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JCT Compiles Reports on Camp Tax Reform Discussion Draft

SEP. 1, 2014

JCS-1-14

DATED SEP. 1, 2014
DOCUMENT ATTRIBUTES
Citations: JCS-1-14

 

[JOINT COMMITTEE PRINT]

 

 

Prepared by the Staff

 

of the

 

JOINT COMMITTEE ON TAXATION

 

 

September 2014

 

 

U.S. Government Printing Office

 

Washington: 2014

 

 

JCS-1-14

 

 

JOINT COMMITTEE ON TAXATION

 

 

113TH CONGRESS, 2ND SESSION

 

 

SENATE

 

 

Ron Wyden, Oregon

 

Chairman

 

John D. Rockefeller IV, West Virginia

 

Debbie Stabenow, Michigan

 

Orrin G. Hatch, Utah

 

Chuck Grassley, Iowa

 

 

HOUSE

 

 

Dave Camp, Michigan

 

Vice Chairman

 

Sam Johnson, Texas

 

Kevin Brady, Texas

 

Sander M. Levin, Michigan

 

Charles B. Rangel, New York

 

 

Thomas A. Barthold, Chief of Staff

 

Bernard A. Schmitt, Deputy Chief of Staff

 

 

                                CONTENTS

 

 

 INTRODUCTION

 

 

 TECHNICAL EXPLANATION OF THE TAX REFORM ACT OF 2014, A DISCUSSION

 

 DRAFT OF THE CHAIRMAN OF THE HOUSE COMMITTEE ON WAYS AND MEANS

 

 TO REFORM THE INTERNAL REVENUE CODE

 

 

 TITLE I -- TAX REFORM FOR INDIVIDUALS

 

 

      A. Individual Income Tax Rate Reform

 

 

         1. Simplification of individual income tax rates (secs. 1001

 

            and 1003 of the discussion draft and secs. 1 and 2 of the

 

            Code)

 

 

         2. Deduction for capital gains and dividends of individuals

 

            (sec. 1002 of the discussion draft and sec. 169 of the

 

            Code)

 

 

      B. Simplification of Tax Benefits for Families

 

 

         1. Standard deduction (sec. 1101 of the discussion draft and

 

            sec. 63 of the Code)

 

 

         2. Increase and expansion of child tax credit (sec. 1102 of

 

            the discussion draft and sec. 24 of the Code)

 

 

         3. Modification of earned income tax credit (sec. 1103 of the

 

            discussion draft and sec. 32 of the Code)

 

 

         4. Repeal of deduction for personal exemptions (sec. 1104 of

 

            the discussion draft and sec. 151 of the Code)

 

 

      C. Simplification of Education Benefits

 

 

         1. American opportunity tax credit (sec. 1201 of the

 

            discussion draft and sec. 25A of the Code)

 

 

         2. Expansion of Pell grant exclusion from gross income (sec.

 

            1202 of the discussion draft and sec. 117 of the Code)

 

 

         3. Repeal of exclusion of income from United States savings

 

            bonds used to pay higher education expenses (sec. 1203 of

 

            the discussion draft and sec. 135 of the Code)

 

 

         4. Repeal of deduction for interest on education loans (sec.

 

            1204 of the discussion draft and sec. 221 of the Code)

 

 

         5. Repeal of deduction for qualified tuition and related

 

            expenses (sec. 1205 of the discussion draft and sec. 222 of

 

            the Code)

 

 

         6. No new contributions to Coverdell education savings

 

            accounts (sec. 1206 of the discussion draft and sec. 530 of

 

            the Code)

 

 

         7. Repeal of exclusion for discharge of student loan

 

            indebtedness (sec. 1207 of the discussion draft and sec.

 

            108(f) of the Code)

 

 

         8. Repeal of exclusion for qualified tuition reductions (sec.

 

            1208 of the discussion draft and sec. 117(d) of the Code)

 

 

         9. Repeal of exclusion for education assistance programs (sec.

 

            1209 of the discussion draft and sec. 127 of the Code)

 

 

        10. Repeal of exception to 10-percent penalty for higher

 

            education (sec. 1210 of the discussion draft and sec. 72(t)

 

            of the Code)

 

 

      D. Repeal of Certain Credits for Individuals

 

 

         1. Repeal of dependent care credit (sec. 1301 of the

 

            discussion draft and sec. 21 of the Code)

 

 

         2. Repeal of credit for adoption expenses (sec. 1302 of the

 

            discussion draft and sec. 23 of the Code)

 

 

         3. Nonbusiness energy property credit (sec.1303 of the

 

            discussion draft and sec. 25C of the Code)

 

 

         4. Credit for residential energy efficient property (sec. 1304

 

            of the discussion draft and sec. 25D of the Code)

 

 

         5. Repeal of credits for alternative fuel vehicles and

 

            alternative fuel refueling property (secs. 1305 through

 

            1308 of the discussion draft and secs. 30, 30B, 30C, and

 

            30D of the Code)

 

 

         6. Repeal of credit for health insurance costs of eligible

 

            individuals (sec. 1309 of the discussion draft and sec. 35

 

            of the Code)

 

 

         7. Repeal of first time homebuyer credit (sec. 1310 of the

 

            discussion draft and sec. 36 of the Code)

 

 

      E. Deductions, Exclusions, and Certain Other Provisions

 

 

         1. Exclusion of gain from sale of a principal residence (sec.

 

            1401 of the discussion draft and sec. 121 of the Code)

 

 

         2. Mortgage interest (sec. 1402 of the discussion draft and

 

            sec. 163 of the Code)

 

 

         3. Charitable contributions (sec. 1403 of the discussion draft

 

            and sec. 170 of the Code)

 

 

         4. Denial of deduction for expenses attributable to the trade

 

            or business of being an employee (sec. 1404 of the

 

            discussion draft and sec. 62(a)(2) and new sec. 262A of the

 

            Code)

 

 

         5. Repeal of deduction for taxes not paid or accrued in a

 

            trade or business (sec. 1405 of the discussion draft and

 

            sec. 164 of the Code)

 

 

         6. Repeal of deduction for personal casualty losses (sec. 1406

 

            of the discussion draft and sec. 165 of the Code)

 

 

         7. Limitation on wagering losses (sec. 1407 of the discussion

 

            draft and sec. 165(d) of the Code)

 

 

         8. Repeal of deduction for tax preparation expenses (sec. 1408

 

            of the discussion draft and sec. 212 of the Code)

 

 

         9. Repeal of deduction for medical expenses (sec. 1409 of the

 

            discussion draft and sec. 213 of the Code)

 

 

        10. Repeal of the disqualification of expenses for

 

            over-the-counter drugs under certain accounts and

 

            arrangements (sec. 1410 of the discussion draft and secs.

 

            106 and 223 of the Code)

 

 

        11. Repeal of deduction for alimony payments and corresponding

 

            inclusion in gross income (sec. 1411 of the discussion

 

            draft and secs. 71 and 215 of the Code)

 

 

        12. Repeal of deduction for moving expenses (sec. 1412 of the

 

            discussion draft and sec. 217 of the Code)

 

 

        13. Termination of deduction and exclusions for contributions

 

            to medical savings accounts (sec. 1413 of the discussion

 

            draft and secs. 106(b) and 220 of the Code)

 

 

        14. Repeal of two-percent floor on miscellaneous itemized

 

            deductions (sec. 1414 of the discussion draft and sec. 67

 

            of the Code)

 

 

        15. Repeal of overall limitation on itemized deductions (sec.

 

            1415 of the discussion draft and sec. 68 of the Code)

 

 

        16. Deduction for amortizable bond premium allowed in

 

            determining adjusted gross income (sec. 1416 of the

 

            discussion draft and sec. 62 of the Code)

 

 

        17. Repeal of exclusion, etc., for employee achievement awards

 

            (sec. 1417 of the discussion draft and secs. 74(c) and

 

            274(j) of the Code)

 

 

        18. Clarification of special rule for certain governmental

 

            plans (sec. 1418 of the discussion draft and sec. 105(j) of

 

            the Code)

 

 

        19. Limitation on exclusion for employer-provided housing (sec.

 

            1419 of the discussion draft and sec. 119 of the Code)

 

 

        20. Fringe benefits (sec. 1420 of the discussion draft and sec.

 

            132 of the Code)

 

 

        21. Repeal of exclusion of net unrealized appreciation in

 

            employer securities (sec. 1421 of the discussion draft and

 

            sec. 402(e)(4) of the Code)

 

 

        22. Consistent basis reporting between estate and person

 

            acquiring property from decedent (sec. 1422 of the

 

            discussion draft and secs. 6035 and 6724 of the Code)

 

 

      F. Employment Tax Modifications

 

 

         1. Modifications of deduction for Social Security taxes in

 

            computing net earnings from self-employment (sec. 1501 of

 

            the discussion draft and sec. 1402(a)(12) of the Code)

 

 

         2. Determination of net earnings from self-employment (sec.

 

            1502 of the discussion draft and secs. 3101, 3102, 2111,

 

            1401, and 1402 of the Code)

 

 

         3. Repeal of exemption from FICA taxes for certain foreign

 

            workers (sec. 1503 of the discussion draft and secs.

 

            3121(b)(1) and (b)(19) and section 3231(e)(1) of the Code)

 

 

         4. Repeal of exemption from FICA taxes for certain students

 

            (sec. 1504 of the discussion draft and sec. 3121(b)(2) and

 

            (b)(10) of the Code)

 

 

         5. Override of Treasury guidance providing that certain

 

            employer-provided supplemental unemployment benefits are

 

            not subject to employment taxes (sec. 1505 of the

 

            discussion draft and sec. 3402(o)(1)(A) and (o)(2)(A) of

 

            the Code)

 

 

         6. Certified professional employer organizations (sec. 1506 of

 

            the discussion draft and new secs. 3511 and 7706 of the

 

            Code)

 

 

      G. Pensions and Retirement

 

 

         1. Changes to rules for individual retirement arrangements

 

            (secs. 1601 through 1604 of the discussion draft and secs.

 

            219, 408, and 408A of the Code)

 

 

         2. Repeal of exception to 10-percent penalty for first-time

 

            home purchases and elimination of first-time home purchase

 

            as a qualified distribution from a Roth IRA (sec. 1605 of

 

            the discussion draft and secs. 72(t) and 408A of the Code)

 

 

         3. Termination of new simplified employee pensions (sec. 1611

 

            of the discussion draft and sec. 408(k) of the Code)

 

 

         4. Termination for new SIMPLE 401(k) plans (sec. 1612 of the

 

            discussion draft and sec. 401(k)(11) of the Code)

 

 

         5. Rules related to designated Roth contributions (sec. 1613

 

            of the discussion draft and secs. 401(a)(30), 402(g), 402A,

 

            and 408(p) of the Code)

 

 

         6. Modification of required distribution rules for pension

 

            plans (sec. 1614 of the discussion draft and sec. 401(a)(9)

 

            of the Code)

 

 

         7. Reduction in age for allowable in-service distributions

 

            (sec. 1615 of the discussion draft and secs. 401(a)(36) and

 

            sec. 457(d)(1) of the Code)

 

 

         8. Modification of rules governing hardship distributions

 

            (sec. 1616 of the discussion draft and sec. 401(k)(2) of

 

            the Code)

 

 

         9. Extended rollover period for the rollover of plan loan

 

            offset amounts in certain cases (sec. 1617 of the

 

            discussion draft and sec. 402(c) of the Code)

 

 

        10. Coordination of contribution limitations for 403(b) plans

 

            and governmental 457(b) plans (sec. 1618 of the discussion

 

            draft and secs. 402(g), 403(b), 415 and 457(b) of the Code)

 

 

        11. Application of 10-percent early distribution tax to

 

            governmental 457 plans (sec. 1619 of the discussion draft

 

            and sec. 72(t) of the Code)

 

 

        12. Inflation adjustments for employer-sponsored retirement

 

            plan dollar limitations on benefits and contributions

 

            (secs. 1620 to 1624 of the discussion draft and secs.

 

            402(g), 415(d), and 408(p) of the Code)

 

 

      H. Certain Provisions Related to Members of Indian Tribes

 

 

         1. Indian general welfare benefits (secs. 1701-1703 of the

 

            discussion draft and new sec. 139E of the Code)

 

 

 TITLE II -- REPEAL OF ALTERNATIVE MINIMUM TAX

 

 

 TITLE III -- BUSINESS TAX REFORM

 

 

      A. Tax Rates

 

 

         1. 25-percent corporate tax rate (sec. 3001 of the discussion

 

            draft and sec. 11 of the Code)

 

 

      B. Reform of Business-Related Exclusions and Deductions

 

 

         1. Revision of treatment of contributions to capital (sec.

 

            3101 of the discussion draft, new sec. 76 of the Code, and

 

            sec. 118 of the Code)

 

 

         2. Repeal of deduction for local lobbying expenses (sec. 3102

 

            of the discussion draft and sec. 162(e) of the Code)

 

 

         3. Expenditures for repairs in connection with casualty losses

 

            (sec. 3103 of the discussion draft and sec. 165 of the

 

            Code)

 

 

         4. Reform of accelerated cost recovery system (sec. 3104 of

 

            the discussion draft and sec. 168 of the Code)

 

 

         5. Repeal of amortization of pollution control facilities

 

            (sec. 3105 of the discussion draft and sec. 169 of the

 

            Code)

 

 

         6. Net operating loss deduction (sec. 3106 of the discussion

 

            draft and sec. 172 of the Code)

 

 

         7. Circulation expenditures (sec. 3107 of the discussion draft

 

            and sec. 173 of the Code)

 

 

         8. Amortization of research and experimental expenditures

 

            (sec. 3108 of the discussion draft and sec. 174 of the

 

            Code)

 

 

         9. Repeal of deductions for soil and water conservation

 

            expenditures and endangered species recovery expenditures

 

            (sec. 3109 of the discussion draft and sec. 175 of the

 

            Code)

 

 

        10. Amortization of certain advertising expenses (sec. 3110 of

 

            the discussion draft and new sec. 177 of the Code)

 

 

        11. Expensing certain depreciable business assets for small

 

            business (sec. 3111 of the discussion draft and sec. 179 of

 

            the Code)

 

 

        12. Repeal of election to expense certain refineries (sec. 3112

 

            of the discussion draft and sec. 179C of the Code)

 

 

        13. Repeal of deduction for energy efficient commercial

 

            buildings (sec. 3113 of the discussion draft and sec. 179D

 

            of the Code)

 

 

        14. Repeal of election to expense advanced mine safety

 

            equipment (sec. 3114 of the discussion draft and sec. 179E

 

            of the Code)

 

 

        15. Repeal of deduction for expenditures by farmers for

 

            fertilizer, etc. (sec. 3115 of the discussion draft and

 

            sec. 180 of the Code)

 

 

        16. Repeal of special treatment of certain qualified film and

 

            television productions (sec. 3116 of the discussion draft

 

            and sec. 181 of the Code)

 

 

        17. Repeal of special rules for recoveries of damages of

 

            antitrust violations, etc. (sec. 3117 of the discussion

 

            draft and sec. 186 of the Code)

 

 

        18. Treatment of reforestation expenditures (sec. 3118 of the

 

            discussion draft and sec. 194 of the Code)

 

 

        19. 20-year amortization of goodwill and certain other

 

            intangibles (sec. 3119 of the discussion draft and sec. 197

 

            of the Code)

 

 

        20. Treatment of environmental remediation costs (sec. 3120 of

 

            the discussion draft and sec. 198 of the Code)

 

 

        21. Repeal of expensing of qualified disaster expenses (sec.

 

            3121 of the discussion draft and sec. 198A of the Code)

 

 

        22. Phaseout and repeal of deduction for income attributable to

 

            domestic production activities (sec. 3122 of the discussion

 

            draft and sec. 199 of the Code)

 

 

        23. Unification of deduction for organizational expenditures

 

            (sec. 3123 of the discussion draft and secs. 195, 248, and

 

            709 of the Code)

 

 

        24. Prevention of arbitrage of deductible interest expense and

 

            tax-exempt interest income (sec. 3124 of the discussion

 

            draft and sec. 265 of the Code)

 

 

        25. Prevention of transfer of certain losses from tax

 

            indifferent parties (sec. 3125 of the discussion draft and

 

            sec. 267 of the Code)

 

 

        26. Entertainment, etc. expenses (sec. 3126 of the discussion

 

            draft and sec. 274 of the Code)

 

 

        27. Repeal of limitation on corporate acquisition indebtedness

 

            (sec. 3127 of the discussion draft and sec. 279 of the

 

            Code)

 

 

        28. Denial of deductions and credits for expenditures in

 

            illegal businesses (sec. 3128 of the discussion draft and

 

            sec. 280E of the Code)

 

 

        29. Limitation on Deduction for FDIC Premiums (sec. 3129 of the

 

            discussion draft and sec. 162 of the Code)

 

 

        30. Repeal of percentage depletion (sec. 3130 of the discussion

 

            draft and secs. 613 and 613A of the Code)

 

 

        31. Repeal of passive activity exception for working interests

 

            in oil and gas property (sec. 3131 of the discussion draft

 

            and sec. 469 of the Code)

 

 

        32. Repeal of special rules for gain or loss on timber, coal,

 

            or domestic iron ore (sec. 3132 of the discussion draft and

 

            sec. 631 of the Code)

 

 

        33. Repeal of like-kind exchanges (sec. 3133 of the discussion

 

            draft and sec. 1031 of the Code)

 

 

        34. Restriction on trade or business property treated as

 

            similar or related in service to involuntarily converted

 

            property in disaster areas (sec. 3134 of the discussion

 

            draft and sec. 1033 of the Code)

 

 

        35. Repeal of rollover of publicly traded securities gain into

 

            specialized small business investment companies (sec. 3135

 

            of the discussion draft and sec. 1044 of the Code)

 

 

        36. Termination of special rules for gain from certain small

 

            business stock (sec. 3136 of the discussion draft and secs.

 

            1045 and 1202 of the Code)

 

 

        37. Certain self-created property not treated as a capital

 

            asset (sec. 3137 of the discussion draft and sec. 1221 of

 

            the Code)

 

 

        38. Repeal special rule for sale or exchange of patents (sec.

 

            3138 of the discussion draft and sec. 1235 of the Code)

 

 

        39. Depreciation recapture on gain from disposition of certain

 

            depreciable realty (sec. 3139 of the discussion draft and

 

            sec. 1250 of the Code)

 

 

      C. Reform of Business Credits

 

 

         1. Repeal credit for alcohol used as a fuel, etc. (sec. 3201

 

            of the discussion draft and sec. 40 of the Code)

 

 

         2. Repeal of credit for biodiesel and renewable diesel used as

 

            fuel (sec. 3202 of the discussion draft and sec. 40A, 6426

 

            and 6427(e) of the Code)

 

 

         3. Research credit modified and made permanent (sec. 3203 of

 

            the discussion draft and sec. 41 of the Code)

 

 

         4. Modification of low-income housing tax credit (sec. 3204 of

 

            the discussion draft and sec. 42 of the Code)

 

 

         5. Repeal of enhanced oil recovery credit (sec. 3205 of the

 

            discussion draft and sec. 43 of the Code)

 

 

         6. Modification and repeal of electricity produced from

 

            certain renewable resources (sec. 3206 of the discussion

 

            draft and sec. 45 of the Code)

 

 

         7. Indian employment credit (sec. 3207 of the discussion draft

 

            and sec. 45A of the Code)

 

 

         8. Repeal of credit for portion of employer Social Security

 

            taxes paid with respect to employee cash tips (sec. 3208 of

 

            the discussion draft and sec. 45B of the Code)

 

 

         9. Repeal of credit for clinical testing expenses for certain

 

            drugs for rare diseases or conditions (sec. 3209 of the

 

            discussion draft and sec. 45C of the Code)

 

 

        10. Repeal of credit for small employer pension plan startup

 

            costs (sec. 3210 of the discussion draft and sec. 45E of

 

            the Code)

 

 

        11. Repeal of credit for employer-provided childcare (sec. 3211

 

            of the discussion draft and section 45F of the Code)

 

 

        12. Repeal of railroad track maintenance credit (sec. 3212 of

 

            the discussion draft and sec. 45G of the Code)

 

 

        13. Repeal of credit for production of low sulfur diesel fuel

 

            (sec. 3213 of the discussion draft and sec. 45H of the

 

            Code)

 

 

        14. Repeal of credit for producing oil and gas from marginal

 

            wells (sec. 3214 of the discussion draft and sec. 45I of

 

            the Code)

 

 

        15. Repeal of credit for production from advanced nuclear power

 

            facilities (sec. 3215 of the discussion draft and sec. 45J

 

            of the Code)

 

 

        16. Repeal of credit for producing fuel from a nonconventional

 

            source (sec. 3216 of the discussion draft and sec. 45K of

 

            the Code)

 

 

        17. Repeal of energy efficient new homes credit (sec. 3217 of

 

            the discussion draft and sec. 45l of the Code)

 

 

        18. Repeal of energy efficient appliance credit (sec. 3218 of

 

            the discussion draft and sec. 45M of the Code)

 

 

        19. Repeal of mine rescue team training credit (sec. 3219 of

 

            the discussion draft and sec. 45N of the Code)

 

 

        20. Repeal of agricultural chemicals security tax credit (sec.

 

            3220 of the discussion draft and sec. 45O of the Code)

 

 

        21. Repeal of credit for carbon dioxide sequestration (sec.

 

            3221 of the discussion draft and section 45Q of the Code)

 

 

        22. Repeal of credit for employee health insurance expenses of

 

            small employers (sec. 3222 of the discussion draft and sec.

