For taxpayers with income below $30,000, the bill raises the rate of the tax credit for expenses incurred in caring for children and dependents. For taxpayers with incomes of $11,000 or less, the rate of the credit is raised from 20 percent to 40 percent, and the rate is phased down to 20 percent as income rises from $11,000 to $30,000. The maximum amount of expenditures eligible for the credit is increased for all taxpayers from $2,000 to $2,400 for each of the taxpayer's first two dependents.

Triggered tax cut for 1984

The bill also provides a further tax cut for 1984. which will take effect only if certain economic and fiscal conditions are satisfied in 1983. This new tax cut provides reductions in tax rates targeted to middle-income taxpayers, a further increase in the zero bracket amount of $100 for single persons and $200 for married couples, and a further increase in the earned income tax credit to 11 percent of the first $6,000 of earnings (maximum credit of $660), phased out in the income range $9,000 to $14,000. This tax cut will take effect only if the federal budget deficit for fiscal year 1983 is less than $22.9 billion, the consumer price index for the third quarter of 1983 is less than 309, and the interest rate on 91-day Treasury bills is less than 7-1/2 percent. These deficit, inflation and interest rate assumptions are the projections of the Reagan Administration in its Mid-Session Review of the 1982 Budget.

Revenue impact

Assuming the triggered 1984 tax cuts do not go into effect, the revenue loss from the individual tax cuts provided in the bill is $27.7 billion in fiscal year 1982, $73.7 billion in fiscal year 1983, and $89.4 billion in fiscal year 1984. In addition, there are increases in outlays resulting from the changes in the earned income tax credit of $49 million in fiscal year 1982, $649 million in fiscal year 1983, and $638 million in fiscal year 1984. If the triggered tax cuts do go into effect, there are further tax reductions of $19.6 billion in fiscal year 1984.

Personal property

For personal property (including machinery and equipment), depreciation and the regular investment tax credit are replaced by a system of "expensing," under which the cost of personal property is to be written off in the year the property is placed in service. The committee adopted expensing because there is wide agreement among experts that expensing eliminates any adverse effects of the tax system on incentives for businesses to invest in equipment and that, unlike the present system, expensing provides the same incentive for investment in different kinds of assets, thereby promoting the efficient allocation of resources.

The committee's expensing proposal is phased in over a 10-year period. Between 1981 and 1985, present law depreciation and the regular investment credit are phased out, and an increasing percentage of investment (20 percent in 1981, 40 percent in 1982, and so forth) is made eligible for the new system. Initially, costs eligible for expensing are written off over a 2-year period. However, starting in 1986, the 2-year write-off is phased into a full expensing system. In order to simplify recordkeeping for small businesses, the bill allows all taxpayers to elect to expense fully $25,000 of investment in any year, starting with 1981.

To provide flexibility, the bill gives taxpayers an election to expense only a portion of their investments eligible for expensing each year and instead to recover costs over a longer useful life.

Real property

Under the bill, real estate is written off over 15 years, and taxpayers may elect to use the 150-percent declining balance method of depreciation. Low-income housing and nonresidential investment in distressed areas are eligible for a 200-percent declining balance method.

When a taxpayer disposes of nonresidential real estate for which an accelerated method of depreciation is elected, all gain is "recaptured" as ordinary income to the extent of all prior depreciation deductions. For residential real estate, however, gain will be recaptured as ordinary income only to the extent of the excess of accelerated over straight-line depreciation. When a straight-line method of depreciation is used, all gain is treated as capital gain for both residential and nonresidential structures.

Public utility property

Public utility property with a useful life under the present ADR system of 18 years or less is eligible for expensing. Public utility property with a life of 18.5 to 25 years (including oil pipelines) is depreciated under an open account system using a 150-percent declining balance rate over a 10-year life (i.e., a depreciation rate of 15 percent per year applied to the balance remaining in the taxpayer's recovery account). Railroad tank cars and certain short-lived real property (e.g., mobile homes and theme park structures) are also included in the 10-year class. Public utility property with a life of more than 25 years is depreciated under a similar open account system with a 15-year life (i.e., a depreciation rate of 10 percent applied to the remaining balance in the taxpayer's recovery account).

Revenue impact

The committee's capital cost recovery proposal will reduce revenues by $9.6 billion in fiscal year 1982, $16.0 billion in 1983, and $23.3 billion in 1984.

Effective date

These changes will apply to property placed in service after December 31, 1980.

Also, to aid small business, the bill widens the graduated corporate rate brackets and reduces the tax rates in those brackets. These changes are phased in over 3 years. When fully effective, in 1984, the corporate tax rate will be 15 percent on the first $50,000 of taxable income, 20 percent on the next $50,000, 25 percent on taxable income between $100,000 and $150,000, and 30 percent on taxable income between $150,000 and $200,000.

The corporate rate cuts will reduce revenues by $0.5 billion in fiscal year 1982, $1.4 billion in 1983 and $4.7 billion in 1984.

These changes apply to expenditures made after December 31, 1981.

Individual retirement accounts

The bill increases the maximum deduction for contributions to an individual retirement account (IRA) from the lesser of 15 percent of compensation or $1,500 to the lesser of 100 percent of compensation or $2,000. Active participants in tax-qualified pension, profit-sharing, or stock bonus plans, tax sheltered annuity programs, and government plans are made eligible for IRA deductions.

Self-employed retirement plans

The bill increases the limit on deductions for contributions to H.R. 10 (Keogh) plans, subchapter S plans, and simplified employee pensions from $7,500 to $15,000.

Interest and dividend exclusion

The bill terminates the present $200 interest and dividend exclusion ($400 for a joint return) after 1981. In 1982, the law will revert to the prior exclusion for up to $100 of dividends per taxpayer.

Interest on qualified savings certificates

The bill introduces an exclusion for interest on a qualified savings certificate. There is a lifetime limit on the amount excludable of $1,000 for a single person and $2,000 for a married couple. These certificates must have a one-year maturity, yield no more than 70 percent of the one-year Treasury bill rate, and be issued between September 30, 1981, and October 1, 1982, by a depository institution which invests a proportion of the new deposits it raises from these certificates in residential financing.

Dividend reinvestment plans

The bill provides a new exclusion for up to $1,500 ($3,000 for a joint return) of dividends from public utility stock which are reinvested in a qualified dividend reinvestment plan. These dividends will be treated as stock dividends; that is, they will increase the capital gain, or reduce the capital loss, when the stock is sold.

Effective date

Except for the exclusion for interest on qualified savings certificates, the savings incentives in the committee's bill are effective in 1982.

Revenue impact

The various savings incentives in the bill will reduce revenues by $0.3 billion in fiscal year 1982, $2.1 billion in fiscal year 1983 and $4.1 billion in fiscal year 1984.

Incremental tax credit

The bill introduces a 25-percent credit for certain research and experimental expenditures in excess of a 3-year moving average base period, effective for expenditures made after June 30, 1981, and before January 1, 1986.

Allocation to foreign income

The bill allows the allocation of research and experimental expenditures which are incurred in activities conducted in the United States entirely to U.S.-source income for one year. The Treasury is directed to make a study of the impact of its regulations on this issue.

Charitable contributions of research equipment

The bill gives corporations an increased charitable deduction for newly manufactured scientific equipment donated to a college or university for research purposes.

Revenue impact

The incentives for additional research and experimentation will reduce revenues by $483 million in fiscal year 1982, $842 million in 1983 and $950 million in 1984.

Subchapter S corporations

The bill raises from 15 to 25 the maximum number of shareholders in a subchapter S corporation (a small business corporation which is taxed, in many respects, like a partnership).

Ordinary loss treatment

The bill extends to preferred stock the ordinary (as opposed to capital) loss treatment now given to common stock of small business corporations.

Accumulated earnings credit

The bill raises from $150,000 to $250,000 the credit against the tax on excess accumulated earnings of corporations.

Study of accounting methods

The bill directs the Treasury Department to study simpler methods of inventory accounting.

Stock options

The bill extends capital gains treatment to stock options. There will be no tax consequences to either the employer or employee either when such options are issued or when they are exercised. When the stock is sold, the employee's gain will be treated as a capital gain. These rules apply to options to purchase up to $75,000 of stock each year.

These exclusions are effective in 1982 and will reduce revenues by $299 million in fiscal year 1982, $563 million in 1983 and $620 million in 1984.

Unified credit

The bill increases the unified credit against the estate and gift taxes over a period of 6 years, starting in 1982. When fully effective, these increases in the unified credit will raise the level of taxable transfers at which the estate and gift tax rates begin from $175,625 to $600,000.

Rate reductions

The bill reduces the top estate tax rate from 70 percent to 50 percent, so that it corresponds with the top income tax rate. When fully phased in, in 1985, the 50-percent tax rate will apply to taxable gifts and bequests in excess of $2-1/2 million.

Marital deduction

The bill eliminates the present limits on the marital deduction under the gift and estate taxes. Thus, there will be no transfer tax on transfers between spouses. Certain terminable interests are made eligible for the marital deduction.

Gift tax exclusion

The annual gift tax exclusion for gifts to any individual person is increased from $3,000 to $10,000 ($20,000 for a married couple which elects to split their gifts). In addition, there is an unlimited gift tax exclusion for gifts to pay medical expenses and school tuition.

Current use valuation

The bill increases the present $500,000 limit on the amount by which the fair market value of farms, woodlands and other business real estate can be reduced for estate tax purposes through the provisions for current use valuation to $1 million over a 3-year period. The bill also makes a number of technical amendments making current use valuation more generous and easier to use, particularly for woodlands.

Deferred payment

The bill merges the two existing provisions which defer payment of estate taxes attributable to interests in closely held businesses. The new deferral provision is simpler and more generous than the existing provisions.

Other amendments

Finally, the bill makes a series of relatively technical amendments to the estate and gift taxes designed to simplify them and reduce the burden of these taxes.

Producer exemption

The bill contains an exemption from the windfall profit tax, for all oil producers, for up to 500 barrels per day of newly discovered, heavy or incremental tertiary oil (that is, oil in tier 3 of the tax), effective January 1, 1982. Producers are also exempt on a limited amount of old or stripper oil (tiers 1 and 2 of the tax). This exemption for tier 1 and tier 2 oil is limited to 100 barrels per day in the years 1982 through 1984, 200 barrels per day in 1985 and 350 barrels per day thereafter. The aggregate amount of oil production which any producer may exempt under these two exemptions is limited to 500 barrels per day.

Royalty owner credit and exemption

The bill provides an exemption from the windfall profit tax for royalty owners. For 1981, there is a credit for the first $2,500 of windfall profit tax paid by a royalty owner. For subsequent years, the royalty credit is converted to an exemption of up to one barrel per day in 1982 through 1984, 2 barrels per day in 1985, and 3-1/2 barrels per day in subsequent years.

Front-end tertiary oil

The bill provides an exemption from the windfall profit tax in cases where independent producers had tertiary recovery projects certified under the Department of Energy's "front-end tertiary" program on or before January 28, 1981, when oil prices were decontrolled and the program terminated.

Gas retailers

The bill changes the definition of independent producer, for purposes of the special tax rates on tier 1 and tier 2 oil in the windfall profit tax, so that retailing of natural gas will not disqualify a producer from those special tax rates.

Child care agency exemption

The bill exempts from the windfall profit tax the oil production of certain residential child care agencies.

This change is expected to raise $577 million in fiscal year 1982, $436 million in fiscal year 1983, and $486 million in fiscal year 1984.

Loss limitation

The bill limits the deduction for losses from commodity-related straddle transactions to the amount of gains from commodity-related transactions, reduced by losses on non-straddle commodity-related transactions. This loss limitation rule applies to straddles in futures contracts, commodities, Treasury bills, other debt instruments, options and other interests in Treasury bills and debt instruments, forward contracts and currency. There is an exemption for hedging transactions.

Capitalization of interest and carrying charges

The bill requires that interest and carrying charges incurred to purchase or carry a commodity held as part of a straddle be capitalized, rather than expensed. However, there is an exemption from this rule for hedging transactions and a special rule for traders of commodity futures contracts.

Treasury bills

The bill treats Treasury bills as capital assets, so that gain or loss on their sale is treated as capital gain or loss, not ordinary gain or loss. The determination of how much of the appreciation of a Treasury bill sold before maturity is capital gain and how much is interest income is based on the market discount on the bill at the time of its acquisition by the taxpayer. Thus, if a bill is purchased six months before maturity and held for three months, one-half of the market discount is treated as interest and taxed as ordinary income and any additional difference between the sales price and the purchase price is treated as capital gain or loss.

Dealer designation rule

The bill requires dealers in securities to identify a security as being held for investment (and thereby eligible for capital gain treatment) on the day of acquisition rather than 30 days after acquisition, as is the case under present law.

Sale or exchange requirement

The bill requires that all taxable dispositions of capital assets which are actively traded or which are commodity related assets be treated as sales or exchanges, thereby producing capital gain or loss.

These changes will raise $512 million in fiscal year 1982, $555 million in fiscal year 1983 and $604 million in fiscal year 1984.

Interest rates

The bill provides for a more current adjustment of the interest rate paid on tax refunds and deficiencies to the prime interest rate. This adjustment will, under the bill, be made annually and be based on 100 percent of the prime rate.

Valuation penalty

A major problem with abusive tax shelters occurs when taxpayers claim excessive valuations for assets which are involved in a transaction. The bill imposes a "no fault" penalty from 10 to 30 percent in the case of underpayments of tax resulting from overstatements of the valuation of property. This additional penalty would not apply in the case of underpayments of tax of less than $1,000, nor would it apply for property held more than 5 years.

Corporate estimated tax

The bill requires that large corporations make estimated tax payments of at least 80 percent of the current year's tax liability.

Estimated tax for individuals

The bill increases from $100 to $500 the exemption from the estimated tax penalty for individuals, phased in over a 4-year period. Thus, after 1984, there will be no estimated tax penalty unless an individual's tax liability exceeds the sum of his withheld and estimated tax payments by more than $500.

TCMP data

The bill safeguards from disclosure the Taxpayer Compliance Measurement Program data used by the IRS for developing formulas to select tax returns for audit.

The bill also permits tax exemption for the obligations of volunteer fire departments, when the proceeds are used for fire fighting equipment.

Targeted jobs tax credit

The bill extends for 3 years the targeted jobs tax credit, which is now scheduled to expire at the end of 1981. It also makes some changes to simplify, and better target, that tax credit. The maximum amount of wages eligible for the credit is raised from $6,000 to $10,000.

Fringe benefits and commuting expenses

The bill extends through May 31, 1983, the recently expired moratorium on the issuance of final regulations on the tax treatment of fringe benefits, as well as a similar moratorium on regulations and rulings changing the tax treatment of expenses to commute to temporary job sites.

State legislators travel expenses

The bill extends through 1982 a modified version of the recently expired rules concerning the tax treatment of the business expenses of State legislators. A legislator will be treated as having incurred business expenses in an amount equal to the sum determined by multiplying the number of his legislative days by the greater of the Federal per diem or the State per diem. "Legislative days" for this purpose include days when the legislator was not away from home overnight.

Construction period interest and taxes

The bill postpones until 1987 the effective date of the requirement that investors in low-income housing projects capitalize interest and taxes paid during the construction period of a building.

Passive solar tax credits

The bill provides a credit to builders of passive solar residences of up to $2,000 per home. These residences use the design of the building to economize on energy costs. The credit would phase out by the end of 1989.

Motor carrier operating rights

The bill allows motor carriers to amortize over 60 months the adjusted basis of their operating rights held on July 1, 1980, many of which declined in value significantly as a result of the deregulation of trucking.

Payments to Guam and the Virgin Islands

The bill authorizes an appropriation for payments to the governments of Guam and the Virgin Islands to reimburse those governments for the loss of tax revenues which results automatically from the tax reductions in the committee's bill. These revenue losses occur because these possessions have tax systems which are "mirror images" of the U.S. tax system, so that their tax law changes automatically whenever the U.S. tax law changes.

The economy has deteriorated over several year, and the tax laws have contributed to this trend by putting successively greater tax burdens on the income from productive activities. Whether from work, investment or savings, income has been subjected to effectively higher tax rates year after year since 1977. Meanwhile, unemployment has risen and worker productivity has declined. Neither investment nor savings have been adequate for necessary adjustments to higher energy costs, international competition and technological advances. For the third consecutive year, the rate of economic growth is likely to be below its postwar average.

The committee believes that a major tax cut is essential to a solid economic recovery. In structuring the tax reduction program, the committee has attempted to design measures which equitably increase incentives for individuals and businesses, whatever their circumstances, to earn, produce, save and invest. In fixing the size of the tax cut, the committee has attempted to provide the appropriate amount of stimulus for a broad and orderly economic expansion, instead of a smaller amount that would be ineffectual or a larger amount that would be inflationary.

The second reason for the personal tax reduction is to stimulate economic recovery. High tax rates on additional dollars of income received not only discourage additional work and savings but also encourage tax avoidance schemes that tie up capital and inventiveness in unproductive uses. The committee believes that these marginal tax rates should be lowered in every tax bracket and that the greatest reduction should be made in the top bracket. However, the committee believes that rate reductions below the top bracket should be targeted to middle-income people.

The committee intends that the individual tax cut should significantly reduce the marriage tax penalty because it is unfair and undermines respect for the tax system. This penalty occurs when persons with relatively equal incomes marry and is reduced approximately in half by the committee bill.

The committee believes that individual income tax reductions should take effect over several years. Multiyear cuts give stronger incentives for individuals to make the long-run commitments that sustain economic growth. Moreover, multiyear cuts impart a steady and measured stimulus to the economy, thus regulating effects of the total tax reduction on inflation, interest rates and the federal budget. However, in approving prospective tax reductions, the committee believes that a contingency mechanism should be provided to implement the final phase of the personal tax cut only if it would be appropriate in light of then current economic conditions. This triggering mechanism for the third-year tax cut will ensure that the tax reductions in the bill do not worsen inflation and interest rates or create large budget deficits.

In order to achieve these objectives, to stay within responsible fiscal targets and to avoid an inflationary over-stimulation of consumer spending, the committee has concluded that the appropriate size of the personal tax reduction is $3.7 billion for calendar year 1981, $46.8 billion for 1982 and $79.9 billion for 1983.

In its hearings on tax reduction, the committee heard numerous witnesses testify that the methods for determining depreciation deductions under current law contribute to insufficient and inefficient investment. Deductions spread over a term of years are eroded by inflation, reducing their real value, the profitability of investment and hence the incentive to invest. In addition, the current system of depreciation and investment credits contains unintended biases that favor acquisition of certain types of assets more for their tax benefits than their productivity, so that investment spending is diverted from more efficient uses. The committee agrees with these criticisms and believes that this tax reduction program should provide for expensing. This simple depreciation rule gives the maximum acceleration of depreciation deductions, insulates these deductions from the adverse effects of inflation, and eliminates tax incentives to make inferior investments.

The committee believes that substantial reductions in corporate income tax rates are necessary for economic recovery to occur along a broad front. These reductions will encourage expansion and innovation in all lines of productive activity--including small businesses, high technology industries, service industries and other businesses which are not capital intensive and which will be helped less by the accelerated depreciation provided in the committee bill. Cuts in the corporate income tax rates are also necessary to reduce the inequity of double taxation, since income from investments made by incorporated business is taxed once under this tax and again under the individual income tax when shareholders receive dividends or sell appreciated shares.

The committee believes that the modernization of plant and equipment in the nation's basic heavy industries is essential for a well grounded economy recovery. However, some of these industries, now economically distressed, are expected to be too little affected in the short run by other provisions of the committee bill that are intended to promote investment. Therefore, the committee has concluded that a tax cut should be structured that will encourage the immediate rebuilding of these distressed industries.

The committee believes that a new tax incentive for research and development is needed to maintain American preeminence in an activity that has contributed heavily to increased productivity.

The committee believes that a reduction is required in taxes on income from savings. Greater savings are needed to fund increased levels of investment for economic expansion. In addition, participation in individual retirement plans should be encouraged, for these plans are an important part of the retirement system. The bill, therefore, provides incentives for individuals to make greater contributions to private retirement accounts and to a new type of savings certificate. It also extends tax incentives for individual retirement accounts to many more taxpayers.

The committee is concerned that, after years of inflation, more transfers of property are being subjected to these taxes. The impact has been especially great on farms and small businesses, traditional and important areas of high productivity. The committee believes that substantial reductions in these taxes are needed. The committee also believes that windfall profit tax reductions are needed to encourage oil production and improve the equity of this tax.

The intent of the committee has been to structure tax reductions for stimulating saving, investment and productivity that are appropriate in the different circumstances under which different businesses operate. Long-term economic growth requires the effort of all persons and all businesses, and the benefits of growth should be equitably shared by all.

As shown in Table 1, the committee bill provides a tax reduction of $1.5 billion in fiscal year 1981, $37.8 billion in fiscal year 1982, $98.4 billion in fiscal year 1983, and $193.9 in fiscal year 1986.

On the calendar year basis, the tax reduction is $8.7 billion in 1981, $66.1 billion in 1982, $112.9 billion in 1983, and $210.3 billion in 1986.

Table 4 presents revenue estimates for provisions of the bill designed primarily for small businesses for fiscal and calendar years 1981-1986.

The committee bill includes an additional tax cut for years after 1983 contingent on certain economic and fiscal conditions being met. The revenue estimates listed above assume that these triggered tax cuts do not take effect. If they do take effect, the additional tax reduction would be $19.6 billion in fiscal year 1984, $30.8 billion in 1985 and $35.6 billion in 1986. In terms of calendar year tax liability, the revenue loss from the triggered tax cut would be $27.5 billion in 1984, $31.8 billion in 1985 and $36.8 billion in 1986.

[Estimate Tables not reproduced.]

The committee has provided a program of substantial individual income tax relief carefully designed to balance three major considerations--an equitable distribution of the tax burden, incentives for work and saving, and a prudent budgetary posture. The committee's program consists of large marginal tax rate reductions, averaging 22 percent below current law levels, a new deduction for two-earner married couples, and increases in the zero bracket amount, earned income credit, and child care credit. These changes will be reflected in successive withholding changes on October 1, 1981, July 1, 1982, and January 1, 1984, and in successive reductions in tax liability for 1981, 1982, 1983, and 1984. However, the 1984 installment of tax reduction will not go into effect unless the actual performance of the economy in 1983 is consistent with the July 1981 Office of Management and Budget forecasts of the 1983 price level, interest rate, and budget deficit.

Inflation causes increases in income taxes because price increases erode the real value of the zero bracket amount, the dollar limits which set the amount of taxable income which is taxed at each rate, the real value of the personal exemption, and the income levels used to which determine eligibility for, and the amount of, the earned income credit. Thus, unless these provisions of the income tax are adjusted, a family whose income rises merely at the rate of inflation finds that income taxes as a percentage of income will increase from one year to the next, even though the purchasing power of that income has remained constant. The committee believes that it is essential to offset this increase in each income class, in order to prevent a rise in the average income tax burden, and to provide a significant net tax reduction, above and beyond these inflation-induced increases in tax liability.

The rate of social security tax on employees has increased from 6.13 percent in 1980 to 6.65 percent in 1981, and the rate on the self employed has increased from 8.1 percent to 9.3 percent. In addition, the base of the tax has increased to $29,700, $1,500 more than the amount which would have been necessary simply to match the increase in average wages. These tax increases have been essential in order to maintain the financial soundness of the social security system; however, the onerous burden of these increases on taxpayers makes it imperative that they be offset by reductions in the income tax.

Table 5 presents figures which compare the amount of aggregate tax reduction provided to each income class by the committee bill to the increases which would occur because of bracket creep and social security increases. As the last column shows, the committee bill provides substantial net tax relief (i.e., total reductions in excess of scheduled increases) for all but one income class. The increase in the lowest income class could not be fully offset because many of the individuals in that class who are liable for payroll taxes have incomes too low to have income tax liability; these individuals cannot benefit from income tax cuts, unless they are families with children who are eligible for the refundable earned income credit which is increased in the bill. The last column of Table 5 also shows that the committee bill provides the largest net percentage tax reduction to those families in the $15,000 to $50,000 income class, since the committee believes that taxpayers in this income class, the great bulk of working taxpayers, are most in need of substantial tax relief. A similar pattern is achieved by the tax reductions provided by the committee bill for 1983 and 1984. Thus, under the committee bill, taxpayers in virtually all income classes, and especially middle income families, can look forward to tax cuts which not only offset inflation and social security increases, but also substantially reduce the percentage of their income absorbed by income and social security taxes.

         Table 5--1982 Tax Reduction, Net of Inflation and Social Security

      Table 6--Aggregate Revenue Loss and Average Tax Reduction Under

With respect to work effort, the committee believes that the reduction in marginal rates, and the resulting increase in the reward for additional work effort, will lead to increased willingness to work fulltime rather than part-time, greater acceptance of overtime assignments, less absenteeism, and more individuals in the labor force. Further, lower marginal rates should reduce the proportion of compensation which employees now demand in the form of tax-free fringe benefits, at least in part for tax reasons, and should improve voluntary compliance with the income tax.

The other individual income tax changes also should stimulate work effort. The earned income credit and child care credit increases will provide further incentive for low-income families with children to work rather than rely on transfer payment programs as a source of support. The deduction for two-earner couples will reduce by 10 percent the marginal rate applicable to the second earner's earnings. The child care credit changes will provide additional incentive for labor force participation to families with children, especially low-and middle-income families.

The committee also believes that the increase, resulting from marginal rate reductions, in the after-tax return to saving will significantly increase personal saving, thus insuring adequate financing for the additional investment encouraged by other provisions of this bill. The importance with which the committee views this need is reflected in its decision to reduce the highest marginal rate by 20 percentage points to 50 percent, a much larger reduction than those provided for other rates. Because the law already provides a special maximum tax rate on earned income, this change is intended to eliminate a substantial disincentive to investment. In addition to providing a stimulus for additional saving, the marginal rate reductions will encourage the expansion of many small business activities by increasing the after-tax return to those activities. Moreover, by increasing the after-tax cost of borrowing, marginal rate reductions will reduce the incentive for borrowing (or dissaving) that results from the present law deduction for interest. Further, individuals will be less inclined to shift their investments from highly taxed, productive activities, to lightly taxed, less productive investments, such as tax shelters and precious metals. Finally, lower marginal rates will reduce the "lock-in" effect of the present treatment of capital gains, thus increasing the likelihood that capital assets will be employed in their efficient uses.

2. Reduction in tax rates and alternative minimum tax (capital gains), increase in zero bracket amount, repeal of maximum tax, and changes in filing requirements and withholding

(secs. 101 and 102 of the bill and secs. 1, 55, 63, 541, 1348, 3402, and 6012 of the Code)

Under present law, individual income tax rates begin at 14 percent on taxable income in excess of $3,400 on a joint return and $2,300 on a single return. There is no tax on taxable income below these amounts, and this tax-free level of taxable income is called the "zero bracket amount." There is also a floor under itemized deductions equal to the zero bracket amount, so that itemizers can deduct only expenses in excess of that amount. Individual tax rates range up to 70 percent on taxable income in excess of $215,400 for joint returns and $108,300 for single returns. The existing tax rate schedule for joint returns is shown in Table 7.

Present law also imposes a 70-percent tax on the undistributed income of personal holding companies. In general, personal holding companies are closely held corporations the income of which consists largely of passive investment income.

Alternative minimum tax (capital gains)

Under present law, noncorporate taxpayers may deduct from gross income 60 percent of the amount of any net capital gain for the taxable year. (Net capital gain is the excess of net long-term capital gain over net short-term capital loss.) The remaining 40 percent of the net capital gain is included in gross income and taxed at the otherwise applicable regular income tax rates. As a result, the highest tax rate applicable to a taxpayer's net capital gain is 28 percent (70-percent top tax rate on the 40-percent includible capital gain).

Present law also imposes an alternative minimum tax (sec. 55) on noncorporate taxpayers in certain circumstances. This tax is payable by an individual to the extent that it exceeds the individual's regular income tax, including the "add-on" minimum tax (sec. 56). The alternative minimum tax is based on the sum of the taxpayer's gross income, reduced by allowed deductions, and increased by two tax preference items: (1) "excess" itemized deductions and (2) the capital gains deduction. The alternative minimum tax rate is 10 percent for amounts from $20,000 to $60,000, 20 percent for amounts from $60,000 to $100,000, and 25 percent for amounts over $100,000.

Maximum tax

Under present law, a maximum tax rate of 50 percent generally applies to personal service (earned) income.¹ Personal service income, for purposes of the maximum tax, includes items such as wages, salaries, professional fees, and amounts received from pensions or annuities. The maximum tax applies to single individuals with taxable personal service income above $41,500 and married couples with taxable personal service income above $60,000, since these are the levels at which present law tax rates exceed 50 percent.

Filing requirements

Under present law, a tax return must be filed by a single person or a head of household if his or her income is $3,300 or more a year and by a married couple filing a joint return if their income is $5,400 or more.

These amounts represent the zero bracket amount of $2,300 for single persons and heads of households and $3,400 for joint returns plus $1,000 for each personal exemption. For each additional exemption resulting from the taxpayer or his spouse being age 65 or older, these amounts are increased by $1,000. Thus, a single person age 65 or older need not file until his or her income is $4,300 or more; a married couple with only one spouse age 65 or over, $6,400 or more; and a married couple, both age 65 or older, $7,400 or more.

Withholding

The withholding tax rates reflect the present tax rates and zero bracket amount.

Individuals whose wages are subject to withholding may be entitled to a number of exemptions. Each exemption exempts $1,000 of annual wages from withholding and is claimed when filing a Form W-4. Exemptions allowed are (1) one exemption for the taxpayer; (2) one additional exemption for the taxpayer who has attained, or will attain, age 65 during the taxable year; (3) one additional exemption if the taxpayer is blind; (4) one exemption for the taxpayer's spouse (and additional exemptions for age or blindness of the spouse) unless the spouse is claiming the exemptions on a separate return; (5) one additional exemption for each dependent of the taxpayer; and (6) a zero bracket allowance (which is equal to one exemption) unless the taxpayer is married and the spouse receives wages subject to withholding or the taxpayer has withholding exemption certificates in effect with respect to more than one employer. In addition to these withholding exemptions, taxpayers may be entitled to claim additional withholding allowances for excess itemized deductions and tax credits; each such additional allowance exempts $1,000 of annual wages from withholding.

An individual who expects that income tax withheld will be less than final tax liability may reduce the number of withholding exemptions claimed or may enter into an agreement with the employer to increase the amount withheld. Individuals who have had no income tax liability for the preceding year and expect to have no tax liability for the current year may claim total exemption from withholding on wages.

The zero bracket amount serves to set an amount of taxable income which is exempt from tax and to determine the percentage of taxpayers who itemize their deductions. In order to prevent too many low-income taxpayers from having an income tax liability, to provide tax relief to low-and middle-income taxpayers, and to preserve the simplification which results when a large group of taxpayers is not required to itemize deductions, the committee determined that a moderate increase in the zero bracket amount was desirable at this time.

With respect to the withholding system, the committee is concerned both with the problem of under-withholding and the problem of over-withholding. The committee believes that the Secretary should have the authority to make the withholding requirements flexible enough to permit taxpayers to adjust their withholding in order to match tax liability as closely as possible and, thus, to reduce the possibility for over-withholding. However, the committee also is concerned that taxpayers claim no more withholding allowances than the number necessary to insure that withholding is approximately equal to tax liability. The committee bill is designed to alleviate both of these problems.

The committee bill provides new tax rate schedules for 1981, 1982, 1983, and 1984 and thereafter. The specific rate schedules for joint returns are shown in table 7. Comparable rate reductions are made in the rate schedules applying to single persons, heads of households, married persons filing separate returns, and estates and trusts.

The committee bill reduces marginal tax rates in all brackets below their present levels by 1983. These rate reductions will average 1 percent in 1981, 10 percent in 1982, 16 percent in 1983 and, contingent on the performance of the economy, 22 percent in 1984. Moreover, the highest marginal tax rate is reduced from 70 percent to 60 percent as of January 1, 1982, and from 60 percent to 50 percent as of January 1, 1983. By 1984, the tax rates on a joint return will range from 10 percent on income over $4,000 to 50 percent on income over $70,000.

In conformance with the reduction in the maximum individual income tax rate from 70 percent to 60 percent in 1982 and to 50 percent in 1983, the bill reduces the tax rate on undistributed personal holding company income to 60 percent in 1982 and to 50 percent in 1983.

 Table 7--Tax Rate Schedules Under Present Law and the Committee Bill

The tax rate reductions applicable to 1984 and the increase in the zero bracket amount and earned income credit applicable to taxable years ending after December 31, 1983, will not apply if certain economic conditions are not met. If these conditions are not all met, the rate schedules, zero bracket amounts and earned income credit applicable in 1983 will continue to apply.

The three conditions in the bill are consistent with the July 1981 Administration forecast of the economy: (1) the deficit in the Federal unified budget in fiscal year 1983 will have to be $22.9 billion or less, (2) the average of the Consumer Price Index (using a 1967 base of 100) for July, August and September of 1983 will have to be 309 or less, and (3) the 91-day Treasury bill rate for bills auctioned during July, August and September of 1981 will have to be 7.5 percent or less.

The Secretary of the Treasury will have to determine whether all of these conditions are met and publish his determination in the Federal Register before November 15, 1983.

c. Increase in zero bracket amount

The committee bill provides for three successive increases in the zero bracket amount. In 1981, the zero bracket amount will be increased by $50 for single taxpayers and married taxpayers filing separately, and by $100 for married taxpayers filing jointly. Thus, the zero bracket amount in 1981 will be $2,350 for single taxpayers, $1,750 for married taxpayers who file separate returns, and $3,500 for married taxpayers who file joint returns.

In 1982 the zero bracket amount will be increased again. The increase will be $150 for single taxpayers and married taxpayers who file separately (for zero bracket amounts of $2,500 and $1,900 respectively) and $300 for married taxpayers filing jointly (for a zero bracket amount of $3,800). Thus, over the two year period (1981 and 1982), the zero bracket amount will be increased by $200 for single taxpayers and by $400 for married taxpayers who file joint returns.

The 1984 increase in the zero bracket amount, contingent on the performance of the economy, will be $100 for single taxpayers and married taxpayers filing separately and $200 for married taxpayers filing jointly. Thus, for 1984 and after the amounts will be $2,600 for single taxpayers, $4,000 for married taxpayers filing jointly, and $2,000 for married taxpayers filing separately if the 1984 tax cuts go into effect.

d. Reduction in alternative minimum tax (capital gains)

As a result of reducing the maximum regular tax rate over a two year period, the committee bill also reduces the maximum rate of tax on net capital gains, over a two year period, even though the deduction for net capital gains is not increased. Under the committee bill, the maximum rate of tax on net capital gains, in 1982, will be 24 percent (60 percent top tax rate on the 40 percent includible capital gain). In 1983, the maximum rate of tax on net capital gains will be 20 percent (50 percent top tax rate on the 40 percent includible capital gain).

In order to conform the alternative minimum tax to the reduction in the maximum regular tax on net capital gains, the bill also reduces the top alternative minimum tax rate over a two year period. In 1982, the top alternative minimum tax rate will be 24 percent for amounts in excess of $100,000. In 1983 and after, the alternative minimum tax rate will be 10 percent for amounts from $20,000 to $60,000 and 20 percent for amounts in excess of $60,000.

e. Repeal of maximum tax

Under the committee bill, the highest marginal tax rate on all types of income is reduced to 50 percent, as of January 1, 1983. Therefore, the maximum tax rate on personal service income, which would become redundant, is repealed by the bill, as of January 1, 1983.

f. Filing requirements

The income levels at which a tax return must be filed will be increased to reflect the increases in the zero bracket amount that will occur in 1981 and 1982. For 1981 tax returns, the filing level will be $3,350 for a single person or head-of-household, $4,500 for a surviving spouse, and $5,500 for a married couple if both spouses are under age 65. The filing level for a married couple with one spouse age 65 or older will be $6,500; if both spouses are age 65 or older, the filing level will be $7,500. For 1982 tax returns, the filing level will be $3,500 for a single person or head-of-household, $4,800 for a surviving spouse, and $5,800 for a married couple if both spouses are under age 65. The filing level for a married couple with one spouse age 65 or older will be $6,800; if both spouses are age 65 or older, the filing level will be $7,800. For 1984 and after, contingent on the performance of the economy, the filing level will be $3,600 for a single person or head of household, $5,000 for a surviving spouse and $6,000 for a married couple if both spouses are under age 65. The filing level for a married couple with one spouse age 65 or older will be $7,000; if both spouses are age 65 or older, the filing level will be $8,000.

g. Withholding changes

The withholding rates and tables are to be changed by the Secretary of the Treasury to reflect the tax rate reductions and the increases in the zero bracket amount provided by the bill. Reductions in withholding rates will take effect on October 1, 1981, and July 1, 1982 and, contingent on the performance of the economy, on January 1, 1984.

In addition to the withholding changes made to reflect the tax reductions provided by the committee bill, the bill provides for several other withholding changes to give the Secretary authority to issue regulations that will permit workers to adjust their withholding to more closely match their tax liability. The committee bill makes it clear that withholding is to be determined in accordance with tables or computational procedures prescribed by the Secretary and that the maximum number of withholding exemptions to be claimed by an individual is to be determined pursuant to Treasury regulations. Under Treasury regulations, an employee will be entitled to additional withholding allowances or additional reductions in withholding. In determining the number of additional withholding allowances (or additional reductions). an employee will be permitted to take into account, to the extent and in the manner provided in the regulations, estimated itemized deductions, estimated tax credits, and such additional deductions and other items that may be specified by the Secretary in regulations. The committee expects the Secretary to issue these regulations promptly and to provide for flexibility and for additional withholding allowances in situations where taxpayers reasonably anticipate business losses during the year.

Furthermore, the bill allows the Secretary to prescribe that more than one additional withholding exemption may be allowed to taxpayers who may claim a zero bracket (special withholding) allowance because they neither are married with a spouse receiving wages nor working for more than one employer (present law allows only one additional exemption for such taxpayers). Moreover, the Secretary is authorized to provide by regulations that employees may have withholding either increased or reduced at their request (present law provides only for increases) and that an employee may achieve such increased or decreased withholding without the employer's consent. (Present law requires both the employer and employee to agree to increased withholding.)

Increases in the zero bracket amount, reductions in the alternative minimum tax, changes in filing requirements and reductions in the personal holding company tax are effective for taxable years beginning after December 31, 1980, December 31, 1981, December 31, 1982 and, contingent on the performance of the economy, for taxable years beginning after December 31, 1983. The repeal of the maximum tax rate on personal service income will be effective for taxable years beginning after December 31, 1982.

The withholding changes will apply to remuneration paid after September 30, 1981, except that the amendment allowing new procedures for computing additional withholding allowances will apply to remuneration paid after December 31, 1981. Additional changes in withholding will take place on July 1, 1982, and, contingent on the performance of the economy, on January 1, 1984.

Assuming that the additional triggered tax reductions take place, there will be additional reduction in fiscal year receipts of $19,615 million in 1984, $30,756 million in 1985, and $35,559 million in 1986. These estimates include the effects of the rate reductions, the increase in the zero bracket amount, the expanded earned income credit, and interactions with the other provisions of the bill.

3. Changes in earned income credit

(sec. 121 of the bill and secs. 43 and 3507 of the Code)

Earned income eligible for the credit includes all wages, salaries, tips, and other employee compensation, plus net earnings from self-employment. Amounts received as pension or annuity benefits may not be taken into account for purposes of the credit, nor is the credit available with respect to income of non-resident alien individuals which is not connected with a U.S. trade or business.

Individuals who are eligible for the credit are married individuals who are entitled to a dependency exemption for a child, surviving spouses (who, by definition must maintain a household for a dependent child), and heads of households who maintain a household for a child. In each case, for a taxpayer to qualify as eligible for the credit, the child must reside with the taxpayer in the United States. Furthermore, in order to claim the credit, an individual must not exclude or deduct any amounts from gross income under Code section 911 (relating to income earned by individuals in certain camps outside the United States), section 913 (relating to deductions for certain expenses of living abroad), or section 931 (relating to income from sources within possessions of the United States).

Because the purpose of the credit has been in part to offset social security taxes, and, thus to provide a work incentive, the committee believes it appropriate to increase the amount of the credit to take into account the increase in social security taxes. Thus, the committee has decided that the rate of the credit should be increased from 10 percent to 11 percent. In addition, in order to compensate for inflation since 1978, the committee has decided to raise the level at which the credit begins to phase out from $6,000 to $8,000. Further increases will be warranted in 1984 to preserve the work incentive value of the credit, and will go into effect in 1984 if the economy's performance has met the conditions specified in the previous section.

For 1984, contingent on the performance of the economy, the amount of earned income on which the credit will be allowed will increase to $6,000, thus increasing the maximum amount of the credit to $660. The credit will be limited to the excess of $660 over 13.2 percent of the excess of adjusted gross income (or, if greater, earned income) over $9,000. Thus, the credit will not be available to individuals with incomes over $14,000.