 

            45R of the Code)

 

 

        23. Repeal of rehabilitation credit (sec. 3223 of the

 

            discussion draft and sec. 47 of the Code)

 

 

        24. Repeal of energy credit (sec. 3224 of the discussion draft

 

            and sec. 48 of the Code)

 

 

        25. Repeal of qualifying advanced coal project credit (sec.

 

            3225 of the discussion draft and sec. 48A of the Code)

 

 

        26. Repeal of qualifying gasification project credit (sec. 3226

 

            of the discussion draft and section 48B of the Code)

 

 

        27. Repeal of qualifying advanced energy project credit (sec.

 

            3227 of the discussion draft and section 48C of the Code)

 

 

        28. Repeal of qualifying therapeutic discovery project credit

 

            (sec. 3228 of the discussion draft and sec. 48D of the

 

            Code)

 

 

        29. Repeal of the work opportunity tax credit (sec. 3229 of the

 

            discussion draft and sec. 51 of the Code)

 

 

        30. Repeal of deduction for certain unused business credits

 

            (sec. 3230 of the discussion draft and sec. 196 of the

 

            Code)

 

 

      D. Accounting Methods

 

 

         1. Limitation on use of cash method of accounting (sec. 3301

 

            of the discussion draft and secs. 448 and 451 of the Code)

 

 

         2. Rules for determining whether taxpayer has adopted a method

 

            of accounting (sec. 3302 of the discussion draft and sec.

 

            446 of the Code)

 

 

         3. Certain special rules for taxable year of inclusion (sec.

 

            3303 of the discussion draft and sec. 451 of the Code)

 

 

         4. Installment sales (sec. 3304 of the discussion draft and

 

            secs. 453 and 453A of the Code)

 

 

         5. Repeal of special rule for prepaid subscription income

 

            (sec. 3305 of the discussion draft and sec. 455 of the

 

            Code)

 

 

         6. Repeal of special rule for prepaid dues income of certain

 

            membership organizations (sec. 3306 of the discussion draft

 

            and sec. 456 of the Code)

 

 

         7. Repeal of special rule for magazines, paperbacks, and

 

            records returned after the close of the taxable year (sec.

 

            3307 of the discussion draft and sec. 458 of the Code)

 

 

         8. Modification of rules for long-term contracts (sec. 3308 of

 

            the discussion draft and sec. 460 of the Code)

 

 

         9. Nuclear decommissioning reserve funds (sec. 3309 of the

 

            discussion draft and sec. 468A of the Code)

 

 

        10. Repeal of last-in, first-out method of inventory (sec. 3310

 

            of the discussion draft and secs. 471, 472, 473 and 474 of

 

            the Code)

 

 

        11. Repeal of lower of cost or market method of inventory (sec.

 

            3311 of the discussion draft and sec. 471 of the Code)

 

 

        12. Modification of rules for capitalization and inclusion in

 

            inventory costs of certain expenses (sec. 3312 of the

 

            discussion draft and sec. 263A of the Code)

 

 

        13. Modification of income forecast method (sec. 3313 of the

 

            discussion draft and sec. 167 of the Code)

 

 

        14. Repeal of averaging of farm income (sec. 3314 of the

 

            discussion draft and sec. 1301 of the Code)

 

 

        15. Treatment of patent or trademark infringement awards (sec.

 

            3315 of the discussion draft and new sec. 91 of the Code)

 

 

        16. Repeal of redundant rules with respect to carrying charges

 

            (sec. 3316 of the discussion draft and sec. 266 of the

 

            Code)

 

 

        17. Repeal of recurring item exception for spudding of oil and

 

            gas wells (sec. 3317 of the discussion draft and sec.

 

            461(i) of the Code)

 

 

      E. Financial Instruments

 

 

         1. Treatment of certain derivatives (sec. 3401 of the

 

            discussion draft and new secs. 485 and 486 of the Code)

 

 

         2. Modification of certain rules related to hedges (sec. 3402

 

            of the discussion draft and sec. 1221 of the Code)

 

 

         3. Current inclusion in income of market discount (sec. 3411

 

            of the discussion draft and new sec. 1278 of the Code)

 

 

         4. Treatment of certain exchanges of debt instruments (sec.

 

            3412 of the discussion draft and secs. 1037 and 1274B of

 

            the Code)

 

 

         5. Coordination with rules for inclusion not later than for

 

            financial accounting purposes (sec. 3413 of the discussion

 

            draft and sec. 451 of the Code)

 

 

         6. Rules regarding certain government debt (sec. 3414 of the

 

            discussion draft and secs. 454 and 1272A of the Code)

 

 

         7. Cost basis of specified securities determined without

 

            regard to identification (sec. 3421 of the discussion draft

 

            and sec. 1012 of the Code)

 

 

         8. Wash sales by related parties (sec. 3422 of the discussion

 

            draft and sec. 1091 of the Code)

 

 

         9. Nonrecognition for derivative transactions by a corporation

 

            with respect to its stock (sec. 3423 of the discussion

 

            draft and sec. 1032 of the Code)

 

 

        10. Termination of private activity bonds (sec. 3431 of the

 

            discussion draft and sec. 103 of the Code)

 

 

        11. Termination of credit for interest on certain home

 

            mortgages (sec. 3432 of the discussion draft and sec. 25 of

 

            the Code)

 

 

        12. Repeal advance refunding bonds (sec. 3433 of the discussion

 

            draft and sec. 149(d) of the Code)

 

 

        13. Repeal tax credit bond rules (sec. 3434 of the discussion

 

            draft and secs. 54A, 54B, 54C, 54D, 54E, 54F and 6431 of

 

            the Code)

 

 

      F. Insurance Reforms

 

 

         1. Exception to pro rata interest expense disallowance for

 

            corporate-owned life insurance restricted to 20-percent

 

            owners (sec. 3501 of the discussion draft and sec. 264 of

 

            the Code)

 

 

         2. Net operating losses of life insurance companies (sec. 3502

 

            of the discussion draft and sec. 805 of the Code)

 

 

         3. Repeal small life insurance company deduction (sec. 3503 of

 

            the discussion draft and sec. 806 of the Code)

 

 

         4. Computation of life insurance tax reserves (sec. 3504 of

 

            the discussion draft and sec. 807 of the Code)

 

 

         5. Adjustment for change in computing reserves (sec. 3505 of

 

            the discussion draft and sec. 807 of the Code)

 

 

         6. Modification of rules for life insurance company proration

 

            (sec. 3506 of the discussion draft and sec. 812 of the

 

            Code)

 

 

         7. Repeal treatment of distributions to shareholders from

 

            pre-1984 policyholders surplus account (sec. 3507 of the

 

            discussion draft and sec. 815 of the Code)

 

 

         8. Modification of proration rules for property and casualty

 

            insurance companies (sec. 3508 of the discussion draft and

 

            sec. 832 of the Code)

 

 

         9. Treatment of Blue Cross and Blue Shield organizations (sec.

 

            3509 of the discussion draft and sec. 833 of the Code)

 

 

        10. Modification of discounting rules for property and casualty

 

            insurance companies (sec. 3510 of the discussion draft and

 

            sec. 846 of the Code)

 

 

        11. Repeal of special estimated tax payments (sec. 3511 of the

 

            discussion draft and sec. 847 of the Code)

 

 

        12. Capitalization of certain policy acquisition expenses (sec.

 

            3512 of the discussion draft and sec. 848 of the Code)

 

 

        13. Tax reporting for life settlement transactions,

 

            clarification of tax basis of life insurance contracts, and

 

            exception to transfer for valuable consideration rules

 

            (secs. 3513, 3514, and 3515 of the discussion draft, new

 

            sec. 6050X of the Code, and secs. 1016 and 101 of the Code)

 

 

      G. Pass-Thru and Certain Other Entities

 

 

         1. Reduced recognition period for built-in gains made

 

            permanent (sec. 3601 of the discussion draft and sec. 1374

 

            of the Code)

 

 

         2. Modifications to S corporation passive investment income

 

            rules (sec. 3602 of the discussion draft and secs. 1362 and

 

            1375 of the Code)

 

 

         3. Expansion of qualifying beneficiaries of an electing small

 

            business trust (sec. 3603 of the discussion draft and sec.

 

            1361 of the Code)

 

 

         4. Charitable contribution deduction for electing small

 

            business trusts (sec. 3604 of the discussion draft and sec.

 

            641(c) of the Code)

 

 

         5. Permanent rule regarding basis adjustment to stock of S

 

            corporations making charitable contributions of property

 

            (sec. 3605 of the discussion draft and sec. 1367 of the

 

            Code)

 

 

         6. Extension of time for making S corporation elections (sec.

 

            3606 of the discussion draft and sec. 1362 of the Code)

 

 

         7. Relocation of C corporation definition (sec. 3607 of the

 

            discussion draft and sec. 7701 of the Code)

 

 

         8. Repeal of rules relating to guaranteed payments (sec.

 

            3611(a) of the discussion draft and sec. 707(c) of the

 

            Code)

 

 

         9. Repeal of rules relating to liquidating distributions (sec.

 

            3611(b) of the discussion draft and secs. 736 and 753 of

 

            the Code)

 

 

        10. Mandatory adjustments to basis of partnership property in

 

            case of transfer of partnership interests (sec. 3612 of the

 

            discussion draft and sec. 743 of the Code)

 

 

        11. Mandatory adjustments to basis of undistributed partnership

 

            property (sec. 3613 of the discussion draft and sec. 734 of

 

            the Code)

 

 

        12. Corresponding adjustments to basis of properties held by

 

            partnership where partnership basis adjusted (sec. 3614 of

 

            the discussion draft and new sec. 736 of the Code)

 

 

        13. Charitable contributions and foreign taxes taken into

 

            account in determining limitation on allowance of partner's

 

            share of loss (sec. 3615 of the discussion draft and sec.

 

            704(d) of the Code)

 

 

        14. Revisions related to unrealized receivables and inventory

 

            items (sec. 3616 of the discussion draft and sec. 751 of

 

            the Code)

 

 

        15. Repeal of time limitation on taxing precontribution gain

 

            (sec. 3617 of the discussion draft and secs. 704(c) and 737

 

            of the Code)

 

 

        16. Partnership interests created by gift (sec. 3618 of the

 

            discussion draft and secs. 704(e) and 761 of the Code)

 

 

        17. Repeal of partnership technical terminations (sec. 3619 of

 

            the discussion draft and sec. 708(b)(1)(B) of the Code)

 

 

        18. Publicly traded partnership exception restricted to mining

 

            and natural resources partnerships (sec. 3620 of the

 

            discussion draft and sec. 7704 of the Code)

 

 

        19. Ordinary income treatment in the case of partnership

 

            interests held in connection with performance of services

 

            (sec. 3621 of the discussion draft and new sec. 710 of the

 

            Code)

 

 

        20. Reform audit and adjustment procedures for partnerships

 

            (sec. 3622 of the discussion draft and secs. 6221 through

 

            6234 and 6240 through 6256 of the Code)

 

 

        21. Prevention of tax-free spinoffs involving REITs (sec. 3631

 

            of the discussion draft and sec. 355 of the Code)

 

 

        22. Extension of period for prevention of REIT election

 

            following revocation or termination (section 3632 of the

 

            discussion draft and section 856(g)(3) of the Code)

 

 

        23. Certain short-life property not treated as real property

 

            for purposes of REIT provisions (section 3633 of the

 

            discussion draft and sec. 856 of the Code)

 

 

        24. Repeal of special rules for timber held by REITs (sec. 3634

 

            of the discussion draft and secs. 856 and 857 of the Code)

 

 

        25. Limitation on fixed percentage rent and interest exceptions

 

            for REIT income tests (sec. 3635 of the discussion draft

 

            and sec. 856 of the Code)

 

 

        26. Repeal of preferential dividend rule for publicly offered

 

            REITS; Authority for alternative remedies to address

 

            certain failures (secs. 3636 and 3637 of the discussion

 

            draft and sec. 562 of the Code)

 

 

        27. Limitations on designation of dividends by REITs (sec. 3638

 

            of the discussion draft and sec. 857 of the Code)

 

 

        28. Non-REIT earnings and profits required to be distributed by

 

            REIT in cash (sec. 3639 of the discussion draft and sec.

 

            857 of the Code)

 

 

        29. Debt instruments of publicly offered REITs and mortgages

 

            treated as real estate assets (sec. 3640 of the discussion

 

            draft and sec. 856 of the Code)

 

 

        30. Asset and income test clarification regarding ancillary

 

            personal property (sec. 3641 of the discussion draft and

 

            sec. 856 of the Code)

 

 

        31. Hedging provisions (sec. 3642 of the discussion draft and

 

            sec. 857 of the Code)

 

 

        32. Modification of real estate investment trust earnings and

 

            profits calculation to avoid duplicate taxation (sec. 3643

 

            of the discussion draft and secs. 562 and 857 of the Code)

 

 

        33. Reduction in percentage limitation on assets of REIT which

 

            may be taxable REIT subsidiaries (sec. 3644 of the

 

            discussion draft and sec. 856 of the Code)

 

 

        34. Treatment of certain services provided by taxable REIT

 

            subsidiaries (sec. 3645 of the discussion draft and sec.

 

            857 of the Code)

 

 

        35. Study relating to taxable REIT subsidiaries (sec. 3646 of

 

            the discussion draft)

 

 

        36. C corporation election to become, or transfer assets to, a

 

            RIC or REIT (sec. 3647 of the discussion draft and new sec.

 

            1062 of the Code)

 

 

        37. Interests in RICs and REITs not excluded from definition of

 

            United States real property interests (sec. 3648 of the

 

            discussion draft and sec. 897 of the Code)

 

 

        38. Dividends from RICs and REITs ineligible for deduction for

 

            United States source portion of dividends from certain

 

            foreign corporations (sec. 3649 of the discussion draft and

 

            sec. 245 of the Code)

 

 

        39. Exclusion of dividends from controlled foreign corporations

 

            from the definition of personal holding company income for

 

            purposes of the personal holding company rules (sec. 3661

 

            of the discussion draft and sec. 543 of the Code)

 

 

      H. Taxation of Foreign Persons

 

 

         1. Prevent avoidance of tax through reinsurance with non-taxed

 

            affiliates (sec. 3701 of the discussion draft and new sec.

 

            849 of the Code)

 

 

         2. Taxation of passenger cruise gross income of foreign

 

            corporations and nonresident alien individuals (sec. 3702

 

            of the discussion draft and secs. 871, 882, 883 and 887 of

 

            the Code)

 

 

         3. Modification of insurance exception to the passive foreign

 

            investment company rules (sec. 3703 of the discussion draft

 

            and sec. 1297 of the Code)

 

 

         4. Limitation on deduction for interest on certain

 

            indebtedness (sec. 3704 of the discussion draft and sec.

 

            163(j) of the Code)

 

 

         5. Limitation on treaty benefits for certain deductible

 

            payments (sec. 3705 of the discussion draft and sec. 894(d)

 

            of the Code)

 

 

      I. Provisions Related to Compensation

 

 

         1. Nonqualified deferred compensation (sec. 3801 of the

 

            discussion draft and new sec. 409B of the Code)

 

 

         2. Modification of limitation on excessive employee

 

            remuneration (sec. 3802 of the discussion draft and sec.

 

            162(m) of the Code)

 

 

         3. Excise tax on excess tax-exempt organization executive

 

            compensation (sec. 3803 of the discussion draft and new

 

            sec. 4960 of the Code)

 

 

         4. Denial of deduction as research expenditure for stock

 

            transferred pursuant to an incentive stock option (sec.

 

            3804 of the discussion draft and sec. 421(a)(2) of the

 

            Code)

 

 

         5. Determination of worker classification (sec. 3811 of the

 

            discussion draft and new secs. 7707, 3402(s) and 6041A(g)

 

            of the Code)

 

 

      J. Zones and Short-Term Regional Benefits

 

 

         1. Empowerment Zones, Enterprise Communities, and Rural

 

            Development Investment Areas (sec. 3821 of the discussion

 

            draft and secs. 1391-1394, 1396, 1397, 1397A-1397F of the

 

            Code)

 

 

         2. DC Zone (sec. 3822 of the discussion draft and secs. 1400,

 

            1400A-1400C of the Code)

 

 

         3. Renewal Communities (sec. 3823 of the discussion draft and

 

            secs. 1400E-1400J of the Code)

 

 

         4. Short-term regional benefits (sec. 3824 of the discussion

 

            draft and secs. 1400L-1400T, 1400U-1, U-2 & U-3 of the

 

            Code)

 

 

 TITLE IV -- PARTICIPATION EXEMPTION SYSTEM FOR THE TAXATION OF

 

 FOREIGN INCOME

 

 

      A. Establishment of Exemption System

 

 

         1. Deduction for dividends received by domestic corporations

 

            from certain foreign corporations (sec. 4001 of the

 

            discussion draft and new sec. 245A of the Code)

 

 

         2. Limitation on losses with respect to specified 10-percent

 

            owned foreign corporations (sec. 4002 of the discussion

 

            draft, and secs. 367(a)(3)(C) and 961 and new sec. 91 of

 

            the Code)

 

 

         3. Treatment of deferred foreign income upon transition to

 

            participation exemption system of taxation (sec. 4003 of

 

            the discussion draft and secs. 965 and 9503 of the Code)

 

 

         4. Look-thru rule for related controlled foreign corporations

 

            made permanent (sec. 4004 of the discussion draft and sec.

 

            954(c)(6) of the Code)

 

 

      B. Modifications Related to Foreign Tax Credit System

 

 

         1. Repeal of section 902 indirect foreign tax credits;

 

            determination of section 960 credit on current year basis

 

            (sec. 4101 of the discussion draft and secs. 902 and 960 of

 

            the Code)

 

 

         2. Foreign tax credit limitation applied by allocating only

 

            directly allocable deductions to foreign source income

 

            (sec. 4102 of the discussion draft and sec. 904 of the

 

            Code)

 

 

         3. Passive category income expanded to include other mobile

 

            income (sec. 4103 of the discussion draft and sec. 904 of

 

            the Code)

 

 

         4. Source of income from sales of inventory determined solely

 

            on basis of production activities (sec. 4104 of the

 

            discussion draft and sec. 863(b) of the Code)

 

 

      C. Rules Related to Passive and Mobile Income

 

 

         1. Subpart F income to only include low-taxed foreign income

 

            (sec. 4201 of the discussion draft and secs. 953 and 954 of

 

            the Code)

 

 

         2. Foreign base company sales income (sec. 4202 of the

 

            discussion draft and secs. 954 and 960 of the Code)

 

 

         3. Inflation adjustment of de minimis exception for

 

            foreign base company income (sec. 4203 of the discussion

 

            draft and sec. 954(b) of the Code)

 

 

         4. Active financing exception extended with limitation for

 

            low-taxed income (sec. 4204 of the discussion draft and

 

            secs. 953, 954, and 960 of the Code)

 

 

         5. Repeal of inclusion based on withdrawal of previously

 

            excluded subpart F income from qualified investment (sec.

 

            4205 of the discussion draft and sec. 955 of the Code)

 

 

         6. Foreign intangible income subject to taxation at reduced

 

            rate; intangible income treated as subpart F income (sec.

 

            4211 of the discussion draft and sec. 954 of the Code)

 

 

         7. Denial of deduction for interest expense of U.S.

 

            shareholders which are members of worldwide affiliated

 

            groups with excess domestic indebtedness (sec. 4212 of the

 

            discussion draft and sec. 163 of the Code)

 

 

 TITLE V -- TAX EXEMPT ENTITIES

 

 

      A. Unrelated Business Income Tax

 

 

         1. Clarification of unrelated business income tax treatment

 

            of entities exempt from tax under section 501(a) (sec.

 

            5001 of the discussion draft and sec. 511 of the Code)

 

 

         2. Name and logo royalties treated as unrelated business

 

            taxable income (sec. 5002 of the discussion draft and

 

            secs. 512 and 513 of the Code)

 

 

         3. Unrelated business taxable income separately computed for

 

            each trade or business (sec. 5003 of the discussion draft

 

            and sec. 512 of the Code)

 

 

         4. Exclusion of research income from unrelated business

 

            taxable income limited to publicly available research

 

            (sec. 5004 of the discussion draft and sec. 512(b)(9) of

 

            the Code)

 

 

         5. Parity of charitable contribution limitation between

 

            trusts and corporations for purposes of computing

 

            unrelated business taxable income (sec. 5005 of the

 

            discussion draft and sec. 512(b)(11) of the Code)

 

 

         6. Increase in specific deduction against unrelated business

 

            taxable income (sec. 5006 of the discussion draft and sec.

 

            512(b)(12) of the Code)

 

 

         7. Repeal of exclusion from unrelated business taxable income

 

            of gain or loss from the disposition of distressed

 

            property (sec. 5007 of the discussion draft and sec.

 

            512(b)(16) of the Code)

 

 

         8. Modify rules concerning qualified sponsorship payments

 

            (sec. 5008 of the discussion draft and sec. 513(i) of the

 

            Code)

 

 

      B. Penalties

 

 

         1. Increase in information return penalties (sec. 5101 of the

 

            discussion draft and sec. 6652(c) of the Code)

 

 

         2. Manager-level accuracy-related penalty on underpayment of

 

            unrelated business income tax (sec. 5102 of the discussion

 

            draft and secs. 6662 and 6662A of the Code)

 

 

      C. Excise Taxes

 

 

         1. Modification of taxes on excess benefit transactions

 

            (intermediate sanctions) (sec. 5201 of the discussion

 

            draft and sec. 4958 of the Code)

 

 

         2. Modification of taxes on self-dealing (sec. 5202 of the

 

            discussion draft and sec. 4941 of the Code)

 

 

         3. Excise tax on failure to distribute within five years a

 

            contribution to a donor advised fund (sec. 5203 of the

 

            discussion draft and new sec. 4968 of the Code)

 

 

         4. Simplification of excise tax on private foundation

 

            investment income (sec. 5204 of the discussion draft and

 

            sec. 4940 of the Code)

 

 

         5. Repeal of exception for private operating foundation

 

            failure to distribute income (sec. 5205 of the discussion

 

            draft and sec. 4942 of the Code)

 

 

         6. Excise tax based on investment income of private colleges

 

            and universities (sec. 5206 of the discussion draft and

 

            new sec. 4969 of the Code)

 

 

      D. Requirements for Organizations Exempt From Tax

 

 

         1. Repeal of tax-exempt status for professional sports

 

            leagues (sec. 5301 of the discussion draft and sec.

 

            501(c)(6) of the Code)

 

 

         2. Repeal of exemption from tax for certain insurance

 

            companies and CO-OP health insurance issuers (sec. 5302 of

 

            the discussion draft and sec. 501 of the Code)

 

 

         3. In-State requirement for certain tax-exempt workmen's

 

            compensation insurance organizations (sec. 5303 of the

 

            discussion draft and sec. 501(c)(27) of the Code)

 

 

         4. Repeal of Type II and Type III supporting organizations

 

            (sec. 5304 of the discussion draft and sec. 509(a)(3) of

 

            the Code)

 

 

 TITLE VI -- TAX ADMINISTRATION AND COMPLIANCE

 

 

      A. IRS Investigation-Related Reforms

 

 

         1. Require section 501(c)(4) organizations to provide notice

 

            of formation (sec. 6001 of the discussion draft and new

 

            sec. 506 of the Code)

 

 

         2. Declaratory judgment procedure for organizations exempt

 

            from tax under section 501(c)(4) (sec. 6002 of the

 

            discussion draft and sec. 7428 of the Code)

 

 

         3. Modify reporting requirements for contributions to social

 

            welfare organizations (sec. 6003 of the discussion draft

 

            and sec. 6033 of the Code)

 

 

         4. Mandatory e-filing by exempt organizations (sec. 6004 of

 

            the discussion draft and sec. 6033 of the Code)

 

 

         5. Duty to ensure that IRS employees are familiar with and

 

            act in accordance with certain taxpayer rights (sec. 6005

 

            of the discussion draft and sec. 7803 of the Code)

 

 

         6. Termination of employment of Internal Revenue Service

 

            employees for taking official actions for political

 

            purposes (sec. 6006 of the discussion draft)

 

 

         7. Release of information regarding the status of certain

 

            investigations (sec. 6007 of the discussion draft and sec.

 

            6103 of the Code)

 

 

         8. Review of Internal Revenue Service examination selection

 

            procedures (sec. 6008 of the discussion draft)

 

 

         9. Prohibition of use of personal email for official

 

            government business (sec. 6009 of the discussion draft.)

 

 

        10. Moratorium on IRS conferences (sec. 6010 of the discussion

 

            draft)

 

 

        11. Applicable standard for determining whether an

 

            organization is operated exclusively for the promotion of

 

            social welfare (sec. 6011 of the discussion draft)

 

 

      B. Taxpayer Protection and Service Reforms

 

 

         1. Extend Internal Revenue Service authority to require

 

            truncated social security numbers on Form W-2 (sec. 6101

 

            of the discussion draft and sec. 6051 of the Code)

 

 

         2. Free electronic filing (sec. 6102 of the discussion draft

 

            and sec. 6011 of the Code)

 

 

         3. Pre-populated returns prohibited (sec. 6103 of the

 

            discussion draft)

 

 

         4. Simplified filing requirements for individuals over 65

 

            years of age (sec. 6104 of the discussion draft and sec.

 

            6011 of the Code)

 

 

         5. Increase refund and credit threshold for Joint Committee

 

            on Taxation review to $5 million for corporate taxpayers

 

            (sec. 6105 of the discussion draft and sec. 6405 of the

 

            Code)

 

 

      C. Tax Return Due Date Simplification

 

 

         1. New due date for partnership form 1065, S corporation form

 

            1120S and C corporation form 1120 (sec. 6201 of the

 

            discussion draft and sec. 6072 of the Code)

 

 

         2. Modification of due dates by regulation (sec. 6202 of the

 

            discussion draft)

 

 

         3. Corporations permitted statutory automatic six-month

 

            extension of income tax returns (sec. 6203 of the

 

            discussion draft and sec. 6081 of the Code)

 

 

      D. Compliance Reforms

 

 

         1. Penalty for failure to file (sec. 6301 of the discussion

 

            draft and sec. 6651 of the Code)

 

 

         2. Penalty for failure to file correct information returns

 

            and provide payee statements (sec. 6302 of the discussion

 

            draft and secs. 6721 and 6722 of the Code)

 

 

         3. Clarification of six-year statute of limitations in case

 

            of overstatement of basis (sec. 6303 of the discussion

 

            draft and sec. 6501(e) of the Code)

 

 

         4. Reform of rules related to qualified tax collection

 

            contracts (sec. 6304 of the discussion draft and sec. 6306

 

            of the Code)

 

 

         5. 100 percent continuous levy authority on payments to

 

            Medicare providers and suppliers (sec. 6305 of the

 

            discussion draft and sec. 6331 of the Code)

 

 

         6. Treatment of refundable credits for purposes of certain

 

            penalties (sec. 6306 of the discussion draft and secs.

 

            6664 and 6676 of the Code)

 

 

 TITLE VII -- EXCISE TAXES

 

 

         1. Repeal of medical device excise tax (sec. 7001 of the

 

            discussion draft and sec. 4221 of the Code)

 

 

         2. Modifications relating to the Oil Spill Liability Trust

 

            Fund (sec. 7002 of the discussion draft and secs. 4611 and

 

            4612 of the Code)

 

 

         3. Modification relating to Inland Waterways Trust Fund

 

            financing rate (sec. 7003 of the discussion draft and sec.

 

            4042 of the Code)

 

 

         4. Excise tax on systemically important financial

 

            institutions (sec. 7004 of the discussion draft and new

 

            sec. 4491 of the Code)

 

 

         5. Clarification of orphan drug exception to annual fee on

 

            branded prescription pharmaceutical manufacturers and

 

            importers (sec. 7005 of the discussion draft)

 

 

 TITLE VIII -- DEADWOOD AND TECHNICAL PROVISIONS

 

 

      A. Repeal of Deadwood Provisions (sec. 8001 of the discussion

 

         draft)

 

 

 ESTIMATED REVENUE EFFECTS OF THE TAX REFORM ACT OF 2014

 

 

 DISTRIBUTIONAL ANALYSIS OF THE TAX REFORM ACT OF 2014

 

 

 MACROECONOMIC ANALYSIS OF THE TAX REFORM ACT OF 2014

 

 

      A. Introduction and Summary

 

 

      B. Description of Proposal

 

 

         1. Individual income tax

 

 

         2. Corporate Income Tax and Business-Related Provisions for

 

            Pass-Through Entities

 

 

         3. Taxation of Multinational Corporations

 

 

         4. Conventional Estimate of the Effects of the Proposal

 

 

      C. Modeling Approaches and Macroeconomic Analysis

 

 

      D. Effects on Economic Activity and Revenues

 

 

         1. Effects on real gross domestic product and revenues

 

 

         2. Effects on the capital stock

 

 

         3. Effects on private sector employment

 

 

         4. Effects on consumption

 

 

         5. Conclusion

 

 

      E. Appendix -- Key Parameter Assumptions

 

INTRODUCTION

 

 

This document1 provides a technical explanation, estimated revenue effects, distributional analysis, and macroeconomic analysis of the Tax Reform Act of 2014, a discussion draft prepared by the Chairman of the House Committee on Ways and Means that proposes to reform the Internal Revenue Code. The Chairman of the House Committee on Ways and Means released his discussion draft on February 26, 2014.2

This document compiles and republishes with minor typographical and content corrections the following 11 documents which were originally published on February 26, 2014:

  • Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title I -- Tax Reform for Individuals (JCX-12-14);

  • Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title II -- Alternative Minimum Tax Repeal (JCX-13-14);

  • Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title III -- Business Tax Reform (JCX-14-14);

  • Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title IV -- Participation Exemption System for the Taxation of Foreign Income (JCX-15-14);

  • Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title V -- Tax Exempt Entities (JCX-16-14);

  • Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title VI -- Tax Administration and Compliance (JCX-17-14);

  • Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title VII -- Excise Taxes (JCX-18-14);

  • Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title VIII -- Deadwood and Technical Provisions (JCX-19-14);

  • Estimated Revenue Effects of the "Tax Reform Act of 2014" (JCX-20-14);3

  • Distributional Effects of the "Tax Reform Act of 2014" (JCX-21-14);4 and

  • Macroeconomic Analysis of the "Tax Reform Act of 2014" (JCX-22-14).5

 

This document corrects the following substantive errors in the original documents.

Page 27 corrects an error in the description of the proposal that is on page 25 of JCX-12-14, relating to the American opportunity tax credit. The original stated that the inflation adjustment was for tax years beginning in 2018. The correction states that the adjustment is for taxable years beginning after 2018.

Page 271 corrects an error in the description of the proposal that is on page 132 of JCX-14-14, relating to the modification of rules for capitalization and inclusion in inventory costs of certain expenses. The original stated that the proposal repeals the exception to section 263A for farming businesses. The correction deletes this statement.

Page 480 corrects an error in the description of present law that is in footnote 1246 on page 341 of JCX-14-14, relating to the increased section 179 expensing limitation for an enterprise zone business. The original stated that for 2012 the limit is $500,000, and for taxable years beginning after 2012, the limit is $200,000. The correction states that for 2010 - 2013 the limit is $2,000,000, and for taxable years beginning after 2013, the limit is $200,000.

Pages 529 and 530 correct two errors in the description of the proposal, on pages 38 and 39 of JCX-15-14, relating to the extension and modification of the active financing exception. The description of the proposal mistakenly states that the proposal extends the exception for taxable years beginning before January 1, 2020. In fact, the proposal extends the exception for taxable years beginning before January 1, 2019. The description of the proposal mistakenly states that for an item of income subject to an effective foreign income tax rate of at least 50 percent of the maximum U.S. corporate tax rate under section 11, the proposal limits the exclusion to 50 percent. In fact, the 50-percent exclusion is for an item of income subject to an effective foreign income tax rate of less than 50 percent of the maximum U.S. corporate tax rate under section 11.

 

TECHNICAL EXPLANATION OF THE TAX REFORM ACT OF 2014,

 

A DISCUSSION DRAFT OF THE CHAIRMAN OF THE HOUSE COMMITTEE

 

ON WAYS AND MEANS TO REFORM THE INTERNAL REVENUE CODE

 

 

TITLE I -- TAX REFORM FOR INDIVIDUALS

 

 

A. Individual Income Tax Rate Reform

 

 

1. Simplification of individual income tax rates (secs. 1001 and 1003 of the discussion draft and secs. 1 and 2 of the Code)

 

Present Law

 

 

In general

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

Tax rate schedules

Separate rate schedules apply based on an individual's filing status. For 2014, the regular individual income tax rate schedules are as follows:

           Table 1. -- Federal Individual Income Tax Rates for 20146

 

 ______________________________________________________________________________

 

 

 If taxable income is:                   Then income tax equals:

 

 ______________________________________________________________________________

 

 

                               Single Individuals

 

 ______________________________________________________________________________

 

 

 Not over $9,075                         10% of the taxable income

 

 

 Over $9,075 but not over $36,900        $907.50 plus 15% of the excess over

 

                                         $9,075

 

 

 Over $36,900 but not over $89,350       $5,081.25 plus 25% of the excess over

 

                                         $36,900

 

 

 Over $89,350 but not over $186,350      $18,193.75 plus 28% of the excess over

 

                                         $89,350

 

 

 Over $186,350 but not over $405,100     $45,353.75 plus 33% of the excess over

 

                                         $186,350

 

 

 Over $405,100 but not over $406,750     $117,541.25 plus 35% of the excess

 

                                         over $405,100

 

 

 Over $406,750                           $118,118.75 plus 39.6% of the excess

 

                                         over $406,750

 

 ______________________________________________________________________________

 

 

                              Heads of Households

 

 ______________________________________________________________________________

 

 

 Not over $12,950                        10% of the taxable income

 

 

 Over $12,950 but not over $49,400       $1,295 plus 15% of the excess over

 

                                         $12,950

 

 

 Over $49,400 but not over $127,550      $6,762.50 plus 25% of the excess over

 

                                         $49,400

 

 

 Over $127,550 but not over $206,600     $26,300 plus 28% of the excess over

 

                                         $127,550

 

 

 Over $206,600 but not over $405,100     $48,434 plus 33% of the excess over

 

                                         $206,600

 

 

 Over $405,100 but not over $432,200     $113,939 plus 35% of the excess over

 

                                         $405,100

 

 

 Over $432,200                           $123,424 plus 39.6% of the excess over

 

                                         $432,200

 

 ______________________________________________________________________________

 

 

         Married Individuals Filing Joint Returns and Surviving Spouses

 

 ______________________________________________________________________________

 

 

 Not over $18,150                        10% of the taxable income

 

 

 Over $18,150 but not over $73,800       $1,815 plus 15% of the excess over

 

                                         $18,150

 

 

 Over $73,800 but not over $148,850      $10,162.50 plus 25% of the excess over

 

                                         $73,800

 

 

 Over $148,850 but not over $226,850     $28,925 plus 28% of the excess over

 

                                         $148,850

 

 

 Over $226,850 but not over $405,100     $50,765 plus 33% of the excess over

 

                                         $226,850

 

 

 Over $405,100 but not over $457,600     $109,587.50 plus 35% of the excess

 

                                         over $405,100

 

 

 Over $457,600                           $127,962.50 plus 39.6% of the excess

 

                                         over $457,600

 

 ______________________________________________________________________________

 

 

                  Married Individuals Filing Separate Returns

 

 ______________________________________________________________________________

 

 

 Not over $9,075                         10% of the taxable income

 

 

 Over $9,075 but not over $36,900        $907.50 plus 15% of the excess over

 

                                         $9,075

 

 

 Over $36,900 but not over $74,425       $5,081.25 plus 25% of the excess over

 

                                         $36,900

 

 

 Over $74,425 but not over $113,425      $14,462.50 plus 28% of the excess over

 

                                         $74,425

 

 

 Over $113,425 but not over $202,550     $25,382.50 plus 33% of the excess over

 

                                         $113,425

 

 

 Over $202,550 but not over $228,800     $54,793.75 plus 35% of the excess over

 

                                         $202,550

 

 

 Over $228,800                           $63,981.25 plus 39.6% of the excess

 

                                         over $228,800

 

 ______________________________________________________________________________

 

 

                               Estates and Trusts

 

 ______________________________________________________________________________

 

 

 Not over $2,500                         15% of the taxable income

 

 

 Over $2,500 but not over $5,800         $375 plus 25% of the excess over

 

                                         $2,500

 

 

 Over $5,800 but not over $8,900         $1,200 plus 28% of the excess over

 

                                         $5,800

 

 

 Over $8,900 but not over $12,150        $2,068 plus 33% of the excess over

 

                                         $8,900

 

 

 Over $12,150                            $3,140.50 plus 39.6% of the excess

 

                                         over $12,150

 

 

Unearned income of children

Special rules (generally referred to as the "kiddie tax") apply to the net unearned income of certain children.7 Generally, the kiddie tax applies to a child if: (1) the child has not reached the age of 19 by the close of the taxable year, or the child is a full-time student under the age of 24, and either of the child's parents is alive at such time; (2) the child's unearned income exceeds $2,000 (for 2014); and (3) the child does not file a joint return.8 The kiddie tax applies regardless of whether the child may be claimed as a dependent by either or both parents. For children above age 17, the kiddie tax applies only to children whose earned income does not exceed one-half of the amount of their support.

Under these rules, the net unearned income of a child (for 2014, unearned income over $2,000) is taxed at the parents' tax rates if the parents' tax rates are higher than the tax rates of the child.9 The remainder of a child's taxable income (i.e., earned income, plus unearned income up to $2,000 (for 2014), less the child's standard deduction) is taxed at the child's rates, regardless of whether the kiddie tax applies to the child. For these purposes, unearned income is income other than wages, salaries, professional fees, other amounts received as compensation for personal services actually rendered, and distributions from qualified disability trusts.10 In general, a child is eligible to use the preferential tax rates for qualified dividends and capital gains.11

The kiddie tax is calculated by computing the "allocable parental tax." This involves adding the net unearned income of the child to the parent's income and then applying the parent's tax rate. A child's "net unearned income" is the child's unearned income less the sum of (1) the minimum standard deduction allowed to dependents ($1,000 for 201412), and (2) the greater of (a) such minimum standard deduction amount or (b) the amount of allowable itemized deductions that are directly connected with the production of the unearned income.13

The allocable parental tax equals the hypothetical increase in tax to the parent that results from adding the child's net unearned income to the parent's taxable income.14 If the child has net capital gains or qualified dividends, these items are allocated to the parent's hypothetical taxable income according to the ratio of net unearned income to the child's total unearned income. If a parent has more than one child subject to the kiddie tax, the net unearned income of all children is combined, and a single kiddie tax is calculated. Each child is then allocated a proportionate share of the hypothetical increase, based upon the child's net unearned income relative to the aggregate net unearned income of all of the parent's children subject to the tax.

Generally, a child must file a separate return to report his or her income.15 In such case, items on the parents' return are not affected by the child's income, and the total tax due from the child is the greater of:

 

1. The sum of (a) the tax payable by the child on the child's earned income and unearned income up to $2,000 (for 2014), plus (b) the allocable parental tax on the child's unearned income, or

2. The tax on the child's income without regard to the kiddie tax provisions.16

 

Under certain circumstances, a parent may elect to report a child's unearned income on the parent's return.17

Indexing tax provisions for inflation

Under present law, many parameters of the tax system are adjusted for inflation to protect taxpayers from the effects of rising prices. Most of the adjustments are based on annual changes in the level of the Consumer Price Index for all Urban Consumers ("CPI-U") .18 The CPI-U is an index that measures prices paid by typical urban consumers on a broad range of products, and is developed and published by the Department of Labor.

Among the inflation-indexed tax parameters are the following individual income tax amounts: (1) the regular income tax brackets; (2) the basic standard deduction; (3) the additional standard deduction for aged and blind; (4) the personal exemption amount; (5) the thresholds for the overall limitation on itemized deductions and the personal exemption phase-out; (6) the phase-in and phase-out thresholds of the earned income credit; (7) IRA contribution limits and deductible amounts; and (8) the saver's credit.

 

Description of Proposal

 

 

Modification of rates

 

In general

 

The proposal replaces the individual income tax rate structure with a new rate structure. The new rate structure generally has three rates, 10 percent, 25 percent and 35 percent, with the 35-percent rate composed of the 25-percent rate imposed on taxable income in excess of the 25-percent rate bracket threshold and an additional 10 percent tax on modified adjusted gross income (modified "AGI") in excess of $450,000 for joint returns ($400,000 for all other filers). The 25-percent rate bracket begins at taxable income of $71,200 for joint returns and surviving spouses ($35,600 for other individuals).19 Estates and trusts have only two rate brackets: a 25-percent bracket and 35-percent bracket, with the 35-percent rate composed of a 25 percent rate on taxable income and an additional 10 percent rate on modified AGI in excess of $12,000. Modified AGI is described in more detail below.

The benefit of the 10-percent rate, as measured against the 25-percent rate on taxable income, is phased out if an individual's modified AGI exceeds a threshold of $300,000 for joint filers and surviving spouses ($250,000 for any other individual other than trusts and estates). For taxpayers whose modified AGI exceeds these thresholds, the benefit amounts to $10,680 for joint filers and $5,340 for all other filers. The benefit amount is phased out at a five-percent rate, and is thus fully phased out at modified AGI of $513,600 (in the case of joint filers) or $356,800 (in the case of other individual taxpayers) above the threshold amount.

The bracket thresholds, and the threshold at which the benefit of the 10-percent rate begins to be phased out, are all adjusted for inflation using a base year of 2013, and then rounded to the next lowest multiple of $100 in future years. Unlike present law (which uses a measure of the consumer price index for all-urban consumers), the new inflation adjustment uses the chained consumer price index for all-urban consumers.

For purposes of the 35-percent bracket and the phaseout of the benefit of the 10-percent bracket, modified AGI is defined as AGI increased by:

 

(i) any amount excluded from income under sections 911 (related to exclusions from income for citizens or residents of the United States living abroad), 931, and 933;

(ii) any amount of interest received or accrued by the taxpayer during the taxable year which is exempt from tax (less any amounts disallowed as a deduction for investment interest with respect to tax-exempt interest,20 and amortizable bond premiums on tax-exempt bonds21);

(iii) any amount excluded by the taxpayer as a cost of employer-sponsored health coverage;

(iv) amounts paid by a self-employed individual for health insurance deducted under section 162(l);

(v) pre-tax contributions to tax-favored defined contribution retirement plans;

(vi) deductible health savings account ("HSA") contributions; and

(vii) excluded Social Security and tier I railroad retirement benefits; and

 

reduced by

 

(i) charitable contributions to the extent eligible for a deduction under section 170, but only if the taxpayer itemizes his or her deductions; and

(ii) qualified domestic manufacturing income.

Qualified domestic manufacturing income

 

For these purposes, qualified domestic manufacturing income is equal to domestic manufacturing gross receipts reduced by the sum of: (1) the costs of goods sold that are allocable to those receipts; and (2) other expenses, losses, or deductions which are properly allocable to those receipts.

Domestic manufacturing gross receipts generally are gross receipts of a taxpayer that are derived from: (1) any lease, rental, license, sale, exchange, or other disposition of tangible personal property that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States;22 or (2) in the case of a taxpayer engaged in the active conduct of a construction trade or business, construction of real property performed in the United States by a taxpayer in the ordinary course of such trade or business if such real property is placed in service after December 31, 2014.

Under the proposal, tangible personal property does not include computer software23 or any motion picture films, video tapes, or sound recordings.24

However, domestic manufacturing gross receipts do not include any gross receipts of the taxpayer derived from property that is leased, licensed, or rented by the taxpayer for use by any related person. Further, domestic manufacturing gross receipts do not include any gross receipts of the taxpayer that are derived from the sale of food or beverages prepared by the taxpayer at a retail establishment; that are derived from the transmission or distribution of electricity, natural gas, or potable water; and that are derived from the lease, rental, license, sale, exchange, or other disposition of land. Domestic manufacturing gross receipts also do not include any gross receipts which are properly allocable to the taxpayer's net earnings from self employment,25 or any amount attributable to a qualified change in method of accounting26 and/or any other change in method of accounting required by the discussion draft.27

A special rule for government contracts provides that property that is manufactured or produced by the taxpayer pursuant to a contract with the Federal Government is considered to be domestic manufacturing gross receipts even if title or risk of loss is transferred to the Federal Government before the manufacture or production of such property is complete to the extent required by the Federal Acquisition Regulation.