4. Deduction for two-earner married couples

(sec. 122 of the bill and secs. 62, 85, 105, and new sec. 221 of the Code)

Any attempt to rectify the marriage penalty involves the reconciliation of several competing objectives of tax policy. For many years, an accepted goal has been the equal taxation of married couples with equal incomes. This has been viewed as appropriate because married couples frequently pool their income and consume as a unit, and, thus, it has been thought that married couples should pay the same amount of tax regardless of how the income is divided between them. This result generally is achieved under current law.

The committee believes that alleviation of the marriage penalty is now necessary because large tax penalties on marriage undermine respect for the family, by affected individuals, and for the tax system itself. To do this, the committee was obliged to make a distinction between one-earner and two-earner married couples. The simplest way to alleviate the marriage penalty is to allow a percentage of the earned income of the spouse with the lower earnings to be, in effect, free from income tax.

The provision also will alleviate another effect of the current system on all married couples--high marginal tax rates on the second earner's income. Recent studies have shown that these high marginal rates have a significant adverse effect on second earners' decisions to seek paying jobs. The 10-percent reduction in marginal tax rates for second earners provided by the new deduction will reduce this work disincentive. In addition, some contend that two-earner couples are less able to pay income tax than one-earner couples with the same amount of income because the former have more expenses resulting from earning income, as well as less free time. Under this theory, the new deduction will improve equity by reducing the tax burden of two-earner couples compared to one-earner couples.

The second-earner deduction will reduce the marriage penalty and improve work incentives for second earners without abandoning the basic principle of joint returns. Allowing married couples to file individual returns as single taxpayers would be very complex because of the necessity for rules to allocate income and deductions between the spouses. If individual filing were optional, many couples would be burdened by having to compute tax liability under both options (separately and jointly) in order to determine which method minimizes their liability. Further, individual filing would provide tax reductions with respect to all types of income received by married couples, while the committee believes that relief should be targeted for wages and salaries received by second earners. Also, individual filing would reduce taxes only for couples affected by the marriage penalty, while the committee believes there should be a reduction for all two-earner married couples.

The substantial reductions in the marriage penalty resulting from both this new deduction and the overall reductions in marginal rates provided by the committee bill are shown in table 8. This new deduction is a major step toward the goal of eliminating the marriage penalty completely.

In general, qualified earned income is earned income within the meaning of section 401(c)(2)(C) or section 911(d)(2) (as redesignated by the bill) less specified deductions allowable under section 62 that are properly allowable to or chargeable against such earned income in determining qualified earned income. Qualified earned income will be determined without regard to the 30-percent limitation on compensation from a trade or business in which both personal services and capital are material income-producing factors. Qualified earned income is not intended to include unemployment compensation paid under a government program.

Under the bill, qualified earned income does not include any amount that is not includible in gross income, because untaxed income does not give rise to a work disincentive or a marriage penalty. In addition, the qualified earned income of each spouse will be computed without regard to any community property laws; that is, earned income will be attributed to the spouse who renders the services for which the earned income is received.

    Table 8--Marriage Tax Penalty for Two-Earner Couples in 1983:

Committee bill computations assume the rate schedules in effect in 1983.

Pensions, annuities, individual retirement plan distributions and deferred compensation are excluded from qualified earned income. In general, deferred compensation is any amount received after the close of the taxable year following the taxable year in which the services to which the amount is attributable are performed. Pensions and annuities are excluded because these amounts are composed largely of investment income (e.g. interest on plan contributions) that has accumulated tax-free. This exclusion is also necessary to focus the benefits of this deduction on individuals currently earning income and to avoid a windfall for those whose work took place in past years. The exclusion of pensions and annuities is consistent with the definitions applicable to the earned income credit. Distributions from individual retirement plans have been excluded to maintain parity with qualified plans. Other forms of deferred compensation are excluded from qualified earned income for similar reasons.

Wages exempt from certain social security taxes because an individual is in the employ of his or her spouse also are excluded from qualified earned income. These amounts are excluded because the existing exemption of these wages from social security tax already provides substantial relief to these second earners and because, otherwise, there could be opportunities to shift earned income between spouses and attribute an inaccurate or unreasonable amount of earned income to the second earner.

Certain items deductible under section 62 must be deducted in computing qualified earned income. These items are: (1) deductions attributable to a trade or business from which earned income is derived, except that if some of the gross income from a trade or business does not constitute earned income, only a proportional share of the deductions attributable to such trade or business must be deducted (section 62(1)); (2) deductions consisting of expenses paid or incurred in connection with the performance of services as an employee (section 62(2)); (3) deductions for contributions by a self-employed person to a qualified retirement plan (section 62(7)); (4) certain deductions relating to pension plans of subchapter S corporations (section 62(9)); (5) contributions to an individual retirement plan (section 62(10)); and (6) deductions for certain required repayments of supplemental unemployment compensation benefits (section 62(15)).

The bill includes conforming amendments specifying that the amounts of unemployment compensation and disability income included in adjusted gross income are to be computed without regard to this deduction. Then, the deduction is to be computed excluding from qualified earned income amounts of disability (or other) income not included in gross income.

The bill also provides that no deduction is allowable if either spouse claims, on the couple's joint return for the taxable year, the benefits of section 911 (relating to income earned by individuals in certain camps outside the United States) or section 931 (relating to income from sources within possessions of the United States). Couples benefiting from these provisions are excluded from the new deduction because of the substantial relief provided elsewhere in the bill for income earned abroad and the complexity of coordinating the new deduction with these provisions. This is consistent with the eligibility rules for the earned income credit.

5. Increase in child and dependent care credit

(sec. 123 of the bill and sec. 44A of the Code)

The maximum dependent care credit is $400, in the case of one qualifying individual, and $800, in the case of two or more qualifying individuals. The credit may not exceed tax liability. Moreover, the employment-related expenses that are taken into account for purposes of the credit generally may not exceed earned income, in the case of an unmarried individual, or the earned income of the lesser-earning spouse, in the case of a married couple. Married couples must file a joint return in order to claim the credit.

The increases in the credit percentage are directed toward low-and middle-income taxpayers because the committee believes that these taxpayers are in greatest need of relief. This is accomplished by a sliding-scale credit which phases down from 40 percent to 20 percent as income rises from $11,000 to $30,000.

In the case of two-earner married couples with children, this provision, along with the new deduction for two-earner married couples, will provide substantial tax reduction (especially at the lower end of the income tax brackets).

The committee bill increases the amount of employment-related expenses that may be taken into account for purposes of the credit from $2,000 to $2,400, if there is one qualifying individual, and from $4,000 to $4,800, if there are two or more qualifying individuals. The percentage amount of the credit will be increased from 20 percent to 40 percent for individuals who have less than $11,000 of adjusted gross income. Thus, the maximum credit would be $960, if there is only one qualifying individual, or $1,920 if there are two or more qualifying individuals. The 40-percent credit is reduced by one percentage point for each full $1,000 of adjusted gross income above $10,000. (For this purpose, a married couple's combined adjusted gross income is the relevant amount since married couples must file a joint return in order to claim the credit.) For example, an otherwise qualified individual with $11,000 of adjusted gross income will be entitled to a credit equal to 39 percent of employment-related expenses. Likewise, an individual with $20,000 of adjusted gross income will be entitled to a credit equal to 30 percent of employment-related expenses. Individuals with $30,000 or more of adjusted gross income will be entitled to a credit equal to 20 percent of employment-related expenses. For those individuals, the maximum credit will be $480 (one qualifying individual) or $960 (two or more qualifying individuals).

The bill provides that employment-related expenses that are incurred outside the taxpayer's household may be taken into account if they are for the care of a physically or mentally incapacitated spouse or dependent of the taxpayer who regularly spends at least 8 hours each day in the taxpayer's household, i.e., who lives with the taxpayer. This provision is intended to allow the credit for out-of-home care, during the day, of an individual who returns to the taxpayer's home each night, but the credit is not allowed for residential or institutional care.

United States citizens and residents generally are taxed by the United States on their worldwide income with the allowance of a foreign tax credit for foreign taxes paid. However, for years prior to 1978, U.S. citizens working abroad could exclude up to $20,000 of earned income a year if they were present in a foreign country for 510 days (approximately 17 months) out of a period of 18 consecutive months or they were bona fide residents of a foreign country for a period which included an entire taxable year (sec. 911). In the case of individuals who had been bona fide residents of foreign countries for three years or more, the exclusion was increased to $25,000 of earned income. In addition, under the law prior to 1978, foreign taxes paid on the excluded income were creditable against the U.S. tax on any foreign income above the $20,000 (or $25,000) limit.

The Tax Reform Act of 1976 would generally have reduced the earned income exclusion for individuals working abroad to $15,000 per year. However, the Act would have retained a $20,000 exclusion for employees of domestic charitable organizations. In addition, the Act would have made certain modifications in the computation of the exclusion.

These amendments made by the 1976 Act never went into general effect because the Foreign Earned Income Act of 1978 generally replaced the section 911 earned income exclusion, for years beginning after December 31, 1977, with a new deduction for the excess costs of working overseas. However, taxpayers were permitted to elect for 1978 to be taxed under the new provisions or under the Tax Reform Act of 1976.

Foreign Earned Income Act of 1978

The Foreign Earned Income Act of 1978 generally replaced the section 911 earned income exclusion, for years beginning after December 31, 1977, with a new deduction for the excess costs of working overseas. The basic eligibility requirements for the deduction generally are the same as for the prior earned income exclusion.

The excess living cost deduction (sec. 913) consists of separate elements for the general cost of living, housing, education, and home leave costs. The cost-of-living element of the deduction is generally the amount by which the cost of living in the taxpayer's foreign tax home exceeds the cost of living in the highest cost metropolitan area in the continental United States (other than Alaska). The deduction is based on the spendable income of a person paid the salary of a Federal employee at grade level GS-14, step 1, regardless of the taxpayer's actual income. The housing element is the excess of the taxpayer's reasonable housing expenses over his base housing amount (generally one-sixth of his net earned income). The education deduction is generally the reasonable schooling expenses for the education of the taxpayer's dependents at the elementary and secondary levels. The deduction for annual home leave consists of the reasonable cost of coach airfare transportation for the taxpayer, his spouse, and his dependents from his tax home outside the United States to his most recent place of residence within the United States.

In addition, taxpayers living and working in certain hardship areas are allowed a special $5,000 deduction in order to compensate them for the hardships involved and to encourage U.S. citizens to accept employment in these areas. For this purpose, hardship areas are generally those designated by the State Department as hardship posts where the hardship post allowance paid government employees is 15 percent or more of their base pay.

As an exception to these rules, present law permits employees who reside in camps in hardship areas to elect to claim a $20,000 earned income exclusion (under sec. 911) in lieu of the excess living cost and hardship area deductions. No foreign tax credit is allowed for foreign taxes attributable to the excluded amount, and deductions attributable to the excludable amount are not allowed. For taxpayers electing the exclusion, the camp is treated as the employer's business premises so that the exclusion for employer-provided meals and lodging also can be claimed (provided the other requirements of sec. 119 are satisfied).

The 1978 Act liberalized the deduction for moving expenses for foreign job-related moves, increasing the dollar limitations applicable to temporary living expenses. The Act also extended the regular 18- or 24-month period for reinvestment of proceeds realized on the sale of a principal residence to up to four years in the case of Americans working abroad.

Under certain circumstances, the time limits of the eligibility requirements for the excess living cost deduction or the exclusion may be waived. Three conditions must be met for the waiver to apply. First, the individual actually must have been present in, or a bona fide resident of, a foreign country. Second, he must leave the foreign country after August 31, 1978, during a period with respect to which the Treasury Department determines, after consultation with the State Department, that individuals were required to leave the foreign country because of war, civil unrest, or similar adverse conditions in the foreign country which precluded the normal conduct of business by those individuals. Third, the individual must establish to the satisfaction of the Treasury that he reasonably could have been expected to meet the time limitation requirements, but for the war, civil unrest, or similar adverse conditions. If these criteria are met, the taxpayer is treated as having met the foreign residence or presence requirements with respect to the period during which he was resident or present in the foreign country even though the relevant time limitation under existing law has not been met.

The committee also believes that the rules of present law are complex. Because the deductions can vary significantly from case to case, it is often difficult for an American to estimate what his tax liability will be if he plans to work overseas. In addition, many Americans employed abroad have found it necessary to use costly professionals to complete their tax returns.

The committee believes that it is necessary to change the tax law to encourage Americans to work abroad to help promote the export of U.S. manufactured goods and services. Reducing the tax burden on Americans working abroad will make American enterprises more competitive in foreign markets. The committee feels that abroad range of activities by Americans abroad benefit the U.S. economy and should be encouraged.

The committee concludes that an appropriate incentive, to replace the present excess foreign living cost deduction and exclusion, is to allow qualifying Americans to elect a substantial exclusion from U.S. tax for their foreign earned income. The exclusion is phased in over a four-year period. The committee has, however, placed a specific dollar limitation on the exclusion. This limitation prevents abuse of the exclusion by, for example, highly paid entertainers or athletes who might otherwise move abroad to escape large amounts of U.S. tax on their income. In addition, the committee has provided an exclusion (or, in appropriate cases, a deduction) from income measured by excess housing costs, which can be a substantial component of excess foreign living costs.

The committee also believes that the period of foreign presence required to qualify for the exclusions should be shortened, and that the residence or presence period should continue to be waived in certain circumstances where civil unrest prevents individuals from meeting those requirements.

Once a taxpayer has elected to exclude foreign earned income the election remains in effect for that year and all future years. The election may be revoked with the consent of the Commissioner. In addition the election may be revoked by the taxpayer without consent. However, if the election is revoked without consent, the taxpayer cannot again elect until the sixth taxable year following the taxable year for which the revocation was made.

If a taxpayer who elects to exclude foreign earned income becomes a resident of the United States and then, a number of years later, moves abroad again, the election remains in effect. Accordingly, that individual would not have to reelect the exclusion for that later year. If that individual does not want to be subject to the exclusion, he would have to revoke the election and would be barred from reelecting the exclusion for five years. However, the Commissioner might, in determining whether to consent to a revocation of the election, take into account U.S. residence for a period of a number of years.

In addition to the exclusion described above, an individual may elect to exclude a portion of his income or, in the case of housing amounts not provided by an employer, elect to deduct an amount for housing, based on his housing expenses. This exclusion is equal to the excess of the taxpayer's "housing expenses" over a base housing amount. The term "housing expenses" means the reasonable expenses paid or incurred during the taxable year by, or on behalf of, the individual for housing for the individual (and for his spouse and dependents, if they reside with him) in a foreign country. The term includes expenses attributable to the housing, such as utilities and insurance, but does not include interest and taxes, which are separately deductible. If the taxpayer maintains a second household outside the United States for his spouse and dependents who do not reside with him because of adverse living conditions, then the housing expenses of the second household also are eligible for the exclusion. Housing expenses are not treated as reasonable to the extent they are lavish or extravagant under the circumstances.

The base housing amount is 16 percent of the salary of an employee of the United States whose salary grade is step 1 of grade GS-14. Currently, this salary is $37,871 so the current base housing amount would be $6,059.

Housing costs attributable to amounts provided by an employer of the individual in the course of his employment are excluded from gross income of the employee. Amounts not attributed to an employer are to be allowed as a deduction in computing adjusted gross income of the employee. The amount of the deduction is limited, subject to a special carryover rule, to the foreign earned income of the individual which is not otherwise excluded from gross income under this provision. For example, if an individual who is not an employee has foreign earned income in 1982 of $100,000 and qualifying housing expenses in excess of the base amount of $20,000, the individual may elect and then deduct $75,000 under the general exclusion plus $20,000 for the excess housing cost exclusion. If, however, that individual had no foreign earned income for the year, then he could not deduct any amount attributable to the housing expenses for the year. However, the special carryover rule may allow the individual to deduct all or a portion of his unused housing expenses in the next taxable year.

The bill provides that an individual who is not an employee and who qualifies for the foreign earned income exclusion, but who has housing expenses in excess of earned income for a year can carry those expenses forward only to the next taxable year and deduct them in that year subject to the limitation in the next year. In determining how much of the carried forward housing expenses could be used in that next year the carried over amounts could be used only after the housing expenses incurred in that year.¹

Deductions and credits attributable to excluded income are not allowed. For example, foreign taxes paid on excluded income may not be credited against U.S. taxes.

As under present law, pensions and annuities, and income from certain trusts are not excludable.

The bill extends the benefits of the exclusion to individuals who are paid by the United States but who are not eligible for any exclusion under section 912 or any other provision of U.S. law. As a general rule, therefore, employees of the Federal Government will not be eligible for the exclusion.

The bill retains with certain modifications the present rule that in the case of an individual who is furnished lodging in a camp located in a foreign country by or on behalf of his employer the camp shall be considered part of the business premises of the employer for purposes of section 119, relating to the exclusion from income of the value of meals and lodging furnished by the employer. To qualify as a camp, the lodging must be furnished for the convenience of the employer because the place at which the services are rendered in a remote area where satisfactory housing is not otherwise available on the open market. The lodging must also be located, as near as practicable, in the vicinity of the site at which the individual performs the services and must also be in a common area, or enclave, which is not available to the public and which normally accommodates 10 or more employees. This provision differs from present law primarily in that the camp does not have to be in a hardship area and need not constitute substandard lodging.

The bill retains the present rules under which an individual is allowed pro rata benefits in certain cases where civil unrest or similar adverse conditions require an individual to leave the foreign country before meeting the time requirements.

The bill authorizes the Secretary of the Treasury to issue such regulations as may be necessary or appropriate to carry out the purposes of this provision, including regulations providing rules for cases in which both spouses have foreign earned income or file separate returns.

The present rule extending the period within which capital gain on the sale of a principal residence must be rolled over to qualify for exemption from tax is retained.

The provision does not affect the treatment of amounts received since December 31, 1962, which are attributable to services performed on or before December 31, 1962, and with respect to which there existed on March 12, 1962, a right (whether forfeitable or nonforfeitable) to receive such amounts. Accordingly, these amounts will continue (as they have since 1962) to be subject to section 911 as in effect before amendment by the Revenue Act of 1962.

Finally, the provision of the Foreign Earned Income Act of 1978 requiring the Secretary to report biannually to the Congress on the operation and effects of sections 911 and 912 is changed to require the report as soon as practicable after enactment and each fourth calendar year thereafter.

(sec. 151 of the bill and sec. 1034 of the Code)

2. Increase in exclusion of gain on sale of principal residence

(sec. 152 of the bill and sec. 121 of the Code)

Method.--Taxpayers are allowed to use the straight-line method of depreciation for all depreciable assets. Under the straight-line method, the recovery of the cost basis of an asset is spread evenly over the asset's useful life. However, the cost basis of most assets also can be recovered using accelerated methods, which allocate a greater share of the deductions to the early years of the asset's useful life. The most generous accelerated methods permitted under present law are the 200-percent declining balance method and the sum of the years-digits (SYD) method.¹

Gain on disposition and recapture.--In general, a taxpayer recognizes gain or loss upon each sale or other disposition of depreciable personal property. However, under ADR, the recognition of gain or loss is postponed for assets retired for routine causes (ordinary retirements), while immediate recognition of gain or loss is required on extraordinary retirements. Similar rules also apply to taxpayers who do not use ADR but who maintain item and group accounts.

When personal property is sold, any recognized gain is treated as ordinary income to the extent of any depreciation previously taken ("sec. 1245 recapture"). Any recognized gain that exceeds previously taken depreciation generally is capital gain.

The IRS guideline lives contained in Rev. Proc. 62-21 range from 40 years for apartments to 60 years for warehouses. However, based on a 1975 study by the Treasury Department's Office of Industrial Economics, average lives claimed by taxpayers for new buildings range from 32 years for apartments to 43 years for bank buildings. These averages reflect, in part, the fact that some taxpayers are using component depreciation.

Component depreciation.--Under the component method of depreciation, a taxpayer allocates the cost of a building to its basic component parts and then assigns a separate useful life to each of these components. These components include the basic building shell, wiring, plumbing and heating systems, roof, and other identifiable components. Each of the component parts is then depreciated as a separate item of property. The component depreciation method may be applied to both new and used property.

The use of component depreciation may substantially reduce the composite life for the entire building if its short-lived components, such as wiring, comprise a large portion of the building's cost as compared to its long-lived components, such as the shell. However, many taxpayers do not use the component method because it is complex and, for used property, requires a competent appraisal. In addition, it is difficult to audit component depreciation and there is no assurance that the lives chosen by the taxpayer for the components would be approved by the Internal Revenue Service or the courts.

Methods.--Allowable methods for real property depend on the use of the property. New residential rental buildings may be depreciated under the declining balance method at a rate of up to 200 percent of the straight-line rate, the sum of the years-digits method, or any other method if the total depreciation allowable during the first two-thirds of the property's useful life does not exceed the amount allowable under the 200-percent declining balance method. A building or structure is considered to be residential rental property for the taxable year only if 80 percent or more of the gross rental income is from the rental of dwelling units. New nonresidential buildings may be depreciated under the declining balance method at a rate of up to 150 percent of the straight-line rate. Used residential property with an estimated useful life of 20 years or more can be depreciated under the declining balance method at a rate of up to 125 percent of the straight-line rate. Any other used property, either residential or nonresidential, must be depreciated under the straight-line method.

Gain on disposition and recapture.--When real property is sold, any gain is treated as ordinary income to the extent the total depreciation taken exceeds the depreciation that would have been allowable had the straight-line method been used (sec. 1250). Thus, if the straight-line method is used, all gain is capital gain. This rule is more generous than the rule for personal property, under which gain is ordinary income to the extent of all depreciation taken (sec. 1245). For subsidized low-income rental housing, the amount of depreciation subject to recapture as ordinary income when the property is sold is phased out by one percentage point for each month after the property has been held for 100 months.

One of the items of tax preference subject to the minimum tax is accelerated depreciation on leased personal property.³ The preference is the amount by which the depreciation (or amortization) allowance with respect to an asset for the year exceeds the depreciation deduction that would have been allowable if the property had been depreciated using the straight-line method over its useful life. If the leased property is depreciated under the ADR system and the taxpayer chooses to use a life shorter than the midpoint life, depreciation attributable to the shorter useful life is included in the amount of the preference. Thus, additional ADR depreciation is a preference even if the straight-line method is used. Accelerated depreciation on leased personal property is not a preference item for corporations other than personal holding companies and subchapter S corporations.

Another preference item is accelerated depreciation on real property, i.e., the excess of the depreciation (or amortization) allowable for the year in excess of the depreciation that would have been allowable for the year computed using the straight-line method over the property's useful life. This item is a tax preference for all taxpayers, whether or not the property is leased.

Under present law, the maximum marginal tax rate on taxable income from personal services is 50 percent (sec. 1348). However, the amount of personal service income subject to the maximum tax is reduced, dollar-for-dollar, by the amount of a taxpayer's preference items. Thus, a taxpayer's preference items not only are subject to a separate minimum tax, but also may cause part of a taxpayer's personal service income to be taxed at a marginal rate greater than 50 percent.

Present law provides that a U.S. corporation must compute its earnings and profits using the straight-line method of depreciation or a similar ratable method such as the unit-of-production method. Earnings and profits may be computed using the 20-percent useful life variance permitted under the ADR system. These rules do not apply to foreign corporations if less than 20 percent of gross income for the taxable year is derived from sources within the United States.

In theory the rates charged to customers by a public utility are set at a level that permits the utility to earn a fair rate of return on its investment and recover its costs of doing business (including a rate-making allowance for Federal income taxes plus a rate-making allowance for depreciation). The straight-line method and relatively long useful lives are generally used to compute the rate-making allowance for depreciation. Normalization of accelerated depreciation methods generally means that the rates charged to utility customers will not reflect a rate-making allowance for Federal income taxes based on the use of a depreciation method more accelerated than the depreciation method used to determine the rate-making allowance for depreciation. Normalization of the 20-percent ADR variance generally means that the rates charged customers will not reflect a rate-making allowance for Federal income taxes based on useful lives shorter than the ADR guideline life or the useful life used to determine the rate-making allowance for depreciation, whichever is shorter. Therefore, normalization generally allows the utilities to collect revenues that reflect a rate-making tax allowance based on straight-line depreciation and ADR midpoint lives.

The use of accelerated methods of depreciation and the ADR useful life variance for Federal income tax purposes, combined with the use of normalization accounting in rate-making, generally results in an actual Federal income tax expense that is less than the rate-making tax allowance in the early years of an asset's useful life and more than the rate-making tax allowance in the later years of an asset's useful life. These "deferred taxes" can be viewed as an interest-free loan to the utility. The utility is able to use this money in lieu of funds that otherwise would have to be obtained by borrowing or raising equity capital.

The normalization rules of the Code do not limit the authority of regulatory bodies to pass through these capital cost savings to utility customers; i.e., the reduction in the costs of acquiring capital can be reflected in the rates charged to utility customers. This may be done either by treating an amount of the utility's capital as cost-free in determining a fair rate of return or by excluding an amount of the utility's assets from the rate base that is permitted to earn a rate of return. In either case, the amount of capital or rate base that is given this rate-making treatment must not exceed the amount of the deferred taxes.

The use of accelerated methods and short useful lives in rate-making to compute the allowance for Federal income taxes is known as "flow-through" accounting because current tax reductions are immediately reflected in lower rates to customers. The normalization rules in the Code generally do not apply to property that was subject to flow-through accounting before 1970 or similar property placed in service after 1969.

For assets accounted for under the RRB method, when a new railroad line is laid (an "addition"), the cost (both materials and labor) of the line is capitalized. No depreciation is claimed for this original installation, but a deduction for these original costs may be claimed if this line is retired or abandoned. If the original installation is replaced with components (rail, ties, etc.) of a like kind of quality, the cost of the replacements (both materials and labor) is deducted as a current expense. When the replacement is of an improved quality, the improved portion of the replacement is a "betterment" that is capitalized, and the remainder of the replacement cost is deducted as a current expense.

Upon the retirement or replacement of rail and other track assets, the salvage value (measured by current fair market value) of the recovered materials is treated as ordinary income.

The regular 10-percent investment credit is allowed for the cost of railroad track material, which includes ties, rails, ballast, and other track material such as bolts. The credit is allowed for costs that are capitalized (additions and betterments) as well as costs that are expensed (replacements) (sec. 48(a)(1)(B)(i) and sec. 48(a)(9)). Some amounts treated as replacement costs under the RRB method (such as the costs of replacing bolts) might be considered repair expenses under a conventional depreciation system and would not be allowed the investment credit.

Present law, however, does provide a deduction for "bonus" first-year depreciation in an amount not exceeding 20 percent of the cost of eligible property. In general, depreciable property placed in service during a taxable year is eligible under the provision if it is tangible personal property with a useful life of 6 years or more. The cost of the property that may be taken into account may not exceed $10,000 ($20,000 for individuals who file a joint return).⁴ Thus, the maximum additional first-year depreciation deduction is limited to $2,000 ($4,000 for individuals filing a joint return).

Carryover Periods for Operating Losses

In general, net operating losses and operating losses of certain insurance companies are allowed a 3-year carryback and a 7-year carryover. Certain financial institutions have only a 5-year carryover, but a 10-year carryback. Certain other net operating losses have special carryover periods as follows:

                                                  Carryover

Carryover Periods for Certain Credits

In general, unused tax credits, such as the investment credit, alcohol fuels credit, WIN credit, and targeted jobs credit, are allowed a 3-year carryback and a 7-year carryover.

The committee believes that greater levels of investment are essential to a robust economic growth and that a new depreciation system is urgently needed to stimulate investment spending. The committee bill, therefore, provides for expensing (with a phaseout of the regular investment credit for expensed property). This simple depreciation rule gives the maximum acceleration of depreciation deductions, makes certain their real value, permits a full write-off in constant dollars and eliminates biases across assets.

The committee believes that a tax reduction is also needed to stimulate investment in real property. Accordingly, the committee bill provides for the simplification and greater acceleration of depreciation deductions for real property.

The committee bill replaces the present system of depreciation with new methods of depreciating most real and personal property. In general, an expense-method depreciation system applies for most tangible personal property, a simplified cost recovery system applies for long-lived public utility property and certain other property, and real property is depreciated on a composite basis using an audit-proof useful life as short as 15 years. With limited exceptions, the new system is mandatory for all eligible property. The entire cost or other basis of eligible property is depreciable under the new system, eliminating the salvage value limitation. No distinction will be made in the treatment of new versus used property. Property that is ineligible for depreciation under the new methods is depreciated under rules similar to present law rules.

Expense-method depreciation permits the cost of property to be recovered by a single deduction for the year the property is placed in service. Taxpayers have the option to expense less than the cost of an asset and to depreciate this nonexpensed cost using the straight-line method over a recovery period which approximates the present law useful life of the asset. After 1984, no regular investment tax credit is allowed for expense-method property, although the energy, ESOP, and rehabilitation credits will continue to apply. The expense-method depreciation system will be phased in over the period 1981 through 1989. However, the taxpayer may annually elect to expense immediately up to $25,000 of property without a phase-in limitation.

Under the simplified cost recovery system, the cost of eligible property (recovery property) is assigned to one of two open-ended recovery accounts representing a recovery period of 10 or 15 years. The amount of the allowable deduction is determined for each recovery account using the 150-percent declining balance method. Included in the 10-year recovery class are public utility property with an ADR midpoint life of more than 18 years but not more than 25 years, oil pipelines, railroad tank cars, certain mobile homes, and real property with an ADR midpoint life less than 13 years (e.g., theme park structures). Public utility property with an ADR midpoint life greater than 25 years is assigned to the 15-year recovery class. The investment credit continues to apply for recovery property eligible for the credit under present law.

Personal property ineligible for either the expense-method depreciation system or simplified cost recovery system includes most property currently ineligible for the investment credit (e.g., property used by tax exempt organizations and foreign assets), certain films, inherited property, livestock (including the cost of a horse not exceeding $100,000) the taxpayer elects to exclude horses to the extent the cost of the horse exceeds $100,000, and property held less than one year.

Under the bill, taxpayers may elect to depreciate eligible real property using a useful life of 15, 25, 35 or 45 years. The taxpayer may use the straight-line method or, if the 15-year useful life is chosen, elect to use the 150-percent declining balance method (200-percent for low-income housing or targeted area property). Foreign real property must be depreciated using a 35-year recovery period and either the straight-line method or the 150-percent declining balance method. Composite depreciation is mandatory.

The bill includes special rules relating to normalization requirements for public utilities and computation of the minimum tax for real property. The minimum tax for personal property is repealed. Special rules are also provided to prevent "churning" of property to obtain the benefits of the new system by transfer of certain used property between related persons. Although railroad-retirement-betterment property is expensed method property, special transitional rules apply. For postponement of the present law rule requiring amortization of construction period interest and taxes for low-income housing, see Title VIII.

In general, the depreciation changes apply to property placed in service after December 31, 1980.

2. Expense-method property

The committee bill excludes certain personal property from the definition of expense-method property. Such excluded property includes (1) railroad tank cars; (2) oil pipelines; (3) public utility property with an ADR midpoint life of more than 18 years as of January 1, 1981; (4) property acquired by the taxpayer by virtue of the death of a decedent, i.e., property, the basis of which is determined under section 1014(a); (5) certain films as defined in section 48(k)(1)(B); (6) property disposed of by the taxpayer within one year after being placed in service; and (7) certain property for which the investment credit is not allowable under present law-property used predominantly outside the United States within the meaning of section 48(a)(2), as amended by the committee bill; property used for lodging (sec. 48(a)(3)); property used by certain tax-exempt organizations or governmental units (sec. 48(a)(4) and (5)); and property leased by certain noncorporate lessors (other than such lessors meeting the requirements of section 46(e)(3)). The committee bill contains special rules for the recovery of the costs of property which is not expense-method property.

Flexibility election by members of affiliated group

As under the present Treasury regulations for the ADR system, each member of an affiliated group of corporations generally may make its own flexibility elections with respect to property it places in service. However, if the affiliated group files a consolidated tax return, the availability of separate elections will depend on the applicable consolidated return regulations prescribed by the Treasury. The provisions of this bill do not curtail Treasury authority to prescribe consolidated return rules, including those relating to cost recovery elections.

Further, appropriate restrictions are imposed to prevent the use of intercompany transfers of assets as a mechanism to change the recovery period or method for property acquired in an intercompany transfer from another member of an affiliated group. (See discussion of related party transfers below.)

Related party transfers and certain nonrecognition transfers

In general, a transferee of property may elect a recovery period or method different from that elected by the transferor. However, for property acquired from a related person or acquired in certain non-recognition transactions, the transferee must "step into the shoes" of the transferor with respect to the recovery period and method of the transferred property. This rule applies only to the extent the basis in the transferee's hands equals the transferor's adjusted basis. For example, assume the transferor elected to use a 10-year life and the straight-line method instead of the expense method. Assume also that the transfer occurred 5 years after the property was placed in service. The transferee may not expense the property but rather must depreciate the property to the extent of the transferor's adjusted basis in the property over the remaining 5 years using straight-line depreciation. The transferee may depreciate the property without regard to the transferor's method of depreciation to the extent the transferor's basis exceeds the transferor's adjusted basis. Transactions subject to this rule are sale-leasebacks and transfers between other related persons as defined in the antichurning rules and transactions described in section 332 (other than a transaction to which section 334(b)(2) applies), 351, 361, 371(a), 374(a), 721, or 731.

Gain or loss will be recognized on each disposition of expense-method property, unless other provisions of the Code provide for nonrecognition. Any gain recognized on the disposition of expense-method property will be treated as ordinary income to the extent of the total of amounts expensed and depreciation taken with respect to the property.

In the case of property that is expensed under present law, the bill provides that any gain recognized on the disposition of such property will be treated as ordinary income to the extent of the amount expensed.

Installment sales

The committee bill provides that the Secretary shall prescribe any regulations necessary to prevent tax avoidance from combining the benefits of expensing and installment sales treatment. For example, a taxpayer should not be able to expense the same or a similar item of property several times by buying and selling property in repeated transactions, and defer the recognition of gain on each disposition of the property through installment sales treatment.

During the period 1981 through 1990, expense-method property will be subject to special rules that phase out present law depreciation rules and the regular investment credit and phase in immediate expensing. These phase-in rules will not apply to expense-method property immediately expensed under an election for up to $25,000 of property for a taxable year.

Immediate expensing election

For property placed in service in taxable years ending before December 31, 1990, a taxpayer other than an estate or trust may designate items of property the costs of which will be immediately expensed for the taxable year in which the property was placed in service. Such property designated as immediate expense property will not be subject to the phase-in rules described below. The total bases of expense-method property that may be so designated shall not exceed $25,000 for each taxable year. The taxpayer will designate the property to be immediately expensed in such manner as the Secretary shall prescribe in regulations. The designation cannot be revoked without the consent of the Secretary. If the designation of an item of property would result in more than $25,000 being immediately expensed, only so much of the basis of the property that can be expensed within the $25,000 limitation will be considered as designated. Otherwise, the entire basis of an item of property must be designated.

For a married individual filing a separate return, the dollar limitation is $12,500. In the case of a partnership the $25,000 limitation applies to both the partnership and each of the partners. In the case of a controlled group (within the meaning of section 1563(a), except that a 50-percent control test shall be used instead of 80-percent), the $25,000 limitation shall be apportioned among the component members of the group in a manner prescribed by regulations.

In the case of a taxable year that begins in 1980 and ends in 1981, the dollar limitation will be proportionate to the number of months in the taxable year that begin in 1981. Thus, a taxable year that ends on March 31, 1981 would have a dollar limitation of $6,250 (3/12 x $25,000). A similar rule applies to determine the dollar limitation for a short taxable year that begins after December 31, 1980.

Phase-in of expense-method depreciation

For an asset placed in service after 1980 and before 1990 (other than property designated under the special immediate expensing election and property that is depreciable under present law over a period of less than two years, a specific percentage of the basis of the property is depreciated under the expense-method system and a specific percentage of the basis is depreciated under present law rules (the remaining basis"). The percentage of basis depreciated under the expense-method system is subject to a half-year convention that is phased out beginning in 1986. The following phase-in schedule will apply to an asset placed in service in the following years:

                Percentage of basis           Percentage of column (2)

For an asset placed in service after 1980 and before 1990, the flexibility rule of the expense-method system applies to any part of the basis of the asset other than the so-called remaining basis. The amount the taxpayer elects to expense for an asset that is subject to the phase-in rules will be deducted in accordance with the appropriate half-year convention percentages, as set forth in columns (3) and (4) of the above table.

In general, expense-method property is ineligible for the regular investment credit. However, prior to 1985, the portion of the cost of property not eligible to be expensed (the remaining basis) is eligible for the regular investment credit. The remaining basis is increased by virtue of an election not to designate property as immediate expense property under the $25,000 rule. However, if a taxpayer elects not to expense any portion of property not part of the remaining basis because he makes the flexibility election, that portion of the property is not eligible for the investment credit.

For example, assume a calendar year taxpayer places a $125,000 asset in service in 1981. The taxpayer elects to immediately expense $25,000. An additional $20,000 (20 percent of $100,000) is eligible for expensing using the half-year convention. However, assume he elects the flexibility option to use straight-line depreciation over the ADR midpoint life for the $20,000. The investment credit will apply only to the $80,000 remaining basis.

The energy, ESOP, and rehabilitation credits will continue to apply to expense-method property. Also movies described in section 48(1)(B), which are eligible for the investment credit under present law, continue to be depreciated under present law (generally, the income forecast method) and continue to be eligible for the investment credit. Railroad rolling stock leased by a U.S. person to a domestic railroad and used within and without the United States is made eligible for the regular credit during the phase-in period.

Useful life limitation

For purposes of applying the useful life limitation on energy, ESOP, and rehabilitation credits (and the regular credit during the phase-in period) for eligible property, the taxpayer must use the class life (ADR midpoint) of the property. If the Secretary has not prescribed a class life for the property, the taxpayer must use a life determined on all facts and circumstances. The Secretary for this purpose may prescribe additional class lives or change the existing class life of property to better reflect the property's actual useful life.

Used property limitation

The $100,000 limitation on the amount of used property eligible for investment credits is retained only with respect to the depreciable portion of the property that is not eligible for expensing. For example, assume that $150,000 of eligible used property is placed in service in 1981 and that the taxpayer expenses the entire first $25,000 immediately, plus 20 percent of the remaining $125.000 under a half-year convention. The remaining $100.000 depreciable portion will be eligible for a regular investment credit. As the expense percentage portion of the cost of an asset increases during the phase-in periods, investment in used property that may be made without exceeding the $100,000 limitation increases to $191,667 property in 1982, $275,000 in 1983, and $25,000 in 1984.

Qualified progress expenditures

Progress expenditures for expense-method property will continue to be eligible for the energy and ESOP credits to the same extent as under present law. However, for the regular credit expenditures for expense-method property will be allowed after December 31, 1980, in general, only to the extent expenditures are attributable to the portion of the property that will be part of the remaining basis under the rules applicable in the year the taxpayer expects the property to be placed in service. For this purpose, the taxpayer must assume that he will property. If in the year the property is placed in service the taxpayer designates less than the entire first $25,000 of cost for the immediate expensing election, additional investment credit could be allowed in that year under the rules applicable for that year.

Under present law, if a taxpayer claims progress expenditures in excess of the amount of investment ultimately eligible for the investment credit in the year the property is placed in service, recapture of the excess credit is required. These rules apply to progress expenditures claimed prior to 1981 on property placed in service after 1980. This recapture will occur when the property is placed in service.

If, however, the property were to be placed in service in 1986, there would be recapture of the 1980 progress expenditures at that time, and the taxpayer would not be entitled to progress expenditures in 1981 and 1982.

3. Simplified cost recovery property (10- and 15-year classes)

Under the committee bill, a new method of depreciating long-lived public utility property and certain other property (the "Simplified Cost Recovery" system) is substituted for present depreciation methods, including the Asset Depreciation Range (ADR) system.

The basis of eligible property ("recovery property"), without reduction for salvage value, is assigned either to a 10-year or 15-year class. Included in the 10-year class are public utility property with a class life as of January 1, 1981 of more than 18 years but not more than 25 years, railroad tank cars, oil pipelines, mobile homes (used for residential purposes) that are section 1250 property, and real property with a class life of 12.5 years or less (such as theme park structures). Included in the 15-year class is public utility property with a class life as of January 1, 1981, of more than 25 years. The class life of property as of January 1, 1981, will be determined without regard to any regulation, ruling, or announcement published by the Secretary after January 1, 1981. Public utility property subject to rate of return regulation will not be eligible recovery property unless the benefits of the simplified cost recovery system are normalized in setting rates charged to customers. (See discussion under "Public utility property.")

Under the committee bill, the costs of all eligible property with the same recovery period are placed in the same account regardless of the year of acquisition. Used and new recovery properties are aggregated in the same recovery account. The amount added to the recovery account is the taxpayer's basis in the property without reduction for salvage value.

The amount of the allowable recovery deduction for any taxable year is computed by applying a recovery percentage to the ending balance (unrecovered costs) in the recovery account. The recovery percentage for the 10-year class is 15 percent and the recovery percentage for the 15-year class is 10 percent. The recovery percentage reflects the number of years in the recovery period and the 150 percent declining balance method. The amount of the allowable recovery deduction is subtracted from the account to determine the opening balance in the account for the following year.