With respect to the domestic manufacturing income of a partnership or S corporation, each partner or shareholder generally will take into account such person's allocable share of the components of the calculation (including domestic manufacturing gross receipts; the cost of goods sold allocable to such receipts; and other expenses, losses, or deductions properly allocable to such receipts) from the partnership or S corporation. For a trust or estate, the components of the calculation are apportioned between (and among) the beneficiaries and the fiduciary under regulations prescribed by the Secretary. However, in the case of a publicly traded partnership described in section 7704(c), each partner shall not take into account any allocable share of the aforementioned components of the calculation.

A phase-in is provided for taxable years beginning before January 1, 2017: for any taxable year beginning in 2015, only 33 percent of a taxpayer's qualified domestic manufacturing income reduces AGI; and for any taxable year beginning in 2016, only 67 percent of a taxpayer's qualified domestic manufacturing income reduces AGI.

Simplification of tax on unearned income of children

The proposal simplifies the "kiddie tax" by effectively applying the rates applicable to trusts to the net unearned income of a child to whom the proposal applies. Specifically, the amount of taxable income taxed at a 10-percent rate may not exceed the amount of taxable income in excess of the net unearned income of the child. The amount of taxable income taxed at rates below 35 percent may not exceed sum of (1) the taxable income in excess of the net unearned income of the child plus (2) the amount of taxable income not in excess of the 35-percent bracket threshold in the case of a trust.

The following examples illustrate the application of the proposal:

Example 1. -- Assume a child to whom the "kiddie tax" applies has $60,000 taxable income (and modified AGI) of which $50,000 is net unearned income. Assume the 25-percent bracket threshold amount for the taxable year is $35,600 for an unmarried taxpayer (other than a child subject to the "kiddie tax"), and the 35-percent bracket threshold for a trust is $12,000.

The child's 25-percent bracket threshold is $10,000 ($60,000 less $50,000) and 35-percent bracket threshold is $22,000 ($10,000 plus $12,000). Thus, $10,000 is taxed at a 10-percent rate, $12,000 is taxed at a 25-percent rate, and $38,000 is taxed at a 35-percent rate.

Example 2. -- Assume the same facts as in Example 1 except that the amount of the child's net unearned income is $20,000 (rather than $50,000).

The child's 25-percent bracket threshold is $35,600 and 35-percent bracket threshold is $52,000 ($40,000 ($60,000 less $20,000) plus $12,000). Thus, $35,600 is taxed at a 10-percent rate, $16,400 is taxed at a 25-percent rate, and $8,000 is taxed at a 35-percent rate.

Replacing CPI-U with chained CPI-U

The proposal requires the use of the chained CPI-U ("C-CPI-U") to index tax parameters currently indexed by the CPI-U. The C-CPI-U is developed and published by the Department of Labor, and differs from the CPI-U in that it accounts for the ability of individuals to alter their consumption patterns in response to relative price changes.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

2. Deduction for capital gains and dividends of individuals (sec. 1002 of the discussion draft and sec. 169 of the Code)

 

Present Law

 

 

In general

In the case of an individual, estate, or trust, any adjusted net capital gain which otherwise would be taxed at the 10- or 15-percent rate is not taxed. Any adjusted net capital gain which otherwise would be taxed at rates over 15-percent and below 39.6 percent is taxed at a 15-percent rate. Any adjusted net capital gain which otherwise would be taxed at a 39.6-percent rate is taxed at a 20-percent rate.

The unrecaptured section 1250 gain is taxed at a maximum rate of 25 percent, and 28-percent rate gain is taxed at a maximum rate of 28 percent. Any amount of unrecaptured section 1250 gain or 28-percent rate gain otherwise taxed at a 10- or 15-percent rate is taxed at the otherwise applicable rate.

In addition, a tax is imposed on net investment income in the case of an individual, estate, or trust. In the case of an individual, the tax is 3.8 percent of the lesser of net investment income, which includes gains and dividends, or the excess of modified adjusted gross income over the threshold amount. The threshold amount is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in the case of any other individual.

Definitions

 

Net capital gain

 

In general, gain or loss reflected in the value of an asset is not recognized for income tax purposes until a taxpayer disposes of the asset. On the sale or exchange of a capital asset, any gain generally is included in income. Net capital gain is the excess of the net long-term capital gain for the taxable year over the net short-term capital loss for the year. Gain or loss is treated as long-term if the asset is held for more than one year.

A capital asset generally means any property except (1) inventory, stock in trade, or property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business, (2) depreciable or real property used in the taxpayer's trade or business, (3) specified literary or artistic property, (4) business accounts or notes receivable, (5) certain U.S. publications, (6) certain commodity derivative financial instruments, (7) hedging transactions, and (8) business supplies. In addition, the net gain from the disposition of certain property used in the taxpayer's trade or business is treated as long-term capital gain. Gain from the disposition of depreciable personal property is not treated as capital gain to the extent of all previous depreciation allowances. Gain from the disposition of depreciable real property is generally not treated as capital gain to the extent of the depreciation allowances in excess of the allowances available under the straight-line method of depreciation.

 

Adjusted net capital gain

 

The "adjusted net capital gain" of an individual is the net capital gain reduced (but not below zero) by the sum of the 28-percent rate gain and the unrecaptured section 1250 gain. The net capital gain is reduced by the amount of gain that the individual treats as investment income for purposes of determining the investment interest limitation under section 163(d).

 

Qualified dividend income

 

Adjusted net capital gain is increased by the amount of qualified dividend income.

A dividend is the distribution of property made by a corporation to its shareholders out of its after-tax earnings and profits. Qualified dividends generally includes dividends received from domestic corporations and qualified foreign corporations. The term "qualified foreign corporation" includes a foreign corporation that is eligible for the benefits of a comprehensive income tax treaty with the United States which the Treasury Department determines to be satisfactory and which includes an exchange of information program. In addition, a foreign corporation is treated as a qualified foreign corporation for any dividend paid by the corporation with respect to stock that is readily tradable on an established securities market in the United States.

If a shareholder does not hold a share of stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date (as measured under section 246(c)), dividends received on the stock are not eligible for the reduced rates. Also, the reduced rates are not available for dividends to the extent that the taxpayer is obligated to make related payments with respect to positions in substantially similar or related property.

Dividends received from a corporation that is a passive foreign investment company (as defined in section 1297) in either the taxable year of the distribution, or the preceding taxable year, are not qualified dividends.

A dividend is treated as investment income for purposes of determining the amount of deductible investment interest only if the taxpayer elects to treat the dividend as not eligible for the reduced rates.

The amount of dividends qualifying for reduced rates that may be paid by a regulated investment company ("RIC") for any taxable year in which the qualified dividend income received by the RIC is less than 95 percent of its gross income (as specially computed) may not exceed the sum of (1) the qualified dividend income of the RIC for the taxable year and (2) the amount of earnings and profits accumulated in a non-RIC taxable year that were distributed by the RIC during the taxable year.

The amount of qualified dividend income that may be paid by a real estate investment trust ("REIT") for any taxable year may not exceed the sum of (1) the qualified dividend income of the REIT for the taxable year, (2) an amount equal to the excess of the income subject to the taxes imposed by section 857(b)(1) and the regulations prescribed under section 337(d) for the preceding taxable year over the amount of these taxes for the preceding taxable year, and (3) the amount of earnings and profits accumulated in a non-REIT taxable year that were distributed by the REIT during the taxable year.

Dividends received from an organization that was exempt from tax under section 501 or was a tax-exempt farmers' cooperative in either the taxable year of the distribution or the preceding taxable year; dividends received from a mutual savings bank that received a deduction under section 591; or deductible dividends paid on employer securities are not qualified dividend income.

 

28-percent rate gain

 

The term "28-percent rate gain" means the excess of the sum of the amount of net gain attributable to long-term capital gains and losses from the sale or exchange of collectibles (as defined in section 408(m) without regard to paragraph (3) thereof) and the amount of gain equal to the additional amount of gain that would be excluded from gross income under section 1202 (relating to certain small business stock) if the percentage limitations of section 1202(a) did not apply, over the sum of the net short-term capital loss for the taxable year and any long-term capital loss carryover to the taxable year.

 

Unrecaptured section 1250 gain

 

"Unrecaptured section 1250 gain" means any long-term capital gain from the sale or exchange of section 1250 property (i.e., depreciable real estate) held more than one year to the extent of the gain that would have been treated as ordinary income if section 1250 applied to all depreciation, reduced by the net loss (if any) attributable to the items taken into account in computing 28-percent rate gain. The amount of unrecaptured section 1250 gain (before the reduction for the net loss) attributable to the disposition of property to which section 1231 (relating to certain property used in a trade or business) applies may not exceed the net section 1231 gain for the year.

 

Description of Proposal

 

 

The proposal repeals the present-law maximum tax rates for capital gain and dividends. The proposal provides a deduction in computing adjusted gross income equal to 40 percent of the adjusted net capital gain of an individual.

Adjusted net capital gain means net capital gain reduced (but not below zero) by the net collectibles gain and increased by the qualified dividend income.

The 3.8 percent tax on net investment income is not affected by the proposal.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

 

B. Simplification of Tax Benefits for Families

 

 

1. Standard deduction (sec. 1101 of the discussion draft and sec. 63 of the Code)

 

Present Law

 

 

Under present law, a taxpayer may reduce his adjusted gross income ("AGI") by the amount of the applicable standard deduction. The basic standard deduction varies depending upon a taxpayer's filing status. For 2014, the amount of the standard deduction is $6,200 for single individuals and married individuals filing separate returns, $9,100 for heads of households, and $12,400 for married individuals filing a joint return and surviving spouses. An additional standard deduction is allowed with respect to any individual who is elderly or blind.28 The amounts of the basic standard deduction and the additional standard deductions are indexed annually for inflation.

In lieu of taking the applicable standard deduction, an individual may elect to itemize deductions. The deductions that may be itemized include State and local income taxes (or, in lieu of income, sales taxes), real property and certain personal property taxes, home mortgage interest, charitable contributions, certain investment interest, medical expenses (in excess of 10 percent of AGI (7.5 percent for certain taxpayers over age 65)), casualty and theft losses (in excess of $100 per loss and in excess of 10 percent of AGI), and certain miscellaneous expenses (in excess of two percent of AGI).

 

Description of Proposal

 

 

The proposal increases the standard deduction for taxpayers across all filing statuses. Under the proposal, the amount of the standard deduction is $22,000 for married individuals filing a joint return and $11,000 for all other taxpayers (the proposal eliminates head of household filing status). The amount of the standard deduction is indexed for inflation using the chained consumer price index for all-urban consumers.29

The proposal also provides that the amount of the standard deduction is phased out by 20 percent of every dollar that a taxpayer's modified AGI exceeds $513,60030 for joint filers ($356,800 for all other filers).31 Thus, using the nominal values, the standard deduction will be completely phased out when a taxpayer's modified AGI reaches $623,600 in the case of a joint return (and $411,800 in any other case). The threshold amount at which the phaseout begins is indexed for inflation.32

To provide parity with those who itemize their deductions, the proposal also provides for a phaseout of $22,000 of itemized deductions, in the case of joint filers ($11,000 for all other filers) over the same modified AGI range. Thus, if a joint filer had $40,000 in itemized deductions, this amount would be reduced to $18,000 (i.e., the $22,000 value of the standard deduction would be phased out) as the taxpayer's modified AGI went from $513,600 to $623,600.

The proposal eliminates the additional standard deduction for the aged and the blind.

The proposal provides for an additional above-the-line deduction for unmarried individuals with at least one qualifying child. These individuals are entitled to an additional deduction of $5,500 (indexed for inflation).33 This additional deduction is phased out for every dollar by which a taxpayer's AGI exceeds $30,000 (this threshold is adjusted for inflation).

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

2. Increase and expansion of child tax credit (sec. 1102 of the discussion draft and sec. 24 of the Code)

 

Present Law

 

 

An individual may claim a tax credit for each qualifying child under the age of 17. The amount of the credit per child is $1,000. A child who is not a citizen, national, or resident of the United States cannot be a qualifying child.

The aggregate amount of child credits that may be claimed is phased out for individuals with income over certain threshold amounts. Specifically, the otherwise allowable child tax credit is reduced by $50 for each $1,000 (or fraction thereof) of modified adjusted gross income ("AGI") over $75,000 for single individuals or heads of households, $110,000 for married individuals filing joint returns, and $55,000 for married individuals filing separate returns. For purposes of this limitation, modified AGI includes certain otherwise excludable income earned by U.S. citizens or residents living abroad or in certain U.S. territories.

The credit is allowable against both the regular tax and the alternative minimum tax ("AMT"). To the extent the child credit exceeds the taxpayer's tax liability, the taxpayer is eligible for a refundable credit34 (the "additional child tax credit") equal to 15 percent of earned income in excess of a threshold dollar amount (the "earned income" formula). Prior to the enactment of the American Recovery and Reinvestment Act of 2009 ("ARRA"), the threshold dollar amount was $10,000 and was indexed for inflation. Under the ARRA, the threshold amount was lowered to $3,000 (the $3,000 amount is not indexed). The $3,000 threshold is currently scheduled to expire for taxable years beginning after December 31, 2017, after which the threshold reverts to the indexed $10,000 amount ($13,600 for 2014).

Families with three or more children may determine the additional child tax credit using the "alternative formula," if this results in a larger credit than determined under the earned income formula. Under the alternative formula, the additional child tax credit equals the amount by which the taxpayer's Social Security taxes exceed the taxpayer's earned income credit ("EIC").

Earned income is defined as the sum of wages, salaries, tips, and other taxable employee compensation plus net self-employment earnings. At the taxpayer's election, combat pay may be treated as earned income for these purposes. Unlike the EIC, which also includes the preceding items in its definition of earned income, the additional child tax credit is based only on earned income to the extent it is included in computing taxable income. For example, some ministers' parsonage allowances are considered self-employment income, and thus are considered earned income for purposes of computing the EIC, but the allowances are excluded from gross income for individual income tax purposes, and thus are not considered earned income for purposes of the additional child tax credit since the income is not included in taxable income.

Any credit or refund allowed or made to an individual under this provision (including to any resident of a U.S. possession) is not taken into account as income and is not be taken into account as resources for the month of receipt and the following two months for purposes of determining eligibility of such individual or any other individual for benefits or assistance, or the amount or extent of benefits or assistance, under any Federal program or under any State or local program financed in whole or in part with Federal funds.

 

Description of Proposal

 

 

The proposal increases the child tax credit to $1,500 per qualifying child and raises the age limit by one year to include qualifying children under age 18 ($500 for other qualifying dependents).35 The proposal generally retains the present-law definition of dependent. However, the definition of a qualifying child is limited to individuals who are citizens or nationals of the United States. The credit amounts are indexed for inflation.36

The credit is phased out for higher-income individuals. Specifically, a taxpayer's child tax credit is reduced at a rate of five percent of the taxpayer's modified AGI as exceeds $623,60037 for joint filers ($411,800 for other filers).38 These thresholds are indexed for inflation.39

The child tax credit is partially refundable against the individual's income tax liability. The refundable portion is limited to the lesser of: (1) the child tax credit otherwise allowed, or (2) 25 percent of the taxpayer's earned income. Earned income is defined as a taxpayer's wages, salaries, tips and other employee compensation includible in gross income for the taxable year, plus the taxpayer's net earnings from self-employment income for the taxable year (determined with regard to the deduction allowed to the taxpayer by section 164(f)). For purposes of calculating a taxpayer's refundable child credit, for taxable years beginning prior to 2018, a taxpayer must reduce earned income by $3,000 (but not below zero). Additionally, the proposal provides that a taxpayer is not allowed the refundable child tax credit for a taxable year in which the taxpayer excludes any amount from gross income under section 911 (relating to the exclusion of foreign earned income).

The proposal requires that the taxpayer include the name and taxpayer identification number of each qualifying child and dependent on the tax return for each taxable year. In the case of a refundable child tax credit the taxpayer must include the taxpayer's Social Security number on the tax return for the taxable year (in the case of a joint return either spouse's Social Security number will suffice). The Internal Revenue Service may assess a deficiency in tax arising from the failure to include the Social Security number on the tax return as a mathematical or clerical error.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

3. Modification of earned income tax credit (sec. 1103 of the discussion draft and sec. 32 of the Code)

 

Present Law

 

 

In general

 

Low- and moderate-income workers may be eligible for the refundable earned income credit ("EIC"). Eligibility for the EIC is based on earned income, adjusted gross income ("AGI"), investment income, filing status, number of children, and immigration and work status in the United States. The amount of the EIC is based on the presence and number of qualifying children in the worker's family, as well as on adjusted gross income and earned income.

The EIC generally equals a specified percentage of earned income up to a maximum dollar amount. The maximum amount applies over a certain income range and then diminishes to zero over a specified phaseout range. For taxpayers with earned income (or AGI, if greater) in excess of the beginning of the phaseout range, the maximum EIC amount is reduced by the phaseout rate multiplied by the amount of earned income (or AGI, if greater) in excess of the beginning of the phaseout range. For taxpayers with earned income (or AGI, if greater) in excess of the end of the phaseout range, no credit is allowed.

An individual is not eligible for the EIC if the aggregate amount of disqualified income of the taxpayer for the taxable year exceeds $3,350 (for 2014). This threshold is indexed for inflation. Disqualified income is the sum of: (1) interest (both taxable and tax exempt); (2) dividends; (3) net rent and royalty income (if greater than zero); (4) capital gains net income; and (5) net passive income that is not self-employment income (if greater than zero).

The EIC is a refundable credit, meaning that if the amount of the credit exceeds the taxpayer's Federal income tax liability, the excess is payable to the taxpayer as a direct transfer payment.

 

Filing status

 

An unmarried individual may claim the EIC if he or she files as a single filer or as a head of household. Married individuals generally may not claim the EIC unless they file jointly. An exception to the joint return filing requirement applies to certain spouses who are separated. Under this exception, a married taxpayer who is separated from his or her spouse for the last six months of the taxable year is not considered to be married (and, accordingly, may file a return as head of household and claim the EIC), provided that the taxpayer maintains a household that constitutes the principal place of abode for a dependent child (including a son, stepson, daughter, stepdaughter, adopted child, or a foster child) for over half the taxable year, and pays over half the cost of maintaining the household in which he or she resides with the child during the year.

 

Presence of qualifying children and amount of the earned income credit

 

Four separate credit schedules apply: one schedule for taxpayers with no qualifying children, one schedule for taxpayers with one qualifying child, one schedule for taxpayers with two qualifying children, and one schedule for taxpayers with three or more qualifying children. The values below are for 2014.40

Taxpayers with no qualifying children may claim a credit if they are over age 24 and below age 65. The credit is 7.65 percent of earnings up to $6,480, resulting in a maximum credit of $496. The maximum is available for those with incomes between $6,480 and $8,110 ($13,540 if married filing jointly). At that point, the credit begins to phase out at a rate of 7.65 percent of earnings above that threshold, resulting in a $0 credit at $14,590 of earnings ($20,020 if married filing jointly).

Taxpayers with one qualifying child may claim a credit of 34 percent of their earnings up to $9,720, resulting in a maximum credit of $3,305. The maximum credit is available for those with earnings between $9,720 and $17,830 ($23,260 if married filing jointly). At that point, the credit begins to phase out at a rate of 15.98 percent of earnings above this threshold, phasing out completely at $38,511 of earnings ($43,941 if married filing jointly).

Taxpayers with two qualifying children may claim a credit of 40 percent of earnings up to $13,650, resulting in a maximum credit of $5,460. The maximum credit is available for those with earnings between $13,650 and $17,830 ($23,260 if married filing jointly). The credit begins to phase out at a rate of 21.06 percent of earnings above that threshold, and is completely phased out at $43,756 of earnings ($49,186 if married filing jointly).

A temporary provision recently extended by the American Taxpayer Relief Act of 2012 ("ATRA")41 allows taxpayers with three or more qualifying children to claim the EIC at an increased rate of 45 percent for taxable years before 2018. Thus, in 2014 taxpayers with three or more qualifying children may claim a credit of 45 percent of earnings up to $13,650, resulting in a maximum credit of $6,143. The maximum credit is available for those with earnings between $13,650 and $17,830 ($23,260 if married filing jointly). The credit begins to phase out at a rate of 21.06 percent of earnings above that threshold, and is completely phased out at $46,997 of earnings ($52,427 if married filing jointly).

A temporary provision recently extended by the ATRA increases the phase-out thresholds for married couples to an amount $5,000 (indexed for inflation from 2009)42 above that for other filers. The increase is $5,430 for 2014. This increase expires for taxable years beginning after December 31, 2017.

 

Description of Proposal

 

 

The proposal modifies the EIC. Under the proposal, certain low-income taxpayers are entitled to a credit equal to the amount of the individual's employment-related taxes for the taxable year. The maximum credit for a taxpayer with two or more qualifying children is $3,000 ($4,000 for those who file joint returns). For taxpayers with one qualifying child,43 the maximum credit is $2,400 (regardless of filing status). For taxpayers with no qualifying children, the maximum credit is $100 ($200 for those who file joint returns). For individuals who pay Federal Insurance Contributions Act ("FICA") or Railroad Retirement Tax Act ("RRTA") taxes under section 3101 or 3201, respectively, the credit is first credited against the employee share of such taxes, but may not reduce the employee share of such taxes below zero.44 Any section 32 credit available to be applied against income tax is reduced by the amount of any credit applied against the taxes imposed by section 3101 or 3201.

For these purposes, employment-related taxes with respect to any taxpayer for any taxable year is the sum of: (1) the employee share and the employer share of FICA tax on the taxpayer's wages received during the calendar year in which the taxable year begins; (2) any RRTA tax imposed (i.e ., on employees, employers, and employee representatives) on compensation received by the taxpayer during the calendar year in which the taxable year begins; and (3) any Self-Employment Contributions Act ("SECA") tax imposed on the self-employment income of the taxpayer for the taxable year. For these purposes, the definition of wages is the same as used for FICA tax purposes in section 3121(a) and the definition of compensation is the same as used for Railroad Retirement Tax purposes in section 3231(e). In the case of taxpayers with no qualifying children, for purposes of the credit, employment-related taxes are defined as the employee share of FICA or RRTA taxes, or, in the case of any SECA tax imposed on the taxpayer, one-half of such amount.