Additions will be made to an account (under a half year convention) when a qualified asset is placed in service.¹ A subtraction will be made from the account balance equal to the amount realized, in the case of the sale of an asset assigned to the account, or the fair market value of the asset, in the case of a transfer other than a sale. Special rules are provided for like-kind exchanges, involuntary conversions, and certain transactions where basis carries over).² If the balance of an account at the end of the taxable year, but prior to computation of depreciation, is either zero or a negative amount, no recovery deduction will be allowed for the year.

Disposition of assets and recapture

Under the simplified cost recovery system, gains and losses on the disposition of recovery property generally are deferred. Instead of immediate gain or loss recognition, the amount realized on the disposition will reduce the balance in the account which, in turn, will reduce the amount of recovery deductions in the year of the disposition and subsequent years. If the amount realized reduces the balance in the account to a negative amount, such amount generally will be recaptured as ordinary income.³ However, the recapture will be reduced to the extent of the remaining one-half of the depreciable bases of assets placed in service during the taxable year.

In a disposition where recovery property is transferred and the transferee's basis is determined by reference to the adjusted basis of the transferor (such as gifts and certain corporate nonrecognition transfers), the amount by which the transferor's recovery account is reduced is generally an amount which bears the same ratio to the balance in the recovery account as the fair market value of the transferred property bears to the fair market value of all assets (including the transferred property) in the account. However, the Secretary of the Treasury may prescribe alternate methods for determining the transferred amount. The transferee's basis in the transferred property will be determined by reference to this amount ("transferred amount").⁴

In the case of like kind exchanges or involuntary conversions where the properties exchanged are assigned to the same recovery account, no changes will be made to the account unless additional consideration in the form of money or other nonqualifying property ("boot") is involved. Where boot is involved or where the properties exchanged are assigned to different recovery accounts, adjustments will be made to the appropriate accounts in accordance with regulations to be prescribed by the Treasury Department.

Property which ceases to be recovery property, such as property which is converted to personal use or to a use predominantly outside of the United States, is treated as if it were disposed of during the taxable year in which it ceases to be recovery property. The balance of the recovery account to which it is assigned is reduced by the fair market value of the property at the time it ceases to be recovery property. If such property continues to be depreciable property in the hands of the taxpayer (as it might if it were used predominantly outside the United States), the property's basis will be its fair market value at the time it ceased to be recovery property.

4. Depreciation of ineligible personal property

Under the committee bill, certain personal property that is not expense-method property or is not in the 10-year or 15-year classes will continue to be depreciated under present law, including the use of accelerated methods, if applicable. Thus, the salvage value limitation remains for such property. However, unlike present law, both new and used property must use the prescribed ADR life. Qualified movies and TV films within the meaning of section 48(k)(1)(B) will continue to be depreciated under present law (generally, the income forecast method). In addition, property costs which are not eligible for expensing during the phase-in period also will continue to be depreciated using present law useful lives and methods.

Certain other property will continue to be depreciated under present law, but with certain limitations. As is the case for other ineligible property, the salvage value limitation remains and new and used property must use the prescribed ADR life. The following property will be depreciated using present law methods over the ADR lower limit life of the asset, or if there is no lower limit life, over a life determined by facts and circumstances--property leased to and used by tax-exempt organizations or governmental units (sec. 48(a)(4), (5)); property used for lodging (sec. 48(a)(3)); property acquired by the taxpayer by virtue of the death of a decedent (i.e., property, the basis of which is determined under section 1014(a)); the cost of a horse in excess of $100,000 even if the taxpayer elects expense-method treatment for the horse; and the cost of other livestock, unless the taxpayer elects to treat the livestock as expense-method property. Assets used predominantly outside the United States within the meaning of section 48(a)(2) will be depreciated using present law methods over the ADR midpoint or, if no ADR midpoint, over a useful life based on the facts and circumstances. In determining whether property is used predominantly outside the United States, the exceptions in section 48(a)(2)(B) apply. The bill adds an exception for railroad rolling stock leased by a U.S. person to a domestic railroad and used within and without the United States, thus making such rolling stock expense-method property. Property leased by noncorporate lessors (other than such lessors meeting the requirements of section 46(e)(3)) will be depreciated using the straight-line method over the property's class life (midpoint life). If there is no class life, the useful life will be determined using facts and circumstances. For purposes of this rule, subchapter S corporations, personal holding companies, and service organizations (as defined in section 414(m)(3)) are considered to be noncorporate lessors. However, in the case of a partnership lessor, a partner of such partnership which is a corporation is eligible to expense its allocable portion of the costs of qualifying property.

5. Real property

Eligible real property does not include real property that is recovery property (i.e.. certain mobile homes and theme park structures and other real property with an ADR mid-point life of less than 13 years), foreign real property, and property the taxpayer elects to amortize (e.g., low-income rehabilitation expenditures or leasehold improvements). Foreign real property will have a 35-year recovery period.

There is an issue under present law whether a single purpose agricultural structure is real or personal property. Under proposed Treasury regulations, these structures are characterized as section 1250 property, which would place these structures in the 15-year real property class. On the other hand, if these structures were considered section 1245 property, they would be expense-method property. No inference is intended with respect to this present law determination. The investment credit continues to apply to these structures only if they are 15-year real property.

The bill retains the present law rule that phases out recapture at one percentage point per month for subsidized low-income housing after the property has been held 100 months.

For purposes of selecting the useful life and method of depreciation, a substantial improvement of a building is treated as a separate building. For example, the taxpayer may use a 15-year period for a substantial improvement even if the rest of the building is depreciable over an optional longer period. Also, the taxpayer may use an accelerated method even if the straight-line method were used for the rest of the building. Under the committee bill, an improvement is a substantial improvement if (a) during the taxable year the amounts added to the capital account for the building are at least 25 percent of the adjusted basis of the building (disregarding adjustments for depreciation or amortization) as of the first day of that period and (b) the improvement is made at least 3 years after the building was placed in service.

If the taxpayer were to use accelerated depreciation for a nonresidential building and straight-line depreciation for a substantial improvement to the building (or vice-versa), all gain on a subsequent disposition of the entire building would be first treated as ordinary income to the extent of all recovery allowances taken pursuant to use of the accelerated method (sec. 1245). The remainder of the gain would be capital gain. A similar rule generally applies for components added to a building placed in service before 1981 if accelerated depreciation is taken for the components. This rule that gain on deposition is first treated as ordinary income under the recapture rules will apply even if a portion of a taxpayer's unadjusted basis in the asset is recovered over an optional longer period.

6. Other changes relating to depreciation and investment credits

Accelerated depreciation on real property continues to be a tax preference item under the bill as under present law. The amount of the preference is the excess of the depreciation deduction taken over that which would have been allowable for the year if the deduction had been computed during the straight-line method over a 15-year period.

For 1981, minimum tax preferences will continue to reduce the amount of personal service income subject to the 50-percent maximum tax. However, this preference "poison" is lessened for taxable years beginning in 1982 because the top income tax rate is reduced to 60 percent. This poison is completely eliminated by the committee's bill for taxable years beginning in 1983 when the maximum tax rate on all income will be 50 percent.

Under the committee bill, the computation of earnings and profits by foreign corporations that currently are not subject to the special earnings and profits rules of Code section 312(k) are basically unchanged. Earnings and profits for such foreign corporations will be computed in accordance with the rules provided for computing the recovery allowance for foreign assets.

Public utility property that is subject to rate of return regulation is expense-method property or simplified cost recovery property only if a normalization method of accounting is used with respect to the property. If normalization accounting is not used for such property, a depreciation allowance for the property will be determined using the straight-line method of depreciation over the ADR-midpoint life for such property under present law. Public utility property that is not subject to rate of return regulation, such as certain common carrier telephone companies, is not subject to a normalization requirement as a condition to being expense-method property or simplified cost recovery property. Thus, under the committee bill, property used by regulated taxpayers in the same industry generally will be subject to the same type of capital cost recovery. However, the normalization requirement will apply to only those taxpayers for whom it is appropriate, i.e., taxpayers regulated on a rate of return basis.

The normalization rules of the committee's bill are substantially the same as the normalization rules in present law. Thus, the committee bill provides that, for rate-making purposes, the taxpayer must use the same depreciation method to compute both its regulated tax expense and regulated depreciation expense. In addition, the taxpayer must use a depreciation period to compute its regulated tax expense that is no shorter than the period used to compute its regulated depreciation expense.

As under present law, the taxpayer must make adjustments to a reserve to reflect the deferral of taxes attributable to the use, for Federal income tax purposes, of a depreciation method or depreciation period different from the method or period used to compute regulated tax expense. As under present law, the committee bill does not restrict the authority of regulatory bodies, in setting rates charged customers, to treat the deferred taxes as zero-cost capital or a reduction in rate base. However, as under present law, the amount of capital treated as zero-cost capital and the amount of rate base reduction may not exceed the amount of deferred taxes attributable to the depreciation method and depreciation period actually used by the taxpayer for Federal income tax purposes.

Under the committee bill, the normalization requirement applies to all rate of return public utility property placed in service after December 31. 1980. This is in distinction to present law, which does not apply a normalization requirement for property similar to property that was not subject to normalization in 1969.

As a consequence of the committee's elimination of any exception to the accelerated depreciation normalization requirement for rate of return public utility property, the exception to the normalization requirement for the investment credit (sec. 46(f)(3)) is also eliminated for rate of return public utility property placed in service after December 31, 1980.

Transition rules provide that the taxpayer's compliance with the normalization requirements that apply to the taxpayer under present law will be treated as compliance with the normalization requirements that will apply as a result of the amendments made by the committee bill. Each of these rules will continue to apply until the first rate order determining the treatment of the investment credit or depreciation, as the case may be, is put into effect after the date of enactment of the bill. In the case of a rate order made with respect to less than all of a taxpayer's property that is subject to the jurisdiction of the regulatory body, the transition rules shall continue to apply to the remaining property of the taxpayer until a rate order is put into effect with respect to the remaining property.

For RRB replacement property, as described in section 48(a)(9), the phase-in rules do not apply and such property placed in service before 1985 is eligible for the regular investment credit. The phase-in rules that apply to other expense-method property also apply to other RRB property, except that the so-called remaining basis of such property will be depreciated using the same schedule of deductions that is used for the adjusted basis of RRB property as of December 31, 1980. The remaining basis for property placed in service in each taxable year will be depreciated, however, as a separate item of property and not as part of the adjusted basis as of December 31, 1980.

The adjusted basis of RRB property as of December 31, 1980 (the costs that were capitalized under the RRB method and have not been recovered through retirement) may be recovered over a 5-year period using the following schedule of deductions:

  PERCENTAGE OF

Special rules are provided to prevent the taxpayer from bringing its property used before 1986 (1981 for real property) within the new depreciation systems under the bill by certain post-1980 transactions (i.e., "churning" transactions). For property subject to the anti-churning rules, present law will govern depreciation of the asset.

Personal property

In general, a transfer of personal property after 1980 will be treated as a churning transaction if the property was (1) owned by the taxpayer or a related person before 1985 or (2) the user of the property after its acquisition used the property before the acquisition or is related to a person that used the property before its acquisition. The requirement that the user must change is designed to prevent lessors of equipment from swapping properties to obtain the benefits of expense-method depreciation or the simplified cost recovery.

Real property

The shortened useful lives under the bill will not apply to real property acquired after 1980 if (1) the taxpayer or a person related to the taxpayer owned the property before 1981, or (2) the property is acquired in certain like-kind exchanges, "rollovers" of low-income housing, involuntary conversions, or repossessions, for property the taxpayer or a related person owned during 1980.

The rule in (2) applies only to the extent of the substituted basis of the property received. Thus, the shortened useful lives under the bill will apply to the extent the taxpayer pays "boot." The taxpayer may not avoid the rule in (2) by transferring the churned property in another like-kind exchange, rollover, etc. Unlike the personal property anti-churning rules, the user need not change for the shortened useful lives under the bill to apply to real property.

Related person

In determining whether the owner or the user of the property has changed under the above anti-churning rules, a person will be considered related to the prior owner or user if the person is related within the meaning of section 267(b) or 707(b)(1) (substituting 10-percent for the 50-percent ownership test), or section 52(a) and (b). In addition, the lessor and lessee in a sale-leaseback will be considered related persons. A subsidiary is not considered a related person in a transaction described in section 334(b)(2), if the required amount of stock is purchased within a 12 month period ending after December 31, 1980.

Nonrecognition transactions

The anti-churning rules apply to real or personal property used before 1981 (1986 for personal property) acquired by a corporation or partnership in a transaction which the basis is determined by reference to its basis to the transferor (i.e., transactions described in sections 332, 351, 361, 371, 374, 721, or 731) (including use of any optional recovery period or method) the transferor used for the transferred property. This rule will continue to apply to successive transfers of such property to the extent the basis to the transferee includes an amount representing the basis of property used during 1980. Post-1980 additions to such basis, however, such as by the payment of boot, will not be subject to the anti-churning rules.

Anti-avoidance rule

Finally, broad authority is granted to the Secretary to prescribe regulations to make ineligible for the expenses method depreciation property transferred between related persons (as previously described) in a transaction the principal purpose of which is to make property eligible for more generous capital cost recovery.

The committee bill, in general, extends to 20 years the carryover period for the investment tax credit, the WIN credit, the new employee credit, and the alcohol fuels credit.

Extension of the carryover period for the credits applies as follows:

Unused investment credits from a taxable year may be carried over and applied against tax liability for the three preceding and seven succeeding years.

Distressed industries are those corporations using qualified industrial property. Qualified industrial property is section 38 property used in connection with the trade or business of (1) operating a railroad, including a railroad switching or terminal company, (2) the furnishing or sale of transportation of persons or property as a common carrier by air, (3) the manufacture or production of steel, (4) the manufacture, production, assembly, sale or delivery of vehicles intended to be used as motor vehicles (as defined in section 6323(h)(3)) or parts, accessories, or components thereof (but only if the property is used by manufacturers or producers of motor vehicles in connection with the above activities), (5) the manufacture, production, or conversion of pulp, paper, or paper products, and (6) the extracting of ores or minerals from the ground (or from the waste or residue of prior mining) and treating or processing such ores or minerals to the form in which they are most commonly marketed by the domestic industry.

In the case of railroads and common air carriers, each must be owned by a domestic common carrier or by a corporation the majority of the voting stock of which is owned directly or indirectly by one or more such common carriers or by persons who were such common carriers before entering proceedings under Title 11 of the United States Code.

Under the committee bill, existing qualified carryovers may be applied against the distressed industry's net tax liability and 25 percent of such carryovers is allowable in each of the taxpayer's next four taxable years beginning after December 31, 1980. The taxpayer's net tax liability is the amount of tax liability for all taxable years during the carryback period (but not including minimum tax liability) reduced by the sum of credits allowable (other than the credit under section 39 relating to certain fuel taxes). The carryback period is the period which begins with the corporation's first taxable year ending after December 31, 1961 and which ends with the corporation's last taxable year beginning before January 1, 1981. Existing qualified carryovers are investment credit carryovers to the taxpayer's first taxable year beginning after December 31, 1980. However, carryovers may be taken into account only to the extent the carryovers are attributable to qualified industrial property. To determine the amount of carryover attributable to qualified industrial property, the taxpayer first determines the taxable year in which the carryover arose. The total unused credits from such year includes the credits carried over to 1981 from the year and credits absorbed in years before 1981. The previously absorbed credits and carryover credits must then be allocated between the qualified and nonqualified property for the year. In making this allocation, the previously absorbed credits are considered to consist first of credits allocable to nonqualified property, thereby increasing the amount of credits allocable to qualified property that are considered to have been carried over to 1981.

For the purposes of determining the net tax liability and the qualified existing carryovers for a member of an affiliated group that files a consolidated return, the member will generally be treated as if it had filed separate returns for prior years, and its allocable shares of consolidated net tax liability and consolidated existing qualified carryovers for the prior years are used to determine the amount of any refund or credit.

The committee bill provides that rules similar to the rules of section 383 (special limitations on certain credits and carryovers in certain corporate acquisitions) will apply with respect to refunds or credits allowable pursuant to this provision. Thus, if a corporation that has made the election is a party to, or is the subject of, the corporate acquisitions covered by section 383, special limitations will apply with respect to the allowance of these refunds. This rule is designed to deter parties from entering into transactions mainly to obtain these tax benefits.

The election with respect to the taxpayer's existing qualified carryovers must be made no later than the time prescribed for filing the return (including extensions) for the taxpayer's first taxable year beginning after December 31, 1980.

Any corporation which receives a refund or credit by virtue of making this election is required to place the refund (or the amount of the credit) in a separate account and use or obligate such amounts for the acquisition of qualified industrial property not later than 3 years after the taxpayer receives the refund or credit. If the corporation fails to do so, it is liable for a penalty in an amount equal to the amount not invested in qualified industrial property, unless it is shown that such failure was due to reasonable cause and not to willful neglect.

At least 20 years must elapse between qualifying rehabilitations. In addition, at least 75 percent of the existing external walls of the building must be retained as external walls after rehabilitation. The rehabilitation expenditures must be made for property with a useful life of 5 years or more. No credit is allowed for any expenditure attributable to the enlargement of the building.

Rehabilitation expenditures qualifying for the investment credit are treated as new property. Therefore, the expenditures are not subject to the $100,000 used property credit limitation.

[Editor's note: because of the width of the table, it has been converted to text format]

The increased credit for rehabilitation expenditures is intended to help revitalize the economic prospects of older locations and prevent the decay and deterioration characteristics of economically distressed areas.

Under the committee bill, the 10-percent regular investment credit (and the additional energy credit) is replaced by a three-tier investment credit. The credit is 15 percent for structures at least 30 years old, 20 percent credit for structures at least 40 years old, and 25 percent for certified historic structures at least 30 years old. At least 30 years must elapse between qualifying rehabilitations (40 years for a 40-year old building). Although no credit is allowed for rehabilitation of a building less than 30 years old, a special rule allows a credit under present law rules for buildings that are more than 20 but less than 30 years old if the rehabilitation began before January 1, 1982.

The 15- and 20-percent credits are limited, as under present law, to nonresidential buildings. However, the 25-percent credit for certified historic rehabilitation is available for both nonresidential and residential buildings (other than a building used at any time during the year for residential purposes by a taxpayer or a member of the taxpayer's family (as defined in section 267(c)(4)). An exception to the present law rule denying investment credit for property used by a tax exempt organization or a governmental unit is provided for rehabilitation expenditures. A rehabilitation credit is available only if the taxpayer elects to use the straight-line method of cost recovery with respect to the rehabilitation expenditures.

As under existing law, certain expenditures will not qualify for the credit. The costs of acquiring a building or an interest in a building (such as a leasehold interest) or the costs of facilities related to an existing building such as a parking lot are not considered as qualifying expenditures. In addition, the cost of constructing a new building, or of completing a new building after it has been placed in service, will not qualify. Construction costs are considered to be for new construction rather than for the rehabilitation of a building if more than 25 percent of the existing external walls of the building are replaced. In addition, any expenditure attributable to an enlargement of a building does not qualify for a credit.

For rehabilitation other than a certified historic rehabilitation, a special rule under the bill requires a reduction of the cost eligible for depreciation by the amount of the rehabilitation credit allowable.

Certified historic structures

As under present law, expenditures for a certified historic structure are not eligible for the 25-percent credit unless the rehabilitation is a certified rehabilitation.

As under present law, taxpayers will have the option to amortize the cost of rehabilitation over a 60-month period in lieu of the credit (sec. 191).

Basis reduction

For a rehabilitated building (other than a certified historic structure), the basis of the building must be reduced under the bill by the rehabilitation credit allowable for the property. The basis reduction applies for purposes of computing depreciation, gain on disposition, and other purposes related to determining income tax. For example, assume a taxpayer acquires a 30 year old building for $10,000 and spends $20,000 to rehabilitate the building. The rehabilitation credit would be $3,000 (15 percent of $20,000), which reduces the depreciable cost of the building from $30,000 to $27,000.

If property for which a basis reduction is required is disposed of in an event subject to investment credit recapture, the basis will be increased (for all purposes, including determination of gain on sale) by the amount of credit subject to recapture.

Property leased to tax-exempt organization or governmental unit

Under the bill, the present law rule denying investment credit for property leased to tax exempt organizations (sec. 48(a)(4)) or governmental units (sec. 48(a)(5)) does not apply to the portion of the basis of the building attributable to qualified rehabilitation expenditures. This corrects a clerical error in the enrollment of the Miscellaneous Revenue Act of 1980. Due to the error, this provision was omitted from that Act.

Demolition disincentives repealed

The present law rule (sec. 167(n)) requiring use of straight-line cost recovery over the useful life of a building placed in service at the site of a demolished or substantially altered certified historic structure is repealed. Thus, the rules under the bill generally applicable to real property will govern depreciation of the building that is constructed or reconstructed at the site of the building demolished or altered. The rule in present law requiring certain demolition costs to be capitalized as part of the cost of the land (sec. 280B) is also repealed, permitting a deduction of demolition costs otherwise deductible.

The provision that permits the credit for property used by tax-exempt organizations and governmental units applies to uses after July 29, 1980 in taxable years ending after that date.

The repeal of section 167(n) applies to basis attributable to construction, reconstruction, or erection after December 31, 1981. The repeal of section 280B applies to demolitions commencing after December 31, 1981.

 Taxable income      Tax rate

In making the tax rate reduction, the committee had to consider two different sets of corporate taxpayers. There are the incorporated small businesses which tend to be less capital intensive than the larger corporations and therefore generally would derive less tax benefit from expensing (or almost any other form for accelerated depreciation). For this group, rate reductions are generally far more important.

Larger, more capital intensive corporations will derive relatively greater benefits from expensing than from a reduction in corporate tax rates. Nevertheless, in order to sustain the stimulative thrust of tax policy on capital formation for as long as possible through the 1980's, the committee decided to follow up the initial impulse of the depreciation reform with reductions in the top corporate tax rate. These corporate tax rate reductions will go into effect after the reductions with primary impact on small business have been completed.

In the first two years, the taxable income brackets will be doubled, with a 50-percent increase over current brackets going into effect each year. Tax rate reductions will go into effect in the third year, 1984, for the four lowest brackets. Beginning in 1984, the top corporate income tax rate will be reduced from 46 percent to 34 percent in 4 steps of 3 percentage points each.

The new graduated corporate income tax structure follows.

 TAXABLE YEARS AND

 Beginning in 1984: Over $200,000                      43

(sec. 231 of the bill and secs. 534, 535, and 537 of the Code)

Since 1975, the minimum credit has been $150,000. During the period from 1958 to 1975, the minimum credit was $100,000, and prior to 1958 the minimum credit was $60,000.

For purposes of imposing the accumulated earnings tax, section 533 establishes a presumption that accumulations of earnings beyond the reasonable needs of the business are determinative of the purpose to avoid income tax with respect to the corporation's shareholders. The corporation can overcome the presumption by a preponderance of the evidence.

If a notice of deficiency with respect to the accumulated earnings tax is based in whole or in part on the allegation that earnings have been permitted to accumulate beyond reasonable business needs and the taxpayer submits a statement of the reasonable business needs on which it relies to justify the accumulation, together with facts sufficient to show the basis thereof, the burden of proof is shifted to the Commissioner to establish that earnings have been permitted to accumulate beyond reasonable business needs (sec. 534). This rule shifting the burden of proof to the Commissioner applies only in Tax Court proceedings contesting the imposition of the accumulated earnings tax.

Also, under present law, a corporation may accumulate earnings beginning in the year of death of a shareholder in order to redeem that shareholder's stock for purposes of paying the estate tax (under sec. 303).

The committee also believes that the taxpayer should not be subject to more stringent requirements with respect to the burden of proof because it chooses to litigate its liability for the accumulated earnings tax in a U.S. District Court or the U.S. Court of Claims rather than the Tax Court.

The bill extends the rule in section 534 shifting the burden of proof with respect to reasonable business needs to the government in suits for refund of the accumulated earnings tax commenced by taxpayers in U.S. District Courts and the Court of Claims, in the same manner as in cases in the Tax Court.

Finally, the bill also allows the accumulation of funds to redeem stock beginning with the year before the death of the shareholder.

2. Subchapter S corporations

(secs. 232-233 of the bill and sec. 1371 of the Code)

Under present law, to be eligible for a subchapter S election, the corporation must have 15 or fewer shareholders. In addition, trusts other than grantor trusts, voting trusts, and certain testamentary trusts (for a 60-day period) may not be shareholders in a subchapter S corporation.

Also, a trust all of which is treated as owned by a person other than the grantor under section 678 will be eligible to hold stock in a subchapter S corporation. The person treated as the owner (and not the trust) will be treated as the shareholder for purposes of determining whether the corporation meets the subchapter S eligibility requirements. The trust will continue to be eligible for 60 days after such person's death.

In addition, under the bill, if the individual beneficiary of a qualified subchapter S trust, or his legal representative, elects to be treated as the owner under section 678, the trust will be an eligible shareholder of such corporation. The election must be irrevocable and apply from the date of the creation of the trust until the trust ceases to be a qualified subchapter S trust.

A qualified subchapter S trust is one with respect to which an election is made and which (1) has as its sole income beneficiary an individual citizen or resident of the United States who on the date of death of the grantor of the trust is disabled for purposes of determining eligibility for benefits under section 216(i) of the Social Security Act, (2) may distribute corpus or income only to such beneficiary during his life, (3) terminates on the death of such beneficiary with corpus and accumulated income being distributed as provided by such beneficiary by will or pursuant to a general power of appointment as defined in Code section 2041, or otherwise to the heirs of such beneficiary or takers in default of appointment, (4) 90 percent or more of the contributions to which in value consist of stock in one subchapter S corporation, and (5) all contributions to which are included in the gross estate of the grantor of the trust and pass to the trust on the grantor's death.

3. Losses on small business corporation stock

(sec. 234 of the bill and sec. 1244 of the Code)

Ordinary loss treatment, rather than capital loss treatment, is provided in certain cases for small business corporation stock (section 1244 stock) which is disposed of at a loss. This special treatment is accorded only to individual shareholders to whom the stock was originally issued.

The maximum amount of ordinary loss from the disposition of section 1244 stock that may be claimed in any taxable year is limited to $50,000 ($100,000 in the case of married taxpayers filing a joint return).

For stock to qualify as section 1244 stock, the following requirements must be met: (1) the stock must be common stock; (2) the corporation issuing the stock must be a domestic corporation; (3) the equity capital of the corporation may not exceed $1,000,000; (4) the stock must be issued for money or other property, subject to certain exceptions; and (5) the corporation must be engaged in the active conduct of a trade or business.

4. Study of accounting methods for inventory

(sec. 235 of the bill)

An approved method of computing LIFO inventories is the dollar-value method. Under dollar-value LIFO the taxpayer accounts for his inventory on the basis of a pool of dollars rather than on an item-by-item basis. In general, the pool of dollars is actually measured in terms of the equivalent dollar value ("base year dollars") of the inventory in the year ("base year") the taxpayer first used the dollar-value LIFO method.

There are three methods of computing dollar-value LIFO: double-extension method, link-chain method, and index method. In general, the double-extension method requires the taxpayer to recompute the cost of the inventory goods in terms of what it would have cost in the base year to manufacture or purchase that product. The ratio of the current year cost to the base year cost is the discount factor and is used to convert the current year ending inventory to base year dollars.

Under the link-chain method a moving discount factor is developed so that the taxpayer does not have to recompute the base year costs of new products each year but only computes the current year discount for which has been developed for the total discount factor from the preceding years. The index method allows the taxpayer to develop a discount factor from a representative portion of the inventory or by the use of other sound and consistent statistical methods.

(sec. 241 of the bill and new Code sec. 44F)

As a general rule, business expenditures to develop or create an asset which has a useful life that extends beyond the taxable year, such as expenditures to develop a new consumer product or improve a production process, must be capitalized and cannot be deducted in the year paid or incurred. These costs usually may be recovered on a disposition or abandonment of the asset, or through depreciation or amortization deductions over the useful life of the asset. However, Code section 174 permits a taxpayer to elect special accounting methods (described below) for certain research or experimental expenditures which are paid or incurred during the taxable year in connection with the taxpayer's trade or business.

Present law does not provide a tax credit specifically for research or experimental expenditures. However, a taxpayer's investment in machinery and equipment employed in research or experimental activities is eligible for the investment tax credit to the same extent as investments in machinery and equipment employed for business purposes, such as manufacturing, or for current production of income (secs. 38, 46--48).

Section 174 deduction elections

In the case of research expenditures resulting in property which does not have a determinable useful life (such as secret processes or formulae), the taxpayer alternatively may elect to deduct the costs ratably over a period of not less than 60 months (sec. 174(b)).

If expenditures relating to development of a product are not eligible for these elections, or if the taxpayer chooses not to elect either current deductions or amortization for qualifying research costs, such expenditures must be capitalized.¹

However, the amounts which can be expensed or amortized under section 174 include amounts for depreciation or depletion with respect to depreciable or depletable property used for research activities (sec. 174(c); Treas. Reg. Sec. 1.174-2(b)). Accordingly, if section 174 expensing is elected, depreciation deductions for research buildings and equipment can be taken to the same extent as for property used for business (e.g., manufacturing) purposes or employed in current income production.

Definition of qualifying expenditures

The Code does not specifically define "research or experimental expenditures" eligible for the deduction elections (except to exclude certain costs, as described above). Treasury regulations (sec. 1.174-2(a)) define the statutory term to mean "research and development costs in the experimental or laboratory sense." This includes generally "all such costs incident to the development of an experimental or pilot model, a plant process, a product, a formula, an invention, or similar property, and the improvement of already existing property of the type mentioned," and also the costs of obtaining a patent on such property.

The regulations provide that qualifying research and experimental expenditures do not include expenditures "such as those for the ordinary testing or inspection of materials or products for quality control or those for efficiency surveys, management studies, consumer surveys, advertising, or promotions." Also, section 174 elections cannot be applied to costs of acquiring another person's patent, model, production, or process or to research expenditures incurred in connection with literary, historical. and similar projects (Treas. Reg. Sec. 1.174-2(a)).

Research and experimentation are basic activities that must precede (1) the development and application of new techniques and equipment to production and (2) the development and manufacture of new products. The committee believes that the approach in the bill, designed to stimulate a higher rate of capital formation and to increase productivity, appropriately includes incentives for greater private activity in research.

In recent years, spending for these purposes has not been adequate. Federal and self-financed expenditures for research and development activities performed by business over the 12-year period 1968-1979 remained at a fairly stable level in real terms, fluctuating between $19 and $22.8 billion in constant dollars. Relative to real gross national product. such expenditures declined from 2.01 percent in 1968 to 1.58 percent in 1975, essentially remaining at that level since then.

Aggregate research and development spending in this country has experienced a similar period of decline. In 1967, total expenditures reached a high of 2.91 percent of GNP before declining over ten years to 2.26 percent in 1977, and then increasing to an estimated 2.30 percent in 1980. If military and space research expenditures are subtracted from the total, the "civilian" research/GNP ratio for the United States is 1.5 percent, compared with 1.9 percent for Japan and 2.3 percent for West Germany. The committee believes that the decline in this country's research and development activities has adversely affected economic growth, productivity gains, and our competitiveness in world markets.

Under the provision, a nonrefundable income tax credit is allowed for certain research and experimental³ expenditures paid or incurred by a taxpayer during the taxable year in carrying on a trade or business of the taxpayer. The credit applies only to the extent that the taxpayer's qualified research expenditures for the taxable year exceed the average amount of the taxpayer's yearly qualified research expenditures in the specified base period (generally, the preceding three taxable years). The rate of the credit (new sec. 44F) is 25 percent of the incremental research expenditure amount.

As described below, the provision contains a definition of research for purposes of the new credit,⁴ and specifies certain types or amounts of research expenditures which enter into the credit computation.

Under the provision, three categories of "in-house" research expenditures are eligible for the credit:

Wages paid to employees for services performed in conducting research; Amounts paid for supplies used in the conduct of research; and Amounts paid (to a person other than the taxpayer) for the right to use personal property, such as a computer, in the conduct of research.

In addition to these categories of in-house research expenses, 65 percent of amounts paid by the taxpayer for contract research also is eligible for the credit. A special rule applies to corporate expenditures for basic research to be performed, pursuant to a written research agreement, by colleges or universities, or by certain tax-exempt scientific research organizations.

Trade or business requirement

Under the provision, the credit is to be available only with regard to research expenditures paid or incurred in carrying on a trade or business of the taxpayer. Generally, the phrase "in carrying on any trade or business" is intended to have the same meaning for credit purposes as it has under the business deduction provisions of section 162. The credit, therefore, is not available for research expenditures paid or incurred by a taxpayer merely in connection with, but not in carrying on, a trade or business. Similarly, the credit is not available with respect to expenditures paid or incurred by a taxpayer as part of a hobby or a financing arrangement.

Although the phrase "in carrying on any trade or business" generally has the same meaning for purposes of the new credit as it has under section 162, there are two significant differences between the credit's intended interpretation and that used for business deduction purposes. Under both provisions, the expenditures in question must be paid or incurred by a taxpayer who is carrying on a trade or business. However, the new credit does not require that the qualified research expenditures must be paid or incurred in the particular business being carried on by the taxpayer, as long as the taxpayer is carrying on a trade or business. In addition, it is intended that the Treasury will issue regulations, for credit purposes only, which will allow the credit in the case of research joint ventures by taxpayers who otherwise satisfy the "carrying on" test and who are entitled to the research results.

The rule that only research expenditures paid or incurred by the taxpayer in carrying on a trade or business can qualify for the credit is a more stringent requirement than that which has been deemed applicable for purposes of section 174 (relating to research expenditures which are paid or incurred "in connection with" the taxpayer's trade or business).

For example, under the trade or business test of new section 44F, the credit generally is not available with regard to a taxpayer's expenditures for "outside" or contract research intended to be transferred by the taxpayer to another in return for license or royalty payments. (Receipt of royalties does not constitute a trade or business under present law, even though expenses attributable to those royalties are deductible from gross income in arriving at adjusted gross income.) In such a case, the nexus between the research and the transferee's activities generally would be insufficient to support a finding that the taxpayer had incurred the research expenditures in carrying on a trade or business. (Under appropriate circumstances, nevertheless, the nexus might be deemed adequate for purposes of the section 174 deduction elections.) If, however, the taxpayer used the product of the research in the taxpayer's trade or business, as well as licensing use of the product by others, the relationship between the expenditures and the taxpayer's trade or business activities generally would be sufficient for credit purposes.

In addition, under the trade or business test of new section 44F, the credit is not available for research wage expenditures paid or incurred prior to commencing a trade or business.

Definition of research

The provision defines "research" to mean a planned search or critical investigation, including experimentation, and "business item" to mean a product or technique for use or sale by the taxpayer⁶ in a trade or business. An "existing" business item refers to a business item (other than the research in question) sold or used by the taxpayer in a trade or business before the taxpayer paid or incurred the amounts for research or for application of research results.

For purposes of this definition, business items include major component parts of a product. For example, in the case of an auto manufacturer, expenditures to bring about improvements in the carburetor or exhaust system constitute research expenditures if the improvements would be significant in comparison to the existing carburetor or exhaust system of the taxpayer's product, without regard to whether these improvements might also be considered as significant improvements in the product (the automobile) as a whole. However, research to bring about improvements (for example) in the dashboard clock or cigarette lighter, even if significant in terms of those parts, would not qualify as research expenditures eligible for the credit, because such improvements would not be significant improvements to either the product as a whole or a major component part of the product.

For purposes of the new credit, the committee intends that otherwise qualifying types of expenditures (for example, direct wage expenditures) which are part of the costs of otherwise qualifying research for the development of new or significantly improved computer software should be eligible for the credit to the extent that such expenditures (1) are treated as similar to costs, incurred in product research or experimentation, which are deductible as research or experimental expenditures under present section 174; (2) satisfy the requirements of new section 44F which apply to research expenditures, including the trade or business requirement; and (3) do not fall within any of the specific exclusions in new section 44F. That is, expenditures which otherwise would qualify for the new credit are not to be disqualified solely because such costs are incurred in developing computer "software", rather than in developing "hardware."

The credit limitations and definitional restrictions (such as the distinction between research and non-research expenditures, discussed below) which apply in the case of product research and experimentation costs also apply in the case of the costs of developing new or significantly improved computer software.

The definition does not allow the new credit for such expenditures as the costs of construction of copies of prototypes after construction and testing of the original model(s) have been completed; of pre-production planning and trial production runs; of engineering follow-through or trouble-shooting during production; or of adaptation of an existing capability to a particular requirement or customer's need as part of a continuing commercial activity. For example, the costs of adapting existing computer software programs to specific customer needs or uses, as well as other modifications of previously developed programs, are not eligible for the credit (regardless of how such costs are treated for purposes of sec. 174 deduction elections).

The types of expenditures listed in the preceding paragraph are not considered research expenditures under the definition for purposes of the new credit. In a further limitation on the scope of research expenditures which otherwise might fall within this definition, the provision provides that expenditures of a taxpayer will not qualify for the credit if paid or incurred for research, or for the application of research results, in connection with a business item after either (1) the new or significantly improved business item meets specific functional and economic requirements of the taxpayer for that item or (2) the new or improved item is ready for manufacture, sale, or use. Also, the costs of acquiring another person's patent, model, production, or process do not constitute research expenditures for purposes of the new credit (just as such costs do not constitute research expenditures for purposes of the sec. 174 deduction elections).

Exclusions

The provision also sets forth four express exclusions from the definition of qualified research for purposes of the new credit.

First, the credit is not available for any activity in the social sciences or humanities (including the arts), such as research on psychological or sociological topics or management feasibility studies. That is, to be eligible for the credit, the research must be performed in a field of laboratory science (such as physics or biochemistry), engineering, or technology.

Second, expenditures to ascertain the existence, location, extent, or quality of mineral deposits (including oil and gas) are excluded from the credit. These expenditures also are excluded, under present law, from eligibility for the section 174 deduction elections.⁷

Third, the credit is not available for any activity performed for another person (or governmental entity), whether pursuant to a grant, contract, or otherwise. Thus, if a taxpayer contracts with a research firm, university, or other person for research to be performed on the taxpayer's behalf, only the taxpayer which makes payments under the research contract and on whose behalf the research is conducted can claim the credit as to those expenditures; the research firm, university, or other person which conducts the research on behalf of the taxpayer cannot claim any credit for its expenditures in performing the contract. Likewise, no credit is allowed for research expenditures to the extent funded from any grant, contract, or subcontract for research with any agency or instrumentality of Federal, State or local government.⁸

Fourth, expenditures for research which is conducted outside the United States do not enter into the credit computation, whether or not the taxpayer is located or does business in the United States; the test is whether the laboratory experiments, etc., actually take place in this country.

In-house expenditures for wages

Under the provision, the term "wages" has the same meaning as provided in section 3401(a) for purposes of employee wage withholding. Thus, amounts of compensation which are not subject to withholding, such as certain fringe benefits, do not enter into the credit computation even though paid for services in performing research. In the case of self-employed individuals and owner-employees, the term "wages" for purposes of the new credit includes earned income of such individuals as defined in section 401(c), and such individuals are treated as employees for purposes of the wages category of in-house qualified research. Any amount of wages taken into account in computing either the targeted new jobs credit (sec. 44B) or the WIN credit (sec. 40) does not enter into the credit computation.

If substantially all (for this purpose, at least 80 percent) of the services performed by an employee for the taxpayer during a taxable year are performed in conducting research, then all services of that individual for the taxpayer during the year are treated as performed in conducting research. Thus, if 90 percent of the services performed by an employee for the taxpayer during a taxable year are performed in conducting research, all wages paid by the taxpayer during the taxable year to that individual enter into the credit computation, even though the remaining amount of the individual's services for the taxpayer was not performed in conducting research.

Definition of qualified services

Other in-house expenditures

The final category of in-house research expenditures eligible for the incremental credit consists of amounts paid or incurred for the right to use personal property in the conduct of qualified research, if such amounts are paid to a person other than the taxpayer. Intercompany charges for the right to use personal property in the conduct of research are not eligible for the credit.

By way of illustration, supplies eligible for the credit include supplies used in experimentation by a laboratory scientist, in the entering by a laboratory assistant of research data into a computer as part of the conduct of research, or in the machining by a machinist of a part of an experimental model. On the other hand, supplies used in preparing salary checks of laboratory scientists or in performing financial or accounting services for the taxpayer (even if related to individuals engaged in research) are not eligible for the new credit. Similarly, amounts paid to another person as computer user charges for use of a computer in the conduct of qualified research are eligible for the credit, but computer user charges paid for use of a computer for payroll preparation, routine data collection, market research, production quality control, etc., are not eligible.

Contract research expenditures

The determination of whether payments from a taxpayer to another person constitute contract expenditures for research to be conducted on behalf of the taxpayer depends on all the facts and circumstances of the particular research arrangement.

Amounts which are treated as contract research expenditures during a particular taxable year pursuant to the prepayment limitation rule, and hence which count as expenditures for such year entering into the credit computation for such taxable year, also are treated as having been made during that same taxable year for purposes of determining average yearly base period expenditures in later year credit computations. Thus, in the example given above, $65,000 enters into the taxpayer's 1983 credit base.

Special basic research rule

For example, assume that a corporation (which is eligible for the special rule) makes qualified in-house and contract research expenditures of $120 million in each of the years 1980, 1981, and 1982. In addition, in 1981 the corporation makes a $5 million grant to a university for basic research which would satisfy the definition of qualifying basic research expenditures under the special rule; all of this amount is expended by the university in that year. In 1983, the corporation makes qualified in-house and contract research expenditures of $130 million and also pays $6 million to a university for basic research pursuant to a written research agreement. The university performs 50 percent of the research during 1983 and the rest during 1984.

Under these facts, the corporation's current-year expenditures for 1983 would equal $130 million plus one-half of 65 percent of $6 million ($1,950,000). The corporation's base period expenditures with respect to 1983 would be the average of its qualified in-house and contract research expenditures for 1980, 1981, and 1982. This average would be $120 million, since the $5 million basic research grant in 1981 would not enter into the credit base. Accordingly, the credit for 1983 would apply to the excess of total current-year expenditures ($131,950,000) over the base period average ($120 million), or $11,950,000.

Assume further that in 1984 the total of the corporation's qualified in-house and contract research expenditures increases to $135 million, and that the corporation makes no new basic research expenditures. The corporation is treated as having qualifying basic research expenditures in 1984 equal to 65 percent of $3 million, or $1,950,000. The corporation's base period expenditures with respect to 1984 would be the average of qualified in-house and contract research expenditures for 1981 ($120 million), 1982 ($120 million), and 1983 ($130 million). The qualifying basic research expenditures made in 1981 and 1983 would not enter into the base period computation. Accordingly, the credit for 1984 would apply to the excess of current-year expenditures ($136,950,000) over the base period average ($123,333,333), or $13,616,667.

For purposes of this special rule, the term "basic research" means any original investigation for the advancement of scientific knowledge not having a specific commercial objective. However, the term basic research does not include expenditures for any activity excluded from the definition of qualified research (described above), such as research conducted outside the United States or research in the social sciences or humanities.

The special basic research rule does not apply to research expenditures by corporations that are subchapter S corporations (sec. 1371(b)), personal holding companies (sec. 542), or service organizations (sec. 414(m)(3)).

The first category of qualified organizations are educational organizations that both (1) are described in section 170(b)(1)(A)(ii) and (2) constitute institutions of higher education as defined in sec. 3304(f). Scientific organizations that qualify under the special basic research rule are organizations that (1) are organized and operated primarily to conduct scientific research, (2) are described in section 501(c)(3) (relating to entities organized and operated exclusively for specified purposes) and exempt from tax under section 502(a), and (3) are not private foundations.

The provision defines a qualified fund as any electing organization, other than a private foundation, which is exempt from tax (under sec. 501(a)) and is described in section 501(c)(3) (relating to entities organized and operated exclusively for specified purposes). In addition, the fund must be organized and operated exclusively (and not merely primarily) for purposes of making grants, pursuant to written research agreements, to colleges or universities for purposes of basic research. The fund must be established and maintained by an organization (established before July 10, 1981) which is described in section 501(c)(3) and exempt from tax under section 501(a), and which is not a private foundation.

Although a qualified fund may not be a private foundation, the fund must elect to be treated as a private foundation for all Code purposes other than the section 4940 excise tax on investment income. An election may be revoked only with the consent of the Treasury Department.

Computation of allowable credit

For the taxpayer's first taxable year to which the new credit applies (and which begins in 1980 or 1981), the credit will apply to the amount of qualified research expenditures for that year which exceeds the amount of such expenditures in the preceding taxable year. For the taxpayer's second taxable year to which the new credit applies (and which begins in 1981 or 1982), the credit will apply to the amount of qualified research expenditures for that year which exceeds the average of such expenditures in the preceding two taxable years. For a subsequent taxable year, the credit will apply to the amount of qualified research expenditures for that year which exceeds the average of such expenditures in the preceding three taxable years.

For example, assume a calendar-year taxpayer has research expenditures as follows: $100,000 for 1980, $60,000 for the period January 1, 1981 through June 30, 1981, and $70,000 for the period July 1, 1981 through December 31, 1981. The base period amount would equal $100,000 times 6/12ths, or $50,000; thus, the credit for 1981 would apply to the difference between $70,000 and $50,000. If the taxpayer's research expenditures for 1982 are $150,000, the credit would apply to the difference between (1) that amount and (2) $115,000, which is the average of 1980 expenditures ($100,000) and 1981 expenditures ($130,000).

For example, assume that a calendar-year taxpayer is organized January 1, 1983; makes qualified research expenditures of $100,000 for 1983; and makes qualified research expenditures of $260,000 for 1984. The new-business rule (described above) provides that the taxpayer is deemed to have base period expenditures of zero for pre-1983 years. Without regard to the 50-percent limitations, the taxpayer's base period expenditures for purposes of determining any credit for 1984 would be the average of its expenditures for 1981 (deemed to be zero), 1982 (deemed to be zero) and 1983 ($100,000), or $33,333. However, by virtue of the 50-percent limitation, the taxpayer's average base period expenditures are deemed to be no less than 50 percent of its current year expenditures ($260,000), or $130,000. Accordingly, the amount of 1984 qualified research expenditures qualifying for the credit is limited to $130,000, and the amount of the taxpayer's credit for 1984 is $32,500.

Rules for aggregation of expenditures

Under the provision, all qualified research expenditures of all corporations that are members of a "controlled group of corporations" are treated as if made by one taxpayer. For this purpose, the same controlled group test (50-percent control) is used as applies under rules for computing the targeted jobs tax credit (sec. 52(a)). Any research credit earned by a controlled group, computed pursuant to this aggregation rule, is to be apportioned among members of the group on the basis of their proportionate share of the increase in aggregate qualified research expenditures giving rise to the credit.

The provision also requires aggregation, pursuant to Treasury regulations, of all qualified research expenditures of partnerships, proprietorships, and any other trades or businesses (whether or not incorporated) which are under common control with the taxpayer. Any allowable research credit, computed pursuant to this aggregation rule, is to be apportioned, as provided in Treasury regulations, among the persons whose expenditures are aggregated on the basis of their proportionate share of the increase in aggregate research expenditures giving rise to the credit. This aggregation and apportionment rule is to be based on principles similar to the principles applicable in the case of a controlled group of corporations.

No amount of credit is apportioned to A, since A's qualified research expenditures did not increase in the taxable year. The full $8,750 credit would be allocated to B, C, and D, i.e., to those members of the group with increases in their expenditures. This allocation would be made on the basis of the ratio of each such corporation's increase in its qualified research expenditures to the sum of increases in such expenditures (counting only members with increases). Inasmuch as the total increase made by those members of the group whose research expenditures went up (B, C, and D) was $55,000, B's share of the $8,750 credit is 5/55; C's share is 40/55; and D's share is 10/55.

If, in the example set forth above, A had zero expenditures in the taxable year, the controlled group as a whole would show a decrease rather than an increase in aggregate expenditures. In that case, no amount of credit would be allowable to any member of the group even though B, C, and D actually increased their research expenditures in comparison with their own base period expenditures.

Rules for changes in business ownership

Under these rules, a taxpayer is not to be treated as acquiring the major portion of a trade or business (or of a separate unit thereof) merely because the taxpayer acquires some assets used in that trade or business. Instead, this determination is to be made on the basis of whether the acquisition involves the transfer of a viable trade or business which can be operated by the taxpayer.

However, the base period expenditures of a taxpayer which so disposes of a trade or business (or separate unit) will be increased if, during any of the three taxable years following the year of disposition, the taxpayer (or a person whose research expenditures must be aggregated under the provision with those of the taxpayer) reimburses the acquiring person (or a person whose research expenditures must be aggregated under the provision with those of the acquiring entity) for research on behalf of the taxpayer. In such a case, the amount of qualified research expenditures of the taxpayer for the base period for such taxable year shall be increased by the lesser of (1) the amount of decrease (under the rules described in the preceding paragraph) which is allocable to such base period, or (2) the product of the number of years in the base period multiplied by the amount of such reimbursement.

Limitation and carryover

The amount of credit which can be used in a particular taxable year is limited to the taxpayer's income tax liability reduced by certain other nonrefundable credits.

If the amount of allowable credit exceeds this limitation, the excess credit can be carried back three years (including carrybacks to years before enactment of the credit) and carried forward 20 years, beginning with the earliest year.⁹

Disallowance of deduction

In the case of a noncorporate taxpayer, no deduction is allowed for that portion of qualified research expenditures, paid or incurred during a taxable year in which a credit for research expenditures is allowable, equal to the amount of credit allowable to the taxpayer for the taxable year. Under the provision, the deduction disallowance also applies in the case of a corporation which is a subchapter S corporation, as defined in section 1371(b); a personal holding company, as defined in section 542; or a service organization, as defined in section 414(m)(3).

The deduction is disallowed by the full amount of the credit without regard to the tax liability limitation discussed above. The disallowed amount may not be deducted under sections 162, 167, 172, or 174, or any other deduction provision; that is, the disallowance is not limited to deductibility pursuant to a section 174 deduction election.

In the case of persons whose research expenditures are aggregated pursuant to the rules discussed above (for purposes of computing the credit), the reduction in the allowable deduction is to be allocated under rules similar to those for allocation of the credit.

2. Charitable contributions of scientific property used for research or experimentation purposes

(sec. 242 of the bill and Code sec. 170(e))

Under present law, a corporation may deduct, within certain limitations, the amount of cash or other property contributed to qualified charitable organizations for exempt purposes, including contributions to colleges and universities for research purposes (Code sec. 170). This charitable deduction is limited to five percent of the corporation's taxable income (computed with certain adjustments) for the year in which the contributions are made. If the amount contributed exceeds the five-percent limitation, the excess may be carried forward and deducted over five succeeding years, subject to the five-percent limitation in those years.

General reduction rule

In general, the amount of charitable deduction otherwise allowable for donated property must be reduced by the amount of any ordinary gain which the taxpayer would have realized had the property been sold for its fair market value at the date of the contribution (sec. 170(e)).¹ Thus a donor of appreciated ordinary-income property (property the sale of which would not give rise to long-term capital gain) generally can deduct only the basis in the property, rather than its full fair market value.

Exception

In 1976, an exception to this general reduction rule was enacted for contributions by corporations of certain types of ordinary income property (e.g., medical equipment) donated for the care of the needy, the ill, or infants (sec. 170(e)(3)(A)). In the case of such a qualifying charitable contribution of inventory, the exception generally allows a deduction equal to the sum of the taxpayer's basis in the property plus one-half of the unrealized appreciation. However, in no event is a deduction allowed for an amount in excess of twice the basis of the property.

This exception was enacted because the Congress concluded that it was desirable to provide a greater tax incentive than in prior law for contributions of certain types of ordinary income property for the specified category of exempt purposes. At the same time, the Congress also determined that the deduction so allowed should not be such that the donor could be in a better after-tax situation by donating the property than by selling it.

Academic research and development expenditures have increased in constant dollars by three percent each year since 1974, reversing a spending decline over the prior six years. However, studies indicate that in equipment-intensive research areas such as physics, chemistry, and electrical engineering, the continuing growth of university expenditures has not kept pace with the rising costs of scientific instrumentation.

The general deduction limitation rule, enacted in the Tax Reform Act of 1969, has been effective to prevent situations which led to its enactment, in which individual taxpayers in high marginal tax brackets or corporations could donate to charity substantially appreciated ordinary income property and be better off, after tax, than they would have been had they sold the property and retained all the after-tax proceeds. At the same time, the 1969 rule has resulted in reduced contributions of certain types of property to charities, including educational institutions.

The committee believes that it is desirable to provide a greater tax incentive than in present law for contributions of certain types of new inventory property, manufactured by the donor corporation no more than two years before contribution, which the donee university or college uses in carrying on scientific research activities, including research training. The committee also believes that the deduction so allowed should not be such that the donor corporation could be in a better after-tax situation by donating the property than by selling it.

The provision provides an additional limited exception to the rules of present law which generally require an otherwise allowable deduction for charitable contributions of appreciated property to be reduced by the amount which would not be long-term capital gain if the property contributed had been sold at its fair market value at the time of the contribution.

The provision allows corporations (with certain exceptions)² a larger deduction than under present law for charitable contributions of new tangible personal property which is of an inventory nature (within the meaning of sec. 1221(1)), if contributed to an institution of higher education (as defined in secs. 170(b)(1)(A)(ii) and 3304(f)), and if used by the college or university for research purposes.

Requirements for favorable treatment

To qualify, a corporate contribution of ordinary-income property to a college or university must satisfy the following requirements:

If all the conditions are satisfied, the charitable deduction is generally for the sum of (1) the taxpayer's basis in the property and (2) one-half of the unrealized appreciation. However, in no event is a deduction to be allowed for an amount which exceeds twice the basis of the property.

3. Allocation of U.S.-based research and experimental expenditures to U.S. source income

In general, U.S. citizens and U.S. corporations are subject to taxation by the United States on their worldwide income. To avoid double taxation of U.S. taxpayers on foreign source income, the United States allows a foreign tax credit against the U.S. taxes imposed on foreign source income.

A fundamental principle of the foreign tax credit is that it may not be used to offset the U.S. tax on U.S. source income. The foreign tax credit provisions contain a limitation that insures that the credit will not be used to offset the U.S. tax on U.S. source income. Under the limitation, a U.S. taxpayer is allowed a credit against its U.S. tax for foreign taxes paid on foreign source income only to the extent of the pre-credit U.S. tax on that foreign source income.

The foreign tax credit limitation is calculated by multiplying the taxpayer's U.S. tax on its total taxable income by a fraction, the numerator of which is the taxpayer's foreign source taxable income and the denominator of which is total taxable income.

Treasury regulation sec. 1.861-8

In determining foreign source taxable income for purposes of computing the foreign tax credit limitation, sections 861-863 require taxpayers to allocate or apportion all of their expenses between foreign source income and U.S. source income. Treasury regulation 1.861-8 sets forth the rules on allocating and apportioning these expenses.

Under this regulation, research and development expenditures ("research expenses") are allocated to income based on a broad classification of 32 product groups enumerated in the Standard Industrial Classification ("SIC") Manual. Research expenses are not allocable solely to the income generated by the particular product which benefited from the research activity. Instead, these expenses are allocable to all the income within the SIC product group in which the product is classified. Accordingly, once a research expense is identified with a SIC product group, it is allocated to foreign sources based on the ratio of total foreign source sales receipts or income, as the case may be, within the SIC product group to the total worldwide sales receipts or income, as the case may be, within the SIC product group.

The regulation provides certain "safe harbors" when more than 50 percent of the research expenses are incurred either within or without the United States. For years beginning in 1979, the regulation allows a taxpayer to allocate 30 percent of the research expenses to the geographic source in which more than 50 percent of such expenses were incurred.

The regulation also provides that if the taxpayer's results of operations justify an allocation of research expenses to the country in which the research is performed that would be higher than the 30 percent that is allowed under this safe harbor rule, then the taxpayer may make such higher allocation. The remaining portion of the research expenses are then apportioned based upon the SIC formula.

Taxpayers that allocate research and development expenses for purposes of the foreign tax credit claim that the allocation results in more deductions being allocated overseas than is allowed as a deduction by the foreign country. Thus, taxpayers claim that their foreign tax credit limitation is lower than the foreign taxes paid and that they will lose foreign tax credits.

Taxpayers argue that because of the application of the regulation, they must transfer research and development activities to the foreign country in order to get a deduction in that country and, thus, get a full foreign tax credit on the income earned in that country. The committee believes that the transfer of research and development activities overseas would not be in the best interest of the United States. Therefore, the committee has concluded that the Treasury should study the impact of the allocation of research and development expenses under Treas. Reg. Sec. 1.861-8 on U.S.-based research and development activities.

The Department of the Treasury is directed to conduct a study of the impact that the research and development allocation provisions of Treasury regulation sec. 1.861-8 has on research and development activities conducted in the United States. The study, with recommendations to the Congress, is to be submitted to the Committee on Ways and Means and the Senate Committee on Finance not later than six months after enactment of the bill.

(secs. 301 and 302 of the bill and secs. 62, 219, 220, 408, 409, 415, 2039, 2503, 3401, 4973, and 6047 of the Code)

An individual generally is entitled to deduct from gross income the amount contributed to an individual retirement account or annuity, or used to purchase retirement bonds (referred to collectively as "IRAs"). The limitation on the deduction for a taxable year is generally the lesser of 15 percent of compensation for the year or $1,500. Under a spousal IRA, the $1,500 contribution limit is increased to $1,750 for a year, if (1) the contribution is equally divided between an individual and the spouse of the individual, and (2) the spouse has no compensation for the year. However, no IRA deduction is allowed for a taxable year to an individual who is an active participant during any part of the taxable year in a qualified pension, profit-sharing or stock bonus plan, a tax-sheltered annuity program maintained by certain tax-exempt organizations or by public educational organizations, or a government plan (whether or not qualified). Except for tax-free rollovers and certain amounts paid for life insurance under an endowment contract, nondeductible contributions are not permitted to be made to an IRA. Income and gain on amounts held under an IRA are not taxed until distributed. Except in the case of certain correcting distributions, all distributions from IRA's are includible in gross income. Distributions made before age 59-1/2 (other than those attributable to disability or death) are subject to an additional 10-percent income tax. If an individual borrows from an IRA or uses amounts in an IRA as security for a loan, the transaction is treated as a distribution and the usual tax rules for distributions apply. Distributions from an IRA must commence no later than the taxable year in which the individual attains age 70-1/2, and special rules require distributions to be made within a prescribed time after the individual's death. Amounts held in an IRA can qualify for exclusions under the estate tax and gift tax rules.

Simplified employee pensions

If an individual retirement account or individual retirement annuity qualifies as a simplified employee pension (SEP), the annual IRA deduction limitation is increased to the lesser of $7,500 or 15 percent of compensation. The $7,500 limit applies only to employer contributions. An employee with a SEP is entitled to make additional deductible contributions to an IRA only to the extent that the annual deduction limitation (i.e., the lesser of 15 percent of compensation or $1,500) exceeds the amount contributed by the employer for the year under the SEP. An individual retirement account or individual retirement annuity qualifies as a SEP for a calendar year if certain requirements relating to employee withdrawals and the employer contribution allocation formula are met. The allocation rules are designed to assure that employer contributions are made on a basis that does not discriminate in favor of employees who are officers, shareholders, or highly compensated.

Employee contributions

Many qualified plans provide for contributions by both the employer and the employee. In many cases, the employee contributions are mandatory (i.e., required as a condition of employment, a condition of participation in the plan, or a condition of obtaining additional employer-derived benefits). In other cases, employee contributions are voluntary, and the amount, within limits, is left to the discretion of the employee. A plan can provide for both mandatory and voluntary employee contributions. Employee contributions to a qualified plan may not discriminate in favor of employees who are officers, shareholders, or highly compensated. Generally, in the case of voluntary employee contributions, within certain limits, there is presumed to be no discrimination on account of those contributions so long as the opportunity to make the contributions is reasonably available to a nondiscriminatory group of employees. Plan income and gain allocable to an employee's contributions to a qualified plan are generally not taxed to the plan or to the employee until distributed or made available to the employee or the employee's beneficiary. However, the employee is generally not entitled to a deduction or exclusion for employee contributions to the plan. Benefits held in a qualified plan can qualify for exclusions under the estate tax and gift tax rules to the extent the benefits are not attributable to employee contributions.

The committee bill is designed to promote greater retirement income security by increasing the amount which individuals can set aside in an IRA and by permitting active plan participants to contribute to an IRA on the same basis as non-participants. The bill also allows employees a limited deduction for voluntary employee contributions by providing for employee IRAs under qualified plans. The committee believes that uniform rules for all individuals and for all deductible individual retirement savings will greatly simplify the administration of IRAs for individual taxpayers, employers, and sponsoring financial institutions.

Present budgetary limits precluded the committee from giving full consideration to the merits of extending the tax-favored treatment of mandatory employee contributions to employer-sponsored plans by allowing a deduction for such contributions. The committee believes that the question of deductibility of mandatory contributions to employer-sponsored plans should be further reviewed on the merits at a future time when budgetary constraints permit.

Under the bill, an individual (including an active participant in a qualified plan, etc.) is allowed a deduction for contributions to an IRA limited annually to the lesser of $2,000 or 100 percent of compensation for the year. In the case of a participant in a qualified plan, the deduction is allowed for contributions to an IRA or for voluntary contributions by or on behalf of the employee to an employee IRA under the plan. Under the bill, the first $2,000 of voluntary employee contributions to a plan for a year will be allocated to the employee IRA unless the employee designates otherwise. An employee can allocate voluntary contributions to employee IRAs under all qualified plans in which the employee participates, so long as the total amount allocated does not exceed the deduction limit for the year.

An employee for whom an employer contributes under a simplified employee pension (SEP) is allowed a deduction for his own IRA contributions without regard to the deduction allowed to the employee for employer contributions to the SEP. Under the SEP rules, the annual deduction limit for employer contributions is applied with respect to contributions by, and compensation from, each employer.

If a married couple files a joint return, their IRA contribution limit for the year is equal to the sum of the separate contribution limits computed for each spouse. A couple's IRA contribution need not be equally divided between the spouses, but annual contribution for either spouse cannot exceed $2,000. Thus, for example, if spouses H and W each had at least $2,000 of compensation includible in gross income for a year, their aggregate deduction limit would be $4,000. Because no more than $2,000 could be deducted on behalf of either spouse, they would be allowed the maximum deduction only if each spouse's IRA received $2,000. If, instead, H earned $20,000 and W earned $1,000, their maximum aggregate deduction would be $3,000. Subject to the rule that neither spouse's IRA could receive more than $2,000 for the year, contributions not exceeding $3.000 could be allocated in any manner chosen by H and W (e.g., H's IRA could receive $1,000, and W's could receive $2,000).

Employee IRAs

An account in a qualified trust or under a qualified annuity plan qualifies as an employee IRA if (1) only voluntary employee contributions may be credited to the account, (2) the first $2,000 of such contributions for a calendar year are credited to the account unless the employee designates that all or a portion of the contributions are to be treated as nondeductible, and (3) the employee's balance under the account is adjusted for any income, gain, losses, and expenses at least contributions may be credited to the account, (2) the first $2,000 of such annually. Of course, an account need not be labeled "employee IRA" to qualify for treatment as an employee IRA. As under present law relating to defined contribution plans, these adjustments are to be based on the fair market value of assets. An employee IRA may not be established under a government plan.

Treasury regulations are to provide rules under which an employee may designate that otherwise deductible voluntary contributions to a qualified plan providing employee IRAs are to be treated as nondeductible. As under the present-law IRA rules, certain contributions made to an employee IRA after the close of a calendar year may be treated as if made on the last day of the year. A qualified plan which accepts contributions to an employee IRA is not required to hold assets acquired with such contributions (or income and gain therefrom) apart from the plan's other assets.

Under the bill, the present-law requirements for a qualified plan generally also apply with respect to an employee IRA under5 the plan. For example, the opportunity to make contributions to an employee IRA must be reasonably available to a nondiscriminatory group of employees. This availability standard will apply to the aggregate of employee IRA contributions and nondeductible voluntary contributions and to the employee IRA contributions alone. If the availability standard is satisfied, the limit on the amount of voluntary contributions permitted under qualified plans of an employer is to be applied only to nondeductible voluntary contributions. In addition, contributions to an employee IRA or to an IRA (other than employer contributions to a SEP) are not taken into account for purposes of the limitations on contributions and benefits for qualified plans and tax-sheltered annuities. In the case of a qualified plan which benefits an owner-employee (a sole proprietor or a partner whose partnership interest exceeds 10 percent), deductible contributions to an employee IRA under the plan are not taken into account under the rules which limit (or preclude) voluntary contributions to the plan by the owner-employee as an employee.

Although the bill changes the tax treatment of voluntary employee contributions to a qualified plan, and benefits derived from such contributions, it does not add new tax qualification requirements to the Code or modify the nontax rules of ERISA (the Employee Retirement Income Security Act of 1974).

Treatment of distributions

Amounts held in an employee IRA generally are subject to the same tax treatment accorded amounts held in an IRA established under present law. All distributions from an employee IRA are includible in gross income, except for tax-free rollovers. Distributions from an employee IRA may be made without penalty after age 59-1/2 or in the event of disability or death. Other distributions from an employee IRA are subject to the same 10-percent additional income tax that applies to early withdrawals from an IRA established under present law. If amounts in an employee IRA are distributed as a life annuity which commences after age 59-1/2 (and which provides for regular, periodic, substantially equal payments), the annuity payments are taxed under the same rules which apply to annuity payments under qualified plans. For this purpose, the balance in the employee IRA at the time the payments commence is treated as an amount contributed by the employer which was excluded from the employee's income. Under this rule, if amounts in an employee IRA are applied together with other amounts (including amounts attributable to nondeductible employee contributions) to provide an annuity to the participant, the portion of an annuity payment attributable to the employee IRA need not be separately accounted for by the payor or by the recipient taxpayer.

Under the rollover rules, a distribution from an employee IRA may be transferred, tax-free, to (1) an IRA established under present law or (2) an employee IRA under another qualified plan if the plan administrator of the other plan permits such rollovers on a nondiscriminatory basis. The amount transferred would not be taken into account under the limits on employee contributions to a qualified plan. Such a rollover may be made without regard to whether the distribution from the employee IRA is included in a lump sum distribution or a distribution on account of termination of the qualified plan, and without regard to whether the distribution constitutes a total distribution of the participant's balance under the employee IRA. In addition, a distribution from an IRA established under present law may be rolled over to an employee IRA under a qualified plan under the same rules which apply to IRA-to-IRA transfers, if the plan administrator of the qualified plan accepts such rollover on a nondiscriminatory basis.

Under the bill, the present-law IRA excise tax rules reflecting the requirement that distributions commence not later than the taxable year in which the individual attains age 70-1/2 and that distributions be made within a prescribed time after the individual's death also apply to amounts held in an employee IRA. If an amount in an employee IRA is applied toward the purchase of life insurance, the amount so applied is treated as a distribution to which the usual tax rules for distributions apply. In addition, if an employee borrows any amount from an employee IRA, the employee's entire balance in the employee IRA is treated as if distributed to the employee. If the employee pledges as security for a loan all or a portion of an interest in an employee IRA under a qualified trust, the amount of the security interest is treated as distributed. If an employee borrows against an interest in an employee IRA under a qualified annuity plan, an amount equal to the fair market value of the employee IRA is treated as a distribution to which the usual distribution rules apply.

The rules for employee IRAs differ in certain respects from the rules for individual retirement accounts. For example, an individual retirement account must specifically provide that no amount in the account may be invested in life insurance and that distributions from the account will commence no later than the close of the taxable year in which the individual attains age 70-1/2. With respect to employee IRAs, the bill reflects these IRA requirements in income tax rules which apply if amounts in an employee IRA are used to purchase life insurance or if distributions do not commence before the close of the employee's taxable year in which he attains age 70-1/2. However, these income tax rules for employee IRAs are not required to be included in plan provisions relating to the purchase of life insurance for employees or to the distribution of plan benefits.

Under the bill, amounts held in an employee IRA can qualify for exclusions under the estate tax and gift tax rules which apply to IRAs established under present law.

The distribution of, or the failure to distribute, amounts held in an employee IRA under a qualified plan is not taken into account in determining whether a distribution under the plan is a lump sum distribution. In addition, amounts distributed from an employee IRA are not eligible for 10-year forward income averaging, long-term capital gain treatment, deferred recognition of gain on employer securities, or the income tax death benefit exclusion for certain benefits under qualified plans. In applying certain IRA rules to deductible employee contributions, the committee does not intend to imply that it necessarily would be appropriate to apply such rules to other plan contributions or benefits.

An employer is not required to withhold income tax on an employee's voluntary contributions to any employee IRA if it is reasonable to believe that the employee will be entitled to a deduction for the contributions.

A clarifying amendment is made with regard to the income tax treatment of the proceeds of an IRA retirement bond purchased with a rollover contribution.

2. Retirement plan deduction for self-employed individuals

(sec. 303 of the bill and secs. 72, 219, 401, 404, 408, 1379, and 4972 of the Code)

A pension or profit-sharing plan is a qualified plan only if it is established by an employer for the benefit of employees or their beneficiaries. For this purpose, a sole proprietor is considered both an employee and the employer, and a partnership is considered the employer of each partner. A qualified plan which benefits a self-employed individual (a sole proprietor or partner) is referred to as an "H.R. 10 plan" or "Keogh plan", and is subject to special rules which are in addition to the Code's other qualification requirements. These special rules include limits on the contributions and benefits which can be provided for a self-employed individual. These limits are generally lower than the overall limits on contributions and benefits applicable with respect to all employees under qualified plans.

Limitation on contributions and benefits for self-employed individuals

Under a qualified defined contribution¹ H.R. 10 plan, deductible contributions on behalf of a self-employed individual generally are limited annually to the lesser of $7,500 or 15 percent of net earnings from self-employment. Nondeductible, employee contributions by a self-employed individual are generally permitted (within limits) unless all employees covered by the plan are owner-employees (an owner-employee is a sole proprietor or a partner whose partnership interest exceeds 10 percent). Annual contributions on behalf of a self-employed individual in excess of the combined limits on deductible and (if permitted) nondeductible contributions are subject to a six-percent nondeductible excise tax.

Under a qualified defined benefit² H.R. 10 plan, the annual benefit accruals for a self-employed individual are limited by a special schedule designed to permit the accrual of a pension benefit no greater than that which could be provided by the accumulated annual contributions permitted under a defined contribution H.R. 10 plan.

Subchapter S corporations

A qualified pension or profit-sharing plan maintained by an electing small business corporation (a subchapter S corporation) is subject to special limitations corresponding to those for H.R. 10 plans as well as the overall limits on contributions and benefits applicable to all qualified plans. Under a qualified defined contribution plan of a subchapter S corporation, annual employer contributions on behalf of a shareholder-employee (an employee who owns more than five percent of employer stock) in excess of the lesser of $7,500 or 15 percent of compensation are includible in the income of the shareholder-employee. Under a qualified defined benefit plan of a subchapter S corporation, benefits are limited under the same schedule that applies to a defined benefit H.R. 10 plan.

Simplified employee pensions

If an individual retirement account or individual retirement annuity qualifies as a simplified employee pension (SEP), the annual IRA deduction limitation is increased to the lesser of $7,500 or 15 percent of compensation. The $7,500 limit applies only to employer contributions. An employee with a SEP is entitled to make additional deductible contributions to an IRA only to the extent that the annual deduction limitation (i.e., the lesser of 15 percent of compensation or $1,500) exceeds the amount contributed by the employer for the year under the SEP. An individual retirement account or individual retirement annuity qualifies as a SEP for a calendar year if certain requirements relating to employee withdrawals and the employer contribution allocation formula are met. The allocation rules are designed to assure that employer contributions are made on a basis that does not discriminate in favor of employees who are officers, shareholders, or highly compensated.

Limit on includible compensation

Under present law, only the first $100,000 of compensation may be taken into account under an H.R. 10 plan, a plan of a subchapter S corporation, or a SEP for purposes of testing for discrimination and applying certain limits on contributions or benefits.

Employee borrowing from qualified plans

In general, loans to participants from a qualified plan are permitted if certain requirements are met.³ However, H.R. 10 plans are not permitted to lend to an owner-employee. Also, if an owner-employee participating in H.R. 10 plan borrows from the plan or uses an interest in the plan as security for a loan, the transaction is treated as a plan distribution, and the usual tax rules for distributions apply.

Plan termination distributions

Under present law, an H.R. 10 plan must provide that no benefits will be paid to an owner-employee before he attains age 59-1/2 or is disabled. If a distribution is made to an owner-employee in violation of the rule, no contributions may be made to an H.R. 10 plan on his behalf for the five taxable years following the taxable year of the distribution. This five-year ban applies even if the distribution is made on account of termination of the plan.

Under the rules permitting tax-free rollovers of distributions from qualified plans, all or a part of a total distribution made to an owner-employee on account of the termination of an H.R. 10 plan may be transferred, tax-free, to an IRA. The portion of the distribution rolled over to an IRA is not subject to the 10-percent additional income tax which generally applies to distributions received by an owner-employee before age 59-1/2.

Under present law, partners who are not owner-employees may borrow against their interest in an H.R. 10 plan without penalty. The committee is concerned that the widespread use of such loans diminishes retirement savings. Accordingly, the committee believes the restrictions on loans and pledges currently applicable to owner-employees should be applied to all partners. The committee also believes that changes should be made to permit timely correction of excess contributions to H.R. 10 plans and to permit contributions to an H.R. 10 plan to continue without interruption where an owner-employee has received a distribution before age 59-1/2 from a terminated H.R. 10 plan.

In general, the bill increases the deduction limit for employer contributions to defined contribution H.R. 10 plans, defined contribution plans maintained by subchapter S corporations, and SEPs to $15,000. The 15-percent limit on contributions is not changed. In addition, the bill provides that if an excess contribution is made, the six-percent excise tax on the excess contribution will not apply if the excess, together with any net income attributable to it, is withdrawn from the plan on or before the date for filing the return for the taxable year (including extensions). This rule corresponds to a rule for excess contributions made to IRAs.

For defined benefit H.R. 10 or subchapter S corporation plans, the compensation taken into account in determining permitted annual benefit accruals is increased to $100,000. The bill continues the requirement of present law under which an increase in the compensation taken into account to determine benefit accruals under a plan is treated as starting a new period of plan participation.

Increase in includible compensation

Under the bill, the maximum amount of compensation which may be used to determine contributions in an H.R. 10 or subchapter S plan, or a SEP is increased from $100,000 to $200,000. However, if annual compensation in excess of $100,000 is taken into account under the plan, the rate of employer contributions for a plan participant who is a common-law employee cannot be less than the equivalent of 7-1/2 percent of that participant's compensation. Of course, as under present law, the amount actually contributed to a particular plan for a participant will be less if the plan is integrated with social security. Also, contributions or benefits under another qualified plan of the employer may be taken into account for the purpose of determining whether the 7-1/2-percent minimum is met.

Employee borrowing

The bill extends to all partners the present law rule under which a loan from an H.R. 10 plan, or the use of an interest in the plan as security for a loan, is treated as a distribution.

Plan termination distributions

The bill provides that the present-law rule which precludes future contributions to an H.R. 10 plan for an owner-employee after certain distributions are made to the owner-employee will not apply with respect to a distribution made on account of plan termination.

3. Rollovers under bond purchase plans

(sec. 304 of the bill and secs. 219, 405, 408, 2039 and 4973 of the Code)

A bond purchased for a plan participant may be redeemed only after the participant dies, attains age 59-1/2, or is disabled. Redemption proceeds in excess of the amount contributed by the employee are includible in gross income as ordinary income. The proceeds may not be rolled over to a qualified plan or to an IRA.

The bill does not change the present-law rule under which a bond may not be redeemed before the individual dies, attains age 59-1/2, or is disabled.

4. Investments in collectibles by an individual retirement account or individually-directed account under a qualified plan

(sec. 305(b) of the bill and sec. 408 of the Code)

Under present law, only a bank, insurance company, or other qualifying financial institution can act as an IRA trustee or custodian. However, the owner of an IRA can self-direct the investment of assets in the account.

A "collectible" is defined in the bill as any work of art, rug, antique, metal, gem, stamp, coin, alcoholic beverage, or any other item of tangible personal property specified by the Secretary.

Although the bill changes the tax treatment of the acquisition of collectibles under individually-directed accounts, it does not modify the tax-qualification standards of the Code for pension, profit-sharing, or stock bonus plans or the nontax rules of ERISA. For example, the tax qualification of a pension plan would not be adversely affected merely because an amount was treated as distributed to a participant under this provision at a time when the plan is not permitted to make a distribution to the participant.

The committee expects that Treasury regulations will provide for appropriate adjustments that will avoid double taxation of benefits under a plan where the collectible is not actually distributed.

(sec. 321 of the bill and secs. 128, 265, 584, 643, 702, and new sec. 129 of the Code)

In addition, savings and loan associations and many banks and credit unions have made long-term, low-rate loans, especially home loans, in the past. Because of high interest rates, the current cost of obtaining funds to carry these old loans is higher than the income accruing on them. The resulting squeeze on the profitability and cash flow of many of these depository institutions may threaten their financial viability, particularly in light of the disintermediation caused by the competition from financial institutions whose interest rates are not regulated.

Another result of high interest rates has been a significant disruption in the mortgage credit market. Money for new long-term mortgages, when it has been available, has demanded very high rates. The home building industry has suffered as a result and many young couples no longer believe they can afford to own a home.

The committee believes that availability of a tax-exempt savings instrument that can be issued only by depository institutions should help to stem, and perhaps reverse, the flow of deposits out of depository institutions. It also is anticipated that some new savings may be generated by such instruments. In addition, the committee believes that the availability of lower-cost funds from tax-exempt certificates for a 2-year period² should give the troubled depository institutions an opportunity to retire much of the low-yield loan portions of their portfolios and replace them with more profitable assets.

Finally, the committee believes revitalization of depository institutions, increases in net savings and the requirement that new deposits be invested, in part, in home mortgages will significantly stimulate the home building and real estate industries.

Qualified certificates

In general, qualified tax-exempt savings certificates are one-year certificates issued after September 30, 1981, and before October 1, 1982, by a qualified depository institution with a yield not in excess of 70 percent of the yield on 52-week Treasury bills.³ A qualified depositor, institution is a bank defined in section 581, a mutual savings bank, cooperative bank, domestic building and loan association, industrial loan association or bank, credit union, or any other savings or thrift institution chartered and supervised under Federal or State law, if the deposits or accounts of the institution are insured under Federal or State law or protected or guaranteed by State law.

For interest to qualify for the exclusion, a certificate issued by a qualified institution must meet several requirements. First, such certificates may be issued only during the one-year period beginning on October 1, 1981, and ending on September 30, 1982. Interest paid after September 30, 1982, with respect to certificates properly issued before that date will be entitled to the exemption. Second, the certificates must have a maturity period of one year. Thus, all of the interest excludable by virtue of the new provision will be earned by October 1, 1983. Third, the certificate must have a yield not in excess of 70 percent of the yield on 52-week Treasury bills. Whether a certificate meets this 70-percent requirement is determined by comparing the yield to maturity on the certificates (including the effect of any compounding of interest) to the yield to maturity on 52-week Treasury bills sold at the last Treasury auction to have occurred in a calendar week preceding the week the certificate is issued. Thus, an auction of 52-week Treasury bills will determine the interest limitation on tax-exempt savings certificates issued from the Monday following such auction until the Monday following the next auction of 52-week Treasury bills.

Finally, the issuing institution must provide that certificates are available for any deposit of $500 or more, subject to any limit on maximum deposits.

The committee does not intend, by this provision, to preempt the authority of Federal or State banking regulatory agencies to regulate interest rates, minimum deposits, interest penalties, maturities or any other aspect of depository accounts. Thus, the provision does not authorize the issuance of qualified tax-exempt savings certificates; however, the committee anticipates that the cognizant regulatory authorities will consider such authorization as expeditiously as practicable.

Required uses of certificate proceeds

Generally, the committee bill requires that at least 75 percent of the proceeds of qualified certificates during calendar quarter issued by an institution other than a credit union be used to provide residential financing by the end of the subsequent calendar quarter. In the case of an institution with net new savings less than the amount of certificates redeemed from such accounts measured at the beginning and end of each calendar quarter. A special rule limits the amount of certificates issued, the 75-percent requirement applies to the amount of net new savings. For this purpose, qualified net savings is the amount by which deposits into passbook savings accounts, 6-month money market certificates, 30-month small saver certificates, time deposits of less than $100,000, and qualified certificates exceeds the amount withdrawn or redeemed from such accounts measured at the beginning and end of each calendar quarter. A special rule limits the amount of certificates issued by a credit union that may be outstanding at the close of any calendar quarter to 100 percent of the credit union's savings deposits as of September 30, 1981, plus 10 percent of any new net savings as of the end of the quarter over the credit union's savings deposits as of September 30, 1981. The amount of qualified certificates, residential financing, and net new savings are to be determined on a net aggregate basis of all corporations (whether or not qualified depository institutions) which are affiliated corporations (within the meaning of sec. 1504), if a consolidated return is filed for any part of that calendar quarter.

Qualified residential financing of an institution is any of the following held by the institution:

If an institution fails to meet the proceeds investment test at the end of any calendar quarter, it may not issue additional certificates until the requirement is satisfied.

Limitations

The amount that any individual may exclude from income under the new provision is limited to $1,000. This limitation applies to the aggregate of all interest paid on all certificates. Thus, a calendar year taxpayer who receives, for example, $800 of otherwise exempt interest in 1982 and $500 in 1983 can exclude only $800 of interest in 1982 and $200 of interest in 1983. In the case of individuals filing returns, the limit is increased to $2,000. This is true even if all of the $2,000 is earned by only one of the individuals filing the joint return. If two individuals file a separate return in one year and a joint return in the next year, the separate amount of any exemption claimed in the first year are combined and taken into account in applying the $2,000 limitation in the second year. Similarly, if two individuals file a joint return in one year, they are treated as each having claimed half the amount of any exclusion shown on that return in applying the limitation in any subsequent year for which they file separate returns or joint returns with different individuals.