In the case of taxpayers with qualifying children, the credit is phased-down by the sum of: (1) 19 percent of the taxpayer's AGI over $27,000 in the case of taxpayers filing a joint return ($20,000 for all other filers); and (2) 100 percent of the taxpayer's investment income as exceeds $3,300. The definition of investment income for these purposes is unchanged from present law.45 For taxpayers with no qualifying children, the credit is phased down by the sum of (1) 19 percent of the taxpayer's AGI over $13,000 in the case of taxpayers filing a joint return ($8,000 for all other filers), and (2) 100 percent of the taxpayer's investment income as exceeds $3,300.

For tax years beginning prior to 2018, taxpayers with qualifying children are allowed an EIC for up to 200 percent of employment-related taxes, subject to the applicable maximum credit. For tax years beginning prior to 2018, the applicable maximum credit for taxpayers with two or more children is $4,000, regardless of filing status (that is, the maximum credit is increased by $1,000 for taxpayers with two or more children who do not file a joint return), and the maximum applicable credit for taxpayers with one child is increased by $600, to $3,000.

Both the maximum amount of the credit and income thresholds for the phaseout of the credit are indexed for inflation.46

No credit is allowed unless the taxpayer includes on the tax return for the taxable year the taxpayer's Social Security number. In the case of taxpayers filing a joint return, this identification requirement will be satisfied if the Social Security number of either spouse is included on the tax return. Additionally, a child shall not be considered a qualifying child for purposes of the credit unless the return includes the name, age and Social Security number of that child. The Secretary of the Treasury or his designee may prescribe other methods for satisfying the second identification requirement.

The proposal also requires the Secretary of the Treasury (or the Secretary's designee) to submit a report to Congress within 180 days of the date of enactment, making recommendations regarding the best method for providing for advance payment of the EIC. The recommendations in the report shall seek to 1) provide for the payment of the EIC as promptly as is feasible, and 2) minimize any administrative burdens on employers and the IRS.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

4. Repeal of deduction for personal exemptions (sec. 1104 of the discussion draft and sec. 151 of the Code)

 

Present Law

 

 

Under present law, in determining taxable income, an individual reduces AGI by any personal exemption deductions and either the applicable standard deduction or his or her itemized deductions. Personal exemptions generally are allowed for the taxpayer, his or her spouse, and any dependents. For 2014, the amount deductible for each personal exemption is $3,950. This amount is indexed annually for inflation.

 

Withholding rules

 

Under present law, the amount of tax required to be withheld by employers from a taxpayer's wages is based in part on the number of withholding exemptions a taxpayer claims on his Form W-4. An employee is entitled to the following exemptions: (1) an exemption for himself, unless he allowed to be claimed as a dependent of another person; (2) an exemption to which the employee's spouse would be entitled, if that spouse does not file a Form W-4 for that taxable year claiming an exemption described in (1); (3) an exemption for each individual who is a dependent (but only if the employee's spouse has not also claimed such a withholding exemption on a Form W-4); (4) additional withholding allowances (taking into account estimated itemized deductions, estimated tax credits, and additional deductions as provided by the Secretary of the Treasury); and (5) a standard deduction allowance.

 

Filing requirements

 

Under present law, an unmarried individual is required to file a tax return for the taxable year if in that year the individual had income which equals or exceeds the exemption amount plus the standard deduction applicable to such individual (i.e., single, head of household, or surviving spouse). An individual entitled to file a joint return is required to do so unless that individual's gross income, when combined with the individual's spouse's gross income for the taxable year, is less than the sum of twice the exemption amount plus the basic standard deduction applicable to a joint return, provided that such individual and his spouse, at the close of the taxable year, had the same household as their home.

 

Qualifying Children

 

Present law contains numerous provisions, including the dependency exemption, that provide benefits for taxpayers with children. In general, a child is a qualifying child of a taxpayer (and thus eligible for these benefits) if the child satisfies each of three tests: (1) the child has the same principal place of abode as the taxpayer for more than one half the taxable year; (2) the child has a specified relationship to the taxpayer; and (3) the child has not yet attained a specified age. A tie-breaking rule applies if more than one taxpayer claims a child as a qualifying child.

Under the residency test , a child must have the same principal place of abode as the taxpayer for more than one half of the taxable year. Special rules apply in the case of divorced or separated parents. The relationship test requires that the individual is the taxpayer's son, daughter, stepchild, foster child, or a descendant of any of them (for example, the taxpayer's grandchild). Additionally, the child can be the taxpayer's brother, sister, half brother, half sister, stepbrother, stepsister, or a descendant of any of them (for example, the taxpayer's niece or nephew).47

The age test varies depending upon the tax benefit involved. In general, a child must be under age 19 (or under age 24 in the case of a full-time student) in order to be a qualifying child. In general, no age limit applies with respect to individuals who are totally and permanently disabled at any time during the calendar year. There are exceptions to these general rules. Two notable exceptions are: (1) a child must be under age 13 (if he or she is not disabled) for purposes of the dependent care credit and (2) a child must be under age 17 (whether or not disabled) for purposes of the child credit.

 

Description of Proposal

 

 

The proposal repeals the deduction for personal exemptions.

The proposal modifies the requirements for those who are required to file a tax return. In the case of an individual who is not married, such individual is required to file a tax return if the taxpayer's gross income for the taxable year exceeds the applicable standard deduction. Married individuals are required to file a return if that individual's gross income, when combined with the individual's spouse's gross income for the taxable year, is more than the standard deduction applicable to a joint return, provided that: (i) such individual and his spouse, at the close of the taxable year, had the same household as their home; (ii) the individual's spouse does not make a separate return; and (iii) neither the individual nor his spouse is a dependent of another taxpayer and has income (other than earned income) in excess of $500.

The proposal modifies the age test for a qualifying child. Under the proposal, a child may only be a qualifying child if that child has not attained the age of 18 as of the close of the calendar year in which the taxable year of the taxpayer begins. Under the proposal, as under present law, there is no age test for an individual who is permanently and totally disabled.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

 

C. Simplification of Education Benefits

 

 

1. American opportunity tax credit (sec. 1201 of the discussion draft and sec. 25A of the Code)

 

Present Law

 

 

Hope credit and American Opportunity credit

 

For taxable years beginning before 2009 and after 2017, individual taxpayers are allowed to claim a nonrefundable credit, the Hope credit, against Federal income taxes of up to $1,950 (estimated 2014 level) per eligible student per year for qualified tuition and related expenses paid for the first two years of the student's post-secondary education in a degree or certificate program.48 The Hope credit rate is 100 percent on the first $1,300 of qualified tuition and related expenses, and 50 percent on the next $1,300 of qualified tuition and related expenses. These dollar amounts are indexed for inflation, with the amount rounded down to the next lowest multiple of $100. Thus, for example, a taxpayer who incurs $1,300 of qualified tuition and related expenses for an eligible student is eligible (subject to the adjusted gross income ("AGI") phaseout described below) for a $1,300 Hope credit. If a taxpayer incurs $2,600 of qualified tuition and related expenses for an eligible student, then he or she is eligible for a $1,950 Hope credit.

The Hope credit that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified AGI between $55,000 and $65,000 ($110,000 and $130,000 for married taxpayers filing a joint return) for 2014, based on inflation adjustments determined by the staff of the Joint Committee on Taxation. The beginning points of the AGI phaseout ranges are indexed for inflation, with the amount rounded down to the next lowest multiple of $1,000. The size of the phaseout ranges for single and married taxpayers are always $10,000 and $20,000 respectively.

A taxpayer may not claim the Hope credit if the qualified tuition and related expenses for the enrollment or attendance of a student, if such student has been convicted of a Federal or State felony offense consisting of the possession or distribution of a controlled substance before the end of the taxable year.49

For taxable years beginning after December 31, 2008, individual taxpayers are eligible to claim the American Opportunity credit, which refers to modifications to the Hope credit that apply for taxable years 2009 through 2017.50 The maximum allowable modified credit is $2,500 per eligible student per year for qualified tuition and related expenses paid for each of the first four years of the student's post-secondary education in a degree or certificate program. The modified credit rate is 100 percent on the first $2,000 of qualified tuition and related expenses, and 25 percent on the next $2,000 of qualified tuition and related expenses. For purposes of the modified credit, the definition of qualified tuition and related expenses is expanded to include course materials. Forty percent of a taxpayer's otherwise allowable modified credit is refundable. The modified credit that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified AGI between $80,000 and $90,000 ($160,000 and $180,000 for married taxpayers filing a joint return). The modified credit may be claimed against a taxpayer's AMT liability.

 

Lifetime learning credit

 

Individual taxpayers may be eligible to claim a nonrefundable credit, the Lifetime Learning credit, against Federal income taxes equal to 20 percent of qualified tuition and related expenses incurred during the taxable year on behalf of the taxpayer, the taxpayer's spouse, or any dependents. Up to $10,000 of qualified tuition and related expenses per taxpayer return are eligible for the Lifetime Learning credit (i.e., the maximum credit per taxpayer return is $2,000). In contrast with the Hope credit, the maximum credit amount is not indexed for inflation.

In contrast to the Hope and American Opportunity tax credits, a taxpayer may claim the Lifetime Learning credit for an unlimited number of taxable years.51 Also in contrast to the Hope and American Opportunity tax credits, the maximum amount of the Lifetime Learning credit that may be claimed on a taxpayer's return does not vary based on the number of students in the taxpayer's family -- that is, the Hope credit is computed on a per student basis while the Lifetime Learning credit is computed on a family-wide basis. The Lifetime Learning credit amount that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified AGI between $55,000 and $65,000 ($110,000 and $130,000 for married taxpayers filing a joint return) in 2014, based on inflation adjustments determined by the staff of the Joint Committee on Taxation. These phaseout ranges are the same as those for the Hope credit as it applies for tax years beginning before 2009, and are similarly indexed for inflation.

 

Reporting requirements

 

Section 6050S imposes reporting requirements, related to higher education tax benefits, on eligible educational institutions if the institution receives payments for qualified tuition and related expenses with respect to any individual for any calendar year. The information an institution subject to the reporting requirements is required to provide includes providing either the aggregate amount of payments received or the aggregate amount billed for qualified tuition and related expenses during the calendar year period.52

 

Description of Proposal

 

 

The proposal permanently replaces the Hope credit with the American Opportunity credit and also modifies the American Opportunity credit. As under present law, the credit rate is 100 percent on the first $2,000 of qualified tuition and related expenses, and 25 percent on the next $2,000 of qualified tuition and related expenses, for a maximum credit of $2,500. Under the proposal, the taxpayer's credit for the first $1,500 of qualified tuition and related expenses is refundable.

The proposal lowers the phaseout range of the credit. The credit phases out for joint filers with modified AGI between $86,000 and $126,000, and for all other filers with modified AGI between $43,000 and $63,000. Both the credit amounts and the phaseout ranges are indexed for inflation for taxable years beginning after 2018.

The proposal repeals the provision that denies the credit with respect to qualified tuition and related expenses for the enrollment or attendance of any student who has been convicted of a felony offense consisting of the possession or distribution of a controlled substance.

The proposal contains a provision that coordinates the credit with Pell Grants, such that Pell Grant amounts are deemed to first apply to expenses other than the qualified tuition and related expenses that are eligible for the credit. Thus, for purposes of calculating the credit, qualified tuition and related expenses are reduced by Pell Grant amounts only to the extent the Pell Grant exceeds the cost of college attendance (other than qualified tuition and related expenses).

The proposal modifies present-law reporting requirements, such that an eligible institution may only report the aggregate amount of tuition received with respect to any individual during the calendar year period. Additionally, the proposal adds a requirement that any taxpayer claiming the credit must include on the tax return the Employer Identification Number of any institution to whom qualified tuition was paid.

The proposal repeals the Lifetime Learning credit.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

2. Expansion of Pell grant exclusion from gross income (sec. 1202 of the discussion draft and sec. 117 of the Code)

 

Present Law

 

 

Present law provides an exclusion from gross income and wages for amounts received as a qualified scholarship by an individual who is a candidate for a degree at a qualifying educational organization.53 Generally, the exclusion does not apply to amounts received by a student that represent payment for teaching, research, or other services by the student as a condition for receiving the scholarship.

In general, a qualified scholarship is any amount received by such an individual as a scholarship or fellowship grant if the amount is used for qualified tuition and related expenses. Qualified tuition and related expenses include tuition and fees required for enrollment or attendance, or for fees, books, supplies, and equipment required for courses of instruction, at the qualifying educational organization. This definition does not include regular living expenses, such as room and board. A qualifying educational organization is an educational organization which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.

 

Description of Proposal

 

 

The proposal modifies the exclusion for qualified scholarships by providing that Federal Pell Grants under section 401 of the Higher Education Act of 196554 are excluded from gross income, without regard to whether the grant is used for qualified tuition and related expenses.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

3. Repeal of exclusion of income from United States savings bonds used to pay higher education expenses (sec. 1203 of the discussion draft and sec. 135 of the Code)

 

Present Law

 

 

Interest earned on a qualified U.S. Series EE savings bond issued after 1989 is excludable from gross income if the proceeds of the bond upon redemption do not exceed qualified higher education expenses paid by the taxpayer during the taxable year.55 Qualified higher education expenses include tuition and fees (but not room and board expenses) required for the enrollment or attendance of the taxpayer, the taxpayer's spouse, or a dependent of the taxpayer at certain eligible higher educational institutions. The amount of qualified higher education expenses taken into account for purposes of the exclusion is reduced by the amount of such expenses taken into account in determining the Hope, American Opportunity, or Lifetime Learning credits claimed by any taxpayer, or taken into account in determining an exclusion from gross income for a distribution from a qualified tuition program or a Coverdell education savings account, with respect to a particular student for the taxable year.

The exclusion is phased out for certain higher-income taxpayers, determined by the taxpayer's modified AGI during the year the bond is redeemed. For 2014, the exclusion is phased out for taxpayers with modified AGI between $76,000 and $91,000 ($113,950 and $143,950 for married taxpayers filing a joint return). To prevent taxpayers from effectively avoiding the income phaseout limitation through the purchase of bonds directly in the child's name, the interest exclusion is available only with respect to U.S. Series EE savings bonds issued to taxpayers who are at least 24 years old.

 

Description of Proposal

 

 

The proposal repeals the exclusion of interest earned on U.S. Series EE savings bonds described above.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

4. Repeal of deduction for interest on education loans (sec. 1204 of the discussion draft and sec. 221 of the Code)

 

Present Law

 

 

Certain individuals who have paid interest on qualified education loans may claim an above-the-line deduction for such interest expenses, subject to a maximum annual deduction limit.56 Required payments of interest generally do not include voluntary payments, such as interest payments made during a period of loan forbearance. No deduction is allowed to an individual if that individual is claimed as a dependent on another taxpayer's return for the taxable year.57

A qualified education loan generally is defined as any indebtedness incurred solely to pay for the costs of attendance (including room and board) of the taxpayer, the taxpayer's spouse, or any dependent of the taxpayer as of the time the indebtedness was incurred in attending on at least a half-time basis (1) eligible educational institutions, or (2) institutions conducting internship or residency programs leading to a degree or certificate from an institution of higher education, a hospital, or a health care facility conducting postgraduate training. The cost of attendance is reduced by any amount excluded from gross income under the exclusions for qualified scholarships and tuition reductions, employer-provided educational assistance, interest earned on education savings bonds, qualified tuition programs, and Coverdell education savings accounts, as well as the amount of certain other scholarships and similar payments.

The maximum allowable deduction per year is $2,500.58 For 2014, the deduction is phased out ratably for taxpayers with AGI between $65,000 and $80,000 ($130,000 and $160,000 for married taxpayers filing a joint return). The income phaseout ranges are indexed for inflation and rounded to the next lowest multiple of $5,000.

 

Description of Proposal

 

 

The proposal repeals the deduction for interest on education loans.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

5. Repeal of deduction for qualified tuition and related expenses (sec. 1205 of the discussion draft and sec. 222 of the Code)

 

Present Law

 

 

An individual is allowed an above-the-line deduction for qualified tuition and related expenses for higher education paid by the individual during the taxable year.59 Qualified tuition includes tuition and fees required for the enrollment or attendance by the taxpayer, the taxpayer's spouse, or any dependent of the taxpayer with respect to whom the taxpayer may claim a personal exemption, at an eligible institution of higher education for courses of instruction of such individual at such institution. The expenses must be in connection with enrollment at an institution of higher education during the taxable year, or with an academic term beginning during the taxable year or during the first three months of the next taxable year. The deduction is not available for tuition and related expenses paid for elementary or secondary education.

The maximum deduction is $4,000 for an individual whose AGI for the taxable year does not exceed $65,000 ($130,000 in the case of a joint return), or $2,000 for other individuals whose AGI does not exceed $80,000 ($160,000 in the case of a joint return).60 No deduction is allowed for an individual whose AGI exceeds the relevant AGI limitations, for a married individual who does not file a joint return, or for an individual with respect to whom a personal exemption deduction may be claimed by another taxpayer for the taxable year. The deduction is not available for taxable years beginning after December 31, 2013.

 

Description of Proposal

 

 

The proposal repeals the deduction for qualified tuition and related expenses.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2013.

6. No new contributions to Coverdell education savings accounts (sec. 1206 of the discussion draft and sec. 530 of the Code)

 

Present Law

 

 

A Coverdell education savings account is a trust or custodial account created exclusively for the purpose of paying qualified education expenses of a named beneficiary.61 Annual contributions to Coverdell education savings accounts may not exceed $2,000 per designated beneficiary and may not be made after the designated beneficiary reaches age 18 (except in the case of a special needs beneficiary). The contribution limit is phased out for taxpayers with modified AGI between $95,000 and $110,000 ($190,000 and $220,000 for married taxpayers filing a joint return); the AGI of the contributor, and not that of the beneficiary, controls whether a contribution is permitted by the taxpayer.

Earnings on contributions to a Coverdell education savings account generally are subject to tax when withdrawn.62 However, distributions from a Coverdell education savings account are excludable from the gross income of the distributee (i.e., the student) to the extent that the distribution does not exceed the qualified education expenses incurred by the beneficiary during the year the distribution is made. The earnings portion of a Coverdell education savings account distribution not used to pay qualified education expenses is includible in the gross income of the distributee and generally is subject to an additional 10-percent tax.63

Tax-free (and free of additional 10-percent tax) transfers or rollovers of account balances from one Coverdell education savings account benefiting one beneficiary to another Coverdell education savings account benefiting another beneficiary (as well as redesignations of the named beneficiary) are permitted, provided that the new beneficiary is a member of the family of the prior beneficiary and is under age 30 (except in the case of a special needs beneficiary). In general, any balance remaining in a Coverdell education savings account is deemed to be distributed within 30 days after the date that the beneficiary reaches age 30 (or, if the beneficiary dies before attaining age 30, within 30 days of the date that the beneficiary dies).

Qualified education expenses include qualified elementary and secondary expenses and qualified higher education expenses. Such qualified education expenses generally include only out-of-pocket expenses. They do not include expenses covered by employer-provided educational assistance or scholarships for the benefit of the beneficiary that are excludable from gross income.

The term qualified elementary and secondary school expenses, means expenses for: (1) tuition, fees, academic tutoring, special needs services, books, supplies, and other equipment incurred in connection with the enrollment or attendance of the beneficiary at a public, private, or religious school providing elementary or secondary education (kindergarten through grade 12) as determined under State law; (2) room and board, uniforms, transportation, and supplementary items or services (including extended day programs) required or provided by such a school in connection with such enrollment or attendance of the beneficiary; and (3) the purchase of any computer technology or equipment (as defined in section 170(e)(6)(F)(i)) or internet access and related services, if such technology, equipment, or services are to be used by the beneficiary and the beneficiary's family during any of the years the beneficiary is in elementary or secondary school. Computer software primarily involving sports, games, or hobbies is not considered a qualified elementary and secondary school expense unless the software is predominantly educational in nature.

The term qualified higher education expenses includes tuition, fees, books, supplies, and equipment required for the enrollment or attendance of the designated beneficiary at an eligible education institution, regardless of whether the beneficiary is enrolled at an eligible educational institution on a full-time, half-time, or less than half-time basis.64 Moreover, qualified higher education expenses include certain room and board expenses for any period during which the beneficiary is at least a half-time student. Qualified higher education expenses include expenses with respect to undergraduate or graduate-level courses. In addition, qualified higher education expenses include amounts paid or incurred to purchase tuition credits (or to make contributions to an account) under a qualified tuition program for the benefit of the beneficiary of the Coverdell education savings account.65

 

Description of Proposal

 

 

The proposal provides that, except in the case of rollover contributions from another Coverdell account, no contributions to Coverdell education savings accounts shall be accepted by such an account after December 31, 2014. Additionally, the proposal provides that qualified tuition programs66 may accept rollover distributions from a Coverdell education savings account on a tax-free basis after December 31, 2014.

 

Effective Date

 

 

The proposal is effective for contributions and distributions made after December 31, 2014.

7. Repeal of exclusion for discharge of student loan indebtedness (sec. 1207 of the discussion draft and sec. 108(f) of the Code)

 

Present Law

 

 

Gross income generally includes the discharge of indebtedness of the taxpayer. Under an exception to this general rule, gross income does not include any amount from the forgiveness (in whole or in part) of certain student loans, provided that the forgiveness is contingent on the student's working for a certain period of time in certain professions for any of a broad class of employers.67

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

In addition, an individual's gross income does not include amounts from the forgiveness of loans made by educational organizations (and certain tax-exempt organizations in the case of refinancing loans) out of private, nongovernmental funds if the proceeds of such loans are used to pay costs of attendance at an educational institution or to refinance any outstanding student loans (not just loans made by educational organizations) and the student is not employed by the lender organization. In the case of such loans made or refinanced by educational organizations (or refinancing loans made by certain tax-exempt organizations), cancellation of the student loan must be contingent upon the student working in an occupation or area with unmet needs and such work must be performed for, or under the direction of, a tax-exempt charitable organization or a governmental entity.

Finally, an individual's gross income does not include any loan repayment amount received under the National Health Service Corps loan repayment program or certain State loan repayment programs.

 

Description of Proposal

 

 

The proposal repeals the above-described exclusion from income for student loan forgiveness.

 

Effective Date

 

 

The proposal applies to amounts discharged after December 31, 2014.