Interest paid on qualified certificates is excludible only when earned by individuals or by estates that receive such certificates by reason of the decedent's death. In the case of a partnership, the individual partners may exclude their distributive shares of interest paid on qualified certificates held by the partnership subject to each partner's $1,000 lifetime limitation on the exclusion. Under an amendment to section 702, each partnership is required to separately state the amount of such interest distributable to the partners. Amounts paid to trusts (other than common trust funds) or corporations (including real estate investment trusts, subchapter S corporations, and regulated investment companies) will be fully taxable.

In applying the dollar limitation to estates, the estate is treated as having claimed any exclusion taken by the decedent or by a surviving spouse who files a joint return claiming an exclusion.

If a taxpayer earns interest in excess of the excludible amount, the first interest earned is the interest eligible for exclusion.

If any portion of a certificate is redeemed or disposed of before maturity, the exclusion from income is not available for any interest earned on the certificate for the year in which the certificate is redeemed or disposed of or in any subsequent year. The receipt of interest earned on the certificate prior to maturity is not a premature redemption. If interest paid on a certificate is excluded from income in one year and the certificate is prematurely redeemed or disposed of in a subsequent year, then the amount of excluded interest in the prior year must be included in income for the year of the redemption or disposition. Previously excluded amounts that are recaptured under this rule are not taken into account for purposes of the $1,000 limitation. Thus, if a holder redeems a certificate and reinvests a portion in a new certificate, interest on the new certificate can be excluded.

The bill provides that using a certificate or any portion of a certificate as collateral or security for a loan will be treated as a redemption of the entire certificate.

The bill also denies deduction for interest paid on indebtedness incurred to purchase or carry investment in qualified tax-exempt savings certificates. These rules are the same as those that apply under present law with respect to debt incurred or continued to purchase or carry tax-exempt obligations (sec. 265(2)).

Treasury study

The committee bill requires the Secretary of the Treasury to report to the Congress before June 1, 1982, on the results of a study to be conducted by the Treasury on the effectiveness of the new saving certificates provision in generating additional savings. The committee intends to use this study in determining what permanent savings incentives should be enacted.

Coordination with interest and dividends exclusion

Since some interest earned in 1981 may otherwise be eligible for exclusion under both the new provision and the section 116 interest and dividend exclusion, the bill provides a special transition rule. This rule provides that any amount earned on a depository institution tax-exempt savings certificate may be excluded only under new section 128 and may not be excluded under the general interest and dividend exclusion in section 116 of present law, even if the interest on the certificate is not tax-exempt because of a premature redemption or disposition.

2. Partial exclusion of dividend and interest income

(sec. 322 of the bill and secs. 116, 265, 584, 643, 702, and 854 of the Code)

Prior to the enactment of the Crude Oil Windfall Profit Tax Act of 1980, section 116 provided an exclusion from gross income for the first $100 of dividends received by an individual from domestic corporations. In the case of a husband and wife, each spouse was entitled to a separate exclusion of up to $100 for dividends received with respect to stock owned by that spouse. In the Crude Oil Windfall Profit Tax Act of 1980, Congress expanded section 116 to provide that up to $200 ($400 on a joint return) of dividend and interest income from certain domestic sources may be excluded from gross income. Any combination of eligible dividends and interest may be included within the limits. To encourage further analysis of the appropriate tax treatment of dividend and interest income, Congress allowed the increase in the exclusion and the expansion of coverage to include interest income only in 1981 and 1982. After 1982, section 116 will revert to the prior law provision (i.e., a $100 exclusion of dividends only).

The committee bill contains a variety of new or expanded incentives for individual savings and investment including reductions in the top marginal tax rate on investment income, a temporary program of tax-exempt savings certificates, increases in the limitations on retirement savings, and a program for dividend reinvestment. In light of the new incentives, the committee believes it is unnecessary to retain the partial interest exclusion.

Stock distributions which are not pro rata, including stock distributions received pursuant to a shareholder's option to receive either stock or cash, are taxable at fair market value when the shares are initially received. The rationale for this different treatment is that with pro rata stock distributions no shareholder has gained any increased interest in the corporation since all shareholders receive a proportionately equal amount of additional stock. But with non-pro rata dividends those receiving the stock distribution do gain an additional interest in the corporation relative to those not receiving stock. Thus, shareholders receiving the stock have gained some value, which is taxed as a dividend. For 1981 and 1982, an individual taxpayer is allowed to exclude from gross income up to $200 ($400 in the case of a joint return) of combined dividends from domestic corporations and certain interest.

In the case of public utilities, where property is to be recovered over a 10-to 15-year period under the bill, the committee wishes to encourage the generation of funds to provide capital for the purchase of new equipment through the reinvestment of dividends by shareholders. Thus, the committee believes that it is appropriate to allow tax-free treatment of certain stock distributions made to shareholders of public utility corporations.

To qualify, the stock must be newly issued common stock. designated by the board of directors of the corporation to qualify for this purpose. The number of shares to be distributed to any shareholder must be determined by reference to a value which is not less than 95 percent (and not more than 105 percent) of the stock's value during the period immediately before the distribution date.

Generally, stock will not qualify where the corporation has repurchased any of its stock within one year before or after the distribution date (or any member of the same affiliated group of corporations has purchased common stock of any other member of such group).

However, if the corporation establishes a business purpose for the purchase not inconsistent with the purpose of the dividend reinvestment provision to aid in the raising of new capital, the purchase will not disqualify any dividend otherwise eligible for exclusion. For example, the purchase of stock to buy out shareholders with very small amounts of stock in order to reduce administrative costs will not disqualify an otherwise qualified distribution. Likewise, redemptions under section 303 to pay estate taxes, or court-ordered repurchases to buy out minority shareholders, will not be deemed inconsistent with the purpose of this section.

Stock received as a qualified dividend will have a zero basis, so that when the stock is later sold the full amount of the sales proceeds will be taxable. In general, proceeds from the sale of such stock will be taxed as capital gains. However, where the stock is sold within one year after distribution, any gain will be treated as ordinary income. In addition, if shares of stock of the distributing corporation are sold by the taxpayer any time after the record date for the dividend and before a date one year after the dividend distribution date, the sale will be treated as a sale of the qualified dividend stock. These rules are designed to prevent the immediate resale of stock without the recognition of ordinary income which would have resulted in the case of a taxable dividend.

Under the bill, the earnings and profits of the distributing corporation will not be reduced by reason of the distribution of qualified stock, whether or not the shareholder elects to exclude the dividend from income.

Only individual shareholders are eligible for the exclusion. Corporations, trusts, estates, non-resident aliens, and persons holding at least 5 percent of the voting power or value of stock in the corporation (using the attribution rules of section 318) are not eligible to exclude any dividends under this provision.

A public utility is qualified if during the 10 years prior to its taxable year in which the dividend is paid, at least 60 percent of the cost of the depreciable property the corporation acquired for the members of an affiliated group (in which the public utility is a member) was public utility recovery property (within the meaning of new sec. 168A). For periods before 1981, the determination of whether property would have been public utility recovery property shall be made as if section 168A had been in effect.

The unified credit applicable to the estates of non-resident aliens is $3,600.

The committee believes that the existing unified credit should be increased to offset the effects of inflation and to provide estate and gift tax relief to small estates, especially those which primarily consist of family businesses.

The bill also revises the estate tax filing requirements to reflect the increased unified credit amount. When the credit is phased in fully, the bill requires that an estate tax return be filed only if the decedent's gross estate exceeds $600,000. During the five year phase-in period, the filing requirements are to be $225,000, $275,000, $325,000, $400,000 and $500,000 in 1982, 1983, 1984, 1985, and 1986, respectively. As under present law, the threshold filing requirement will be reduced (but not below zero) by the sum of the adjusted taxable gifts made by the decedent after December 31, 1976, and the amount of the specific gift tax exemption under prior law which may have been used by the decedent with respect to gifts made after September 8, 1976, and before January 1, 1977.

The bill makes no changes to the unified credit for non-resident aliens.

Under present law, the estate tax is computed first by determining the gross estate tax and then subtracting the gift taxes payable on gifts made after 1976 (sec. 2001(b)). In order to prevent the change in rates from having a retroactive effect to gifts made prior to 1985, the reduction allowed under section 2001(b) for gift taxes attributable to gifts made after December 31, 1976, will be the amount of tax which would have been payable had the gifts been subject to the rate schedule in effect upon the decedent's death. For example, where a decedent dying in 1982 made a post-1976 gift which was entirely subject to tax at the highest marginal gift tax rate of 70 percent, the amount of the puting the gift tax that would have been payable using the maximum rate in effect at his death (i.e., 65 percent under the committee bill). A similar rule already is provided in present law for gift tax purposes.

Present law allows a limited deduction for gifts and bequests between spouses. Under present law, an unlimited gift tax marital deduction is allowed for transfers between spouses for the first $100,000 of gifts. Thereafter, a deduction is allowed for 50 percent of interspousal lifetime transfers in excess of $200,000. In addition, an estate tax marital deduction equal to the greater of $250,000 or one-half of the decedent's adjusted gross estate generally is allowed for the value of property passing from a decedent to the surviving spouse. This amount is adjusted by the excess of the amount of the unlimited marital gift tax deduction over one-half of the lifetime gifts to the surviving spouse.

Under these provisions, transfers of community property or terminable interests do not qualify for either the gift or estate tax marital deductions. Terminable interests generally are created where an interest in property passes to the spouse and another interest in the same property passes from the donor or decedent to some other person for less than adequate consideration.¹

Jointly held property

The present estate tax provisions contain several special rules governing the treatment of jointly held property for estate tax purposes. These rules apply to forms of ownership where there is a right of survivorship upon the death of one of the joint tenants. They do not apply to community property or property owned as tenants in common.

In general, under these rules, the gross estate includes the entire value of property held jointly at the time of the decedent's death by the decedent and another person or persons with the right of survivorship, except that portion of the property that was acquired by the other joint owner, or owners, for adequate and full consideration in money or money's worth, or by bequest or gift from a third party (sec. 2040(a)). The decedent's estate has the burden of proving that the other joint owner, or owners, acquired their interest for consideration, or by bequest or gift. Consideration furnished by the surviving joint owner, or owners, does not include money or property shown to have been acquired from the decedent for less than full and adequate consideration in money or money's worth.

In addition, special rules are provided for (1) certain qualified joint interests held by a decedent and his spouse (secs. 2040(b), (d) and (e)) and (2) certain jointly held property used in a farm or other trade or business in which both spouses materially participated (sec. 2040(c)).

The present gift tax provisions contain two special rules governing the treatment of jointly held property. Under section 2515, where a husband and wife take ownership of real property as joint tenants, there is not a gift between spouses until the tenancy is terminated, unless the spouses elect otherwise. Under section 2515A, where a joint interest is created by a husband and wife after December 31, 1976, any gift is computed assuming each spouse owned one-half of the value of the joint interest.

Because the maximum estate tax marital deduction generally is limited, under present law, to one-half of a decedent's adjusted gross estate, the estate of a decedent who bequeaths his entire estate to his surviving spouse may be subject to estate taxes even though the property remains within the marital unit. When the surviving spouse later transfers the property (often to their children), the entire amount is subject to transfer taxes. The cumulative effect is to subject their property to tax one and one-half times, i.e., one-half upon the death of the first spouse and again fully upon the death of the second spouse. This effect typically occurs in the case of jointly held property. Because this additional tax falls most heavily on widows, it is often referred to as the "widow's tax."

Although the committee recognizes that this additional tax can be minimized through proper estate planning,² it believes that an individual should be free to pass his entire estate to a surviving spouse without the imposition of any additional tax. For similar reasons, the committee believes it appropriate to permit unlimited lifetime transfers between spouses without the imposition of any transfer taxes.

In addition, the committee believes that substantial simplification of the estate and gift taxes can be achieved by allowing an unlimited deduction for transfers between spouses. Under present law, it is often extremely difficult to determine the ownership of property held by the marital unit and to determine whose funds were used to acquire that property. These problems generally will not arise with an unlimited marital deduction.

In addition, the committee believes that the present limitations on the nature of interests qualifying for the marital deduction should be liberalized to permit certain transfers of terminable interests to qualify for the marital deduction. Under present law, the marital deduction is available only with respect to property passing outright to the spouse or in specified forms which give the spouse control over the transferred property. Because the surviving spouse must be given control over the property, the decedent cannot insure that the spouse will subsequently pass the property to his children. Because the maximum marital deduction is limited under present law to one-half of the decedent's adjusted gross estate, a decedent may at least control disposition of one-half of his estate and still maximize current tax benefits. However, unless certain interests which do not grant the spouse total control are eligible for the unlimited marital deduction, a decedent would be forced to choose between surrendering control of the entire estate to avoid imposition of estate tax at his death or reducing his tax benefits at his death to insure inheritance by the children. The committee believes that the tax laws should be neutral and that tax consequences should not control an individual's disposition of property. Accordingly, the committee believes that a deduction should be permitted for certain terminable interests.

Nevertheless, the committee believes that property subject to terminable interests qualifying for the marital deduction should be taxable, as under present law, upon the death of the second spouse (or, if earlier, when the spouse disposes of the terminable interest in such property). Though the committee believes that property subject to the qualifying income interest should be aggregated with the spouse's cumulative gifts to determine the amount of the transfer tax, it does not believe that the spouse's heirs should bear the burden of this tax. Accordingly, the committee believes it appropriate to provide an apportionment rule to avoid imposition of any additional taxes on the property subject to qualifying terminable interests the spouse's heirs and to insure that the transfer taxes imposed on property subject to certain terminable interests are borne by that property.

Jointly held property

The committee believes that present rules governing the taxation of jointly held property between spouses are unnecessarily complex. In particular, the tracing requirements are burdensome to estates and survivors because jointly held assets are frequently purchased with joint funds. Further, because few taxpayers understand the gift tax consequences of joint ownership, there is widespread noncompliance.

In view of the unlimited marital deduction adopted by the committee bill, the taxation of jointly held property between spouses is only relevant for determining the basis of property to the survivor (under sec. 1014) and the qualification for certain provisions (such as current use valuation under sec. 2032A, deferred payment of estate taxes under secs. 6166 or 6166A,³ and for income taxation of redemptions to pay death taxes and administration expenses under sec. 303). Accordingly, the committee believes it appropriate to adopt an easily administered rule under which each spouse would be considered to own one-half of jointly held property, regardless of which spouse furnished the original consideration.

The committee bill removes the quantitative limits on the marital deduction for both estate and gift tax purposes. Thus, unlimited amounts of property (other than certain terminable interests) can be transferred between spouses without estate or gift tax. The bill removes the provisions of present law which disallow the martial deduction for transfer between spouses of community property. In addition, certain transfers of qualified terminable interests would qualify for the deduction.

Under the bill, if certain conditions are met, a life interest granted to a surviving spouse will not be treated as a terminable interest. The entire property subject to such interest will be treated as passing to such spouse and no interest in such property will be considered to pass to any person other than the spouse. Accordingly, the entire interest will qualify for a marital deduction.

In general, transfers of terminable interests may be considered qualified terminable interests if the decedent's executor (or donor) so elects and the spouse receives a qualifying income interest for life. A qualifying income interest must meet several conditions. First, the spouse must be entitled for a period measured solely by the spouse's life to all the income from the entire interest, or all the income from a specific portion thereof, payable annually or at more frequent intervals. Thus, income interests granted for a term of years or life estates subject to termination upon remarriage or the occurrence of a specified event will not qualify under the committee bill. The bill does not limit qualifying income interests to those placed in trust. However, a qualifying life income interest in any other property must provide the spouse with rights to income which are sufficient to satisfy the rules applicable to marital deduction trusts under present law (Treas. Reg. Sec. 20,2056(b)-(f)).

Second, there must be no power in any person (including the spouse) to appoint any part of the property subject to the qualifying income interest to any person other than the spouse during the spouse's life. This rule will permit the existence of powers in the trustee to invade corpus for the benefit of the spouse but will insure that the value of the property not consumed by the spouse is subject to tax upon the spouse's death (or earlier disposition). However, the bill permits the creation or retention of any powers over all or a portion of the corpus, provided all such powers are exercisable only at or after the death of the spouse.

The bill provides that property subject to an election to be treated as a qualified terminable interest will be subject to transfer taxes at the earlier of (1) the date on which the spouse disposes (either by gift, sale, or otherwise) of all or part of the qualifying income interest, or (2) upon the spouse's death.

If the property is subject to tax as a result of the spouse's lifetime transfer of the qualifying income interest, the entire value of the property, less amounts received by the spouse upon disposition, will be treated as a taxable gift by the spouse under new Code sec. 2519. In general, no annual gift tax exclusion will be permitted with respect to the imputed transfer of the remainder interest (to a person other than the income beneficiary) because the remainder is a future interest. However, if the spouse makes a gift of the qualifying income interest, the gift of the income interest will be considered a gift to the donee, eligible for the annual exclusion and marital deduction, if applicable.

If the property subject to the qualifying income interest is not disposed of prior to the death of the surviving spouse, the fair market value of the property subject to the qualifying income interest determined as of the date of the spouse's death (or the alternate valuation date, if so elected) will be included in the spouse's gross estate pursuant to a new Code section 2044.

The bill also provides apportionment provisions under which the additional estate taxes attributable to the taxation of the qualified terminable interest property (other than the spouse's life estate) are borne by that property. Unless the spouse directs otherwise, the spouse (or the spouse's estate) is granted a right to recover the gift tax paid on the remainder interest as a result of a lifetime transfer of the qualifying income interest, or the estate tax paid as a result of including such property in the spouse's estate. Under the bill, the spouse is also entitled to recover any penalties or interest paid which are attributable to the additional gift or estate tax. If, however, as a result of a lifetime disposition of the qualifying income interest, the inclusion of the entire property as a taxable transfer uses up some or all of the spouse's unified credit, the bill does not permit the spouse to recover the credit amount from the remainder.

Similar rules may apply with respect to lifetime transfers to a spouse which are qualifying terminable interests if the donor makes a irrevocable election at the time of gift.

Charitable gifts

If an individual transfers property outright to charity, no transfer taxes generally are imposed. Similarly, under the unlimited marital deduction provided in the committee bill, no tax generally will be imposed on an outright gift to the decedent's spouse. As a result, the committee finds no justification for imposing transfer taxes on a transfer split between a spouse and a qualifying charity. Accordingly, the bill provides a special rule for transfers of interests in the same property to a spouse and a qualifying charity.

Under the bill, if an individual creates a qualified charitable remainder annuity trust or a charitable remainder unitrust, and the only noncharitable beneficiaries are the donor and his spouse, the disallowance rule for terminable interests does not apply. Therefore, the individual will receive a charitable deduction (under sec. 2055 or 2522) for the amount of the remainder interest and a marital deduction (under sec. 2056 or 2523) for the value of the annuity or unitrust interest; no transfer tax will be imposed.⁴

Gift tax filing requirements

Because an unlimited marital deduction is permitted for interspousal transfers, the bill generally exempts all such transfers from the gift tax filing requirements. Nevertheless, such transfers will be brought back into the decedent's estate to the extent the rules on inclusion in a decedent's estate of gifts made within three years of death (under sec. 2035) still apply under the committee bill.⁵ Where the rules of section 2035 apply, gifts made within three years of death for which a gift tax return is not required generally are not includible in the gross estate. However, the bill provides that if section 2035 still applies, this rule does not apply to interspousal gifts for which a return is not required because of the marital deduction. Thus, all interspousal transfers made within three years of death (other than transfers which are less than the annual exclusion (under sec. 2503(b)) will be included in a decedent's gross estate pursuant to section 2035 (without reduction for the amount of the annual exclusion). This rule insures that the exemption for filing a gift tax return on interspousal transfers does not permit decedents to make deathbed transfers to insure that their estates qualify for certain provisions depending on the size and composition of the gross estate (e.g., secs. 303, 2032A, and 6166).

Jointly held property

The bill provides special rules for determining the amount to be included in the gross estate in the case of property held by spouses in joint tenancy with a right of survivorship. Under the bill, the estate of the first spouse to die will include one-half of the value of the property regardless of which spouse furnished the consideration for the acquisition of the property. The bill also repeals certain of the special present law rules applicable to treatment of jointly held property between spouses (secs. 2040(c) to 2040(e), 2515, and 2515A).

The committee understands that many existing wills and trusts include a maximum marital deduction formula clause under which the amount of property transferred to the surviving spouse is determined by reference to the maximum allowable marital deduction. Because the maximum estate tax marital deduction under present law is limited to the greater of $250,000 or one-half of the decedent's adjusted gross estate, the committee is concerned that many testators, although using the formula clause, may not have wanted to pass more than the greater of $250,000 or one-half of the adjusted gross estate (recognizing the prior law limitation) to the spouse which might otherwise occur under the committee's adoption of an unlimited marital deduction. For this reason, a transitional rule provides that the increased estate tax marital deduction, as provided by the bill, will not apply to transfers resulting from a will executed or trust created before the date which is 30 days after the date of the bill's enactment, which contains a maximum marital deduction clause provided that (1) the formula clause is not amended before the death of the decedent to refer specifically to an unlimited marital deduction, and (2) there is not enacted a State law, applicable to the estate, which would construe the formula clause as referring to the increased marital deduction as amended by the bill.

For estate tax purposes, real property ordinarily must be included in a decedent's gross estate at its fair market value based upon its highest and best use. If certain requirements are met, however, present law allows family farms and real property used in a closely held business to be included in a decedent's estate at its current use value, rather than its full fair market value, provided that the gross estate may not be reduced by more than $500,000 (sec. 2032A).¹

Qualification requirements

An estate may qualify for current use valuation if (1) the decedent was a citizen or resident of the United States at his death; (2) the adjusted value² of the farm or closely held business assets in the decedent's estate, including both real and personal property, is at least 50 percent of the adjusted value of the decedent's gross estate; (3) at least 25 percent of the adjusted value of the gross estate is qualified farm or closely held business real property;³ (4) the real property qualifying for current use valuation passes to a qualified heir;⁴ (5) such real property has been owned by the decedent or a member of his family and used or held for use as a farm or closely held business ("a qualified use") for five of the last eight years prior to the decedent's death and on the date of the death;⁵ (6) there has been material participation in the operation of the farm or closely held business by the decedent or a member of his family for periods aggregating at least five years out of the eight years immediately preceding the decedent's death;⁶ (7) the executor makes an election within the time prescribed for filing the decedent's estate tax return; and (8) all parties with any interest in the property to be specially valued enter into an agreement consenting to the election.7

Property is considered to be acquired from a decedent only if the qualified heir receives the property by bequest, devise, or inheritance. Property which is purchased from the decedent's estate by a qualified heir (or is subject to an option in a qualified heir to purchase it from the estate) passes by purchase rather than bequest, devise, or inheritance and may not, therefore, be specially valued.

Property owned indirectly through ownership of an interest in a partnership, a corporation, or a trust qualifies for current use valuation to the extent that it would qualify if it were owned directly.⁸

Valuation methods

Under present law, the current use value of qualified real property⁹ can be determined under either of two methods: (1) the multiple factor method or (2) the formula method.

The comparable property used by the executor to value the decedent's qualified real property under the formula method must be located in the same locality as the specially valued property. The determination of whether property is comparable is factual and is made on a case-by-case basis, with no single factor being conclusive. Different parcels of real property need not be exactly alike to be comparable, however. Comparability requires only that the value of the different parcels be equivalent or similar in their farming use.¹²

Recapture

If, within 15 years after the death of the decedent (and before the death of the qualified heir), the property is disposed of to nonfamily members or ceases to be used for the farming or other closely held business purpose based upon which it was valued in the decedent's estate, all or a portion¹³ of the Federal estate tax benefits obtained by virtue of the reduced valuation are recaptured by means of a special "additional estate tax" or "recapture tax" imposed on the qualified heir.¹⁴

Failure by the heir or a member of the heir's family to materially participate in the business operation for periods aggregating three years or more during an eight-year period ending within 15 years after the decedent's death is treated as a cessation of qualified use. Under a special rule, no additional estate tax is imposed where property has been involuntarily converted to the extent it is replaced by qualified property (under sec. 1033) and the heir makes an election.¹⁵

If an election is made to value property based on its current use, the qualified heir's income tax basis in the property is the current use value. No adjustment is made to this basis if the additional estate tax is imposed.

The current use valuation provision has provided extensive relief to numerous family farms and businesses. However, a number of technical requirements of the current use valuation provision have resulted in incomplete relief being received by the owners of many family farms and other businesses which the committee wishes to aid. Additionally, the committee believes that substantive changes to the provision are needed in some instances to insure that the full relief available under the provision is received by its intended beneficiaries. For these reasons, the committee has provided for a number of changes to the current use valuation provision to assist further in the preservation of family owned and operated farms and other businesses.

The committee bill makes numerous technical changes in the current use valuation provision as well as several substantive changes affecting each of the major areas of the provision: pre-death qualification requirements, election requirements, valuation rules, and post death recapture rules. The bill also provides special rules for woodlands and a limited right of judicial review in certain cases where present law provides no such right. These changes generally expand availability of current use valuation to estates not eligible under present law, enable additional estates to satisfy the election requirement, enable additional farm estates to take advantage of the formula valuation method included in the provision, and reduce the post-death restrictions on qualified heirs inheriting specially valued real property. Some of the technical changes will apply retroactively to certain estates of decedents dying after December 31, 1976.

2. Changes to pre-death qualification requirements

To facilitate the orderly transfer of responsibility for farming operations before death, the bill provides that the qualified use requirement of present law, applicable to periods on and before the date of the decedent's death (sec. 2032A(b)(1)), may be satisfied if either the decedent or a member of the decedent's family uses real property otherwise eligible for current use valuation as a farm for farming purposes, in a timber operation, or in another trade or business.¹⁶ As stated above, the bill does not change the present law requirement that this use be an active trade or business use as opposed to a passive, or investment, use.

For example, if a decedent leased otherwise qualified real property to a son pursuant to a net cash lease,¹⁷ and the son conducted a farming operation on the property, the son's business use is attributed under the bill to the decedent for purposes of satisfying the qualified use requirement (sec. 2032A (b)(1)). Likewise, if the decedent permitted a member of his family to use the property in a qualified use for the required pre-death periods, without paying any rent, the qualified use requirement would be satisfied.

The bill does not change the present requirement that the qualified heir owning the real property after the decedent's death use it in the qualified use throughout the recapture period.

Under the bill, an individual is considered to be disabled if the individual is mentally or physically unable to materially participate in the operation of the farm or other business. However, while failure by an individual to materially participate may be evidence of disability, no presumption of disability arises from such a failure to materially participate. The committee anticipates that the Treasury Department will develop regulations providing rules for determining when an individual is disabled for purposes of this provision of the bill.

Active management treated as material participation for certain surviving spouses.--The committee recognizes that some surviving spouses may be unable to materially participate in farm operations following the death of the first spouse to die. Therefore, the bill provides an alternative to the material participation requirement for qualification of real property for current use valuation in the estates of surviving spouses who receive the property from a decedent spouse in whose estate it was eligible to be valued based on its current use. The bill provides that the spouse will be treated as having materially participated during periods when the spouse (but not a family member) engaged in active management of the farm or other business operation. The bill contains a special rule for tacking material participation by a decedent spouse in the case of a surviving spouse who dies within eight years of the decedent spouse's death. This rule is illustrated by the following example.

Assume that B dies two years after A (B's spouse) in whose estate Whiteacre was eligible for current use valuation. B engaged in the active management of Whiteacre during the two years following A's death. A was retired for the five years immediately before A's death, but had materially participated in Whiteacre's operation for eight years before his retirement. The six most recent of the eight years before A's retirement will be considered with B's two years of active management for purposes of satisfying the five years of an eight-year period pre-death material participation requirement for B's estate.

Meaning of active management.--Active management means the making of business decisions other than the daily operating decisions of a farm or other trade or business. The determination of whether active management occurs is factual, and the requirement can be met even though no self-employment tax is payable under section 1401 by the spouse with respect to income derived from the farm or other trade or business operation. Among the farming activities, various combinations of which constitute active management, are inspecting growing crops, reviewing and approving annual crop plans in advance of planting, making a substantial number of the management decisions of the business operation, and approving expenditures for other than nominal operating expenses in advance of the time the amounts are expended. Examples of management decisions are decisions such as what crops to plant or how many cattle to raise, what fields to leave fallow, where and when to market crops and other business products, how to finance business operations, and what capital expenditures the trade or business should make.

Qualification of certain property acquired in nontaxable events.--The bill permits tacking of the ownership, qualified use, and material participation requirements in the case of replacement property acquired pursuant to like-kind exchanges under section 1031 and involuntary conversions under section 1033. This tacking is available only for that portion of the replacement property or exchange property which does not exceed the value of the property disposed of in the exchange or conversion, and is permitted only when the replacement property or exchange property is used in the same qualified use as the property which was disposed of. The bill contains special rules for determining the portion of the replacement property or exchange property that qualifies in the case of an exchange in which the two properties are not equal in value.

3. Changes to election requirements

4. Change in valuation requirements

The amount of a net share rental is equal to the gross value of the produce received by the lessor of the comparable land during a calendar year minus the cash operating expenses (other than real property taxes) of growing the produce which are paid by the lessor.¹⁸ The term "produce" means a crop or other product, such as cattle, production of which is the business purpose of the farming operation. Where produce is disposed of in an arm's-length transaction within a period no longer than the period established by the U.S. Department of Agriculture for its price support program immediately following the date or dates on which the produce is received (or constructively received) by the lessor, the committee intends that the gross amount received in the disposition will be the gross value of the produce.¹⁹

If there is no arm's-length disposition within the established period, the value of the produce may be determined as of the date or dates on which the produce is received (or constructively received) and shall equal the weighted average price for which the produce sold on the closest national or regional commodities market to the farm property on that date or dates.

As under present law, if there is no comparable land from which a cash or share rental can be determined, the real property subject to the election is to be valued using the multiple factor valuation method.

5. Changes to post-death recapture rules

Eligible qualified heirs include the spouse of the decedent, a qualified heir who has not attained the age of 21, a qualified heir who is a full-time student (within the meaning of sec. 151(e)(4)), and a qualified heir who is disabled (within the meaning of sec. 2032A(b)(4)(B), as added by the bill). Active management means the making of business decisions other than the daily operating decisions of the trade or business.23

The basis determined under this rule is the basis the qualified heir would have received had current use valuation not been elected for the decedent's estate. This increase in basis is effective as of the date before the disposition or cessation of qualified use; therefore, no retroactive changes in depreciation, or other deductions or credits, would be made to reflect the increased basis. However, in the case of a recapture tax arising from a disposition of the property, the increased basis is used in determining the gain or loss from the disposition.

The bill provides that, in the case of a partial disposition, the income tax basis of the heir's entire interest will be increased by the proportionate amount of the difference in the fair market value and current use value of the entire interest equal to the proportionate part of the total potential recapture tax which is imposed.

If the heir elects this basis adjustment, the heir must pay interest on the amount of the recapture tax from the date which is nine months after the decedent's death until the due date of the recapture tax. The interest is computed at the rate (or rates) charged on deficiencies of tax for the period involved. If the heir does not make the election and pay the interest, no adjustment is made to the basis of the property.

6. Special rules for qualified woodlands

Under the current use valuation provision as amended by the bill, if specially valued standing timber is severed or otherwise disposed of by the qualified heir during the recapture period, a recapture tax is imposed (sec. 2032A(c)). This recapture tax is determined by treating the timber as an interest in the real property on which the timber stands or stood. For purposes of the present rules governing imposition of the recapture tax in the event of a partial disposition of qualified property (sec. 2032A(c)(2)(D)). the pro rata portion of the value of the property disposed of shall be determined by comparing the number of acres of land on which timber is severed, or otherwise disposed of to the total number of acres of specially valued real property owned by the qualified heir.

The bill provides a special rule for a severance or other disposition of a portion of the standing timber on an identifiable portion of the specially valued land. In such a case, the amount realized (or the fair market value on the date of severance or disposition in any case other than a sale or exchange at arm's-length) on each such severance or disposition is payable as recapture tax until the pro rata portion of recapture tax attributable to an identifiable portion of the land (including all timber thereon) has been paid.

For purposes of these rules on partial dispositions, an identifiable portion of land is defined as an acre or such other area of land by which the taxpayer normally maintains his business records. The committee anticipates that the Treasury Department will develop regulations defining when a complete severance or other disposition of timber on an identifiable portion of land occurs.

A qualified woodland means an identifiable area of real property (for which business records are normally maintained) which is used in qualified timber operations. Qualified woodlands must comprise the otherwise applicable percentages of the adjusted value of the decedent's estate and the same minimum amount of woodland (25 percent of the adjusted value of the decedent's gross estate) would have to be specially valued as is required of other operations before the current use valuation election is available to the estate.

Active management means the making of business decisions other than the daily operating decisions of the trade or business.²⁸

In the case of qualified woodlands, active management includes combinations of activities such as reviewing annual management plans for the property, inspecting the trees for disease and directing any remedial steps when diseased trees are found, determining whether pre-commercial and commercial thinning should be conducted, and deciding where fire lines should be located as well as making other financial and business decisions.

7. Miscellaneous technical changes

If purchased property is specially valued, the qualified heir who purchases the property is limited to the current use value of the property as his income tax basis.³¹

The bill provides that the estate does not recognize gain on the sale for income tax purposes, except to the extent that the sales price exceeds the fair market value of the property on the date of the decedent's death.

The committee is aware that many decedents establish the purchase price for family farm and closely held business property in their wills. In cases where this price is established in the decedent's will by reference to estate tax value, the price will normally be construed under applicable local law as meaning the fair market value unless the will expressly refers to the current use valuation provision. In such cases, the qualified heir's purchase price frequently will be in excess of his income tax basis. The committee intends that this excess not be treated as a taxable gift by the purchasing heir to the estate or the other heirs. In cases where the purchase price is construed under applicable local law as the current use value of the property, the other qualified heirs also are not to be treated as making a taxable gift to the purchasing heir by virtue of giving any required consent to the current use valuation election (and thereby to the lower purchase price).

The bill permits an executor to request the Treasury Department to audit the fair market value of the qualified property and thereby finally determine that value for all purposes. The bill further provides that the Treasury can initiate such audits without the executor's request and thereby finally determine the fair market value of the qualified property for all purposes.

If the Treasury Department determines the fair market value of the specially valued property is different from that value as reported by the executor (either pursuant to an audit requested by the executor or an audit initiated by the Treasury), a notice of the Treasury's determination is to be sent, to the executor by registered or certified mail. If the executor and the Treasury agree on the fair market value after the notice is sent, that value is binding on all parties in future actions. If the executor does not agree with the Treasury Department's determination, the executor has ninety days from the date on which notice of the Treasury's determination is sent in which to petition the Tax Court to review the fair market value of the property. A decision of the Tax Court is binding on all parties in future actions in which the fair market value of the specially valued property on the date of the decedent's death is at issue. The Tax Court decision is not subject to review by any other court.

Failure by the executor to petition the Tax Court within the ninety day period following the date on which the notice of the Treasury Department's determination is sent results in the value as determined by the Treasury being binding on all parties, except where a qualified heir establishes another value to the satisfaction of the Treasury Department. Any disagreement between the qualified heir and the Treasury Department arising from the heir's attempt to establish a different value is not subject to judicial review, except as provided below, and such a disagreement does not affect the binding nature of a previous determination for which judicial review was available.

Because the fair market value of the specially valued property determines the maximum amount of the recapture tax for which a qualified heir is personally liable, the heir is granted a right to intervene in any action brought by an executor. The heir is also given the right to initiate an action in the Tax Court himself within the ninety day period available to the executor. If the heir initiates such an action, the executor is joined as a party in interest.

If the Treasury Department does not determine that the fair market value of the property is different from that value as reported by the executor on the decedent's estate tax return within the period of limitations for assessment of estate tax, the value as reported by the executor is not binding on the executor, the qualified heirs, or the Treasury Department in any future actions involving any matters arising under the use valuation provision, the special lien under section 6324B, and with respect to the qualified heir's income tax basis in the specially valued property.

The increase in the limitation on the amount by which the fair market value of specially valued property can be reduced applies to estates of decedents dying after December 31, 1980.

The changes to the recapture period rules on involuntary conversions (under sec. 1033) and like-kind exchanges (under sec. 1031) apply to such exchanges occurring after December 31, 1981, even if the decedent in whose estate the property was specially valued died before that date.

The committee believes that four of the changes included in the bill are primarily technical and should be applied retroactively in certain cases as well as to all estates for which estate tax returns are not due to be filed until after the date of enactment of the bill. The changes which are to be applied retroactively are--

Under current income tax law, if more than 50 percent of the gross estate (reduced by allowable expenses losses, and indebtedness) consists of stock in a single corporation,¹ redemption of all or a portion of that stock to pay estate taxes, funeral expenses, and administration expenses will be treated as a sale or exchange subject to capital gains treatment instead of dividend income (sec. 303).

Because the existence of two deferral provisions with differing requirements creates confusion, the committee believes that these provisions should be simplified by merging the two sections to provide a single set of rules to govern the installment payment of estate taxes attributable to an interest in a closely held business.

In addition, the committee believes that the provisions of present law section 6166, which restrict eligibility for deferral to an estate in which the closely held business interest comprises at least 65 percent of the adjusted gross estate, have proven unduly restrictive. The committee believes the minimum percentage of the adjusted gross estate required to be invested in a closely held business should be reduced to 35 percent of the adjusted gross estate.

The committee also believes that certain changes are needed to the present law rules requiring acceleration of the deferred installments of tax. First, the committee believes that deferred payments should not be accelerated because of the late payment of the interest or principal if the entire installment of principal and all accrued interest is paid within six months of the original due date. Second, the committee believes that the requirement that deferred payments be accelerated upon the disposition of the decedent's interest in a closely held business or upon the withdrawal of money from such business should be liberalized to permit dispositions or withdrawals of up to 50 percent of the decedent's interest. Third, in order to help preserve ownership of closely held businesses within a family, the committee believes that the transfer of a qualified interest in a closely held business upon the death of decedent's heir should not trigger acceleration of the original decedent's unpaid deferred estate tax where the subsequent transferee is a family member of the transferor.

Under present law, the decision of the Internal Revenue Service to deny an election to pay all or a portion of the estate tax attributable to closely held businesses generally is not subject to judicial review because no deficiency is involved. The committee believes that taxpayers should be provided with a judicial forum to resolve disputes involving an estate's eligibility for the deferral of estate tax attributable to interests in closely held businesses.

Under present law, the redemption of certain stock in certain closely held businesses to pay estate taxes, funeral expenses, and administration expenses is treated as a sale or exchange instead of a dividend (sec. 303). However, this provision contains a definition of an interest in a closely held business and rules for aggregating multiple interests in closely held businesses which are different from either of the provisions which permit deferred payment of the estate taxes attributable to interests in closely held businesses. The committee believes that the rules governing redemptions of closely held business stock to pay estate taxes, funeral expenses. and administration expenses should be coordinated with the provisions governing the deferral of estate taxes attributable to interests in closely held businesses.

The bill makes several changes to the acceleration rules provided by section 6166. First. the bill allows dispositions of up to 50 percent of the decedent's interest in a closely held business and withdrawals from the business of amounts up to 50 percent of the decedent's interest before triggering acceleration. Under the committee bill, dispositions and withdrawals are aggregated to determine applicability of the acceleration rules. Thus, if an estate withdraws amounts equal to 30 percent of the decedent's interest in all closely held businesses for which deferred payment is elected and separately disposes of 20 percent or more of the decedent's interest in such businesses, the remaining unpaid tax balance will be accelerated.

Second, the bill provides that the transfer of an interest in a closely held business upon the death of the original decedent's heir, or the death of any subsequent transferee receiving the interest as a result of the prior transferor's death, will not be considered a disposition which accelerates payment of the original decedent's unpaid estate taxes provided that each subsequent transferee is a family member (within the meaning of sec. 267(c)(4)) of the transferor from whom the property was received.

Third, the bill provides that acceleration will be triggered by a delinquent payment of interest as well as a delinquent payment of tax. Therefore, an estate may not avoid payment of interest during the initial 5-year period without accelerating payment of the remaining tax balance. However, if the full amount of the delinquent payment (principal and all accrued interest) is paid within six months of its original due date, the remaining tax balance will not be accelerated. Rather, the payment loses eligibility for the special 4-percent interest rate (under sec. 6601(j)) and a penalty is imposed, equal to 5 percent per month, based on the amount of the payment.

In addition, the committee bill provides a procedure for obtaining a declaratory judgment with respect to (1) an estate's eligibility for deferred payment of estate taxes attributable to an interest in a closely held business under section 6166, (2) the computation of the adjusted gross estate. based on the facts and circumstances in existence on the date (including extensions) for filing the estate tax return or, if earlier, the date such return was filed, and (3) whether there is an acceleration of the deferred payments. However, because this declaratory judgment procedure only applies where there is an actual controversy, no declaratory judgment will be available prior to decedent's death (with respect to eligibility for deferral or the amount of the adjusted gross estate) or prior to a transaction involving dispositions or withdrawals of an interest in a closely held business (with respect to whether there is an acceleration). Jurisdiction to issue a declaratory judgment is limited to the United States Tax Court and the determination of that court is final and conclusive and is not reviewable by any other court.