8. Repeal of exclusion for qualified tuition reductions (sec. 1208 of the discussion draft and sec. 117(d) of the Code)

 

Present Law

 

 

Present law provides an exclusion from gross income and wages for qualified tuition reductions for certain education provided to employees (and their spouses and dependents) of certain educational organizations.68 The exclusion does not apply to any amount received by a student that represents payment for teaching, research or other services by the student required as a condition for receiving the tuition reduction.69

 

Description of Proposal

 

 

The proposal repeals the exclusion for qualified tuition reductions.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

9. Repeal of exclusion for education assistance programs (sec. 1209 of the discussion draft and sec. 127 of the Code)

 

Present Law

 

 

If certain requirements are satisfied, up to $5,250 annually of educational assistance provided by an employer to an employee is excludable from gross income for income tax purposes and from wages for employment tax purposes.70 This exclusion applies to both graduate and undergraduate courses. For the exclusion to apply, certain requirements must be satisfied. The educational assistance must be provided pursuant to a separate written plan of the employer.71

For purposes of the exclusion, educational assistance means the payment by an employer of expenses incurred by or on behalf of the employee for education of the employee including, but not limited to, tuition, fees and similar payments, books, supplies, and equipment. Educational assistance also includes the provision by the employer of courses of instruction for the employee (including books, supplies, and equipment). Educational assistance does not include (1) tools or supplies that may be retained by the employee after completion of a course, (2) meals, lodging, or transportation, and (3) any education involving sports, games, or hobbies. The exclusion for employer-provided educational assistance applies only with respect to education provided to the employee (i.e., it does not apply to education provided to the spouse or a child of the employee).

 

Description of Proposal

 

 

The proposal repeals the exclusion for income attributable to an education assistance program.

 

Effective Date

 

 

The proposal is effective for amounts paid or incurred in taxable years beginning after December 31, 2014.

10. Repeal of exception to 10-percent penalty for higher education (sec. 1210 of the discussion draft and sec. 72(t) of the Code)

 

Present Law

 

 

The Code imposes an early distribution tax on distributions made from qualified retirement plans, section 403(b) plans and individual retirement accounts ("IRAs") before an employee (or an IRA owner) attains age 59 1/2 unless an exception applies.72 The tax is equal to 10 percent of the amount of the distribution that is includible in gross income.73 One of the exceptions to the early distribution tax is for distributions from IRAs used for qualified higher education expenses.74

 

Description of Proposal

 

 

The proposal repeals the exception from the 10-percent early distribution tax that applies to distributions from IRAs that are made before age 59 1/2 and used for qualified higher education expenses.

 

Effective Date

 

 

The proposal applies to distributions after December 31, 2014.

 

D. Repeal of Certain Credits for Individuals

 

 

1. Repeal of dependent care credit (sec. 1301 of the discussion draft and sec. 21 of the Code)

 

Present Law

 

 

A taxpayer who maintains a household that includes one or more qualifying individuals may claim a nonrefundable credit against income tax liability for up to 35 percent of a limited amount of employment-related dependent care expenses. Eligible child and dependent care expenses related to employment are limited to $3,000 if there is one qualifying individual or $6,000 if there are two or more qualifying individuals. Thus, the maximum credit is $1,050 if there is one qualifying individual and $2,100 if there are two or more qualifying individuals. The applicable dollar limit is reduced by any amount excluded from income under an employer-provided dependent care assistance plan. The 35-percent credit rate is reduced, but not below 20 percent, by one percentage point for each $2,000 (or fraction thereof) of AGI above $15,000. Thus, for taxpayers with adjusted gross income above $43,000, the credit rate is 20 percent. The phase-out point and the amount of expenses eligible for the credit are not indexed for inflation.

Generally, a qualifying individual is: (1) a qualifying child of the taxpayer under the age of 13 for whom the taxpayer may claim a dependency exemption, or (2) a dependent or spouse of the taxpayer if the dependent or spouse is physically or mentally incapacitated, and shares the same principal place of abode with the taxpayer for over one half the year. Married taxpayers must file a joint return in order to claim the credit.

 

Description of Proposal

 

 

The proposal repeals the credit for dependent care expenses.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

2. Repeal of credit for adoption expenses (sec. 1302 of the discussion draft and sec. 23 of the Code)

 

Present Law

 

 

In general

 

A tax credit is allowed for qualified adoption expenses paid or incurred by a taxpayer subject to a maximum credit amount per eligible child.75 An eligible child is an individual who: (1) has not attained age 18; or (2) is physically or mentally incapable of caring for himself or herself. The maximum credit is applied per child rather than per year. Therefore, while qualified adoption expenses may be incurred in one or more taxable years, the tax credit per adoption of an eligible child may not exceed the maximum credit.

For taxable years beginning in 2014, the maximum credit amount is $13,190, and the credit is phased out ratably for taxpayers with modified adjusted gross income ("AGI") above a certain amount. In 2014, the phase out range begins at modified AGI of $197,880, with no credit allowed for taxpayers with a modified AGI of $237,880. Modified AGI is the sum of the taxpayer's AGI plus amounts excluded from income under sections 911, 931, and 933 (relating to the exclusion of income of U.S. citizens or residents living abroad; residents of Guam, American Samoa, and the Northern Mariana Islands and residents of Puerto Rico, respectively).

 

Special needs adoptions

 

In the case of a special needs adoption finalized during a taxable year, the taxpayer may claim as an adoption credit the amount of the maximum credit minus the aggregate qualified adoption expenses with respect to that adoption for all prior taxable years. A special needs child is an eligible child who is a citizen or resident of the United States whom a State has determined: (1) cannot or should not be returned to the home of the birth parents; and (2) has a specific factor or condition (such as the child's ethnic background, age, or membership in a minority or sibling group, or the presence of factors such as medical conditions, or physical, mental, or emotional handicaps) because of which the child cannot be placed with adoptive parents without adoption assistance.

 

Qualified adoption expenses

 

Qualified adoption expenses are reasonable and necessary adoption fees, court costs, attorneys fees, and other expenses that are: (1) directly related to, and the principal purpose of which is for, the legal adoption of an eligible child by the taxpayer; (2) not incurred in violation of State or Federal law, or in carrying out any surrogate parenting arrangement; (3) not for the adoption of the child of the taxpayer's spouse; and (4) not reimbursed (e.g., by an employer).

 

Description of Proposal

 

 

The proposal repeals the credit for adoption expenses.

 

Effective Date

 

 

The proposal applies to amounts paid or incurred after December 31, 2014.

3. Nonbusiness energy property credit (sec.1303 of the discussion draft and sec. 25C of the Code)

 

Present Law

 

 

Credits in varying amounts are allowed through 2013 for certain (1) insulation, (2) energy efficient window, doors, skylights, and roofs, (3) advanced main air circulating fans, (4) natural gas, propane, or oil furnace or hot water boilers, (5) electric heat pump, natural gas, propane, or oil water heaters, (6) central air conditions, or (7) wood stoves. The maximum total credit is $500 for all taxable years.

 

Description of Proposal

 

 

The proposal repeals the nonbusiness energy property credit.

 

Effective Date

 

 

The proposal is effective for property placed in service after December 31, 2013.

4. Credit for residential energy efficient property (sec. 1304 of the discussion draft and sec. 25D of the Code)

 

Present Law

 

 

A thirty percent credit is available through 2016 for residential (1) solar water heating or solar electric property, (2) small wind property, (3) geothermal heat pump property, and (4) fuel cell property placed in service.

 

Description of Proposal

 

 

The proposal repeals the credit.

 

Effective Date

 

 

The proposal applies to property placed in service after December 31, 2014.

5. Repeal of credits for alternative fuel vehicles and alternative fuel refueling property (secs. 1305 through 1308 of the discussion draft and secs. 30, 30B, 30C, and 30D of the Code)

 

Present Law

 

 

Fuel cell vehicles (sec. 30B)

A credit is available through 2014 for new vehicles propelled by chemically combining oxygen with hydrogen and creating electricity. The base credit is $4,000 for vehicles weighing 8,500 pounds or less. Heavier vehicles can get up to a $40,000 credit, depending on their weight. An additional $1,000 to $4,000 credit is available to cars and light trucks to the extent their fuel economy exceeds the 2002 base fuel economy set forth in the Code.

Plug-in electric-drive motor vehicles (secs. 30 and 30D)

A credit is available for new four-wheeled vehicles (excluding low speed vehicles and vehicles weighing 14,000 pounds or more) propelled by a battery with at least 4 kilowatt-hours of electricity that can be charged from an external source. The base credit is $2,500 plus $417 for each kilowatt-hour of additional battery capacity in excess of 4 kilowatt-hours (for a maximum credit of $7,500). Qualified vehicles are subject to a 200,000 vehicle-per-manufacturer limitation.

A 10-percent credit up to $2,500 is available for vehicles acquired before 2012 that otherwise qualify for the above credit but for the fact that they have limited speed. A similar 10-percent credit is available for two- and three-wheeled vehicles acquired before 2014 that have a battery capacity of at least 2.5 kilowatt-hours and are capable of achieving a speed of 45 miles per hour or greater. The 10-percent credits are not subject to the 200,000 vehicle-per-manufacturer limitation.

Credit for alternative fuel refueling property (sec. 30C)

A 30-percent credit is available through 2013 (2014 for hydrogen refueling property) for property that dispenses alternative fuels, including ethanol, biodiesel, natural gas, hydrogen, and electricity. The credit may not exceed $30,000 per location for business property and $1,000 for property installed at a principal residence.

 

Description of Proposal

 

 

The proposal repeals the credits for fuel cell and plug-in electric drive motor vehicles. The proposal also repeals the credit for alternative fuel refueling property.

 

Effective Date

 

 

For fuel cell vehicles, the proposal applies to property purchased after December 31, 2014. In the case of low speed plug-in electric vehicles, the proposal applies to vehicles acquired after December 31, 2011. For other plug-in electric vehicles, the proposal applies to vehicles acquired after December 31, 2014. For alternative fuel refueling property, the proposal applies to property placed in service after December 31, 2014.

6. Repeal of credit for health insurance costs of eligible individuals (sec. 1309 of the discussion draft and sec. 35 of the Code)

 

Present Law

 

 

In the case of an eligible individual, for months beginning before January 1, 2014, a refundable tax credit is provided for a portion (currently 72.5 percent) of the individual's premiums for qualified health insurance of the individual and qualifying family members76 for each eligible coverage month beginning in the taxable year. The credit is commonly referred to as the health coverage tax credit ("HCTC"). The credit is available only with respect to amounts paid by the individual and is available on an advance basis once a qualified health insurance costs credit eligibility certificate is in effect.77

Eligibility for the credit is determined on a monthly basis. In general, an eligible coverage month is any month if the month begins before January 1, 2014, and, as of the first day of the month, the individual (1) is an eligible individual, (2) is covered by qualified health insurance, (3) does not have other specified coverage, and (4) is not imprisoned under Federal, State, or local authority. In the case of a joint return, the eligibility requirements are met if at least one spouse satisfies the requirements.

An eligible individual is an individual who is (1) an eligible Trade Adjustment Assistance ("TAA") recipient, (2) an eligible alternative TAA recipient, or (3) an eligible Pension Benefit Guaranty Corporation ("PBGC") pension recipient. In general, an individual is an eligible TAA recipient for a month if the individual (1) receives for any day of the month a trade readjustment allowance under the Trade Act of 1974 or would be eligible to receive such an allowance but for the requirement that the individual exhaust unemployment benefits before being eligible to receive an allowance and (2) with respect to such allowance, is covered under a required certification.78 An individual is an eligible alternative TAA recipient for a month if the individual participates in a certain program under the Trade Act of 1974 and receives a related benefit for the month. Generally, an individual is a PBGC pension recipient for any month if the individual (1) is age 55 or over as of the first day of the month and (2) receives a benefit, any portion of which is paid by the PBGC. A person who may be claimed as a dependent on another person's tax return is not an eligible individual. In addition, an otherwise eligible individual is not eligible for the credit for a month if, as of the first day of the month, the individual has certain specified coverage, such as certain employer-provided coverage or coverage under certain governmental health programs.

 

Description of Proposal

 

 

The proposal repeals the health coverage tax credit in accordance with expiration of the credit for months beginning after December 31, 2013.

 

Effective Date

 

 

The proposal is effective for months beginning after December 31, 2013.

7. Repeal of first time homebuyer credit (sec. 1310 of the discussion draft and sec. 36 of the Code)

 

Present and Prior Law

 

 

Under present law, there is no credit for the purchase of a home. Prior law provided an individual who is a first-time homebuyer a refundable tax credit equal up to a maximum of $8,000 ($4,000 for a married individual filing separately) or 10 percent of the purchase price of a principal residence purchased after April 9, 2008. The credit expired for purchases after July 1, 2010 (July 1, 2011 for certain individuals on qualified official extended duty outside of the United States).

 

Description of Proposal

 

 

The proposal repeals section the first time homebuyer credit. Credit recapture provisions continue to apply to residences purchased before July 1, 2011.

 

Effective Date

 

 

The proposal applies to residences purchased after June 30, 2011.

 

E. Deductions, Exclusions, and Certain Other Provisions

 

 

1. Exclusion of gain from sale of a principal residence (sec. 1401 of the discussion draft and sec. 121 of the Code)

 

Present Law

 

 

A taxpayer who is an individual may exclude up to $250,000 ($500,000 if married filing a joint return) of gain realized on the sale or exchange of a principal residence. To be eligible for the exclusion, the taxpayer must have owned and used the residence as a principal residence for at least two of the five years ending on the date of the sale or exchange. A taxpayer who fails to meet these requirements by reason of a change of place of employment, health, or, to the extent provided under regulations, unforeseen circumstances, is able to exclude an amount equal to the fraction of the $250,000 ($500,000 if married filing a joint return) that is equal to the fraction of the two years that the ownership and use requirements are met.

The exclusion under this provision may not be claimed for more than one sale or exchange during any two-year period.

 

Description of Proposal

 

 

The proposal extends the length of time a taxpayer must own and use a residence to qualify for this exclusion. Specifically, the exclusion is available only if the taxpayer has owned and used the residence as a principal residence for at least five of the eight years ending on the date of the sale or exchange. A taxpayer who fails to meet these requirements by reason of a change of place of employment, health, or, to the extent provided under regulations, unforeseen circumstances is able to exclude an amount equal to the fraction of the $250,000 ($500,000 if married filing a joint return) that is equal to the fraction of the five years that the ownership and use requirements are met.

The proposal limits the exclusion so that the exclusion may not apply to more than one sale or exchange during any five-year period.

The proposal phases-out the exclusion by one dollar for every dollar a taxpayer's AGI exceeds $250,000 ($500,000 if married filing a joint return).

 

Effective Date

 

 

The proposal applies to sales and exchanges after December 31, 2014.

2. Mortgage interest (sec. 1402 of the discussion draft and sec. 163 of the Code)

 

Present Law

 

 

As a general matter, personal interest is not deductible.79 Qualified residence interest is not treated as personal interest and is allowed as an itemized deduction, subject to limitations.80 Qualified residence interest means interest paid or accrued during the taxable year on either acquisition indebtedness or home equity indebtedness. A qualified residence means the taxpayer's principal residence and one other residence of the taxpayer selected to be a qualified residence. A qualified residence can be a house, condominium, cooperative, mobile home, house trailer, or boat.
Acquisition indebtedness
Acquisition indebtedness is indebtedness that is incurred in acquiring, constructing or substantially improving a qualified residence of the taxpayer and which secures the residence. The maximum amount treated as acquisition indebtedness is $1 million ($500,000 in the case of a married person filing a separate return).

Acquisition indebtedness also includes indebtedness from the refinancing of other acquisition indebtedness but only to the extent of the amount (and term) of the refinanced indebtedness. Thus, for example, if the taxpayer incurs $200,000 of acquisition indebtedness to acquire a principal residence and pays down the debt to $150,000, the taxpayer's acquisition indebtedness with respect to the residence cannot thereafter be increased above $150,000 (except by indebtedness incurred to substantially improve the residence).

Interest on acquisition indebtedness is allowable in computing alternative minimum taxable income. However, in the case of a second residence, the acquisition indebtedness may only be incurred with respect to a house, apartment, condominium, or a mobile home that is not used on a transient basis.

Home equity indebtedness
Home equity indebtedness is indebtedness (other than acquisition indebtedness) secured by a qualified residence.

The amount of home equity indebtedness may not exceed $100,000 ($50,000 in the case of a married individual filing a separate return) and may not exceed the fair market value of the residence reduced by the acquisition indebtedness.

Interest on home equity indebtedness is not deductible in computing alternative minimum taxable income.

Interest on qualifying home equity indebtedness is deductible, regardless of how the proceeds of the indebtedness are used. For example, personal expenditures may include health costs and education expenses for the taxpayer's family members or any other personal expenses such as vacations, furniture, or automobiles. A taxpayer and a mortgage company can contract for the home equity indebtedness loan proceeds to be transferred to the taxpayer in a lump sum payment (e.g., a traditional mortgage), a series of payments (e.g., a reverse mortgage), or the lender may extend the borrower a line of credit up to a fixed limit over the term of the loan (e.g., a home equity line of credit).

Thus, the aggregate limitation on the total amount of a taxpayer's acquisition indebtedness and home equity indebtedness with respect to a taxpayer's principal residence and a second residence that may give rise to deductible interest is $1,100,000 ($550,000, for married persons filing a separate return).

Reporting requirements
Any person who, in the course of a trade or business during a calendar year, received from an individual $600 or more of interest during a calendar year on an obligation secured by real property (such as mortgage interest) must file an information return with the IRS and must provide a copy of that return to the payor. The information return generally must include the name, address, and taxpayer identification number of the individual from whom the interest was received, and the amount of the interest and points received for the calendar year.

 

Description of Proposal

 

 

The proposal modifies the limitations on the amount of indebtedness that may be treated as acquisition indebtedness with respect to which interest payments are deductible. The proposal is phased in. The maximum amount of indebtedness treated as acquisition indebtedness incurred in 2015 is $875,000; in 2016 is $750,000; in 2017 is $625,000; and in 2018 and thereafter, is $500,000. In the case of a married person filing a separate return the maximum amounts are half these amounts.

Under the proposal, interest paid on home equity indebtedness incurred after 2014 is not treated as qualified residence interest, and thus is not deductible.

The proposal does not change the treatment of interest on qualified residence indebtedness incurred before 2015.

Special rules apply in the case of indebtedness from refinancing existing qualified residence indebtedness. Specifically, present law continues to apply to any indebtedness incurred on or after January 1, 2015, to refinance qualified residence indebtedness incurred before that date to the extent the amount of the indebtedness resulting from the refinancing does not exceed the amount of the refinanced indebtedness. Thus, the maximum dollar amount that may be treated as qualified indebtedness will not decrease by reason of a refinancing.

The proposal modifies the reporting requirements with respect to taxpayers who, in the course of a trade or business during a calendar year, received from an individual $600 or more of interest during a calendar year on an obligation secured by real property (such as mortgage interest). In addition to the present-law reporting requirements, the proposal requires that taxpayers report both the amount of outstanding principal on the mortgage as of the beginning of the calendar year and the date of origination of the mortgage.

 

Effective Date

 

 

The modification of the limitations on the deductibility of interest applies to interest paid or accrued on indebtedness incurred after December 31, 2014. The modification of the reporting requirements applies to returns and statements for calendar years after 2014.

3. Charitable contributions (sec. 1403 of the discussion draft and sec. 170 of the Code)

 

Present Law

 

 

In general

The Internal Revenue Code allows taxpayers to reduce their income tax liability by taking deductions for contributions to certain organizations, including charities, Federal, State, local and Indian tribal governments, and certain other organizations.

To be deductible, a charitable contribution generally must meet several threshold requirements. First, the recipient of the transfer must be eligible to receive charitable contributions (i.e., an organization or entity described in section 170(c)). Second, the transfer must be made with gratuitous intent and without the expectation of a benefit of substantial economic value in return. Third, the transfer must be complete and generally must be a transfer of a donor's entire interest in the contributed property (i.e., not a contingent or partial interest contribution). To qualify for a current year charitable deduction, payment of the contribution must be made within the taxable year.81 Fourth, the transfer must be of money or property -- contributions of services are not deductible.82 Finally, the transfer must be substantiated and in the proper form.

As also discussed below, special rules limit a taxpayer's charitable contributions in a given year to a percentage of income, and those rules, in part, turn on whether the organization receiving the contributions is a public charity or a private foundation. Other special rules determine the deductible value of contributed property for each type of property.

Contributions of partial interests in property

In general
In general, a charitable deduction is not allowed for income, estate, or gift tax purposes if the donor transfers an interest in property to a charity while retaining an interest in that property or transferring an interest in that property to a noncharity for less than full and adequate consideration.83 This rule of nondeductibility, often referred to as the partial interest rule, generally prohibits a charitable deduction for contributions of income interests, remainder interests, or rights to use property.

A charitable contribution deduction generally is not allowable for a contribution of a future interest in tangible personal property.84 For this purpose, a future interest is one "in which a donor purports to give tangible personal property to a charitable organization, but has an understanding, arrangement, agreement, etc., whether written or oral, with the charitable organization that has the effect of reserving to, or retaining in, such donor a right to the use, possession, or enjoyment of the property."85

A gift of an undivided portion of a donor's entire interest in property generally is not treated as a nondeductible gift of a partial interest in property.86 For this purpose, an undivided portion of a donor's entire interest in property must consist of a fraction or percentage of each and every substantial interest or right owned by the donor in such property and must extend over the entire term of the donor's interest in such property.87 A gift generally is treated as a gift of an undivided portion of a donor's entire interest in property if the donee is given the right, as a tenant in common with the donor, to possession, dominion, and control of the property for a portion of each year appropriate to its interest in such property.88

Other exceptions to the partial interest rule are provided for, among other interests: (1) remainder interests in charitable remainder annuity trusts, charitable remainder unitrusts, and pooled income funds; (2) present interests in the form of a guaranteed annuity or a fixed percentage of the annual value of the property; (3) a remainder interest in a personal residence or farm; and (4) qualified conservation contributions.

Qualified conservation contributions
Qualified conservation contributions are not subject to the partial interest rule, which generally bars deductions for charitable contributions of partial interests in property.89 A qualified conservation contribution is a contribution of a qualified real property interest to a qualified organization exclusively for conservation purposes. A qualified real property interest is defined as: (1) the entire interest of the donor other than a qualified mineral interest; (2) a remainder interest; or (3) a restriction (granted in perpetuity) on the use that may be made of the real property (generally, a conservation easement). Qualified organizations include certain governmental units, public charities that meet certain public support tests, and certain supporting organizations. Conservation purposes include: (1) the preservation of land areas for outdoor recreation by, or for the education of, the general public; (2) the protection of a relatively natural habitat of fish, wildlife, or plants, or similar ecosystem; (3) the preservation of open space (including farmland and forest land) where such preservation will yield a significant public benefit and is either for the scenic enjoyment of the general public or pursuant to a clearly delineated Federal, State, or local governmental conservation policy; and (4) the preservation of an historically important land area or a certified historic structure.

Percentage limits on charitable contributions

Individual taxpayers
Charitable contributions by individual taxpayers are limited to a specified percentage of the individual's contribution base. The contribution base is the taxpayer's adjusted gross income ("AGI") for a taxable year, disregarding any net operating loss carryback to the year under section 172.90 In general, more favorable (higher) percentage limits apply to contributions of cash and ordinary income property than to contributions of capital gain property. More favorable limits also generally apply to contributions to public charities (and certain operating foundations) than to contributions to nonoperating private foundations.

More specifically, the deduction for charitable contributions by an individual taxpayer of cash and property that is not appreciated to a charitable organization described in section 170(b)(1)(A) (public charities, private foundations other than nonoperating private foundations, and certain governmental units) may not exceed 50 percent of the taxpayer's contribution base. Contributions of this type of property to nonoperating private foundations generally may be deducted up to the lesser of 30 percent of the taxpayer's contribution base or the excess of (i) 50 percent of the contribution base over (ii) the amount of contributions subject to the 50 percent limitation.

Contributions of appreciated capital gain property to public charities and other organizations described in section 170(b)(1)(A) generally are deductible up to 30 percent of the taxpayer's contribution base (after taking into account contributions other than contributions of capital gain property). An individual may elect, however, to bring all these contributions of appreciated capital gain property for a taxable year within the 50-percent limitation category by reducing the amount of the contribution deduction by the amount of the appreciation in the capital gain property. Contributions of appreciated capital gain property to nonoperating private foundations are deductible up to the lesser of 20 percent of the taxpayer's contribution base or the excess of (i) 30 percent of the contribution base over (ii) the amount of contributions subject to the 30 percent limitation.

Finally, more favorable percentage limits sometimes apply to contributions to the donee charity than to contributions that are for the use of the donee charity. Contributions of capital gain property for the use of public charities and other organizations described in section 170(b)(1)(A) also are limited to 20 percent of the taxpayer's contribution base.91 In contrast to property contributed directly to a charitable organization, property contributed for the use of an organization generally has been interpreted to mean property contributed in trust for the organization.92 Charitable contributions of income interests (where deductible) also generally are treated as contributions for the use of the donee organization.

             Table 2. -- Charitable Contribution Percentage Limits

 

                           For Individual Taxpayers93

 

 _____________________________________________________________________________

 

 

                                                                 Capital Gain

 

                                                Capital Gain     Property for

 

                             Ordinary Income    Property to      the use of

 

                             Property and Cash  the Recipient94  the Recipient

 

 _____________________________________________________________________________

 

 

 Public Charities, Private          50%                 30%95          20%

 

 Operating Foundations,

 

 and Private Distributing

 

 Foundations

 

 

 Nonoperating Private               30%                 20%            20%

 

 Foundations

 

Corporate taxpayers
A corporation generally may deduct charitable contributions up to 10 percent of the corporation's taxable income for the year.96 For this purpose, taxable income is determined without regard to: (1) the charitable contributions deduction; (2) any net operating loss carryback to the taxable year; (3) deductions for dividends received; (4) deductions for dividends paid on certain preferred stock of public utilities; and (5) any capital loss carryback to the taxable year.97
Carryforwards of excess contributions
Charitable contributions that exceed the applicable percentage limit generally may be carried forward for up to five years.98 In general, contributions carried over from a prior year are taken into account after contributions for the current year that are subject to the same percentage limit. Excess contributions made for the use of (rather than to) an organization generally may not be carried forward.
Temporary rule for qualified conservation contributions
Under a temporary provision that was effective for contributions made in taxable years beginning before January 1, 2014,99 preferential percentage limits and carryforward rules apply for qualified conservation contributions. In general, under the temporary provision, the 30-percent contribution base limitation on contributions of capital gain property by individuals does not apply to qualified conservation contributions. Instead, individuals may deduct the fair market value of any qualified conservation contribution to an organization described in section 170(b)(1)(A) (generally, public charities) to the extent of the excess of 50 percent of the contribution base over the amount of all other allowable charitable contributions. These contributions are not taken into account in determining the amount of other allowable charitable contributions. Individuals are allowed to carry forward any qualified conservation contributions that exceed the 50-percent limitation for up to 15 years. In the case of an individual who is a qualified farmer or rancher for the taxable year in which the contribution is made, a qualified conservation contribution is allowable up to 100 percent of the excess of the taxpayer's contribution base over the amount of all other allowable charitable contributions.

In the case of a corporation (other than a publicly traded corporation) that is a qualified farmer or rancher for the taxable year in which the contribution is made, any qualified conservation contribution is allowable up to 100 percent of the excess of the corporation's taxable income (as computed under section 170(b)(2)) over the amount of all other allowable charitable contributions. Any excess may be carried forward for up to 15 years as a contribution subject to the 100-percent limitation.100

A qualified farmer or rancher means a taxpayer whose gross income from the trade or business of farming (within the meaning of section 2032A(e)(5)) is greater than 50 percent of the taxpayer's gross income for the taxable year.

Valuation of charitable contributions

In general
For purposes of the income tax charitable deduction, the value of property contributed to charity may be limited to the fair market value of the property, the donor's tax basis in the property, or in some cases a different amount.

Charitable contributions of cash are deductible in the amount contributed, subject to the percentage limits discussed above. In addition, a taxpayer generally may deduct the full fair market value of long-term capital gain property contributed to charity.101 Contributions of tangible personal property also generally are deductible at fair market value if the use by the recipient charitable organization is related to its tax-exempt purpose.

In certain other cases, however, section 170(e) limits the deductible value of the contribution of appreciated property to the donor's tax basis in the property. This limitation of the property's deductible value to basis generally applies, for example, for: (1) contributions of inventory or other ordinary income or short-term capital gain property;102 (2) contributions of tangible personal property if the use by the recipient charitable organization is unrelated to the organization's tax-exempt purpose;103 and (3) contributions to or for the use of a private foundation (other than certain private operating foundations).104

For contributions of qualified appreciated stock, the above-described rule that limits the value of property contributed to or for the use of a private nonoperating foundation to the taxpayer's basis in the property does not apply; therefore, subject to certain limits, contributions of qualified appreciated stock to a nonoperating private foundation may be deducted at fair market value.105 Qualified appreciated stock is stock that is capital gain property and for which (as of the date of the contribution) market quotations are readily available on an established securities market.106 A contribution of qualified appreciated stock (when increased by the aggregate amount of all prior such contributions by the donor of stock in the corporation) generally does not include a contribution of stock to the extent the amount of the stock contributed exceeds 10 percent (in value) of all of the outstanding stock of the corporation.107

Contributions of property with a fair market value that is less than the donor's tax basis generally are deductible at the fair market value of the property.

Enhanced deduction rules for certain contributions of inventory and other property
Although most charitable contributions of property are valued at fair market value or the donor's tax basis in the property, certain statutorily described contributions of appreciated inventory and other property qualify for an enhanced deduction valuation that exceeds the donor's tax basis in the property, but which is less than the fair market value of the property.

As discussed above, a taxpayer's deduction for charitable contributions of inventory property generally is limited to the taxpayer's basis (typically, cost) in the inventory, or if less, the fair market value of the property. For certain contributions of inventory, however, C corporations (but not other taxpayers) may claim an enhanced deduction equal to the lesser of (1) basis plus one-half of the item's appreciation (i.e., basis plus one-half of fair market value in excess of basis) or (2) two times basis.108 To be eligible for the enhanced deduction value, the contributed property generally must be inventory of the taxpayer, contributed to a charitable organization described in section 501(c)(3) (except for private nonoperating foundations), and the donee must (1) use the property consistent with the donee's exempt purpose solely for the care of the ill, the needy, or infants, (2) not transfer the property in exchange for money, other property, or services, and (3) provide the taxpayer a written statement that the donee's use of the property will be consistent with such requirements.109 Contributions to organizations that are not described in section 501(c)(3), such as governmental entities, do not qualify for this enhanced deduction.

To use the enhanced deduction provision, the taxpayer must establish that the fair market value of the donated item exceeds basis.

Under a temporary provision that was effective for contributions made before January 1, 2014, any taxpayer engaged in a trade or business, whether or not a C corporation, is eligible to claim the enhanced deduction for certain donations of food inventory.110 Another expired provision (effective for contributions made before January 1, 2012) allowed an enhanced charitable deduction for certain contributions of book inventory.111

Selected statutory rules for specific types of contributions
Special statutory rules limit the deductible value (and impose enhanced reporting obligations on donors) of charitable contributions of certain types of property, including vehicles, intellectual property, and clothing and household items. Each of these rules was enacted in response to concerns that some taxpayers did not accurately report -- and in many instances overstated -- the value of the property for purposes of claiming a charitable deduction.

Vehicles. -- Under present law, the amount of deduction for charitable contributions of vehicles (generally including automobiles, boats, and airplanes for which the claimed value exceeds $500 and excluding inventory property) depends upon the use of the vehicle by the donee organization. If the donee organization sells the vehicle without any significant intervening use or material improvement of such vehicle by the organization, the amount of the deduction may not exceed the gross proceeds received from the sale. In other situations, a fair market value deduction may be allowed.

Patents and other intellectual property. -- If a taxpayer contributes a patent or other intellectual property (other than certain copyrights or inventory)112 to a charitable organization, the taxpayer's initial charitable deduction is limited to the lesser of the taxpayer's basis in the contributed property or the fair market value of the property.113 In addition, the taxpayer generally is permitted to deduct, as a charitable contribution, certain additional amounts in the year of contribution or in subsequent taxable years based on a specified percentage of the qualified donee income received or accrued by the charitable donee with respect to the contributed intellectual property. For this purpose, qualified donee income includes net income received or accrued by the donee that properly is allocable to the intellectual property itself (as opposed to the activity in which the intellectual property is used).114

Clothing and household items. -- Charitable contributions of clothing and household items generally are subject to the charitable deduction rules applicable to tangible personal property. If such contributed property is appreciated property in the hands of the taxpayer, and is not used to further the donee's exempt purpose, the deduction is limited to basis. In most situations, however, clothing and household items have a fair market value that is less than the taxpayer's basis in the property. Because property with a fair market value less than basis generally is deductible at the property's fair market value, taxpayers generally may deduct only the fair market value of most contributions of clothing or household items, regardless of whether the property is used for exempt or unrelated purposes by the donee organization. Furthermore, a special rule generally provides that no deduction is allowed for a charitable contribution of clothing or a household item unless the item is in good used or better condition. The Secretary is authorized to deny by regulation a deduction for any contribution of clothing or a household item that has minimal monetary value, such as used socks and used undergarments. Notwithstanding the general rule, a charitable contribution of clothing or household items not in good used or better condition with a claimed value of more than $500 may be deducted if the taxpayer includes with the taxpayer's return a qualified appraisal with respect to the property.115 Household items include furniture, furnishings, electronics, appliances, linens, and other similar items. Food, paintings, antiques, and other objects of art, jewelry and gems, and certain collections are excluded from the special rules described in the preceding paragraph.116

College athletic seating rights. -- In general, where a taxpayer receives or expects to receive a substantial return benefit for a payment to charity, the payment is not deductible as a charitable contribution. However, special rules apply to certain payments to institutions of higher education in exchange for which the payor receives the right to purchase tickets or seating at an athletic event. Specifically, the payor may treat 80 percent of a payment as a charitable contribution where: (1) the amount is paid to or for the benefit of an institution of higher education (as defined in section 3304(f)) described in section (b)(1)(A)(ii) (generally, a school with a regular faculty and curriculum and meeting certain other requirements), and (2) such amount would be allowable as a charitable deduction but for the fact that the taxpayer receives (directly or indirectly) as a result of the payment the right to purchase tickets for seating at an athletic event in an athletic stadium of such institution.117

 

Description of Proposal

 

 

The proposal makes the following modifications to present law.

Two-percent floor on charitable deduction for individuals

The proposal imposes a two-percent floor on charitable contributions by taxpayers who are individuals. Specifically, the amount of an individual's charitable contributions for a taxable year (determined without regard to excess contributions carried over from a prior year under section 170(d)) are reduced by two percent of the taxpayer's contribution base for the taxable year.

The two-percent reduction is applied in the following order: (1) first, to charitable contributions to which paragraph 170(b)(1)(B) applies (generally, contributions subject to a 25-percent limitation, as reduced under the proposal); (2) second, to qualified conservation contributions; and (3) third, to charitable contributions to which paragraph 170(b)(1)(A) applies (generally, other contributions subject to a 40-percent limitation, as reduced under the proposal).

Extension of time for individuals to make charitable contributions

The proposal permits individuals to elect to deduct for a taxable year charitable contributions made after the close of the taxable year but not later than the due date (determined without regard to extensions) for the individual's income tax return for the taxable year. The election must be made at the time of the filing of the tax return in the manner provided by the Secretary. For example, if a calendar year taxpayer makes a charitable contribution on February 15, 2015, the individual may elect to treat the contribution as having been made during 2014. The election must be made at the time of the filing of the 2014 income tax return in the manner prescribed by the Secretary.

Deduction for contributions of appreciated property generally limited to basis

Under the proposal a charitable contribution of property generally is reduced by the amount of gain that would have been realized if the property contributed had been sold by the taxpayer for its fair market value (determined at the time of the contribution). In other words, the proposal generally limits a charitable contribution of appreciated property to the taxpayer's basis in the property.

The proposal provides that contributions of certain property are reduced only by the amount of gain that would not have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market (determined at the time of the contribution). In other words, the amount of such contributions of property need only be reduced by the amount of any short-term capital gain or ordinary income, resulting in more preferential treatment for such property relative to other property under the proposal. These contributions include:

 

1. Contributions of tangible personal property if the use of the property by the donee organization is related to the purpose or function constituting the basis for its exemption under section 501 (or, in the case of a governmental unit, to any purpose or function described in section 170(c));

2. Qualified conservation contributions described in section 170(h)(1);

3. Contributions of inventory and similar property that qualify for an enhanced charitable contribution deduction under present law118;

4. Contributions of scientific property used for research that qualify for an enhanced deduction under present law119; and

5. Contributions of qualified appreciated stock (generally limited to 10 percent of the outstanding stock of a corporation), as described in present-law sections 170(e)(5)(B) and (C), to an organization described in section 170(c).

 

The special rules of present law continue to apply in determining whether the sale of certain property would result in a long-term gain.

Modifications to income-based percentage limits and repeal of separate, lower percentage limits for contributions of capital gain property

The proposal reduces the income-based percentage limit described in section 170(b)(1)(A) for certain charitable contributions by an individual taxpayer of cash and property that is not appreciated to public charities and certain other organizations from 50 percent to 40 percent. The proposal reduces the percentage limit for certain charitable contributions by an individual taxpayer to nonoperating private foundations from 30 percent to 25 percent.

The proposal repeals the provisions that provide lower percentage limitations on contributions of capital gain property (section 170(b)(1)(C), which generally imposes a 30-percent limit on charitable contributions of capital gain property to public charities and certain other organizations, and 170(b)(1)(D), which generally imposes a 20-percent limit on charitable contributions of capital gain property to nonoperating private foundations and certain other organizations). Thus, all contributions generally qualify for the more preferential 40- and 25-percent limitations, respectively, of sections 170(b)(1)(A) and 170(b)(1)(B), as amended.

Qualified conservation contributions

The proposal extends and makes permanent the special rules for qualified conservation contributions that provide for increased charitable contribution percentage limits and extended carryforward periods for excess contributions.

Golf course easements

The proposal modifies the definition of a qualified real property interest that may be treated as a qualified conservation contribution under section 170(h) generally to exclude golf course property. Specifically, an interest in real property is not treated as a qualified real property interest if (at the time of the contribution of such interest) the property is, or is intended to be, used as a golf course. As a result, charitable contributions of conservation easements on golf course property will not: (1) be excepted from the "partial interest" rule that generally denies a charitable deduction for a contribution of a partial interest in property, and (2) qualify for the preferential percentage limit and carryforward rules that generally apply to qualified conservation contributions.

College athletic event seating rights

The proposal repeals section 170(l), which generally provides that a taxpayer may deduct 80 percent of certain payments to institutions of higher education in exchange for which the taxpayer receives the right to purchase tickets or seating at an athletic event of such an institution.

Contributions of intellectual property

The proposal repeals section 170(m), under which certain donee income from intellectual property is treated as an additional charitable contribution.

Effective Date

The proposal generally is effective for contributions made in taxable years beginning after December 31, 2014.

The permanent extension of the special rules for qualified conservation contributions is effective for contributions made in taxable years beginning after December 31, 2013.

4. Denial of deduction for expenses attributable to the trade or business of being an employee (sec. 1404 of the discussion draft and sec. 62(a)(2) and new sec. 262A of the Code)

 

Present Law

 

 

In general, business expenses incurred by an employee are deductible, but only as an itemized deduction and only to the extent the expenses exceed two percent of adjusted gross income.120 However, in the case of certain employees and certain expenses, a deduction may be taken in determining adjusted gross income (referred to as an "above-the-line" deduction), including expenses of qualified performing artists, expenses of State or local government officials performing services on a fee basis, expenses of eligible educators (applicable under present law for taxable years beginning after 2001 and before 2014), and expenses of members of a reserve component of the Armed Forces.121

A working condition fringe provided to an employee is excluded from the employee's income and wages.122 For this purpose, a working condition fringe means property or services provided to an employee to the extent that, if the employee paid for the property or service, the payment would be deductible as a business expense or depreciation.

 

Description of Proposal

 

 

Under the proposal, business expenses incurred by an employee are not deductible, other than expenses that are deductible in determining adjusted gross income (that is, above-the-line deductions). In addition, the proposal repeals the provisions allowing above-the-line deductions for expenses of qualified performing artists and expenses of State or local government officials performing services on a fee basis. The proposal also repeals the provision allowing an above-the-line deduction for expenses of eligible educators for taxable years beginning after 2001 and before 2014.123 The proposal retains the provision allowing an above-the-line deduction for expenses of members of a reserve component of the Armed Forces.124 In addition, whether property or services provided by an employer are excluded as a working condition fringe is determined without regard to the proposal, that is, the same standard as under present law applies for this purpose.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

5. Repeal of deduction for taxes not paid or accrued in a trade or business (sec. 1405 of the discussion draft and sec. 164 of the Code)

 

Present Law

 

 

Individuals are permitted a deduction for certain taxes paid or accrued, whether or not incurred in a taxpayer's trade or business. These taxes are: (i) State, local real and foreign property taxes;125 (ii) State and local personal property taxes;126 (iii) State, local and foreign income, war profits, and excess profits taxes.127 For taxable years beginning before 2014, at the election of the taxpayer, an itemized deduction may be taken for State and local general sales taxes in lieu of the itemized deduction for State and local income taxes.128

Property taxes may be allowed as a deduction in computing adjusted gross income if incurred in connection with property used in a trade or business; otherwise they are an itemized deduction. In the case of State and local income taxes, the deduction is an itemized deduction notwithstanding that the tax may be imposed on profits from a trade or business.129

Individuals also are permitted a deduction for Federal and State generation skipping transfer tax ("GST tax") imposed on certain income distributions that are included in the gross income of the distributee.130

In determining a taxpayer's alternative minimum taxable income, no itemized deduction for property, income, or sales tax is allowed.

 

Description of Proposal

 

 

The proposal provides that in the case of an individual, State, local and foreign property taxes shall be allowed as a deduction only when paid or accrued in carrying on a trade or business or an activity described in section 212 (relating to expenses for the production of income).131

The proposal also provides that in the case of an individual, State and local income, war profits, and excess profits taxes are not allowable as a deduction.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

6. Repeal of deduction for personal casualty losses (sec. 1406 of the discussion draft and sec. 165 of the Code)

 

Present Law

 

 

A taxpayer may generally claim a deduction for any loss sustained during the taxable year, not compensated by insurance or otherwise. For individual taxpayers, deductible losses must be incurred in a trade or business or other profit-seeking activity or consist of property losses arising from fire, storm, shipwreck, or other casualty, or from theft.132 Personal casualty or theft losses are deductible only if they exceed $100 per casualty or theft. In addition, aggregate net casualty and theft losses are deductible only to the extent they exceed 10 percent of an individual taxpayer's adjusted gross income.

 

Description of Proposal

 

 

The proposal repeals the deduction for personal casualty losses.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

7. Limitation on wagering losses (sec. 1407 of the discussion draft and sec. 165(d) of the Code)

 

Present Law

 

 

Losses sustained during the taxable year on wagering transactions are allowed as a deduction only to the extent of the gains during the taxable year from such transactions.133

 

Description of Proposal

 

 

The proposal clarifies the scope of "losses from wagering transactions" as that term is used in section 165(d). The proposal provides that this term includes any deduction otherwise allowable under chapter 1 of the Code incurred in carrying on any wagering transaction.

The proposal is intended to clarify that the limitation on losses from wagering transactions applies not only to the actual costs of wagers incurred by an individual, but to other expenses incurred by the individual in connection with the conduct of that individual's gambling activity.134 The proposal clarifies, for instance, an individual's otherwise deductible expenses in traveling to or from a casino are subject to the limitation under section 165(d).