This remedy is available only if the petitioner (i.e., the executor of the decedent's estate) has exhausted all available administrative remedies within the Internal Revenue Service. Thus, the executor must demonstrate that the Internal Revenue Service has acted adversely to the decedent's estate, and that he has appealed any adverse determination by a district office to the appellate division of the Internal Revenue Service, or has requested or obtained through the District Director technical advice of the National Office. To exhaust his administrative remedies, a party must satisfy all procedural requirements of the Service.

In addition, no petition to the Tax Court may be filed after 90 days from the date on which the Secretary or his delegate sends notice to the executor of his determination as to (1) the estate's eligibility for deferred payment, (2) the amount of the adjusted gross estate (determined on the facts and circumstances in existence on the date (including extensions) for filing the estate tax return, or, if earlier, the actual filing date), or (3) the application of the acceleration rules.

The bill also makes conforming changes to section 303 which permits redemption of stock in a closely held business to pay estate taxes, funeral expenses, and administration expenses. Under the bill, redemptions will be permitted if the decedent's interest in closed held corporations comprise at least 35 percent of the decedent's adjusted gross estate. In addition, the section 303 rules regarding the aggregation of interests in two or more corporations are conformed to those in section 6166.

The Treasury Department takes the position that an original work of art and a copyright interest relating to that work of art are two interests in the same property (Treas. Regs. Sec. 1.170A-7(b)(1)). Under this interpretation, no charitable deduction is allowable where an individual gives the original of an art work to charity and retains the copyright interest attributable to that art work.

A qualified organization is a public charity (i.e., an organization described in sec. 501(c)(3) which is not a private foundation under sec. 509) or a private operating foundation (under sec. 4942(j)(3)). The committee bill provides that a qualified contribution is any transfer to a qualified charitable organization provided the use of the property by the organization is related to its charitable purpose or function.

An exception to these rules applies with respect to transfers of property (other than transfers with respect to a life insurance policy) where no gift tax return was required to be filed with respect to the gift. Thus, a gift for which no gift tax return was required is generally not included in the decedent's gross estate, while a gift subject to the filing requirements is included at its appreciated value, without reduction for the amount of the gift tax annual exclusion.

Generally, where an interest is included in a decedent's gross estate under this provision, the donee's basis in such interest is its fair market value on the date of the decedent's death (or alternate valuation date, if elected), reduced by amounts claimed by the donee as a deduction in computing taxable income prior to the decedent's death.

Under the unified transfer tax system adopted in the Tax Reform Act of 1976, the inclusion in the gross estate of gifts made within 3 years of death generally has the effect of including only the property's post-gift appreciation in the gross estate (because the gift tax paid with respect to the transfer is allowed as a credit against the decedent's estate tax). The committee believes that inclusion of such appreciation generally is unnecessary except for gifts of life insurance and certain property included in the gross estate pursuant to certain of the so-called transfer sections (secs. 2036, 2037, 2038, 2041, and 2042). However, gifts made within 3 years of death should be included in a decedent's gross estate to determine the estate's eligibility for favorable redemption, valuation, and deferral provisions (under secs. 303, 2032A, and 6166) to preclude deathbed transfers designed to qualify that estate for such favorable treatment.

The committee bill contains exceptions which continue the application of section 2035(a) to (1) gifts of life insurance and (2) interests in property otherwise included in the value of the gross estate pursuant to sections 2036, 2037, 2038, 2041, or 2042 (or those which would have been included under any of such sections if the interest had been retained by the decedent).

In addition, all transfers within 3 years of death (other than gifts eligible for the annual gift tax exclusion) will be included for purposes of determining the estate's qualification for special redemption, valuation, and deferral purposes (under secs. 303, 2032A, and 6166) and for purposes of determining property subject to the estate tax liens (under subchapter C of Chapter 64).

Section 2035(c), requiring the inclusion of all gift taxes paid by the decedent or his estate on any gift made by the decedent or his spouse after December 31, 1976, and within 3 years of death, will continue to apply to all estates.

Because the committee bill provides an unlimited marital deduction and substantially increases the unified credit, the committee believes that there would be an even greater incentive to plan such deathbed transfers of appreciated property to a donee-decedent. Because the committee believes that allowing a stepped-up basis in this situation permits unintended and inappropriate tax benefits, the committee provides that the stepped-up basis rules should not apply with respect to appreciated property acquired by the decedent through gift within 3 years of death where such property passes from the decedent to the original donor or the donor's spouse.

For example, assume that A transfers appreciated property with a basis of $10 and a fair market value of $100 to D within 3 years of D's death and that D's date of death basis was $20 and the date of death fair market value of the property was $200. If A is entitled to receive the property from the decedent, A's basis in the property will be $20. If A subsequently sells the property for its fair market value of $200, he will recognize gain of $180. If, instead, the executor disposes of the property, distributing the proceeds to A, similar rules will apply and the estate will recognize a gain of $180.

This rule applies only to the extent that the donor-heir is entitled to receive the value of the appreciated property. If the heir is only entitled to a portion of the property (e.g., because the property must be used to satisfy debts or administration expenses), the rule applies on a pro-rata basis. Thus, if in the above example, the decedent's estate consisted only of the appreciated property and total estate liabilities were $50, the heir would only be entitled to three-fourths of the appreciated property. Accordingly, the portion of the property to which the donor-heir was not entitled (one quarter in the example) will receive a stepped-up basis. In such a case, the basis of the appreciated property in the hands of the executor or the heir will be $65 (i.e., one quarter of $200 (or $50) plus three quarters of $20 (or $15)).

Section 2518 requires, among other conditions, that the disclaimer be effective under local law to pass title without direction on the part of the person making the disclaimer. As a result, a disclaimer that is ineffective under local law cannot be treated as a qualified disclaimer for purposes of the Federal estate and gift taxes, even if the disclaimant timely transfers the property to the individual who, under local law, would have received the property if there had been an effective disclaimer. Because local disclaimer laws are not uniform, identical refusals to accept property may be treated differently for Federal estate and gift tax purposes depending upon the applicable local law.

Thus, contrary to the original Congressional intent, present law does not provide uniform treatment of disclaimers under the Federal estate and gift tax law. In order to provide uniform treatment among States, the committee believes that where an individual timely transfers the property to the person who would have received the property had the transferor made an effective disclaimer under local law, the transfer will be treated as an effective disclaimer for Federal estate and gift tax purposes provided the transferor has not accepted the interest or any of its benefits.

Local law will be applicable to determine the identity of the transferee, but the transfer need not satisfy any requirements of the local disclaimer statute. In addition, the individual's direction of the transfer to the individual who would have taken under local law pursuant to an effective disclaimer will not be construed as an acceptance of the property.

As enacted, section 2057 permits a limited deduction only if a minor child has no known surviving parent and the decedent does not have a surviving spouse. The aggregate amount of the deduction allowed under this provision may not exceed an amount equal to $5,000, multiplied by the excess of 21 over the child's attained age, in years, on the date of decedent's death.

To insure that there is a reasonable correlation between the amount of the exclusion and the amount received by the orphan, the deduction is permitted only if the property passes in certain specified forms. In order to qualify for the deduction, the property passing to an orphaned child may not be a terminable interest (such as a life estate) except that the property is permitted to pass to a person other than the child's estate if the child dies before the youngest living child attains age 21. In addition, amounts passing to a qualified minor's trust are eligible for the deduction.

In addition, the committee is concerned that certain payments of tuition made on behalf of children who have attained their majority, and medical expenses on behalf of elderly relatives are technically considered gifts under present law. The committee believes such payments should be exempt from gift taxes without regard to the amount paid for such purposes.

In addition, the bill provides that any amounts paid on behalf of any individual (1) as tuition to certain educational organizations for the education or training of such individual. or (2) as payment for medical care to any person who provides medical care (as defined in section 213(e)) with respect to such individual. will not be considered as transfers by gift. This exclusion for medical expenses and tuition would be in addition to the $10,000 annual gift tax exclusion and would be permitted without regard to the relationship between the donor and the donee.

The exclusion for medical expenses (including medical insurance) applies only with respect to direct payments made by the donor to the individual or organization providing medical services (i.e., no reimbursement to the donee, as intermediary, will be excludable). Qualifying medical expenses are limited to those defined in section 213 (i.e., those incurred essentially for the diagnosis, cure, mitigation, treatment, or prevention of disease, or for the purpose of affecting any structure or function of the body). However, medical expenses are excludable from gift tax without regard to the percentage limitation contained in section 213.

However, the unlimited exclusion is not permitted for amounts that are reimbursed by insurance. Thus, if a donor pays a qualifying medical expense and the donee also receives insurance reimbursement, the donor's payment, to the extent of the reimbursement, is not eligible for the unlimited exclusion whether or not such reimbursement is paid in the same or subsequent taxable year.

With respect to educational expenses, an unlimited exclusion is permitted with respect to any tuition paid on behalf of an individual directly to the qualifying educational institution providing such service. A qualifying organization is an educational organization described in section 170(b)(1)(A)(ii), i.e., an institution which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. The exclusion is permitted with respect to both full-and part-time students, but is limited to direct tuition costs (i.e., no exclusion is provided for books, supplies, dormitory fees, etc.).

In providing an unlimited exclusion for certain medical expenses and tuition, the committee does not intend to change the law that there is no gift if the person paying the medical expenses or tuition is under an obligation under local law to provide such items to the recipient. In addition, the committee bill does not change the income tax consequences otherwise applicable to such payments.

Many existing trusts provide powers of appointment specifically defined in terms of the section 2503(b) annual gift tax exclusion which, under present law, is limited to $3,000. The committee is concerned that many settlors, although limiting the power by reference to section 2503(b), may not have wanted to provide a power over property in excess of $3,000. For this reason, the bill contains a transitional rule that the increased annual gift tax exclusion will not apply to powers granted under a trust created before 30 days after the date of enactment and not amended after that date provided that (1) the power is exercisable after December 31, 1981, (2) the power is defined in terms of the section 2503(b) annual gift tax exclusion, and (3) there is not enacted a State law applicable to such instrument which construes the power of appointment as referring to the increased gift tax exclusion provided by the bill.

If all transfers made in a calendar year that are subject to the gift tax filing requirements do not exceed $25,000 in taxable gifts, a return must be filed, and any gift tax paid, by the filing date for gifts made during the fourth calendar quarter of the calendar year. In 1979 (P.L. 96-167), the due date for an annual return or a return for the fourth calendar quarter was conformed to the due date for filing individual income tax returns, i.e., April 15 of the following year.

In the case of a corporation, the net capital gain is taxed at an alternative rate of 28 percent. Capital losses are allowed only against capital gains. Any excess loss may be carried back 3 years and forward 5 years.

Individuals' ordinary income is taxed at rates up to 70 percent. The maximum rate of tax on corporate ordinary income is 46 percent. Ordinary losses which are net operating losses may be carried back to each of the three taxable years preceding the losses and forward to each of the seven subsequent taxable years (sec. 172(b)).

Generally, the Internal Revenue Code contains no special rules dealing with straddles in commodities or commodity futures contracts. In the case of the typical straddle in commodities (i.e. the holding of a futures contract to buy a commodity in one month and the holding of another futures contract to sell the same commodity in a different month), neither the wash sale rule applicable to stocks or securities (sec. 1091), nor the special short sales rules preventing conversion of short-term gain to long-term gain or long-term losses to short-term losses (sec. 1233(b) and (d)) apply.

In Revenue Ruling 77-185, 1977-1 C.B. 148, the Internal Revenue Service ruled that the loss from certain silver futures contracts constituting part of a straddle was not deductible because the taxpayer "had no reasonable expectation of deriving an economic profit from the transactions." The ruling also stated that the loss claimed on the disposition of one leg of the straddle was not bona fide because the disposition represented no real economic change and was not a closed and completed transaction. This ruling has been the subject of much controversy, and the IRS is litigating the deductibility of certain losses claimed in straddle transactions.

The committee believes that legislation is necessary to eliminate the uncertainty of present law rules governing the taxation of commodity transactions, particularly those executed in futures contracts. Any judicial determination of the issues raised in Revenue Ruling 77-185 will not be final for years. The longer these issues remain unresolved, the greater the dangers to the tax system and the Treasury from commodity tax shelters. Therefore, the committee bill provides new rules for the taxation of certain commodity-related transactions.

The bill disallows losses on commodity straddles to the extent such losses exceed gains from both straddle transactions and net non-straddle commodity transactions. The rule is designed to limit the use of straddle losses to defer income which is not related to commodity transactions and to prevent conversion of such income from short-term capital gain into long-term capital gain.

Gain which limits the current deductibility of straddle losses is gain from both straddle transactions and non-straddle commodity transactions which are sales, exchanges, or other dispositions of specified commodity-related property. The types of property covered by these rules are futures contracts, forward contracts, commodities (including metals), Treasury bills, all other evidences of indebtedness, currencies, or any interests in these properties. However, to the extent gain from the sale, exchange, or other disposition of any evidence of indebtedness constitutes interest (including any acquisition or original issue discount), it is not treated as gain from either a straddle or non-straddle commodity transaction. This rule prevents ordinary income from generating the allowance of straddle losses in excess of capital gain from straddle transactions and net capital gain from non-straddle commodity transactions.

The loss disallowance rules in new section 1092 and the present law rules of section 1211 (which limit capital losses) are intended to operate in the following order:

When all of the steps outlined above are completed, the net amount and character of the taxpayer's capital gain or loss for the taxable year will have been determined.

Special rules

A hedging transaction may be executed to reduce the risk of price change or of currency fluctuations with respect to property which is held or to be held by the taxpayer and which, if disposed of, whether by sale, exchange, lapse, cancellation, or otherwise, at a gain. produces ordinary income. Also, a hedging transaction may be executed to reduce risk of price or interest rate changes, or currency fluctuations with respect to borrowings made or to be made. or obligations incurred or to be incurred, by the taxpayer, provided all income or gain on such borrowings or obligations is treated as ordinary income. Transactions in ordinary income or loss property executed to maintain a positive return from holdings of interest-producing property whose disposition results only in ordinary income or loss should be considered executed primarily to reduce interest rate risks and should be treated as hedging transactions. provided all the requirements of the hedging rules are met and there is no likelihood of tax avoidance through deferral or conversion.

Transactions which result in capital gains or capital losses do not qualify for the hedging exemption. Speculation in commodity futures contracts, for example, does not qualify for this exemption whether a trader takes outright long or short positions, or whether a trader speculates in spreads, because futures speculation is treated as producing capital gains or capital losses.

A transaction in an asset which results in capital gain or loss generally is an investment and is not to be considered a transaction in the normal course of a trade or business.

A special rule for banks, as defined in section 581, permits a bank to treat any transaction entered into in the normal course of its trade or business, as a hedging transaction, provided the transaction is so identified in a timely and proper manner and any gain or loss on the transaction is treated as ordinary income or loss.

For a transaction which would generate ordinary income or loss under normal tax principles to qualify as a hedging transaction, the transaction must be clearly identified in the taxpayer's records as being a hedging transaction before the close of the day on which the transaction was entered into. Regulations should allow taxpayers to minimize bookkeeping identification requirements in as many cases as practicable. In situations where hedging transactions are numerous and complex, but opportunities for manipulation of transactions to obtain deferral or conversion of income are minimal, it generally is unnecessary to require taxpayers to identify and match in their records hedging activities with hedged properties. In certain hedging transactions, for example, those conducted by banks, it may be extremely difficult to match a hedging contract with a specific hedged property. In such cases, it may be sufficient for this identification requirement to mark an entire account, such as a bank's securities trading account, as a hedged account, provided the bank's securities trading account produces only ordinary income or loss and is managed and recorded independently and separately from the bank's investment account (and any other capital asset account).

However, in cases where taxpayers do not maintain and manage their ordinary income transactions separately from their capital transactions and where other factors indicate a danger of manipulation, more detailed identification records should be required. If property, whose disposition is either a straddle or a non-straddle commodity transaction (sec. 1092(d)(4) and (5), has even been identified by the taxpayer as being part of a hedging transaction, gain from the sale or exchange of the property may never be treated as capital gain but must be reported as ordinary income. In no event is the provision of this hedging exemption to be interpreted as precluding the Commissioner of Internal Revenue from exercising his present law authority to require that taxpayers employ accounting methods which clearly reflect their income.

A syndicate means any partnership or other entity (other than a regular, subchapter C corporation), if at any time interests in the entity have been offered for sale in an offering required to be submitted to any Federal or State agency authorized to regulate security sales offerings; or, if more than 35 percent of the entity's losses during any period are allocable to limited partners or limited entrepreneurs within the meaning of section 464(e)(2). An individual who actively participates in the management of an entity is not considered a limited partner or a limited entrepreneur (within the meaning of section 464(e)(2)) with respect to the entity for the period of the individual's active management.

The Secretary of the Treasury shall develop such forms and schedules and shall require persons filing tax returns to supply such information as the Secretary considers necessary to evaluate the effect of this new code section for purposes of the reports to the Congress which are required by section 507 of this bill.

The bill provides that taxpayers may elect to apply the straddle loss disallowance rule to all gains and losses from commodity-related transactions in taxable years ending after January 27, 1981, whether the property is acquired before, on, or after January 27, 1981.

However, a limitation is imposed under section 163(d) on interest on investment indebtedness. Generally, the deduction for such interest is limited to $10,000 per year plus the individual taxpayer's net investment income. Any remaining amount can be carried over to future years.

"Cash and carry" tax shelters usually involve the purchase of a physical commodity, such as silver, and the acquisition of a futures contract to deliver (sell) an equivalent amount of the same commodity more than twelve months in the future. The taxpayer finances the purchase with borrowed funds, and deducts the interest expense, storage, and insurance costs in the first year. These deductions offset ordinary investment income, e.g., interest and dividends.

Because the price differential between the current price of the physical commodity and the price of the futures contract for a distant month is largely a function of interest and other carrying charges, the futures contract will have a price approximately equal to the total payment for the physical commodity plus interest and carrying costs. The taxpayer will hold the silver and the offsetting futures contract into the next year.

When the 12-month holding period has passed, the taxpayer will deliver the silver on the futures contract and realize a gain on the silver. If the price of silver has increased, the taxpayer can sell the silver, producing long-term capital gain while closing out the short futures position, creating a short-term capital loss. In either event, the net gain on the two positions will be about equal to the interest and carrying charges but will be treated as long-term capital gain. Thus, in 1981, investment income taxable at rates as high as 70 percent, would be deferred for a year and converted into capital gains taxable at maximum rates no higher than 28 percent.

Because the committee believes that certain legitimate business transactions, such as hedging, which result only in ordinary income or loss, lack significant tax avoidance potential, it exempts such activities from the bill's rules on "cash and carry" transactions.

In order to encourage speculation in commodity futures contracts, the committee bill provides a special rule for futures traders who may continue to deduct currently their expenditures for interest and carrying charges in connection with cash and carry straddles, provided they treat such expenses as straddle losses subject to the new rules pertaining to commodity-related transactions in new section 1092, discussed above.

The committee bill requires taxpayers to capitalize certain otherwise deductible expenditures for personal property if the property is held as part or all of an offsetting position belonging to a straddle. Such expenditures must be charged to the capital account of the property for which the expenditures are made. Thus, these expenditures will reduce the gain or increase the loss recognized upon the disposition of the property.

Expenditures subject to this capitalization requirement are interest on indebtedness incurred or continued to purchase or carry the property, as well as amounts paid or incurred for insuring, storing or transporting the property. The amount of expenditures, called carrying charges, to be capitalized is reduced by any interest income from the property (including original issue discount), which is includible in gross income for the taxable year.

The capitalization rule applies only to cash and carry transactions structured as straddles. The capitalization requirements do not apply to any identified hedging transactions (sec. 1092(e)) or to any position which is not part of a straddle. Thus, for example, a farmer still can deduct currently the costs of financing crops. Similarly, securities dealers' expenses for financing their inventory and trading accounts which generate ordinary income or loss remain deductible currently.

Commodity futures traders are not required to capitalize interest and carrying charges but may deduct such expenditures currently as losses on straddle transactions under the straddle loss disallowance rules in section 1092. This special rule for future traders applies to an individual whose principal activity for the taxable year is engaging in futures contracts transactions for his or her own account and whose principal source of income or loss for the taxable year is from such transactions conducted for his or her own account. Thus, the rule applies to individuals whose principal activity is trading, but does not apply to individuals who are primarily brokers or managers. An individual's principal activity is to be determined by reference to all activities in which the individual engages to make a livelihood. Principal means both substantial and more than any other activity. A principal activity should be determined by taking into account such factors as the time spent by the taxpayer on the activity and the amount of the taxpayer's money and risk involved in it.

The bill defines straddles as offsetting positions with respect to personal property. A taxpayer is treated as holding a straddle if there is a substantial reduction in the taxpayer's risk of loss from holding any position in personal property because the taxpayer holds one or more other positions with respect to personal property. Although the concept of offsetting positions is not narrowly defined in the statute, certain cases fall outside its scope. For example, a mere diversification of positions usually would not substantially diminish risk for purposes of this bill where the positions are not balanced, and thus, would not be offsetting.

Positions in personal property may be treated as offsetting whether or not the property is the same kind. Thus, a straddle can consist of two futures contracts for delivery of silver. A straddle also may consist of two positions which are not the same type of interest in property. A straddle may be made up of a cash position in silver, i.e., holding the physical commodity itself, and of a futures contract to sell the same amount of silver.

If one or more positions offset only a portion of one or more other positions, the method for determining the portion of the latter position or positions to be taken into account is to be established by regulations.

Under the bill, taxpayers are presumed to hold offsetting positions in certain specified circumstances. The first presumption provides that positions in the same personal property, whether in the physical commodity itself or in a contract for the commodity, are considered offsetting positions, provided the values of the positions vary inversely with each other. Generally, values vary inversely if the value of one position decreases when the value of the other position increases. A straddle in silver futures contracts or a straddle in cash silver and a futures contract to sell silver falls within this presumption.

The second presumption covers positions in the same personal property, even though the property may be in a substantially altered form, provided the values of the offsetting positions vary inversely with respect to each other.

The third presumption covers positions in debt instruments of similar maturities if the positions ordinarily vary inversely in value in relation to each other. The Secretary may prescribe other types of positions in debt instruments which will be presumed to be offsetting, provided the inverse variation test is passed.

The fourth presumption treats positions sold or marketed as offsetting positions as straddles. The presumption does not depend on the positions being labeled by any particular name, such as straddle, spread, or butterfly.

The fifth presumption provides that positions are presumed offsetting if the aggregate margin requirement for such positions ordinarily is lower than the sum of the margin requirements for each of the positions when held separately. Thus, if the value or amount of the deposit, pledge, payment, security, or other requirement for holding two or more positions together ordinarily is less than the cost of holding each alone, this presumption applies. Generally, the lower margin for the aggregate holdings is evidence that there is less economic risk associated with holding the combined positions than with holding each of the positions separately.

The bill also authorizes the Secretary to issue regulations prescribing other factors, including subjective or objective tests, to establish a presumption that positions are offsetting. The values of positions presumed offsetting under this regulatory authority must vary inversely. This authority enables the Secretary to develop presumptions which treat complex or innovative types of straddles as offsetting positions.

The presumptions established by the bill may be rebutted if the taxpayer establishes to the satisfaction of the Secretary that the positions were not offsetting.

Definition and special rules

The bill defines personal property as any personal property (other than stock) of a type which is actively traded. However, the term "personal property" also includes commodity substitute stock. A position is an interest in personal property, including a futures contract, a forward contract, or an option. In addition to corporate stock, the bill does not apply to real property nor to property which is not actively traded.

The term "position" includes any stock option which is part of a straddle and which is an option to buy or sell actively traded stock, but does not include a stock option which is traded on a domestic exchange (or similar foreign exchange designated by the Secretary) and which has less than one-year between the date the option was granted and the end of its exercise period.

Commodity-substitute stock is defined as stock of a corporation with 80 percent or more of the value of its business and investment assets consisting of interests in commodities. For purposes of this definition, the term "business and investment assets" means assets used or held for use in the trade or business, and assets held for investment.

The bill would provide that positions held by related persons are treated as held by the taxpayer for purposes of determining whether any positions are offsetting. Under the bill, a person is a related person to the taxpayer if the relationship between such person and the taxpayer would result in a disallowance of losses under section 267 or 707(b), or if such person and the taxpayer are under common control (within the meaning of subsection (b) or (c) of section 414). However, an individual's family would consist only of the individual, his or her spouse, and the individual's children under 18 years of age. In addition, the bill provides attribution of positions to and from a partnership, trust, or other entity if any gain or loss with respect to a position held by such flow-through entity would properly be taken into account by a taxpayer with respect to whom the entity is not a related person.

The Secretary of the Treasury shall develop such forms and schedules and shall require persons filing tax returns to supply such information as the Secretary considers necessary to evaluate the effect of this provision for purposes of the reports to the Congress which are required by section 507 of this bill.

Certain governmental obligations (Treasury bills) issued on a discount basis payable without interest at a fixed maturity not exceeding one year from the date of issue are not treated as capital assets (sec. 1221(5)). This provision was originally added to the Internal Revenue Code in 1941, to relieve taxpayers of the requirement of separating the interest element from the short-term capital gain or loss element when an obligation is sold before maturity.¹ Thus, all gains or losses from transactions in such obligations are treated as ordinary income or ordinary loss at the time the obligation is paid at maturity, sold, or otherwise disposed of (sec. 454(b)).

The IRS has held that a futures contract to purchase Treasury bills is a capital asset if held for investment.² Thus, for tax-avoidance purposes, some taxpayers holding offsetting positions in Treasury bill futures take delivery of the Treasury bills on the loss leg of the straddle and sell the bills themselves in order to convert the short-term capital loss on the futures contract into a fully-deductible ordinary loss on the bills.

Tax straddles in Treasury bill future are believed to offer features unavailable in other futures straddles. These shelters can be used to convert ordinary income, including, for example, salary, wages, interest, and dividends, into long-term capital gain. This opportunity occurs because, under statutory rule, gain or loss on the sale of Treasury bills is considered ordinary income or loss, while, under IRS interpretation, gain or loss on the sale of T-bill futures contracts is considered capital gain or loss. Straddles in Treasury bill futures generally are structured in the same way as other futures straddles: contracts to buy Treasury bills are offset by an equivalent number of contracts to sell Treasury bills. The execution of these "T-bill" shelters involves one difference: in the case of a loss on a long leg, when the delivery month for the loss leg of the straddle arrives, the taxpayer takes delivery of the bills and then disposes of the bills themselves creating an ordinary loss; in the case of a loss on a short leg, the taxpayer purchases the bills at the market price and delivers the bills themselves at the contract's lower price creating an ordinary loss. Ordinary losses are fully deductible against any type of ordinary income.

The remainder of the straddle transaction is executed in the usual fashion. The taxpayer immediately replaces the liquidated leg. In the following year, the entire straddle is closed out and, if the gain occurs on the long position (contract to buy), the gain is reported as long-term capital gain. Some taxpayers may decide to re-straddle in the second year and roll-over their gains and other income indefinitely into the future.

The committee is concerned about the adverse impact of Treasury bill straddles on Government tax revenues. Moreover, the number of contract holders demanding performance on Treasury bill futures contracts has at the end of some years threatened to exceed the supply of deliverable bills. This delivery problem could disrupt Treasury bill markets and damage Government financing generally. Therefore, the committee believes that Government revenue and finance considerations require that these shelter activities be discouraged and that Treasury bills be characterized as capital assets. This change will protect both Government revenues and debt management.

Because securities dealers' inventories are ordinary income or loss accounts under present law, without regard to sec. 1221(5), this change does not affect their operations. The computation of discount income will entail only a minor increase in taxpayers' paperwork. The committee rule is adopted as the simplest and most correct method of measuring such income.

In order to facilitate the determination of discount applicable to any holder, the bill adds a new paragraph (4) to section 1232(a), treating as ordinary income the gain from the disposition of an obligation to the extent to the ratable share of "acquisition discount" applicable to the taxpayer. The ratable share is the portion equal to the ratio of the number of days the obligation is held by the taxpayer to the number of days between the date of acquisition by the taxpayer and the date of maturity. Acquisition discount is the excess of the stated redemption price at maturity over the taxpayer's basis for the obligation. This formulation will enable each holder to determine the portion of any proceeds from disposition of an obligation to be treated as ordinary discount income without reference to original issue discount or the treatment applicable to any other holder. Any gain exceeding the taxpayer's ratable share of acquisition discount is short-term capital gain and any loss on disposition of an obligation is short-term capital loss.

The Secretary of the Treasury shall develop such forms and schedules and shall require persons filing tax returns to supply such information as the Secretary considers necessary to evaluate the effect of this provision for purposes of the reports to the Congress which are required by section 507 of this bill.

Gains and losses of a taxpayer from the sale of property of a type held by the taxpayer primarily for sale are generally ordinary. However, a securities dealer may identify and segregate certain of its assets as held for investment (sec. 1236). Gains and losses from the sale of these assets may be treated as capital gains or losses.

In order to receive capital gains treatment, a security held by a dealer must be "clearly identified" on the dealer's records as held for investment within 30 days following the date of acquisition and may not thereafter be held primarily for sale to customers. If a security is at any time clearly identified as held for investment, ordinary loss treatment is denied.

The term "security" means any share of corporate stock, any note, bond, debenture, or other evidence of indebtedness, or any evidence of an interest in, or right to subscribe to any of the above.

Some taxpayers consider securities dealers' unique tax-planning opportunities so significant that they establish themselves as broker-dealers solely to exploit these opportunities. Large broker-dealer partnerships pass these tax benefits through to hundreds of partners. Many of these broker-dealer partnerships sell shares in their operations for fees which are based on a percentage, usually ten percent, of the tax loss sought by the investor.

The committee believes that requiring dealers to identify securities held for investment on their date of acquisition will end most abuse of the broker-dealer role. Because computers are used commonly now and because prudent investors, including dealers, know the purpose of their transactions when executed, delay in identification is unnecessary and unwise.

The Secretary of the Treasury shall develop such forms and schedules and shall require persons filing tax returns to supply such information as the Secretary considers necessary to evaluate the effect of this provision for purposes of the reports to the Congress which are required by section 507 of this bill.

Some taxpayers and tax shelter promoters have attempted to exploit court decisions holding that ordinary income or loss results from certain dispositions of property whose sale or exchange would produce capital gain or loss. These decisions rely on the definition of capital gains and losses in section 1222 which requires that there be a sale or exchange of a capital asset.

As a result of these interpretations, losses from the termination, cancellation, lapse, abandonment and other dispositions of property, which are not sales or exchanges of the property, are reported as fully deductible ordinary losses instead of as capital losses, whose deductibility is restricted. However, if such property increases in value, it is sold or exchanged so that capital gains, long-term when the holding period requirements are met, are reported. The committee considers this ordinary loss treatment inappropriate if the transaction, such as settlement of a contract to deliver a capital asset, is economically equivalent to a sale or exchange of the contract.

Some of the more common of these tax-oriented ordinary loss and capital gain transactions involve cancellations of forward contracts for currency or securities. For example, a taxpayer may simultaneously enter into a contract to buy German marks for future delivery and a contract to sell German marks for future delivery with very little risk. If the price of German marks thereafter declines, the taxpayer will assign his contract to sell marks to a bank or other institution for a gain equivalent to the excess of the contract price over the lower market price and cancel his obligation to buy marks by payment of an amount in settlement of his obligation to the other party to the contract. The taxpayer will treat the sale proceeds as capital gain and will treat the amount paid to terminate his obligation to buy as an ordinary loss.

The Secretary of the Treasury shall develop such forms and schedules and shall require persons filing tax returns to supply such information as the Secretary considers necessary to evaluate the effect of this provision for purposes of the reports to the Congress which are required by section 507 of this bill.

The Secretary must submit two reports of this study to the Committee on Ways and Means and to the Committee on Finance. The first report must be submitted on or before July 1, 1983, and must include an analysis of tax returns filed for taxable years beginning in 1981. The second report must be submitted on or before July 1, 1984, and must include an analysis of tax returns filed for taxable years beginning in 1982.

(sec. 601 of the bill, and secs. 4991, 4992 and new sec. 4991A of the Code)

Oil in tier 3 of the tax consists of newly discovered oil, heavy oil, and incremental tertiary oil. Oil in tier 3 of the tax generally is subject to the same rate of tax (30 percent) regardless of the identity of its owner.

 In the case of qualified    The amount in

Because both the exemption and existing law's lower rates for up to 1,000 barrels per day of oil produced by independent producers apply to oil from tiers 1 and 2, the bill provides that any person's independent producer amount eligible for lower rates is reduced by the amount of tier 1 and 2 oil to which the exemption is applied. The independent producer amount is not reduced, however, by the number of barrels of exempt tier 3 oil.

2. Windfall profit tax treatment of royalty owners

(sec. 602 of the bill and secs. 4991, 4992, 6429 and new sec. 4991B)

Present law also provides qualified royalty owners with a credit (or refund) of up to $1,000 against the windfall profit tax imposed on the removal of their royalty oil during calendar year 1980. The credit is available only to individuals, estates, and qualified family farm corporations. It may be claimed in 1981, in accordance with Treasury regulations, either on the royalty owner's income tax return or in a separate refund claim.

For 1982 and subsequent years, the committee bill provides a limited exemption from the windfall profit tax for specified amounts of royalty production. In 1982 through 1984, royalty owners will be exempt from tax on 1 barrel per day of qualified royalty production. In 1985, the exemption will apply to 2 barrels a day of production, and in 1986 and thereafter 3.5 barrels a day of production will be eligible for the royalty owner exemption. The bill also provides that the royalty owner may designate which barrels of qualified production will be exempt under the provision. It is estimated that a royalty owner with a representative mix of different types of oil will receive benefits from the exemption equal to approximately $5,300 in 1982, $5,700 in 1983, $6,000 in 1984, $12,900 in 1985, and $23,800 in 1986.

The committee bill also provides that the Secretary shall issue regulations permitting royalty owners to claim exemption from withholding of windfall profit tax on qualified royalty owner production.

To prevent a proliferation of royalty interests eligible for the credit and exemption, the committee bill retains, for purposes of the exemption, the allocation and related party rules applicable to the $1,000 credit (with the appropriate conforming modifications). In addition, the credit or exemption will not apply to production from an interest in proven property transferred after June 9, 1981, in a transfer described in the rules relating to eligibility for percentage depletion (sec. 613A(c)(9)(A)). This transfer rule applies to all tiers of oil, and without regard to the methods of its production. However, the transfer rule does not apply to transfers between persons required to share a single $2,500 credit or a single exempt amount if production from the property interest transferred was qualified royalty production for the transferor. There also is an exception to the transfer rule for transfers that would not result in loss of percentage depletion because of the exceptions contained in the depletion rules for transfers at death or among related persons (sec. 613A(c)(9)(B)). Similarly, the credit and exemption are not available for production from an overriding royalty, net profits interest, production payment, or similar interest created out of an interest in a proven property after June 9, 1981. This rule will prevent the creation of new royalty interests out of existing working interests in proven properties. An exception is provided for interests created under binding contracts entered into before June 10, 1981. The rule does not affect the ability of a landowner to retain a royalty on the lease of a proven property.

The committee bill modifies the definition of a qualified family farm corporation to provide that the family ownership and asset usage tests of present law must be satisfied at all times during the calendar year in question. The committee bill eliminates the requirements that a qualified family farm corporation must have been in existence on and must have satisfied the asset usage test on, June 25, 1980.

3. Front-end tertiary projects for independent producers

(sec. 603 of the bill and new sec. 4994(e)(5) of the Code)

Oil that DOE deregulated as front-end tertiary oil generally was exempt from the windfall profit tax until October 1981 if the project was on a property controlled on January 1, 1980, by independent producers. Front-end tertiary oil related to projects controlled by a major company is covered by other rules.

Oil decontrolled to finance "prepaid expenses," or which could have been deregulated under any other part of the crude oil price control rules, cannot qualify under the provision. As a result, the tax's exemption for front-end tertiary oil was ended when the President eliminated crude oil price controls on January 28, 1981.

The bill provides that the rules relating to refunds for tertiary projects of integrated producers (Code sec. 4994(c)(2)) are to be applied as if the bill's special rule for independent projects had not been enacted.

4. Natural gas retailers

(sec. 605 of the bill and sec. 4992(b) of the Code)

The bill provides that a taxpayer who was disqualified from eligibility for reduced tax rates solely because of retail sales of natural gas would not have his oil properties disqualified for purposes of the transfer rule. However, this special rules applies only with respect to transfers after July 22, 1981.

The bill does not alter the definition of integrated oil company for depository and withholding purposes (Code sec. 4995(b)), the percentage depletion rules (Code sec. 613A(c)(9)), or the front-end tertiary exemption.

5. Windfall profit tax exemption for oil production of residential child care agencies

(sec. 606 of the bill and sec. 4994(b)(1)(A) of the Code)

An organization for the residential placement, care, or treatment of delinquent, dependent, neglected, or handicapped children generally would not qualify as an educational organization or medical facility for purposes of this exemption.

Except to the extent that oil production is attributable to a royalty or an overriding royalty (Code sec. 512(b)(2)), income from a qualified charitable interest is subject to the unrelated business income tax (Code secs. 511-513).

If the interest is not held by the organization, the exemption may apply if the interest was held by a church for the benefit of the organization and if all the proceeds from the interest were dedicated on January 21, 1980, and at all times thereafter before the close of the calendar quarter, to the qualifying child care organization. These rules are the same as the present rules for qualifying charitable interests.

The foreign tax credit was enacted to prevent U.S. taxpayers from being taxed twice on their foreign income--once by the foreign country where the income is earned and again by the United States as part of the taxpayer's worldwide income. The foreign tax credit is intended to allow U.S. taxpayers to offset the U.S. tax on their foreign income by the income taxes paid to a foreign country. Foreign tax credits may not be used to offset U.S. tax on domestic income.

The credit is available only with respect to foreign income, war profits, or excess profits taxes and certain "in lieu of" taxes (for ease of reference, referred to generally as foreign income taxes). Other taxes paid by the taxpayer are generally not creditable but are treated only as deductible expenses.¹

In the case of amounts paid to a foreign government with respect to oil and gas extraction income, it has been difficult to determine whether the payment was a tax on the extraction income or a royalty on the oil and gas extracted (or some other deductible but non-creditable payment such as a severance tax or a share of production--for ease of reference, generally referred to herein as royalties). In most foreign countries, the rights to the oil or gas extracted by the U.S. oil companies are owned by the foreign government. Consequently, the foreign government can collect its revenues from the oil or gas extraction operations either by charging a royalty on the oil and gas extracted or by imposing a tax on the extraction income.

In an attempt to clarify the foreign tax credit rules in this area the Service issued proposed and temporary regulations on November 17, 1980 that set forth certain rules for determining whether a foreign charge was a creditable tax. Essentially, these regulations provide that a payment to a foreign government is an income tax that can be credited against U.S. income taxes only if the charge is computed on realized net income and is not imposed as compensation for a specific economic benefit. In determining whether a tax is imposed on realized net income, the foreign income tax must be "substantially equivalent" to the U.S. income tax, but need not exactly parallel the U.S. tax.

A fundamental premise of the foreign tax credit is that it should not offset the U.S. tax on U.S. source income. Accordingly, the computation of the foreign tax credit contains a limitation to insure that the credit only offsets the U.S. tax on the taxpayer's foreign income. The limitation operates by prorating the taxpayer's total U.S. tax liability before foreign tax credits ("pre-credit U.S. tax") between his U.S. and foreign source taxable income. Therefore, the limitation is determined by using a simple ratio of foreign source taxable income divided by total taxable income. The resulting fraction is multiplied by the total pre-credit U.S. tax to establish the amount of U.S. taxes paid on the foreign income and, thus, the upper limit on the foreign tax credit.

Under the special section 907 extraction tax limitation which was added to the Code in 1975 and later amended, amounts claimed as taxes paid on foreign oil and gas extraction income of a U.S. company only qualify as creditable taxes (if they otherwise so qualify) to the extent they do not exceed 46 percent (which equals the highest U.S. corporate tax rate) of such extraction income.² Foreign taxes paid in excess of that amount are, in general, neither creditable nor deductible. However, a foreign tax credit carryover is allowed for excess extraction taxes paid to the extent of 2 percent of foreign oil extraction income.

Present law also provides that a taxpayer is to compute the foreign tax credit limitation on a worldwide basis separately for his foreign oil-related income.³ Thus, foreign taxes paid on the taxpayer's foreign oil-related income may not offset his U.S. tax on his other income and vice versa.

The taxpayer's extraction income is generally the sum total of the taxpayer's income and loss from worldwide foreign extraction operations. However, if the extraction activities and sales of the extraction assets in any country result in a net loss for any year, the loss from that country is not taken into account in the computation of the foreign oil extraction income for the year (the special "per-country extraction loss rule"). This benefits the taxpayer because his oil and gas extraction tax limitation is greater by 46 percent of the nonincluded loss. This increases the amount of oil and gas extraction taxes that the taxpayer can treat as a creditable tax. (It should be noted, however, that the per-country extraction loss is included in computing the taxpayer's overall foreign tax credit limitation for foreign oil-related income for the year.)

Another way of describing the impact of this per-country loss rule is that it allows a company to use against any low-taxed foreign trading, refining or shipping income excess oil tax credits from its net foreign extraction income from all foreign countries (that is, its net income taking into account all income and losses from its extraction activities in all foreign countries). To illustrate, if a company's extraction activities generated $300 income in country A and a $100 loss in country B, it would have net income of $200 from those foreign extraction activities on which it would pay $92 of U.S. tax (at a 46-percent rate) before the foreign tax credit. However, because the $100 loss would not be taken into account in computing the 46-percent extraction limitation under present law, the company would be entitled to claim oil tax credits of $138 (46 percent of $300)--using $92 in credits against the U.S. tax on the net extraction income and the $46 excess credits against other income. It should be noted, however, that the $46 of extraction tax credits being used against the tax on other income are generated only as a result of the per-country loss.

Subpart F Income

Under present law, the United States imposes income tax upon the worldwide income of any corporation organized under the laws of the United States. However, foreign corporations (even those which are subsidiaries of U.S. companies) generally are taxed by the United States only to the extent they are engaged in business in the United States or derive investment income here. As a result, the United States usually does not impose a tax on the foreign source income of a foreign corporation even though it is owned or controlled by U.S. persons. Instead, the foreign source earnings of a foreign corporation generally are subject to U.S. income taxes only when they are actually remitted to U.S. shareholders as dividends. The tax in this case is imposed on the U.S. shareholder and not the foreign corporation. U.S. tax on the dividend income may be offset by foreign tax credits. The fact that no U.S. tax is imposed until, and unless, the income is distributed to the U.S. shareholders is generally referred to as "tax deferral."

An exception to the general rule of tax deferral is provided for certain base company type "tax haven" activities of controlled foreign corporations. These are foreign corporations more than 50 percent of the stock of which is owned by U.S. shareholders that own at least 10 percent of the corporation's stock. The U.S. shareholders of these corporations are taxed under the subpart F. provisions of the Code. Under these provisions, this subpart F income is deemed to be distributed to the U.S. shareholders, and it is taxed to them currently whether or not they actually receive the income in the form of a dividend.

There are five categories of subpart F income taxed currently to U.S. shareholders of controlled foreign corporations: (1) income from the insurance of U.S. risks; (2) passive investment income such as dividends, interest royalties, and rents; (3) sales income earned by the foreign subsidiary on the sale of property purchased from, or sold to, a related company if the property was neither manufactured in nor sold for use in the country in which the subsidiary is incorporated: (4) income from services performed for or on behalf of a related person by the foreign subsidiary outside of the country in which it is incorporated: and (5) shipping income earned by a foreign subsidiary outside of the country in which it is incorporated, if that income is not reinvested in shipping assets.

The foreign tax credit is available only for "income taxes" paid to a Foreign government. Because of the wide variety of tax systems and types of transactions, defining the term "income tax" with any precision has proved difficult. This difficulty has been compounded where the income relates to the extraction of minerals.

When U.S. oil companies began operations in a number of major oil exporting countries, they only paid a royalty for the oil extracted since there was generally no applicable income tax in those countries. However, in part because of the benefit to the oil companies of imposing a foreign income tax, as opposed to a royalty, those countries have adopted taxes applicable to extraction income and have labeled them income taxes. Moreover, because of this relative advantage to the oil companies of paying income taxes rather than royalties, most oil-producing nations in the post-World War II era have tended to increase their revenues from oil extraction by increasing their taxes on U.S. oil companies. Even after the foreign oil tax rates had been increased to levels higher than the U.S. rate--with the result that additional increases would only produce excess credits unusable by the companies--foreign countries have tended to increase their take by increasing their effective tax rate rather than by increasing the royalty rate. This approach was taken by the foreign countries in large part because the taxes could be increased unilaterally while increases in the royalty rate would require renegotiation of the contract. In any event, as the result of these increases in the effective tax rate, most oil-producing countries now impose taxes on oil income at effective rates as high as 80 percent or more, while the charges designated as royalties are imposed at relatively low rates (usually 20 percent or less) as compared to the taxes paid to those countries.

Beginning with Revenue Ruling 76-215, 1976-1 C.B. 194, which denied the foreign tax credit for amounts paid to Indonesia under production-sharing contracts, the IRS has issued a series of revenue rulings and other administrative determinations denying the foreign tax credit, on a prospective basis, for foreign "taxes" paid to various foreign countries on the grounds that those taxes do not constitute income taxes within the meaning of section 901 of the Internal Revenue Code and thus do not qualify for the credit. These rulings revoked the earlier IRS rulings which had allowed the foreign tax credit for the Saudi Arabian tax and the oil taxes of certain other countries. These rulings have generally been applicable only on a prospective basis (under the authority of sec. 7805(b)), treating taxes paid in prior years as qualifying for the credit.

In addition to the recent series of rulings dealing with particular foreign taxes and with various specific issues as to the creditability of those taxes, in 1978 the IRS and Treasury commenced a regulations project that is intended to clarify on a more comprehensive basis the requirements which the IRS and Treasury believe must be satisfied before a foreign tax can qualify for the U.S. foreign tax credit. The proposed regulations were first issued on June 15, 1979. On November 17, 1980 the regulations were substantially changed and reissued as proposed and temporary regulations.

The rules set forth in the proposed regulations generally follow those which have been articulated in the recent rulings with respect to particular taxes. It can be expected that under the criteria contained in the proposed regulations, most foreign petroleum taxes presently imposed would not be considered to be income taxes qualifying for the foreign tax credit. It should be noted, however, that the regulations are in proposed form and temporary and thus possibly might be changed in certain respects in response to public comments. It is also possible that the proposed regulations might be challenged in court by certain oil companies or other taxpayers who would be denied foreign tax credits by application of the regulations. Alternatively, foreign countries might restructure their taxes on petroleum income so that the taxes satisfy the criteria adopted in the regulations and thus qualify for the foreign tax credit. (This, for example, was done by Indonesia in response to the 1976 ruling disallowing the credits for amounts paid under production sharing contracts; the restructured tax was held to qualify for the foreign tax credit in Rev. Rul. 78-222, 1978-1 CB 232.) Given these possible developments, the exact impact of the proposed regulations on the foreign tax credits claimed for foreign oil taxes will not be finally resolved for some time.

During the last 14 years, the Congress has repeatedly addressed the issue of the creditability of foreign taxes imposed on extraction related activities. This issue was the subject of the Congress' attention in 1969, 1974, 1975, 1976 and in 1979. (See, for example, the testimony by the Honorable George P. Shultz, Secretary of the Treasury, before your Committee on February 4, 1974.) The Congress has repeatedly adopted more and more complex rules in an attempt to resolve the issue. Constant technical tightening of the foreign tax credit has not succeeded. Furthermore, despite this tightening, little additional revenue has accrued to the Treasury.

As a result of these attempts, the Code has been amended in recent years to place additional limitations on the use of excess credits arising from oil and gas production to offset U.S. tax on other foreign source income. These special extraction tax limitations were designed to deal, at least in part, with both the problem of determining what portion of a payment to a foreign government constitutes a creditable income tax and what portion is serving the function of a royalty, and also the problem of excess extraction taxes being used against other income.

The committee has concluded that the rulings, regulations, and legislation that were intended to resolve the issue of the creditability of foreign oil and gas taxes have not achieved their purpose.

The committee recognizes the great difficulty in ascertaining whether a payment labeled as an income tax is, in fact, an income tax or a royalty (or other deductible but not creditable payment such as an excise tax) and concludes that this difficulty leads to a distortion of the foreign tax credit mechanism in the oil and gas area. The committee also is aware that even if the Code were amended to provide a revised and more detailed definition of a creditable tax for foreign oil taxes, the foreign oil-producing countries could, and would, restructure their taxes so they qualified for the foreign tax credit as revised.

Foreign subsidiaries

In addition to extraction income, multinational oil companies earn significant revenues from so-called downstream activities such as the transportation of petroleum, shipping, refining, trading, and retail sales of the petroleum. Prior to 1975, the multinational oil companies had unfettered discretion to shelter their downstream income (often earned in low tax countries) with high extraction taxes. In addition, they were able to use foreign losses to offset U.S. income.

Even with the changes made in 1975 and succeeding years that limited the opportunity to use excess credits to shelter non-extraction income, multinational oil companies have paid relatively little U.S. tax on their foreign operations. In part, this is due to the special source rule of section 907(c)(4) which provides that in computing the 46-percent limitation on extraction taxes, extraction losses are not taken into account if they arise in a country for which the taxpayer has a net extraction loss for the year. Moreover, when the downstream activities are conducted in a foreign subsidiary, U.S. tax can generally be avoided through use of a foreign subsidiary, even if foreign income taxes are not sufficient to shelter all of the foreign income. Also, because of the fungible nature of oil and because of the complex structures involved, oil income is particularly suited to tax haven type operations.

The net result has been that the petroleum companies have paid little or no U.S. tax on their foreign operations despite their extremely high revenues. Your committee believes that its decision to exempt foreign extraction income from U.S. tax and to resolve the oil company's uncertainty as to the creditability of foreign taxes should in the long run be of benefit to them.

However, the committee believes that multinational oil companies should pay U.S. tax on foreign oil related income that is not subject to foreign income tax. Accordingly, your committee's provision will apply the present law anti-tax haven provisions (subpart F) currently to tax certain low taxed foreign oil related income earned by foreign subsidiaries of U.S. companies. Your committee recognizes that international shipping, because it is highly competitive and is generally not taxed by other countries, presents special problems. Accordingly, the tax treatment of that income should not be changed without further study.

The bill provides that gross income does not include foreign oil and gas extraction income. Deductions and credits attributable to foreign oil and gas extraction income are not allowed.

The present law definition of the term "foreign oil and gas extraction income" for purposes of the special oil foreign tax credit limitation is retained, but modified so that it does not include gains from the sale of assets used in the oil or gas business. The bill defines foreign oil and gas extraction income as including any amount derived from sources without the United States and its possessions from the extraction of minerals from oil or gas wells.

In addition to income earned directly from the extraction of oil or gas, the term also includes dividends from a foreign corporation in respect of which foreign taxes are deemed paid by the taxpayer under section 902, amounts with respect to which taxes are deemed paid under section 960(a) and the taxpayer's distributive share of any partnership income or loss. These amounts are treated as foreign oil and gas extraction income to the extent that they are attributable to foreign oil and gas extraction income.

Deductions are not allowed for amounts allocated to or chargeable against amounts which are excluded from gross income as foreign oil and gas extraction income to the extent that they are attributable to amounts expended for the exploration for oil and gas outside the United States and its possessions, or for the development of any oil or gas property located outside the United States and its possessions. However, the extraction income eventually generated by those activities would also be exempt from tax.

The provision denies the credit against United States tax for foreign taxes paid or accrued (or deemed paid) with respect to foreign oil and gas extraction income. The investment tax credit is denied for any property used predominantly for exploration and development outside the United States or which is used for the production of income which is excluded from gross income a foreign oil and gas extraction income.

The provision limits the deductibility of losses sustained during a taxable year from the sale, exchange, abandonment, or other disposition of an asset used in a foreign oil and gas extraction business. These losses would be allowed only to the extent of the gains recognized during the year from the sale or exchange of those assets. Gains from the sale of such property are not foreign oil and gas extraction income and therefore are taxable and are not excludable from gross income. Losses that exceed gains from the disposition of foreign oil assets during a year may be carried to the next year as short-term capital gain.

2. Current taxation of foreign oil and gas related income of foreign subsidiaries

The bill would impose current U.S. tax on foreign oil and gas related income earned by a controlled foreign corporation. This would be accomplished by treating foreign oil related income as an additional category of foreign base company income currently included in the U.S. shareholder's income under subpart F. This category of income is foreign base company oil related income.

Foreign oil related income is taxable income derived from sources outside the United States from the processing of minerals extracted from oil or gas wells into their primary products, the transportation of the minerals or primary products, the distribution of oil or gas minerals or primary products,⁴ the sale or exchange of assets used by the taxpayer in a trade or business encompassing one of these activities, and the performance by the controlled foreign corporation of services for or on behalf of a related person who is engaged in an oil related activity, or in a foreign oil and gas extraction activity. Services include, for example, transportation of oil for a related party, accounting or managerial services for a related party, or insuring oil related or extraction assets of a related party.

Foreign oil related income also includes dividends and interest from a foreign corporation with respect to which taxes are deemed paid by the taxpayer, interest and dividends from a domestic corporation which are treated as income from sources without the United States under the Internal Revenue Code, amounts with respect to which taxes are deemed paid under the subpart F provisions of the Code, and the taxpayer's distributive share of the income of partnerships. These amounts are treated as oil related income, however, only to the extent that they are attributable to foreign oil related income. In addition, interest from a foreign corporation and interest and dividends from a domestic corporation which are treated as foreign source are foreign oil and gas related income (and not excluded extraction income) to the extent attributable to foreign oil and gas extraction income. Accordingly, such interest and dividends would continue to be subject to tax.

Consistent with the base company concept, two exceptions to current taxation are provided. First, foreign oil related income derived from sources within a foreign country in connection with oil or gas which was extracted by the foreign corporation or a related person from an oil or gas well in that foreign country would not be subject to the current taxation rules. For example, income derived in a foreign country by a subsidiary from the purchase and sale of oil extracted by an affiliate in that country would not be treated as subpart F income, but income the subsidiary derives from the purchase and sale of oil extracted in that country by an unrelated party or the government would be subpart F income. Second, foreign oil related income derived from sources within a foreign country in connection with oil or gas related products which are sold by that foreign corporation or by a related person for use or consumption in that country would not be subject to current taxation rules.

For example, if a controlled foreign corporation had income from refining in country A, and half of the income of the corporation was from refining oil extracted by the corporation in country A and half elsewhere, only half of its income would be base company income.

Shipping income which is foreign based company shipping income would not be subject to current tax in the hands of U.S. shareholders as foreign base company oil related income. It would, however, continue to be subject to the provisions of subpart F relating to foreign base company shipping income. The special rule that excludes from base company income amounts earned by a foreign corporation not formed or availed of to reduce taxes does not apply to foreign base company oil related income.

While the bill eliminates the foreign tax credit for taxes paid to foreign countries with respect to foreign oil and gas extraction income, foreign tax credits are still permitted for taxes paid with respect to oil related income.

The special foreign tax credit limitation for oil income is repealed and the general foreign tax credit rules and the overall limitation provided in section 904 of the Code apply.

Under the bill, any foreign income taxes otherwise creditable under the Code which are paid or accrued to any foreign country with respect to foreign oil related income will be creditable against U.S. income taxes, unless those taxes are considered to be abnormally high. The amounts are not creditable to the extent that the Secretary determines that the foreign law that imposes the tax is structured, or in fact operates, so that the amount imposed with respect to foreign oil related income will in most cases be materially greater than the amount generally imposed on income that is not oil related income. The amount not treated as a tax under this provision will be treated as a deduction under the foreign law. Accordingly, the excess amount would be deductible for purposes of computing an appropriate level of foreign income tax.

In determining the amount of taxes which are creditable, the Secretary would take into account the deduction for amounts treated as excess payments under the provision, so that the rate of tax on the oil profits after deduction for the amounts treated as excess payments would not exceed the rate of tax generally imposed by the country on other income.

For example, a foreign country has a generally applicable tax of 40 percent and imposes a "tax" on oil-related income which results in a tax of 55-percent. A company earning $100 of oil-related income on which it paid final oil "taxes" of $55 would, for purposes of computing the amount creditable as a foreign income tax, treat $25 of that payment as a deductible excess payment, leaving U.S. taxable income of $75. The company would be entitled to treat the remaining $30 of the foreign tax as a credit against the $34.50 pre-credit U.S. tax on that $75 taxable income--leaving a net U.S. tax liability of $4.50. The amount of the foreign tax allowed as a credit ($30) would be 40 percent (the generally applicable tax rate of that country) of $75 net taxable income from that country. The amount treated as an income tax is about 55 percent of the amount treated under that country's law as a tax.

The provision contains special rules for the carryover of certain oil taxes. The rules are designed to prevent the carryover of credits disallowed under the special excess deduction provision. Under the carryover rules, foreign oil-related taxes paid in taxable years beginning before, January 1, 1981, can be carried back two years and carried forward five years under the regular foreign tax credit rules. However, the amount of oil-related taxes carried to a taxable year beginning on or after January 1, 1981, cannot, exceed the amount that would have been creditable if the provisions of this Act had been in effect the year in which the foreign taxes were paid. A further limitation is provided so that the old foreign tax credit rules relating to foreign oil related income will be deemed to be in effect for the excess credit year (the year in which the taxes were paid), and for all taxable years thereafter.

Present law allows a residential energy tax credit equal to 40 percent of so much of the taxpayer's "qualified renewable energy source expenditures" as do not exceed $10,000 (sec. 44C(b)(2)). For this purpose, the term "renewable energy source expenditure" means expenditures made by the taxpayer on or after April 20, 1977, for "renewable energy source property" installed in connection with the taxpayer's principal residence. Renewable energy source expenditures include labor costs properly allocable to the onsite preparation, assembly, or original installation of renewable energy source property, as well as certain expenditures for an onsite well drilled for any geothermal deposit. Renewable energy source expenditures do not include any expenditures properly allocable to a swimming pool or to any other property which has a primary function other than energy purposes. Thus, while renewable energy source expenditures include costs for both active and passive solar systems, Treasury regulations specify that expenditures for dual function components of a passive solar system are not eligible for the credit (Treas. Regs. Sec. 1.44C-2(f)(3)). However, expenditures for a solar panel installed as a roof do not fail to qualify for the credit solely because the panel constitutes a structural component of the dwelling.

The term "renewable energy source property" means property which, when installed in connection with a dwelling in the U.S., transmits or uses (1) solar energy, energy derived from geothermal deposits, or any other form of renewable energy specified in Treasury regulations, for heating or cooling the dwelling or for providing hot water or electricity for use within the dwelling, or (2) wind energy for non-business residential purposes. In addition, the original use of "renewable energy source property" must begin with the taxpayer. The property reasonably must be expected to remain in operation for at least 5 years, and it must meet specified performance and quality standards.

In the case of a newly constructed or reconstructed dwelling, renewable energy source expenditures are treated as made when the original use of the constructed or reconstructed dwelling begins. In addition, in the case of newly constructed residences, the original purchaser may claim the credit, when original use of the residence begins, for separately stated renewable energy sources expenditures.

Property is not eligible for the credit to the extent it is financed with funds provided under a government program a principal purpose of which is to provide subsidized financing for projects designed to conserve or produce energy (sec. 44C(c)(10)(A)).

Solar Bank

Title V of the Energy Security Act of 1980 (Pub. L. 96-294) established the Solar Energy and Energy Conservation Bank (the "Bank") to encourage energy conservation, to promote the use of solar energy, and to contribute to the reduction of U.S. dependence on foreign energy sources. The Bank is authorized to provide funds to lending institutions, utilities, and local governments to further these objectives.

Initially, $1 billion was authorized to fund the Bank's activities through fiscal year 1984, and the fiscal year 1981 appropriation provided $121 million.

In the conference on the Omnibus Reconciliation Act of 1981, the conferees have reached a preliminary agreement to approve annual authorizations of $50 million for each of fiscal years 1982, 1983, and 1984.

Passive systems generally can be classified as direct gain, indirect gain, or isolated gain systems. The most common of these types of systems are described below. The choice between different systems may depend on topography, esthetics, and heating and cooling needs.

In a direct gain passive solar energy system, sunlight enters and directly heats the living area. If the living space is constructed of materials that absorb and store this heat (e.g., masonry floors and walls) or if a storage mass is introduced to the living area, the collected heat is stored and liberated to maintain the living area's temperature when the sun is not present. These systems can be used in most environments.

In a system that uses indirect gain, the thermal storage mass is positioned between the sun and the living space. Sunlight warms the mass which then gradually releases the heat to the living space. The storage masses used in such systems typically are either storage walls or roof ponds. In both cases the storage mass must be enclosed, at least in the absence of sunlight, so that the mass does not lose its heat to the outdoors. These systems are attractive in retrofitting existing masonry structures, in using attached greenhouse applications or in locations where summer cooling is an important consideration.

Isolated gain systems are those in which the collector and storage mass are located apart from the living space. Heat is carried to the living space as needed. These systems are attractive particularly where constant heat is not required.

To qualify for the credit, a new unit must contain a "passive solar energy system." Such a system contains five recognizable elements. The first element is a "solar collection area." This is defined as an expanse of transparent or translucent material located to allow the sun to warm the absorber directly (see below). This definition includes windows and skylights.

The second element of a passive solar system is an "absorber." An absorber is a hard surface exposed to the sun which absorbs solar radiation and transmits the resulting heat to a "storage mass". The absorber also must have an area of directly irradiated material which is equal to or greater in area than the solar collection area. Typical examples of absorbers include the surfaces of slate floors, stone walls, and enclosed thermal ponds. Since a hard surface is required, open surface or PVC enclosed thermal roof ponds, swimming pool surfaces, and carpeted areas do not qualify as absorbers.

The third required element of a passive solar system is a "storage mass." A "storage mass" is defined as a dense, heavy material that receives and holds heat from the absorber and later releases it to the interior of the structure. Such a mass must have sufficient volume, depth and thermal capacity that store and deliver adequate amounts of solar heat for the structure. The bill also requires proper location of the storage mass so that the stored heat can be distributed directly to the habitable areas. Examples of dense, heavy material which, if properly applied, could have sufficient thermal capacity, include water, eutectic salts in aqueous solutions, stone, and masonry. An inefficient or ineffective mass (due to oversizing) would not qualify as a storage mass.

The fourth requirement of a passive system is the presence of a "heat distribution method." Such methods include the direct release of heat into the structure's habitable areas and the movement of heat from the mass by convection through airflow paths or ducts. A fan or pump of 1 horsepower or less may be used in distributing heat.

The final required element of a passive solar energy system is a "heat regulation device." Such devices are (1) shading or venting mechanisms to control the amount of heat admitted through the collection area, and (2) nighttime insulation (or its equivalent) to control the heat loss from the building. Examples of shading devices include deciduous trees, overhanging rooflines and shutters. Examples of nighttime insulation (or the equivalent) include shutters, thermal windows, and insulating curtains.

If a particular home qualifies for the credit, the builder will calculate the credit as follows. First, the heating load of the house is determined by multiplying the habitable area of the house by one of eight insulation factors determined using a table to be prescribed by the Treasury. These insulation factors will be based on the level of insulation in floors, walls, and ceilings and on the number of panes of glass in each window (i.e., single, double or triple glazing). The factors will range in eight steps from house with no added insulation to a house having the maximum feasible insulation.

Once the heating load is known, the builder will calculate the passive capacity of the house by dividing the heating load by the passive solar collection area. In determining the passive capacity of the home. the builder does not need to consider glazed areas that do not admit direct sunlight or the thermal capacity of the storage mass.

The third step in calculating the credit is to use the passive capacity and location. of the home to find the appropriate credit on a solar construction credit table prescribed by the Treasury. The solar construction table will be based on the estimated annual energy savings of the home when compared to a nonsolar house of similar location and heating load. The credit would be at the rate of $60 per million Btu's saved annually up to a maximum of $2,000 per unit. The table must be developed in consultation with the Department of Energy and the Department of Housing and Urban Affairs.

The bill also provides rules to prevent builders and homeowners from taking advantage of more than one solar tax credit or energy financing program. Specifically, in determining the amount of the passive solar credit for builders, no portion of the passive solar energy system financed from subsidized energy financing (within the meaning of sec. 44C(c)(10)(C)) is taken into account. In addition, the maximum amount of the credit for renewable energy source expenditures is reduced by the amount of the credit allowed to the builder under the new provision. Similarly, an expenditure which gave rise to the builder's passive solar credit would not give rise to a renewable energy source credit under section 44C.

(sec. 701 of the bill and sec. 6103(i) of the Code)

Before the GAO receives tax data in connection with the audit of an agency, it must notify the Joint Committee of the audit. The Joint Committee may disapprove an audit by a vote of two-thirds of its members within 30 days of receipt of notice of the proposed audit.

2. Prohibition of disclosure of methods for selection of tax returns for audit

(sec. 702 of the bill and sec. 6103 of the Code)

Some doubt has been raised concerning whether the disclosure restrictions cover data derived by the Internal Revenue Service from its Taxpayer Compliance Measurement Program (TCMP).² This data is used by the IRS to develop variables used to derive scores that are used for the purpose of selecting tax returns for audit.

In other words, disclosure of any information that the bill protects will not be permitted after that date.

The current tax interest rate, for the period from February 1, 1980, is 12 percent.

The committee believes that the current disparity between the tax interest rate and the actual cost of borrowing has contributed to the increasing number and value of delinquent tax accounts. From 1978 to 1980, for example, the number of delinquent tax accounts increased from 886,000 to 1,204,000, and their value increased from $2,356 million to $3,631 million. A similar pattern is discernible from the cases filed in the Tax Court.

To encourage timely refunds and tax payments, the committee has decided to modify the rules for determining the tax interest rate.

Starting in 1983, the tax interest rate will become effective on January 1st, rather than on February 1st, of the year immediately following that in which the rate is set.

(sec. 721 of the bill and secs. 6682 and 7205 of the Code).

Because it applies generally to wage withholding, the penalty applies to statements which provide the basis for determining the amount to be withheld. Thus, for example, the penalty applies to statements relating to withholding exemptions (Code sec. 3402(b), (c), (f)), estimated itemized deductions (Code sec. 3402(m)), absence of tax liability (Code sec. 3402(n)), and situations to which Code section 6682 of present law applies.

The penalty, however, may be waived by the Secretary if the individual's income taxes for the taxable year do not exceed the sum of the individual's estimated income tax payments and tax credits.

The committee bill also increases the criminal penalty for willfully failing to supply information, or for willfully supplying falsified information, in connection with wage withholding to $1,000.

2. Penalty for valuation overstatements

(sec. 722 of the bill and new sec. 6659 of the Code)

The committee recognizes that valuation issues frequently involve difficult questions of fact. Often, these issues seem to be resolved simply by "dividing the difference" in the values asserted by the Internal Revenue Service and those claimed by the taxpayer. Because of this approach to valuation questions, the committee believes that taxpayers have been encouraged to overvalue certain types of property and to delay the resolution of valuation issues. Because the tax interest rate has been below the prevailing cost of borrowing, this tendency probably has been accentuated somewhat.

In recognition of the fact that valuation issues often are difficult, especially where unique property is concerned, the committee has decided to adopt a "bright line" test for the application of a new penalty. Under this test, only significant overvaluations will be penalized. This approach to the problem, however, is not intended to condone minor overvaluations; rather, it is intended to remove questions involving small differences from the ambit of this new penalty.

Under the bill, there is a valuation overstatement if the value of any property, or the adjusted basis of any property, claimed on any return exceeds 150 percent of the amount determined to be the correct amount of the valuation, or adjusted basis. If there is a valuation overstatement, the following percentages are used to determine the applicable addition to tax:

 If the valuation claimed

For purposes of the penalty, the term "underpayment" has the same meaning as under the present law rules relating to negligence and civil fraud penalties (Code sec. 6653(c)(1)).

The new addition to tax applies only to individuals, closely held corporations, and personal service corporations. A closely held corporation is defined as a corporation (described in Code sec. 465(a)(1)(C), relating to at risk rules) with respect to which more than 50 percent in value of its outstanding stock is owned, directly or indirectly, by or for not more than 5 individuals. See Code sec. 542(a)(2). A personal service corporation is a corporation which is a service organization (within the meaning of Code section 414(m)(3), relating to pension plans).

3. Addition to negligence penalty

(sec. 722(b) of the bill and new sec. 6653(a)(2) of the Code)

As an addition to tax, amounts imposed under this new penalty are nondeductible.

4. Information return penalties

(sec. 723 of the bill and secs. 6401, 6652, and 6678 of the Code)

The statement required as to payments of $600 or more must be furnished on or before January 31 of the year following the calendar year for which the return relates.

The provision also increases the penalty for failure to file most information returns with the Secretary. The returns with respect to which the increased penalty applies are those required by section 6041(a) or (b) (relating to certain information at the source), section 6042(a)(1) (relating to dividend payments aggregating $10 or more), section 6044(a)(1) (relating to patronage dividends aggregating $10 or more), section 6049(a)(1) (relating to interest payments of $10 or more), section 6050A (relating to fishing boat operators), and section 6051(d) (relating to information returns with respect to withheld income taxes). The increased penalty is $10 for each return, subject to a maximum penalty of $25,000 for only calendar year. As under present law, the penalty does not apply if the failure is due to reasonable cause and not to willful neglect.

Because the obligation to furnish a statement and the requirement to file an information return are different obligations, a taxpayer could be subject to both the information and statement penalties.

The bill retains the $1 penalty of present law for failure to file information returns with respect to certain payments aggregating less than $10.

5. Penalty for overstated tax deposit claims

(sec. 724 of the bill and new sec. 6656(b) of the Code)

The bill provides that the term 'overstated deposit claim' means the excess of the tax claimed, in a return filed with the Secretary, to have been deposited in a government depository for any period, over the aggregate amount deposited in a government depository, for that period, on or before the date that the return is filed. Thus, overstated deposit claims include failure to deposit, as well as claims of deposits in excess of the amount actually deposited in a government depository and claims of deposits which are not deposited in such a depository. However, overstated deposit claims do not include accurate and timely deposits of taxes required to be deposited which are deposited in a government depository other than the one indicated on the return filed.

The bill also provides for the assessment, collection, and payment of the penalty in the same manner as applicable to the assessment, collection, and payment of taxes, as specified in Code section 6659(a).

6. Declaration and payment of estimated taxes by individuals

(sec. 725 of the bill and secs. 6015 and 6654 of the Code)

Individuals who fail to pay, in full, an installment of estimated tax on or before the due date may be subject to a penalty which may not be waived for reasonable cause (Code sec. 6654). This penalty, which is applied to the period of underpayment of any installment (currently at a rate of 12 percent), applies to the difference between the payments (including withholding), made on or before the due date of each installment and 80 percent of the total tax shown on the return for the year, divided by the number of installments that should have been made. In addition, present law contains four exceptions to the general underpayment penalty. No penalty is imposed upon a taxpayer if: (1) total tax payments (withholding plus estimated tax payments) exceed the preceding year's tax liability; (2) total tax payments exceed the tax on prior year's income under the current year's tax rates and exemptions; (3) total tax payments exceed 80 percent of the taxes which would be due if the income already received during the current year were placed on an annual basis; or (4) total tax payments exceed 90 percent of the tax which would be due on the income actually received from the beginning of the year to the computation date.

The increase in the tax liability threshold will be phased in over a four-year period, beginning in 1982. For 1982, the tax liability threshold will be $200. For 1983 and 1984, the amount will be $300 and $400 respectively. For 1985, and subsequent years, the amount will be $500.

                                  The following percentages

In general, no penalty is charged with respect to the underpayment of a corporation's estimated tax liability if the corporation made payments on or before the due date of the installment and the total payments up to the particular due date in question equal or exceed the amount which would have been due had the estimated tax been based on any of the following amounts: (1) the preceding year's liabilities, if a return showing a tax liability was filed by the corporation for the preceding taxable year and such preceding year was a taxable year of 12 months; (2) tax liabilities computed by using the current year's tax rates for the prior year's return and the law that applies to the prior year; or (3) 80 percent of the taxes which would have been due if the income which the corporation had already received during the current year had been placed on an annualized basis.

However, in the case of the two exceptions based upon prior year's tax liability (items (1) and (2) above), a special rule applies to large corporations. The estimated tax payments of a large corporation generally must equal at least 60 percent of the tax shown on its income tax return for the taxable year (or the actual tax if no return is filed). A large corporation, for purposes of this requirement, is a corporation that had taxable income of $1 million or more in any of the three taxable years immediately preceding the taxable year involved.

In the case of component members of a controlled group of corporations (within the meaning of Code section 1563), the $1 million amount for any taxable year in the 3-year base period is divided among the members of the group in the same manner in which the benefits of the graduated tax rates are allocated for that year.

(sec. 741 of the bill and secs. 3201, 3211, and 3221 of the Code)

Under present law, the flow of revenue from railroad retirement taxes is inadequate to finance existing benefit levels. The current yearly deficit is nearly $835 million and is expected to continue to be of that order of magnitude. The need to restore a measure of financial soundness to the system is urgent; the administration and the Congressional Budget Office predict that, under existing law, insufficient balances to issue full benefit payments may occur in the Railroad Retirement Account as early as spring of 1982.

The current structure of the railroad retirement system stems from a reorganization enacted in 1974. The 1974 Railroad Retirement Act established three benefit components. The system was divided into two "tiers," one of which roughly approximates social security (tier I), and the other, an industry staff retirement benefit (tier II). The first tier pays benefits based upon combined railroad industry and any social security covered earnings, and is financed by a tax on employers and employees on the same basis as social security. The second tier is related to service in the railroad industry and is financed by taxes on industry employers. The industry pension tier-II component is a principal factor causing the system's financial problems. The third component preserved certain "windfalls" for employees who had qualified for both Railroad Retirement and Social Security benefits prior to the 1974 Act. The phaseout of these windfalls was to be financed by level general revenue payments to the Railroad Retirement Account through the attrition of eligible beneficiaries.

It is estimated that the Railroad Retirement Account will run into cash flow problems in the spring of 1982. The shortfall is expected to be temporarily alleviated by that year's financial interchange with Social Security, but would recur in the spring of 1983, with complete insolvency predicted within two years after that.

Several factors contribute to a cash flow problem for the Railroad Retirement Account. First, because of differences between Social Security and Railroad Retirement Tier I benefits, Tier I disbursements are inadequately financed by the matching employer/employee Tier I tax and the Social Security interchange payment. Second, Tier II is inadequately financed by the current employer tax rate for those benefits. Third, the Railroad Retirement Account experience for windfall benefit payments exceeds reimbursement from the Federal Government. Fourth, because reserves are being depleted, interest on invested reserves is a declining source of revenues to the fund. Finally, over the life of the Railroad Retirement system, there has been a steady increase in the number of beneficiaries, while the number of employees has fallen. Although the relationship of employees to beneficiaries has apparently stabilized (and the trend will actually reverse, probably by the end of the decade), the experience over the last few decades of a falling employee-to-beneficiary ratio has meant lower revenue to the fund during a time of increasing demand for payment.

Traditionally, because management and labor are affected by Federal decisions in railroad retirement, both have been given leading roles in the development of solutions to problems arising in the program. Over the last three years, representatives of management and labor have sought agreement for placing the system on a sound financial basis. The provision adopted by the committee reflects the agreement negotiated by representatives of railway management and labor (including benefit restructuring included in the House-passed omnibus reconciliation bill, H.R. 3982, June 26, 1981).

The rate of tax on railroad employers will be increased from 9.5 to 11.75 percent of taxable compensation. In addition, there will be imposed a tax, in addition to other taxes under the Railroad Retirement Tax Act, of 2.0 percent on the taxable compensation of railroad employees. For the purposes of both the railroad employer and employee taxes, taxable compensation will be that amount of compensation determined under sections 230(c) and (d) of the Social Security Act.

2. Advance transfers to the railroad retirement account

Generally, under the interchange, for a given fiscal year there is computed the amount of social security taxes that would have been collected if railroad employment had been covered directly by social security. This amount is netted against the amount of benefits social security would have paid to railroad beneficiaries based on railroad and nonrailroad earnings during that period. Where social security benefits that would have been paid exceed social security taxes that would have been due, the excess, plus an allowance for interest and administrative expenses, is transferred from the social security trust funds to the Railroad Retirement Account. That transfer is currently estimated to be approximately $1.6 billion for fiscal year 1981. The determination of the amount to be transferred through the financial interchange for a given fiscal year is made in June of the year following the close of the preceding fiscal year. There is no authority in current law that would enable the Railroad Retirement Account to receive transfers of any other funds from the general fund of the Treasury. Revenues to the system are limited under present law to automatically appropriated receipts from railroad retirement taxes, a Federal Government contribution for certain "windfall benefits", and interest earned on invested reserves.

3. Payments of employee taxes by railroad employers

The provision would amend the Railroad Retirement Tax Act so that payments by an employer of employee railroad taxes under sec. 3201, without deduction from the remuneration of the employee, would be included in taxable compensation for RRTA purposes.

(sec. 801 of the bill and sec. 424 of the Code)

An employer who grants a stock option generally is allowed a business expense deduction equal to the amount includible in the employee's income in its corresponding taxable year (sec. 83(h)).

The Revenue Act of 1950 enacted provisions for "restricted stock options," under which neither grant nor exercise of the option gave rise to income to the employee. Instead, income generally was recognized when the employee sold stock received through exercise of the option. No deduction was allowed to the employer matching the amount of income recognized by the employee (the gain or sale of the stock).

If the option price was at least 95 percent of the market price of the stock at the time the option was granted, the entire amount of any gain realized by the employee at the time the stock was sold was treated as capital gain. If the option price was between 85 and 95 percent of the market price at the time the option was granted, the difference between the market value of stock at the time of the option grant and the option price was treated as ordinary income when the stock was sold, and any additional gain at the time the stock was sold was treated as capital gain.

For a stock option to be classified as "restricted," the option price had to have been at least 85 percent of the market price of the stock at the time the option was granted; the stock or the option had to have been held by the employee for at least two years after the date of the granting of the option, and the stock held for at least six months after it was transferred to the employee; the option could not have been transferable other than at death; the individual could not have held ten percent or more of the stock of the corporation (unless the option price was at least 110 percent of the fair market value); and the option could not have been for a period of more than ten years.

Qualified stock options

The Revenue Act of 1964 repealed the restricted stock option provisions and enacted provisions for "qualified stock options." These qualified stock options generally were taxed similarly to restricted stock options.

Qualified options had to be granted with an option price of at least the stock's market price when the option was granted (subject to a 150-percent inclusion in income if a good faith attempt to meet this requirement failed). In addition, qualified stock options were subject to the requirements that the stock had to be held three years or more; the option could not be held more than five years; stockholder approval had to be obtained; the options had to be exercised in the order granted; and no option could be granted to shareholders owning more than five percent of the stock (increased up to ten percent for corporations with less than $2 million equity capital).

1969 Tax Reform Act--Minimum tax and maximum tax

The Tax Reform Act of 1969 enacted a minimum tax, under which a tax was imposed equal to ten percent of the items of tax preference (reduced by a $30,000 exemption plus regular tax liability). Both the bargain element on restricted and qualified stock options and the excluded portion of capital gains were items of tax preference.

In addition, a 50-percent maximum marginal tax rate on income from personal services was added by the 1969 Act. Income eligible for this rate was reduced generally by the sum of the items of tax preference in excess of $30,000.

1976 Tax Reform Act--Repeal of qualified stock options

The Tax Reform Act of 1976 repealed qualified stock option treatment for options granted after May 20, 1976 (except for certain transitional options which ceased to be qualified after May 20, 1981). The 1976 Act also increased the minimum tax rate to 15 percent, reduced the exemptions for the minimum and maximum tax, and permitted deferred compensation to qualify for the 50-percent maximum rate on personal service income.

Revenue Act of 1978--Treatment of capital gains

The Revenue Act of 1978 removed the excluded portion of capital gains from the minimum and maximum tax and made it subject to a new alternative minimum tax. In addition, taxes on capital gains were reduced, so that the maximum rate of tax on capital gains is 28 percent.

The bill reinstitutes "restricted stock options," under which there is no tax consequences when a restricted stock option is granted or when the option is exercised, and the employee is generally taxed at capital gains rates when the stock received on exercise of the option is sold.¹ Similarly, no business expense deduction will be allowed to the employer with respect to a restricted stock option.

Requirements (holding period, etc.)

To receive restricted stock option treatment, the bill provides that the employee must not dispose of the stock within two years after the option is granted, and must hold the stock itself for at least one year. If all requirements other than these holding period rules are met, the tax will be imposed on sale of the stock, but gain will be treated as ordinary income rather than capital gain, and the employer will be allowed a deduction at that time.

In addition, at the time the option is exercised, the option holder must be an employee either of the company granting the option, a parent or subsidiary of that corporation, or a corporation (or parent or subsidiary of that corporation) which has assumed the option of another corporation as a result of a corporate reorganization, liquidation, etc., or must have been such an employee within three months of the date of exercise (twelve months if the employee is disabled (within the meaning of section 105(d)). This requirement and the holding period requirements are waived in the case of the death of the employee.

Terms of option

For an option to qualify as a "restricted stock option," terms of the option itself must meet the following conditions:

The bill provides that stock acquired on exercise of the option may be paid for with stock of the corporation (or its parent or subsidiary) granting the option.

The difference between the option price and the fair market value of the stock at the exercise of the option will not be an item of tax preference.

In the case of an option granted after May 21, 1976, and outstanding on the date of enactment, the option terms (or the terms of the plan under which the option was granted) may be changed, to conform to the restricted stock option rules, within one year of the date of enactment of the bill, without the change giving rise to a new option requiring the setting of an option price based on a later valuation date.

All such changes relate back to the time of granting the original option. For example, if the option price of a ten-year option granted in 1978 is increased during the one year after date of enactment to 85 percent (110 percent, if applicable) of the fair market value of the stock on the date the option was granted in 1978, the price requirement will be met. Likewise, if the term of an option held by a 10-percent shareholder is shortened to five years from the date the option was granted, the 10-percent stock ownership limitation will not apply.

Any restricted stock option must meet the requirements of new section 424(b)(5), limiting the amount of options which may be granted to an employee to $75,000 per year (determined at time of grant). In the case of options outstanding on date of enactment granted under a plan (or plans) providing for the granting of more than $75,000 of options per year, the employer may amend the plan to specify that only certain options under the plan (up to $75,000 granted per year) will be treated as restricted stock options.

2. Property transferred to employees subject to certain restrictions

(sec. 810 of the bill and sec. 83 of the Code)

Generally, if property (including stock) received is not transferable or is subject to a substantial risk of forfeiture (such as the obligation to perform future services), taxation is postponed until the stock or the property is transferable or is no longer subject to a substantial risk of forfeiture. The Tax Court has ruled¹ that section 16(b) of the Securities Exchange Act of 1934, under which an "insider's" profit may be recovered by a corporation if the stock is sold within six months of receipt, does not make the stock nontransferable, and therefore does not affect the taxation of the stock. Thus, the value of the stock (less any amount paid) is treated as compensation when received.

An employer generally is allowed a business expense deduction equal to the amount includible in the employee's income in its corresponding taxable year (sec. 83(h)).

A similar rule is applicable if the stock is subject to restriction by reason of the need to comply with the "Pooling-of-Interests Accounting" rules set forth in Accounting Series Release Numbered 130 ((10/5/72) 37 FR 20937; 17 CFR 211.130) and Accounting Series Release Numbered 135 ((1/18/73) 38 FR 1734; CFR 211.135).

However, for taxable years beginning before January 1, 1982, the provision will apply only if the person receiving the property elects, in accordance with Treasury regulations, to have the provision apply.

Under present law, an individual is allowed a deduction for traveling expenses (including amounts expended for meals and lodging) while away from home overnight in the pursuit of a trade or business (Code sec. 162(a)).¹ These expenses are deductible only if they are reasonable and necessary in the taxpayer's business and directly attributable to it. "Lavish or extravagant" expenses are not allowable deductions. In addition, except as expressly allowed under the Code, no deductions are allowed for personal, living, and family expenses (Code sec. 262). Moreover, deductible "away from home" expenses exclude commuting costs.²

Generally, under Code section 262, expenses and losses attributable to a dwelling unit which is occupied by a taxpayer as his personal residence are not deductible. However, deductions for interest, certain taxes, and casualty losses attributable to a personal residence are expressly allowed under other provisions of the tax laws (Code secs. 163, 164, and 165).

A taxpayer's "home" for purposes of the deduction of traveling expenses generally means his principal place of business or employment. Where a taxpayer has more than one trade or business, or a single trade or business which requires him to spend a substantial amount of time at two or more localities, his "home" is held to be at his principal place of business. A taxpayer's principal place of business is determined on an objective basis taking into account the facts and circumstances in each case. The more important factors to be considered in determining the taxpayer's principal place of business (or tax home) are: (1) the total time ordinarily spent by the taxpayer at each of his business posts, (2) the degree of business activity at each location, (3) the amount of income derived from each location, and (4) other significant contracts of the taxpayer at each location. No one factor is determinative.3

State legislators

Prior to the Tax Reform Act of 1976, there was no special rule for ascertaining the location of a State legislator's tax home. As a result, the generally applicable rules, described previously, determined the location of a State legislator's tax home.

The Tax Reform Act of 1976 provided an election for the tax treatment of State legislators for taxable years beginning before January 1, 1976. This was extended for one year by the Tax Reduction and Simplification Act of 1977 to taxable years beginning before January 1, 1977, and was extended further by Public Law 95-258 to taxable years beginning before January 1, 1978. Public Law 96-167, again, extended the State legislator election to taxable years beginning before January 1, 1981. In the absence of further congressional action, the tax home of a State legislator, for taxable years beginning after 1980, must be determined under the general rules described previously.

The election provisions of the 1976 Act applied to all taxable years beginning before January 1, 1976, for which the period of assessing or collecting a deficiency had not expired before the Act's date of enactment.

Under this election, a State legislator may, for any such taxable year, treat his place of residence within his legislative district as his tax home for purposes of computing the deduction for living expenses. If this election is made, the legislator is treated as having expended for living expenses an amount equal to the sum of the daily amount for per diem generally allowed to employees of the U.S. Government for traveling away from home,⁴ multiplied by the numbers of days during that year that the State legislature was in session, including any day in which the legislature was in recess for a period of four or fewer consecutive days. In addition, if the State legislature was in recess for more than four consecutive days, a State legislator may count each day in which his physical presence was formally recorded at a meeting of a committee of the State legislature. For this purpose, the rate of per diem to be used is to be the rate that was in effect during the period for which the deduction was claimed.

These limitations apply only with respect to living expenses incurred in connection with the trade or business of being a legislator. The 1976 Act did not impose a limitation on living expenses incurred by a legislator in connection with a trade or business other than that of being a legislator. As to any other trade or business, the ordinary and necessary test of prior law continues to apply.⁵

The State legislator provision of the 1976 Act was construed by the Tax Court in Eugene A. Chappie v. Commissioner, 73 T.C. 823 (1980). In that case, the Tax Court held that the generally applicable business deduction rules of the Code (sec. 162) required a California Assemblyman to be away from home overnight in order to be entitled to a business deduction for traveling and living expenses. Because section 604 of the Tax Reform Act of 1976 made no change in this rule for State legislators, the Tax Court held that no such deduction was available as to days when a legislator actually was not away from his tax home (i.e., his place of residence in the district represented) overnight. The Court explained that the present law rules pertaining to business deductions and commuting expenses (Code secs. 162 and 262) precluded a deduction for expenditures incurred in the legislator's travels to and from Sacramento. Because the legislator did not comply with the generally applicable business deduction rules, as modified by section 604 of the Tax Reform Act of 1976, he could not be deemed to have expended the per diem amount allowable to electing State legislators as living expenses under the provision of the 1976 Act.

The bill allows a State legislator to elect, for any taxable year, to treat his residence within the legislative district represented as his "tax home" for purposes of computing the deduction for living expenses allowed under section 162 of the Code. An electing legislator is treated as having expended for living expenses (incurred in connection with the trade or business of being a legislator) an amount equal to the sum determined by multiplying each of the individual's legislative days during the taxable year by the greater of: (1) the amount generally allowable with respect to such a day to employees of the executive branch of the State of which the individual is a legislator for per diem while away from home, or (2) the amount generally allowable for per diem with respect to such day to employees of the U.S. Government for traveling away from home. In determining which per diem allowance is greater, a State per diem allowance for a day is taken into account only to the extent that it does not exceed 110 percent of the Federal per diem for that day.

Under the bill, an electing State legislator is deemed to have expended for business purposes an amount equal to the sum of the appropriate per diem times the legislator's legislative days for the taxable year. In addition, an electing legislator is deemed to be away from home in the pursuit of a trade or business on each legislative day. This is an exception to the general rules of Code section 162. As a result, an electing legislator is entitled to a deduction equal to the sum of that computed under the statutory formula. Because such an individual is deemed to be away from home in the pursuit of a trade or business while incurring the deemed expenses, such an electing legislator is not required to be present at the legislature for that day (or for any day in a legislative recess of four or fewer consecutive days), or away from home overnight. This change, in effect, reverses the Tax Court decision in Chappie v. Commissioner, 73 T.C. 823 (1980), as to electing State legislators only, for open and future tax years. The bill, however, does not provide for opening closed years or for new elections in past years.

In determining the appropriate rate of per diem to be utilized for the deduction computation, the rate of both Federal and State per diems to be used are those rates which were in effect for the legislative days for which the deduction is claimed.

For taxable years beginning after 1980, the bill provides that the generally applicable State legislator rules do not apply to any legislator whose actual home within the district represented is within 50 miles or less of the State capitol building. As a result, such legislators may not elect to have this special provision apply to them. Instead, such legislators must establish the location of their tax homes under the generally applicable facts and circumstances test. In addition, legislators excluded by this 50 mile test may not use the statutory formula for computing deductible business expenses. Rather, these legislators are subject to the business expense tests of Code sections 162 and 274.

(sec. 803 of the bill and sec. 103(b) of the Code)

Certain industrial development bonds qualify for tax exemption where the proceeds of the bonds are used to provide exempt activity facilities. Such facilities include mass commuting facilities. These facilities do not include the equipment used for commuting purposes, such as buses, subway cars, or railroad passenger cars used in a commuting system.

2. Tax exemption for interest on obligations of certain volunteer fire departments

(sec. 811 of the bill and sec. 103 of the Code)

In general, present law excludes from gross income interest on obligations of a State or of its political subdivisions (Code sec. 103(a)(1)). Under Treasury Regulations, the term "political subdivision" includes any division of a State or local governmental unit which is a municipal corporation or which has been delegated the right to exercise part of the sovereign power of the unit (Treas. Reg. sec. 1.103-1(b)). Three generally acknowledged sovereign powers of States are the power to tax, the power of eminent domain, and the police power.¹

Present Treasury Regulations treat obligations issued by or on behalf of any State or local governmental unit by constituted authorities empowered to issue such obligations as the obligations of such a unit (Treas. Reg. sec. 1.103-1(b)). Several requirements must be satisfied in order for an issuer to qualify as a constituted authority of a State or local governmental unit (See Rev. Rul. 57-187, 1957-1 C.B. 65; Rev. Rul. 63-20, 1963-1 C.B. 26; and Prop. Treas. Reg. sec. 1.103-1(c)(2)).²

In an early ruling,³ the Internal Revenue Service ruled that interest received on certificates of indebtedness, known as "fire relief certificates," issued in the State of Minnesota constituted interest on the obligations of a State and, therefore, was not taxable. In another early ruling,⁴ the Service held that interest on fire district bonds issued by a political subdivision of a State and assumed by a private corporation (without releasing the municipality from liability) was exempt from taxation.

The U.S. Tax Court has held that certain volunteer fire departments (in Pennsylvania, West Virginia, Delaware, Maryland, and Kentucky) were not political subdivisions of the States in which they were located and, hence, that interest on their obligations was not exempt from tax under Code section 103(a)(1)(Seagrave Corporation, 38 T.C. 247 (1962)). The rationale for this holding was that the volunteer fire departments involved were not created by any special statutes and received no delegation of State power.

Bonds for tax-exempt fire departments

The exclusion for interest on State and local government bonds does not apply, with certain exceptions, to interest on State and local government issues of "industrial development bonds." An obligation constitutes an industrial development bond if (1) all or a major portion of the proceeds of the issue are to be used in any trade or business of a person other than a State or local government or an organization which is exempt from tax under Code section 501(c)(3), and (2) payment of principal or interest is secured by an interest in, or derived from payments with respect to, property, or borrowed money, used in a trade or business (Code sec. 103(b)(2)). Thus, an obligation issued by a State or local government the proceeds of which would be used by a volunteer fire department that qualifies for tax exemption under Code section 501(c)(3) would not be an industrial development bond⁵ and the interest thereon would be exempt from tax.

To be qualified, the department must be organized and operated to provide firefighting services for persons in an area (within the jurisdiction of a political subdivision of a State) which is not provided with any other firefighting services, and must be required by the political subdivision (by agreement or otherwise) to furnish firefighting services in such area. Furthermore, the fire department must receive more than half of the funds for outfitting its members and providing and maintaining its qualified firefighting property from the political subdivision, and must not charge for its firefighting services.

Qualified firefighting property, for which a tax-exempt obligation can be issued, is depreciable property that is used principally in the performance of (or in training for the performance of) firefighting or ambulance services, or property that is used principally to house such property.

Since no more than $6,000 of wages during either the first or second year of employment may be taken into account with respect to any individual, the maximum credit per individual is $3,000 in the first year of employment and $1,500 in the second year of employment. However, the deduction for wages is reduced by the amount of the credit (determined without regard to the tax liability limitation on the credit). Thus, for an employer who hires an eligible employee who earns $6,000 in his first year of employment, the credit results in an actual tax reduction that ranges from $900 (for an employer in the 70-percent bracket) to $2,580 (for an employer in the 14-period bracket). However, because all wages are deductible for employees who are not members of target groups, after-tax costs of the first $6,000 of wages paid to such employees range from $1,800 (for an employer in the 70-percent bracket) to $5,160 (for an employer in the 14-percent bracket). Thus, the credit provides a 50-percent reduction in the after-tax costs of the first $6,000 of wages paid to target group employees in the first year of employment, regardless of the employer's tax bracket.

The statute contains certification provisions which relieve the employer of responsibility for proving to the Internal Revenue Service that an individual is a member of a target group. The Secretaries of Treasury and Labor are required jointly to designate a single employment agency in each locality to make this determination and to issue a certificate which, without further investigation on the part of the employer, is sufficient evidence that the individual is a member of such group. An exception to this procedure is made for cooperative education students, whose eligibility is certified by the qualified school participating in the program.

The seven target groups are described in detail in the following discussion:

For this purpose, a qualified school is (1) a specialized high school used exclusively or principally for the provision of vocational education to individuals who are available for study in preparation for entering the labor market, (2) the department of a high school used exclusively or principally for providing vocational education to persons who are available for study in preparation for entering the labor market, or (3) a technical or vocational school used exclusively or principally for the provision of vocational education to persons who have completed or left high school and who are available for study in preparation for entering the labor market. In order for a nonpublic school to be a qualified school, it must be exempt from income tax under section 501(a) of the Code. In the case of individuals in this group, wages paid or incurred by the employer are taken into account only if the school certifies that the individual is enrolled in and actively pursuing the qualified cooperative education program, is age 16 through 19, and is not a vocational or high school graduate.

Qualified first-wages for all targeted employees may not exceed 30 percent of FUTA wages for all employees during the calendar year ending in the current tax year.

Finally, in order to prevent taxpayers from escaping all tax liability by reason of the credit, the credit may not exceed 90 percent of the employer's tax liability after being reduced by all other non-refundable credits, except the residential energy credit (sec. 44C), the credit for producing fuel from a non-conventional source (sec. 44D), and the alcohol fuel credit (sec. 44E). Excess credits may be carried back three years and carried forward seven years.

The targeted jobs tax credit may be used as an offset against the alternative minimum tax except to the extent that the minimum tax is attributable to net capital gains and adjusted itemized deductions.

WIN tax credit

No more than $6,000 of wages during either the first or second year may be taken into account with respect to any individual. Thus, the maximum credit per individual employed in a trade or business is $3,000 in the first year of employment and $1,500 in the second year of employment. Since the employer's deduction for wages is reduced by the amount of the credit, an employer who pays an eligible employee $6,000 in his first year of trade or business employment receives an actual reduction in taxes ranging from $900 (for an employer in the 70-percent bracket) to $2,580 (for an employer in the 14-percent bracket). However, because all wages are deductible for non-eligible employees, after-tax costs of the first $6,000 of wages paid to such employees range from $1,800 (for an employer in the 70-percent bracket) to $5,160 (for an employer in the 14-percent bracket). Thus, the credit provides a 50-percent reduction in after-tax costs of the first $6,000 of wages paid to eligible employees in the first year of employment, regardless of the employer's tax bracket.

No credit is available in the case of: (1) expenses reimbursed, for example, by a grant; (2) employees who displace other employees from employment; (3) migrant workers; or (4) employees who are close relatives, dependents, or major stockholders of the employer.

In the case of non-trade or business wages, the maximum amount of creditable wages is $12,000. In effect, this permits a taxpayer to claim the credit for up to two full-time nonbusiness employees.

Finally, the credit for dependent care expenses (Code sec. 44A) may not be claimed with respect to any wages for which the taxpayer is allowed a WIN-welfare recipient credit.

The WIN credit may be used as an offset against the alternative minimum tax, except to the extent that the alternative minimum tax is attributable to net capital gains and adjusted itemized deductions, to the extent the credit is attributable to the active conduct of a trade or business by the taxpayer claiming the credit.

First, the committee believes that the credit should be extended for three years, so that all employees who are hired before 1985 will be eligible for a full two years of credit.

Second, the bill provides an increase in the amount of annual wages taken into account, in order to provide an additional incentive for employers to hire target group members for jobs the wages of which may exceed the minimum wage.

Third, the committee believes that cooperative education students should be eligible only if they are members of economically disadvantaged families. At the same time, other economically disadvantaged youth, in other educational programs, should be eligible for the credit, since the increased availability of jobs may encourage them to continue their schooling. Handicapped children in special education programs also should be eligible for the credit.

Fourth, the WIN credit is merged with the targeted jobs credit. The existence of similar credits for different groups of employees has proved to be confusing to employers, and it is hoped that including AFDC recipients and WIN registrants in the targeted jobs credit will increase the hiring opportunities available to these individuals and simplify the overall administration of the program.

Fifth, the bill requires that certification that an individual is a member of a target group be made within 30 days of the hiring date. This change will allow the credit only to those employers for whom it provides an incentive to hire target-group members.

Sixth, the bill provides that the state employment security agencies and the United States Employment Services are the agencies which should have the responsibility for administering and publicizing the credit. The diffusion of responsibility among several agencies in the past few years has limited employer participation.

In addition, the bill provides for various technical amendments in order to simplify the structure and administration of the credit.

Extension of credit

Under the bill, the targeted jobs tax credit is available for the wages paid to eligible individuals who begin work for the employer before January 1, 1985. Thus, if an eligible individual begins work on December 31, 1984, the employer would be able to claim the credit with respect to qualified first-year and qualified second-year wages paid to that employee.

Amount of credit

The amount of wages eligible for the credit is increased from $6,000 to $10,000. Thus, the maximum credit is $5,000 for the first year of employment and $2,500 for the second year of employment. In the case of an employee who begins work prior to January 1, 1982, the increased credit would apply to qualified second-year wages if the employee's second year of employment begins after December 31, 1981.

Targeted groups

Several changes are made to the provisions relating to targeted groups. The credit for youths participating in qualified cooperative education programs is limited to youths who are economically disadvantaged, in the case of youths hired after December 31, 1981. Qualified cooperative education includes a program of special education for handicapped children, and participants in such a program will be target group members even if they are not members of economically disadvantaged families. Economically disadvantaged youths includes individuals who are 16 and 17 years of age, provided that, unless they have graduated from high school or vocational school, they have not terminated their education. The committee intends that the State employment security agencies are to develop a system to insure that employers cannot claim a credit for continued employment of students who drop out of school after their hiring date. Moreover, WIN registrants and AFDC recipients will be added to the list of targeted groups. Because of this, the WIN credit will not be available with respect to amounts paid or incurred in taxable years beginning after December 31, 1981. Furthermore, in the case of Vietnam veterans, the age limitation will be eliminated. Thus, employers will be able to claim credit for hiring Vietnam veterans who are age 35 or over.

Certification

The bill revises the rules relating to the certification of individuals or members of target groups. In general, a certification is not effective unless made before the 30th day after the hiring date, however, later certifications will be permitted if the employer requests certification in writing within that time. The bill provides that certifications are to be made by State employment security agencies. The committee intends that other agencies involved in providing information for certification, such as the Social Security Administration (for SSI recipients) and the Veterans' Administration (for handicapped and Vietnam-era veterans), will fully cooperate with the State employment security agencies requests for assistance in administering the certification process.

Wage limitation

The bill eliminates the FUTA wage limitation on first-year wages eligible for the credit. Thus, employers will receive credit for first-year wages paid to targeted employees even though those wages may exceed 30 percent of FUTA wages paid to all employees.

Technical changes

The bill makes several technical changes to the targeted jobs tax credit. For example, the bill provides that a determination that an individual is a member of an economically disadvantaged family will be valid for 45 days from the date on which the determination is made. Moreover, the bill provides that the United States Employment Service (rather than the Department of Labor) will have the responsibility for keeping employers apprised of the availability of the targeted jobs tax credit. The committee intends that the Internal Revenue Service should fully cooperate with the Employment Service's efforts to market and publicize the credit. Furthermore, the bill provides that no credit will be available for the hiring of certain related individuals (primarily dependents of the taxpayer). The bill also clarifies that the hiring date is the day on which the employee is first hired by the employer, and thus is not any date on which an employee is subsequently rehired by the same employer. This result was the original intent of the provision.

The changes in the certification requirements will apply to individuals whose hiring dates are after July 16, 1981.

Some fringe benefits, such as the provision of health insurance by an employer for its employees, are expressly excluded from gross income by the Internal Revenue Code; others are excluded by legislation outside the Code; and yet other exclusions are based on judicial authority or on administrative practice. Some fringe benefits have been excluded under administrative practice on the basis of a de minimis principle, i.e., accounting for the benefit would be unreasonable or administratively impractical. Other items are excluded due to a combination of valuation difficulties and wide-held perceptions that the items do not constitute income.

In 1978, Congress enacted Public Law 95-427, to prohibit the Treasury Department from issuing final regulations, under section 61 of the Code, relating to the income tax treatment of fringe benefits prior to 1980. The Act further provided that no regulations relating to the treatment of fringe benefits under section 61 were to be proposed which were to be effective prior to 1980. Public Law 96-167 extended the prohibition on fringe benefit regulations through May 31, 1981.

Although the provisions of the bill relate only to the issuance of regulations, it is the committee's intent that the Treasury Department not alter, or deviate from, in any significant way, the historical treatment of fringe benefits through the issuance of revenue rulings or revenue procedures.

On November 22, 1976, the IRS published Revenue Ruling 76-453 (1976-2 C.B. 86) which states that a taxpayer's transportation expenses incurred in traveling between the taxpayer's residence and place of work, even though temporary, will be nondeductible commuting expenses, regardless of the nature of the work performed, the distance traveled, the mode of transport, or the degree of necessity. In addition, the ruling states that reimbursement for such expenses will be considered "wages" for purposes of FICA, FUTA, and income tax withholding. The ruling was originally effective for transportation costs paid or incurred after December 31, 1976. The Service postponed the effective date of this ruling, and on September 23, 1977, announced that the ruling was suspended indefinitely and that proposed regulations inviting public comment would be issued shortly. Proposed regulations have not as yet been issued.

Public Law 95-427 was enacted in 1978, and amended by Public Law 96-167, to require that the application of the income tax, FICA, FUTA, and withholding provisions relating to the treatment of transportation expenses paid or incurred after 1976 and before June 1, 1981, in traveling between a taxpayer's residence and place of work, made fully in accordance with the rules in effect prior to the issuance of Revenue Ruling 76-453 on November 22, 1976.

As a result of using the "mirror image," whenever U.S. income tax law is amended, the tax laws of Guam and the Virgin Islands are also changed automatically. The passage of the Tax Reduction Act of 1975 and the Tax Reduction and Simplification Act of 1977, for example caused an identical change in the "mirror image" laws of these possessions. Thus, the refunds and other income tax reductions under the 1975 and 1977 Acts reduced the tax collections in these possessions, which, in interaction with restrictions placed upon their governments to issue indebtedness, caused a financial hardship for the possessions.

In the case of the Virgin Islands, the burden caused by the Tax Reduction Act of 1975 was reduced by passage in late 1976 of legislation (P.L. 94-392) which authorized an $8.5 million appropriation for the government of the Virgin Islands to reimburse it for at least part of the tax revenues it lost under the 1975 Act. Public Law 95-134 authorized additional appropriations of $15 million to Guam and $14 million to the Virgin Islands to reimburse them for lost revenues under the 1975 Act and the Tax Reform Act of 1976. Both of these reimbursement bills were handled by the Interior Committees and together they provided Guam and the Virgin Islands with compensation for the losses they sustained in 1975 and 1976 as the result of the 1975 and 1976 Acts.

The Tax Reduction and Simplification Act of 1977 authorized appropriations to compensate Guam, the Virgin Islands, and American Samoa for reductions during 1977 in their tax receipts attributable to changes in the standard deduction and general tax credit made by the Act. Further, Public Law 96-597 authorized additional declining appropriations ranging from $15 million in fiscal 1982 to $4 million in fiscal 1985 for Guam and $12 million to $3 million for the same years for the Virgin Islands.

Receipt of this payment by a possession is made contingent on its furnishing certain information to the Secretary of the Treasury that may be needed to prevent double payments of a tax refund and a special payment to beneficiaries of certain income maintenance programs.

Enacted in 1935, Part II of the Interstate Commerce Act (the "1935 Act") provided the basic framework for regulation of the motor carrier industry until enactment of the Motor Carrier Act of 1980. Under the 1935 Act, carriers were obligated to provide nondiscriminatory service at regulated rates for the public convenience and necessity, and further industry regulation was effected by issuing or withholding certificates of operating authority.

During the period 1935 to 1980, the Interstate Commerce Commission ("ICC") granted a limited number of permits and certificates of operating authority to motor carriers and freight forwarders. The basis for the grant of an authority from the ICC was a showing that additional services of the type for which authority was sought was, or would be, required by the public convenience and necessity. Businesses with existing operating rights could intervene in a proceeding for a request of operating authority to show that the proposed service was not, or would not be, required by the public convenience and necessity.

The right of existing operators to intervene (based on ICC procedural rules) and the applicant's burden of showing that the proposed service was required by the public convenience and necessity (based on the 1935 Act) gave existing operators protection against competition. Persons wishing either to enter the motor carrier business or expand an existing business, therefore, often would purchase an existing business with its operating authority.

Substantial amounts were paid for these operating authorities, reflecting, in part, the protection against competition afforded authority owners under ICC administration of the 1935 Act. The value of the operating authorities provided owners with an asset that constituted a substantial part of a carrier's asset structure and a source of loan collateral.

In 1975, the ICC began to grant a higher percentage of requests for operating authorities under the standard of "required by the public convenience and necessity." On July 1, 1980, the Motor Carrier Act of 1980 was enacted (P.L. 96-296). Under the 1980 Act, applicants need not show that the proposed service is required by the public convenience and necessity. Existing operators protesting the grant of an authority bear the burden of showing the proposed service is inconsistent with the public convenience and necessity. Thus, the 1980 statute further lessened restrictions on entry into the interstate motor carrier business. However, an operating authority still must be obtained to conduct interstate motor carrier business. As a result of the increased ease of gaining entry into the interstate motor carrier business, the value of motor carrier operating authorities has been diminished substantially.

The ICC, following an opinion of the Financial Accounting Standards Board, has required that the value assigned to certificates of authority in the regulated books of motor carriers be written off in one year.

Deduction for realized loss of property

Code section 165 allows a deduction for certain losses, including any loss incurred in a trade or business which is sustained during the taxable year and not compensated for by insurance or otherwise. In general, the amount of the deduction equals the adjusted basis of the property involved (sec. 165(b)).

Treasury regulations provide that, to be allowable as a deduction, the loss must be realized, i.e., "evidenced by closed and completed transactions, fixed by identifiable events" (Treas. Reg. Sec. 1.165-1(b)). As a general rule, no deduction is allowed for a decline in value of property absent a sale, abandonment, or other disposition of the property¹ nor for loss of anticipated income or profits.² Thus, for a loss to be allowed under present law, generally either the business must be discontinued or the property must be abandoned or permanently discarded from use in the business (Treas. Reg. Sec. 1.165-2). Generally, if a capital asset declines in value and is sold or exchanged at a loss, the loss is a capital loss, the deduction of which is subject to the limitations of sections 1211 and 1212 (sec. 165(f)).

The courts, in several decisions,³ have denied a loss deduction when the value of an operating permit or license decreased as a result of legislation expanding the number of licenses or permits that could be issued. These decisions held that the diminution in the value of a license or permit did not constitute an event giving rise to a loss deduction under section 165 if the license or permit continued to have value as a right to carry on a business.

In the Consolidated Freight Lines case,⁴ the Ninth Circuit denied deductions for lost "monopoly rights" when the State of Washington deregulated the intrastate motor carrier industry by eliminating restrictions on entry. The court reasoned that the taxpayer had not lost any rights conferred by the certificate of operating authority because the taxpayer still was permitted to do business and the operating authority had not given any further rights. Any "monopoly rights," the court stated, resulted from legislation and State administration restricting the availability of operating authorities. Since the taxpayer could not own (or purchase) property rights in legislation or regulations, repeal or modification of legislation or regulations did not give rise to a deductible loss, even if such action had the result of making the taxpayer's business property less valuable.

The committee concludes that the unique circumstances of the deregulation of the interstate motor carrier industry requires some form of relief that is not available under the present tax laws.

Under the committee bill, adjustments are to be made to the bases of operating authorities held on July 1, 1980 (or acquired thereafter under a binding contract in effect on July 1, 1980) to reflect amounts allowable as deductions.

Under regulations to be prescribed by the Secretary, a taxpayer may elect to allocate to the basis of an operating authority held by the taxpayer on July 1, 1980, a portion of the cost basis in the stock of a qualified acquiring corporation. A qualified acquiring corporation is a corporation that directly or indirectly acquired the stock of a corporation on or before July 1, 1980 (or after such date under a binding contract in effect on such date) and such acquired corporation held the operating authority at the time of acquisition. If the acquiring corporation directly acquired the stock of a corporation holding the operating authority, a portion of the acquiring corporation's cost basis in the stock of the acquired corporation could be allocated to the operating authority. The portion allocable is the amount that would have been properly allocable under section 334(b)(2) if the acquiring corporation had liquidated the acquired corporation immediately after its acquisition. In the case of an acquiring corporation that indirectly acquired the stock of a corporation holding an operating authority (such as by directly acquiring the stock of one or more other corporations), a portion of the acquiring corporation's cost basis in the stock of the directly acquired corporation or corporations could be allocated to the operating authority. The portion allocable is the portion that would have been properly allocable under section 334(b)(2) if immediately after the direct acquisition the directly and indirectly acquired corporations had been liquidated in such a way that the acquiring corporation would have received the operating authority.

It is anticipated that under regulations the holder of an authority on July 1, 1980, will be able to make an election under this special provision only if the holder is the qualified acquiring corporation or a member of an affiliated group as defined in section 1502(a) of which the qualified acquiring corporation is a member.

Further, it is anticipated that under regulations, a holder will not have a choice of more than one election with respect to one operating authority because more than one qualified acquisition has been made by a member or members of an affiliated group.

In all cases, adjustments shall also be made to the basis of the stock of the acquiring corporation to take into account any allocation of the basis in the stock to an operating authority. In addition, the regulations shall in all cases, provide for an appropriate adjustment to the basis of other assets.

If State unemployment tax revenues exceed unemployment benefits expenditures, the surplus amounts are retained by the State in an interest-bearing account in the Federal Unemployment Trust Fund. If benefit costs exceed revenues, States draw down their accumulated surpluses from prior years. If those surpluses become depleted, States are allowed to receive interest-free Federal loans, up to the amount necessary to meet State unemployment benefit costs, from an account which is funded through the Federal unemployment payroll tax. (If there are insufficient Federal unemployment tax revenues for this purpose, additional funds are obtained from the general fund of the Treasury.)

The standard net Federal unemployment tax (FUTA), which is paid by all covered employers in all States, is currently 0.7 percent on the first $6,000 of wages paid annually to each employee. (The gross FUTA tax rate is 3.4 percent: however, employers are eligible for a 2.7 percent credit, unless this credit has been reduced because of overdue outstanding loans as explained below. The standard 2.7 percent credit reduces the gross tax rate from 3.4 to the net rate of 0.7 percent.)

States that borrow funds from the Federal unemployment account have 2 to 3 years to repay the loan, depending on the month the loan is received. (Technically, a State has until November 10 of the calendar year in which the second consecutive January 1 passes with the State still having an outstanding advance. This means that a State may have from 22 months and 10 days to 34 months and 10 days to repay the advance, depending on when it obtained the outstanding advance.) If a State does not fully repay the loan within the 2-to 3-year period, employers in the State become subject to an annual 0.3 percent reduction in the 2.7 percent credit against the 3.4 Federal tax. (In other words, the 0.7 percent net Federal unemployment tax rate becomes subject to 0.3 percent annual increases). The credit reduction is applied to the calendar year beginning with the second consecutive January 1 in which the loan has been outstanding and continues until it is repaid fully. The increase in the Federal tax resulting from the credit reduction is payable no later than January 31 of the calendar year following the calendar year to which the increase applies. The proceeds from the increased tax are used to reduce the principal of the State's outstanding loan.

The credit reduction (or increase in the 0.7 percent net Federal tax rate) of 0.3 percent per year increases each year until the maximum FUTA tax rate of 3.4 percent is reached. In addition, there are two additional potential credit reductions during the ensuing calendar year in which the loan is outstanding: (a) in the calendar years in which the third and fourth consecutive January firsts pass, the employers in the State face an additional reduction equal to the amount that 2.7 percent exceeds the State's average tax rate on taxable wages in the calendar year to which the reduction applies: (b) in the calendar years in which the fifth through ninth consecutive January firsts pass, the employers face a reduction equal to the higher of the amount in (a) or the amount that the State's 5-year benefit-cost rate exceeds the State's average tax rate on taxable wages in the calendar year to which the reduction applies. The 5-year benefit-cost rate is one-fifth of the benefits paid in the first 5 of the last 6 completed calendar years preceding the calendar year to which the credit reduction applies, divided by taxable wages in the last of the same preceding calendar years.

The committee determined that the current reduction in Federal credit offset did not contemplate the huge debt which some States have accumulated. The 0.3 of 1 percent (in some cases even greater) increase each year rapidly escalates into a huge tax burden and does not recognize any action the State might take to lower benefits or raise State taxes in order to become solvent. The committee capped the Federal credit reduction only when certain solvency conditions are met. Again, because of the nature of the problem facing several States, the solvency test becomes more difficult with the passage of time. The solvency test adopted by the committee recognized that the solvency of the unemployment compensation system should be measured over the length of an economic cycle and not by what happens to a State's trust fund over a one-year period.

Effective October 1, 1981, in States that meet the solvency requirements described below, reductions in the Federal tax credit resulting from outstanding Federal loans would be limited to 0.6 percent; or, if higher, the level that was in effect in the year prior to the year the State qualifies for the limitation. In a State in which the credit reduction exceeds 1.0 percent, it would be decreased by 0.3 percent per year, but not below 1.0 percent, in any year in which the State meets the solvency requirements. The years in which a State meets the requirements, and therefore qualifies for a limitation (or decrease) in the credit reduction, would not count in determining the level of the increase in the net Federal tax in subsequent years in which the State does not meet the solvency requirements.

In order to qualify for the limitation on the credit reduction, a State must meet the following conditions:

A State with outstanding Federal loans in default (i.e., loans that have not been repaid within the period allowed before a credit reduction takes effect) could avoid the automatic increase in the Federal tax for any year in which it repays by September 30 of that year a lump sum amount equal to the amount of revenues that would have been generated by the increase in the Federal tax, plus, for tax years beginning with 1983, any additional loans it received during the previous 12 months. A State could use this method of repayment only if the Secretary of Labor certifies that it has sufficient funds in its State unemployment trust fund to finance all unemployment compensation benefits for the months remaining in the calendar year in which the lump sum repayment is made without borrowing additional Federal funds.

For any year in which a State uses the lump-sum repayment option, the additional Federal unemployment taxes that would have been levied on employers if the State had not made the lump sum repayment would not be added to the State taxes for purposes of determining the estimated average unemployment tax rate in the State under the solvency requirement (c) described above. A lump-sum repayment in lieu of increases in the Federal tax would not be considered a "non-FUTA repayment" for purposes of the provision described in item 4 below.

3. Interest on Federal unemployment compensation loans to States

Interests would be charged on Federal unemployment loans to States received after October 1, 1982. The rate of interest charged in any year would be the same rate as that paid by the Federal government on balances in State unemployment trust funds for the quarter ending December 31 of the preceding year, up to a maximum of 10 percent per annum.

A State would not have to pay interest on a loan that is repaid by September 30 of the calendar year in which the advance was received, if the State receives no new advances during the period remaining in the calendar year following the repayment. If a State does receive additional loans during the period remaining in calendar year after such a repayment, interest would be charged on the repaid loan from the date it was received until the date it was repaid. Interest on new loans would be waived for a period of up to two years (depending on the month in which the loan is received) if the State is not subject to a credit reduction because of outstanding Federal unemployment loans and the State has an average State tax rate (State unemployment taxes divided by total wages) equal to at least 150 percent of the national average.

Beginning January 1, 1989, interest would be charged on the outstanding amounts of all loans received prior to or after enactment of this act, except as specifically excluded in the preceding paragraph.

Interest would be payable on the last day of the fiscal year in which the loan is received. The payment of interest on loans received in the last six months of any fiscal year could be delayed until the last day of the following fiscal year; however, interest at the rate specified above would be charged against the amount of interest for which payment was delayed. A State could not pay interest on Federal loans out of its unemployment trust fund.

4. Non-FUTA repayments

Any non-FUTA State repayments (not including the lump sum repayment in lieu of the credit reduction in Item #2 above) would be credited first to the most recent loans received by the State that have not triggered a credit reduction.

The interest charge on unemployment loans to States applies to loans received after October 1, 1982.

[Estimate Table not reproduced.]

Under the Administration's economic assumptions, the Treasury Department estimates of the net budget changes made by H.R. 4242 differ from those made by the committee. Treasury estimates are shown below and are comparable to the committee estimates, but do not include the effects of the 1984 individual income tax rate reductions.

[Estimate Table not reproduced.]

As a result, the committee took the following actions: (1) it reduced individual income taxes generally and provided other reductions for certain targeted individuals; (2) it increased the ability of business to replace obsolescent equipment and to increase capital formation by depreciation reform, adjustments in the investment credit, reducing corporate income tax rates and modified small business tax provisions; (3) it expanded incentives for personal saving through increases in deductions for individual retirement accounts, tax-exemption for all-savers certificates interest and reinvestment of public utility dividends; (4) it reduced the tax burden on smaller estates by increasing the credit against the unified estate and gift tax, eased the tax burden on estates with a closely held business or farm, and reduced the tax rates on the taxable estate; (5) it reduced the ability of individuals to use tax straddles on commodity exchanges to shelter from the income tax ordinary income earned in other activities; (6) it made revisions to oil and energy-related tax provisions; (7) it made adjustments in various activities related to tax administration and estimated tax payment provisions; (8) it approved several miscellaneous amendments; (9) it modified the railroad retirement tax provisions; and (10) it made revisions in the Federal unemployment fund loan provisions.

Under the tax cuts that would go into effect in 1981 and 1982, the increased outlays due to revisions in the refundable earned income credit will be $49 million in fiscal year 1982, $649 million in 1983, $638 million in 1984, $586 million in 1985, and $540 million in 1986. If the tax cuts approved provisionally for 1984 are put into effect because of economic conditions, the additional outlays that result will increase total outlays in fiscal year 1984 to $656 million, in 1985 to $1,130 million and in 1986 to $1,039 million.

This bill authorizes payments to the Governments of Guam and the Virgin Islands to compensate for the losses in tax revenue associated with the tax reductions. The estimated increases in budget outlays will be $17 million in fiscal year 1982, $38 million in fiscal year 1983, $54 million in fiscal year 1984, $56 million in fiscal year 1985, and $58 million in fiscal year 1986.

Increased tax expenditures

Increases in individual tax expenditures will be made for the earned income credit, the child care credit, and U.S. citizens who earn income in foreign countries. Business tax expenditures will be increased by the general acceleration of rates of depreciation for both personal and real property, increasing the investment credit for rehabilitation of older structures, extending the period during which construction period interest and taxes may be expensed, extending the investment carryback period for unused investment credits of distressed industries, increasing the carryforward period for all unused investment tax credits, and lower tax rates for small corporations.

Tax expenditures for personal savings will be expanded by increasing deductible amounts for contributions to individual retirement accounts, the exclusion of interest income on certain savings certificates, and allowing tax-free reinvestment of dividend income in public utility stock. Capital gains received from the sale of a principal residence need not be reinvested in another principal residence for 2 years, and the one-time exclusion of gain for taxpayers 55 years or older is increased from $100,000 to $125,000. Certain tax expenditures within the estate and gift tax provisions will be increased.

Other increases in tax expenditures are the increased allowance for State legislators' expenses away from home, tax-exempt financing for fire-fighting equipment for volunteer fire companies and vehicles used for mass commuting vehicles, and adjustments in the targeted jobs credit.

New tax expenditures

Under the bill, the new tax expenditures are the deduction for two-earner families, the tax credits for increasing research expenditures and for contributions to university research activities, and the tax credit to builders of passive solar homes.

Decreased tax expenditures

Tax expenditures will be decreased by the repeal of the investment tax credit for expense-method depreciated property, reducing use of commodity tax straddles, treating loans to owner-employees from self-employed pension plans as taxable contributions, reducing the deferral on foreign gas and oil income, and repealing the $100/$200 interest exclusion.

U.S. CONGRESS, CONGRESSIONAL BUDGET OFFICE, Washington, D.C., July 24, 1981. Hon. DAN ROSTENKOWSKI, Chairman, Committee on Ways and Means, U.S. House of Representatives, Washington, D.C.

DEAR MR. CHAIRMAN: Pursuant to Section 403 of the Budget Act, the Congressional Budget Office has examined the House Committee on Ways and Means tax bill, H.R. 4242, the Tax Incentive Act of 1981. This bill contains the following general tax provisions:

Sincerely, ALICE M. RIVLIN, Director.