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

8. Repeal of deduction for tax preparation expenses (sec. 1408 of the discussion draft and sec. 212 of the Code)

 

Present Law

 

 

For regular income tax purposes, individuals are allowed an itemized deduction for expenses for the production of income. These expenses are defined as ordinary and necessary expenses paid or incurred in a taxable year: (1) for the production or collection of income; (2) for the management, conservation, or maintenance of property held for the production of income; or (3) in connection with the determination, collection, or refund of any tax.135

 

Description of Proposal

 

 

The proposal repeals the deduction for expenses in connection with the determination, collection, or refund of any tax. Expenses in the other two categories are not changed by the proposal.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

9. Repeal of deduction for medical expenses (sec. 1409 of the discussion draft and sec. 213 of the Code)

 

Present Law

 

 

Individuals are allowed an itemized deduction for unreimbursed medical expenses, but only to the extent that such expenses exceed 10 percent of adjusted gross income. However, for the years 2013, 2014, 2015 and 2016, if either the taxpayer or the taxpayer's spouse turns 65 before the end of the taxable year, the threshold is at 7.5 percent of adjusted gross income.

 

Description of Proposal

 

 

The proposal repeals the itemized deduction for unreimbursed medical expenses.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

10. Repeal of the disqualification of expenses for over-the-counter drugs under certain accounts and arrangements (sec. 1410 of the discussion draft and secs. 106 and 223 of the Code)

 

Present Law

 

 

Individual deduction for medical expenses

Expenses for medical care, not compensated for by insurance or otherwise, are deductible by an individual under the rules relating to itemized deductions to the extent the expenses exceed 10 percent of adjusted gross income ("AGI").136 Medical care generally is defined broadly as amounts paid for diagnoses, cure, mitigation, treatment or prevention of disease, or for the purpose of affecting any structure of the body.137

Under an explicit limitation, any amount paid during a taxable year for medicine or drugs is deductible as a medical expense only if the medicine or drug is a prescribed drug or insulin.138 The term prescribed drug means a drug or biological which requires a prescription of a physician for its use by an individual.139 Thus, any amount paid for medicine available without a prescription ("over-the-counter medicine") is not deductible as a medical expense, including any medicine prescribed or recommended by a physician.140

Exclusion for employer-provided health care

Employees are not taxed on (that is, may exclude from gross income) the value of employer-provided health coverage under an accident or health plan.141 In addition, any reimbursements under an employer-provided accident or health plan for medical care expenses for employees, their spouses, their dependents, and adult children under age 27 generally are excludible from gross income.142 An employer may agree to reimburse expenses for medical care of its employees (and their spouses and dependents), not covered by a health insurance plan, through a flexible spending arrangement ("FSA") which allows reimbursement not in excess of a specified dollar amount. The amounts available for reimbursement must be exclusively for reimbursement for medical care because the exclusion does not apply to amounts to which the employee would be entitled irrespective of whether he or she incurs expenses for medical care.143

Such dollar amount is either elected by an employee under a cafeteria plan ("Health FSA") or otherwise specified by the employer under a health reimbursement arrangement ("HRA"). Reimbursements under these arrangements are also excludible from gross income as reimbursements for medical care under employer-provided health coverage.

Health savings accounts

An individual with a high deductible health plan (and no other health plan other than a plan that provides certain permitted insurance or permitted coverage) may establish a health savings account ("HSA"). In general, HSAs provide tax-favored treatment for current medical expenses as well as the ability to save on a tax-favored basis for future medical expenses. In general, HSAs are tax-exempt trusts or custodial accounts created exclusively to pay for the qualified medical expenses of the account holder and his or her spouse and dependents. Thus, earnings on amounts in HSAs are not taxable.

Subject to limits,144 contributions made to an HSA by an employer, including contributions made through a cafeteria plan through salary reduction, are excludible from income (and from wages for payroll tax purposes). Contributions made by individuals are deductible for income tax purposes, regardless of whether the individuals itemize. Distributions from an HSA that are used for qualified medical expenses are excludible from gross income. Distributions from an HSA that are not used for qualified medical expenses are includible in gross income and are subject to an additional tax of 20 percent. The 20-percent additional tax does not apply if the distribution is made after death, disability, or the individual attains the age of Medicare eligibility (i.e., age 65). Similar rules apply for another type of medical savings arrangement called an Archer medical savings account ("Archer MSA").145

Medical care for excludible reimbursements

For purposes of the exclusion for reimbursements under employer-provided accident and health plans (including under Health FSAs and HRAs), and for distributions from HSAs and Archer MSAs used for qualified medical expenses, the definition of medical care is generally the same as the definition that applies for the itemized deduction for the cost of medical care. However, prior to the enactment of the Patient Protection and Affordable Care Act (referred to as the "Affordable Care Act"),146 the limitation (applicable to the itemized deduction) that only prescription medicines or drugs and insulin are taken into account did not apply. Thus, for example, amounts paid from a Health FSA or HRA, or funds distributed from an HSA to reimburse a taxpayer for nonprescription drugs, such as nonprescription aspirin, allergy medicine, antacids, or pain relievers, were excludible from income even though, if the taxpayer paid for such amounts directly (without such reimbursement), the expenses could not be taken into account in determining the itemized deduction for medical expenses.147

For years beginning after December 31, 2010, the Affordable Care Act changed the definition of medical care for purposes of the exclusion for reimbursements for medical care under employer-provided accident and health plans and for distributions from HSAs and Archer MSAs used for qualified medical expenses to require that over-the-counter medicine (other than insulin) be prescribed by a physician in order for the medicine to be medical care for these purposes.148 Thus, under present law, a Health FSA or an HRA is only permitted to reimburse an employee for the cost of over-the-counter medicine if the medicine is prescribed by a physician and distributions from an HSA or an Archer MSA used to purchase over-the-counter medicine is not a qualified medical expense unless the medicine is prescribed by a physician.

 

Description of Proposal

 

 

The proposal repeals the change to the definition of medical care made by the Affordable Care Act for purposes of the exclusion for reimbursements for medical care under employer-provided accident and health plans and for distributions from HSAs or Archer MSAs used for qualified medical expenses that requires that over-the-counter medicine (other than insulin) be prescribed by a physician in order for the medicine to be medical care for these purposes. Thus, for example, amounts paid from a Health FSA or HRA, or funds distributed from an HSA or an Archer MSA to reimburse a taxpayer for nonprescription drugs, such as nonprescription aspirin, allergy medicine, antacids, or pain relievers, are excludible from income.

 

Effective Date

 

 

The proposal is effective with respect to expenses incurred after December 31, 2014.

11. Repeal of deduction for alimony payments and corresponding inclusion in gross income (sec. 1411 of the discussion draft and secs. 71 and 215 of the Code)

 

Present Law

 

 

Alimony and separate maintenance payments are deductible by the payor spouse and includible in income by the recipient spouse.149 Child support payments are not treated as alimony.150

 

Description of Proposal

 

 

Under the proposal, alimony and separate maintenance payments are not deductible by the payor spouse. The proposal repeals sections 61(a)(8) and 71 of the Code. Those sections specified that alimony and separate maintenance payments are included in income. Thus, the intent of the proposal is to follow the rule of the Supreme Court's holding in Gould v. Gould,151 in which the Court held that such payments are not income to the recipient. The treatment of child support is not changed.

 

Effective Date

 

 

The proposal is effective for any divorce or separation instrument executed after December 31, 2014, or for any divorce or separation instrument executed on or before December 31, 2014, and modified after that date, if the modification expressly provides that the amendments made by this section apply to such modification.

12. Repeal of deduction for moving expenses (sec. 1412 of the discussion draft and sec. 217 of the Code)

 

Present Law

 

 

Individuals are allowed an itemized deduction for moving expenses paid or incurred during the taxable year in connection with the commencement of work by the taxpayer as an employee or as a self-employed individual at a new principal place of work.152 Such expenses are deductible only if the move meets certain conditions related to distance from the taxpayer's previous residence and the taxpayer's status as a full-time employee in the new location.

 

Description of Proposal

 

 

The proposal repeals the deduction for moving expenses.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

13. Termination of deduction and exclusions for contributions to medical savings accounts (sec. 1413 of the discussion draft and secs. 106(b) and 220 of the Code)

 

Present Law

 

 

Archer MSAs

As of 1997, certain individuals are permitted to contribute to an Archer MSA, which is a tax-exempt trust or custodial account.153 Within limits, contributions to an Archer MSA are deductible in determining adjusted gross income if made by an individual and are excludable from gross income and wages for employment tax purposes if made by the employer of an individual.

An individual is generally eligible for an Archer MSA if the individual is covered by a high deductible health plan and no other health plan other than a plan that provides certain permitted insurance or permitted coverage. In addition, the individual either must be an employee of a small employer (generally an employer with 50 or fewer employees on average) that provides the high deductible health plan or must be self-employed or the spouse of a self-employed individual and the high deductible health plan is not provided by the employer of the individual or spouse.

For 2014, a high deductible health plan for purposes of Archer MSA eligibility is a health plan with an annual deductible of at least $2,200 and not more than $3,250 in the case of self-only coverage and at least $4,350 and not more than $6,550 in the case of family coverage. In addition, for 2014, the maximum out-of-pocket expenses with respect to allowed costs must be no more than $4,350 in the case of self-only coverage and no more than $$8,000 in the case of family coverage. Out-of-pocket expenses include deductibles, co-payments, and other amounts (other than premiums) that the individual must pay for covered benefits under the plan. A plan does not fail to qualify as a high deductible health plan if substantially all of the coverage under the plan is certain permitted insurance or is coverage (whether provided through insurance or otherwise) for accidents, disability, dental care, vision care, or long-term care.

The maximum annual contribution that can be made to an Archer MSA for a year is 65 percent of the annual deductible under the individual's high deductible health plan in the case of self-only coverage (65 percent of $3,250 for 2014) and 75 percent of the annual deductible in the case of family coverage (75 percent of $6,550 for 2014), but in no case more than the individual's compensation income. In addition, the maximum contribution can be made only if the individual is covered by the high deductible health plan for the full year.

Distributions from an Archer MSA for qualified medical expenses are not includible in gross income. Distributions not used for qualified medical expenses are includible in gross income and subject to an additional 20-percent tax unless an exception applies. A distribution from an Archer MSA may be rolled over on a nontaxable basis to another Archer MSA or to a health savings account and does not count against the contribution limits.

After 2007, no new contributions can be made to Archer MSAs except by or on behalf of individuals who previously had made Archer MSA contributions and employees of small employers that previously contributed to Archer MSAs (or at least 20 percent of whose employees who were previously eligible to contribute to Archer MSAs did so).

Health savings accounts

As of 2004, an individual with a high deductible health plan (and no other health plan other than a plan that provides certain permitted insurance or permitted coverage) generally may contribute to a health savings account ("HSA"), which is a tax-exempt trust or custodial account. HSAs provide similar tax-favored savings treatment as Archer MSAs. That is, within limits, contributions to an HSA are deductible in determining adjusted gross income if made by an individual and are excludable from gross income and wages for employment tax purposes if made by the employer of an individual, and distributions for qualified medical expenses are not includible in gross income.154 However, the rules for HSAs are in various aspects more favorable than the rules for Archer MSAs. For example, the availability of HSAs is not limited to employees of small employers or self-employed individuals and their spouses.

For 2014, a high deductible health plan for purposes of HSA eligibility is a health plan with an annual deductible of at least $1,250 in the case of self-only coverage and at least $2,500 in the case of family coverage. In addition, for 2013, the sum of the deductible and the maximum out-of-pocket expenses with respect to allowed costs must be no more than $6,350 in the case of self-only coverage and no more than $12,700 in the case of family coverage. A plan does not fail to qualify as a high deductible health plan for HSA purposes merely because it does not have a deductible for preventive care.

For 2014, the maximum aggregate annual contribution that can be made to an HSA is $3,300 in the case of self-only coverage and $6,550 in the case of family coverage. The annual contribution limits are increased by $1,000 for individuals who have attained age 55 by the end of the taxable year (referred to as "catch-up contributions"). The maximum amount that an individual make contribute is reduced by the amount of any contributions to the individual's Archer MSA and any excludable HSA contributions made by the individual's employer. In some cases, an individual may make the maximum HSA contribution, even if the individual is covered by the high deductible health plan for only part of the year. A distribution from an HSA may be rolled over on a nontaxable basis to another HSA and does not count against the contribution limits.

 

Description of Proposal

 

 

Under the proposal, contributions to Archer MSAs for taxable years beginning after December 31, 2014, are not deductible or excluded from income and wages.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

14. Repeal of two-percent floor on miscellaneous itemized deductions (sec. 1414 of the discussion draft and sec. 67 of the Code)

 

Present Law

 

 

An individual may claim an itemized deduction for certain miscellaneous expenses only to the extent of such expenses in excess of two percent of the taxpayer's adjusted gross income.155 Miscellaneous expenses subject to the two-percent floor include certain unreimbursed employee business expenses and expenses for the production or collection of income, for the management, conservation, or maintenance of property held for the production of income, and in connection with the determination, collection, or refund or any tax.

To be deductible, an unreimbursed employee business expense must be: (1) paid or incurred during the taxable year; (2) for carrying on the trade or business of being an employee; and (3) an ordinary and necessary business expense. Thus, unreimbursed employee business expenses are those expenses that would be deductible above the line if the employee were engaged in a trade or business (other than the trade or business of being an employee). Generally, the two-percent floor applies to unreimbursed employee business expenses after any other deduction limit (such as the 50-percent limit on expenses for business-related meals and entertainment). Unreimbursed employee expenses include such expenses as certain business and professional dues, uniform costs, home office deductions, business bad debts of an employee, employment related education expenses, licenses and regulatory fees, malpractice insurance premiums, medical examinations required by an employer, occupational taxes, publications and subscriptions, job search, employment and outplacement agency fees, and union dues and expenses.

The two-percent floor does not apply to the following itemized deductions: (1) otherwise deductible interest; (2) State and local income (or in lieu of such, State sales), real property, and certain personal property taxes; (3) casualty and theft losses; (4) gambling losses to the extent of gambling winnings; (5) charitable contributions; (6) medical expenses; (7) impairment-related work expenses of a disabled individual; (8) the estate tax on income in respect to a decedent; (9) any deduction allowable in connection with personal property used in a short sale; (10) certain adjustments occurring when a taxpayer restores amounts held under a claim of right; (11) amortizable bond premium; (12) certain terminated annuity payments; and (13) deductions in connection with cooperative housing corporations. The two-percent floor does not apply to deductions allowable to estates or trusts under sections 642(c), 651, and 661.

 

Description of Proposal

 

 

The proposal repeals the two-percent floor on miscellaneous itemized deductions.156

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

15. Repeal of overall limitation on itemized deductions (sec. 1415 of the discussion draft and sec. 68 of the Code)

 

Present Law

 

 

The total amount of most otherwise allowable itemized deductions (other than the deductions for medical expenses, investment interest and casualty, theft or gambling losses) is limited for certain upper-income taxpayers.157 All other limitations applicable to such deductions (such as the separate floors) are first applied and, then, the otherwise allowable total amount of itemized deductions is reduced by three percent of the amount by which the taxpayer's adjusted gross income exceeds a threshold amount.

For 2014, the threshold amounts are $254,200 for single taxpayers, $279,650 for heads of household, $305,050 for married couples filing jointly, and $152,525 for married taxpayers filing separately. These threshold amounts are indexed for inflation. The otherwise allowable itemized deductions may not be reduced by more than 80 percent by reason of the overall limit on itemized deductions.

 

Description of Proposal

 

 

The proposal repeals the overall limitation on itemized deductions.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

16. Deduction for amortizable bond premium allowed in determining adjusted gross income (sec. 1416 of the discussion draft and sec. 62 of the Code)

 

Present Law

 

 

Under present law, a deduction for amortizable bond premium is allowed to the holder of a taxable bond acquired for more than the amount payable on maturity.158 The deduction is an itemized deduction.159 The amount amortizable is computed on a constant yield basis. The amount of bond premium is allocated among the interest payments received on the bond, and the allocated amount reduces the amount the of the interest payments to the extent thereof, in lieu of any deduction otherwise allowable.160

 

Description of Proposal

 

 

The proposal allows the deduction for amortizable bond premium of an individual as an "above-the-line" deduction which reduces adjusted gross income.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

17. Repeal of exclusion, etc., for employee achievement awards (sec. 1417 of the discussion draft and secs. 74(c) and 274(j) of the Code)

 

Present Law

 

 

An employer's deduction for the cost of an employee achievement award is limited to a certain amount.161 Employee achievement awards that are deductable by an employer (or would be deductible but for the fact that the employer is a tax-exempt organization) are excluded from an employee's gross income and wages for employment tax purposes.162 An employee achievement award is an item of tangible personal property given to an employee in recognition of either length of service or safety achievement and presented as part of a meaningful presentation.

 

Description of Proposal

 

 

The proposal repeals the deduction limitation and the exclusion for employee achievement awards.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

18. Clarification of special rule for certain governmental plans (sec. 1418 of the discussion draft and sec. 105(j) of the Code)

 

Present Law

 

 

Reimbursements under an employer-provided accident or health plan for medical care expenses for employees, their spouses, their dependents, and adult children under age 27 are excludible from gross income.163 However, in order for these reimbursements to be excluded from income, the plan may reimburse expenses of only the employee and the employee's spouse, dependents, and children under age 27. In the case of a deceased employee, the plan generally may reimburse medical expenses of only the employee's surviving spouse, dependents and children under age 27. If a plan reimburses expenses of any other beneficiary, all expense reimbursements under the plan are included in income, including reimbursements of expenses of the employee and the employee's spouse, dependents and children under age 27 (or the employee's surviving spouse, dependents and children under age 27).164

Under a limited exception, reimbursements under a plan do not fail to be excluded from income solely because the plan provides for reimbursements of medical expenses of a deceased employee's beneficiary, without regard to whether the beneficiary is the employee's surviving spouse, dependent, or child under age 27. In order for the exception apply, the plan must have provided, on or before January 1, 2008, for reimbursement of the medical expenses of a deceased employee's beneficiary. In addition, the plan must be funded by a medical trust (1) that is established in connection with a public retirement system, and (2) that either has been authorized by a State legislature, or has received a favorable ruling from the IRS that the trust's income is not includible in gross income by reason of the exclusion for income of a State or political subdivision.165 This exception preserves the exclusion for reimbursements of expenses of the employee and the employee's spouse, dependents, and children under age 27 (or the employee's surviving spouse, dependents, and children under age 27). Reimbursements of expenses of other beneficiaries are included in income.

 

Description of Proposal

 

 

The proposal expands the exception to apply to plans funded by medical trusts in addition to those covered under present law. As expanded, the exception would apply to a plan funded by a medical trust (1) that is either established in connection with a public retirement system or established by or on behalf of a State or political subdivision thereof, and (2) that either has been authorized by a State legislature or has received a favorable ruling from the IRS that the trust's income is not includible in gross income by reason of either the exclusion for income of a State or political subdivision or the exemption from income tax for a voluntary employees' beneficiary association ("VEBA").166 The plan would still be required to have provided, on or before January 1, 2008, for reimbursement of the medical expenses of a deceased employee's beneficiary.

The proposal also clarifies that this exception preserves the exclusion for reimbursements of expenses of the employee and the employee's spouse, dependents, and children under age 27 (or the employee's surviving spouse, dependents, and children under age 27) and that, as under present law, reimbursements of expenses of other beneficiaries are included in income.

 

Effective Date

 

 

The proposal is effective with respect to payments made after the date of enactment of the proposal.

19. Limitation on exclusion for employer-provided housing (sec. 1419 of the discussion draft and sec. 119 of the Code)

 

Present Law

 

 

The value of lodging furnished to an employee, spouse, or dependents by or on behalf of an employer for the convenience of the employer (referred to as "employer-provided lodging") is excluded from the employee's gross income, but only if the employee is required to accept the lodging on the business premises of the employer as a condition of employment. The value of employer-provided lodging is also excluded from wages for employment tax purposes.167

 

Description of Proposal

 

 

The proposal limits the amount that may be excluded as employer-provided lodging. The exclusion with respect to employer-provided lodging for a taxable year may not exceed $50,000 ($25,000 in the case of a married individual filing a separate return). In addition, the exclusion does not apply to more than one residence at any given time. In the case of spouses filing a joint return, the one residence limit may be applied separately to each spouse for a period during which the spouses reside in separate residences provided in connection with their respective employments.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

20. Fringe benefits (sec. 1420 of the discussion draft and sec. 132 of the Code)

 

Present Law

 

 

In general

A fringe benefit that is a no-additional-cost service, qualified employee discount, or a qualified transportation fringe is excluded from an employee's gross income and wages for employment tax purposes.168

No-additional-cost services and qualified employee discounts

A no-additional-cost service is a service provided by an employer to an employee for use by the employee if (1) the service is offered for sale to customers in the ordinary course of the employer's line of business in which the employee performs services, and (2) the employer incurs no substantial additional cost (including foregone revenue) in providing the service to the employee. A qualified employee discount may apply to services provided by an employer to an employee at a discount (that is, at less than the price the employer offers the services to customers) for use by the employee, (1) if the services are offered for sale to customers in the ordinary course of the employer's line of business in which the employee performs services, and (2) to the extent the discount does not exceed 20 percent of the price at which the services are offered by the employer to customers. For purposes of these exclusions, use by a spouse or dependent child of an employee is treated as use by the employee. In addition, use of air transportation by a parent of an employee is treated as use by the employee.

Qualified transportation fringes

Qualified transportation fringes include parking, transit passes, vanpool benefits, and qualified bicycle commuting reimbursements. Qualified transportation fringes also include a cash reimbursement (under a bona fide reimbursement arrangement) by an employer to an employee for parking, transit passes, or vanpooling. In the case of transit passes, however, a cash reimbursement is considered a qualified transportation fringe only if a voucher or similar item that may be exchanged only for a transit pass is not readily available for direct distribution by the employer to the employee.

In general, the amount that can be excluded as qualified transportation fringe benefits is limited to $100 per month in combined transit pass and vanpool benefits and $175 per month in qualified parking benefits, with the limits being adjusted annually for inflation. For months beginning on or after February 17, 2009169 and before January 1, 2014, the exclusion limit that applies to employer-provided parking applies also to combined employer-provided transit pass and vanpool benefits. For 2013, the monthly exclusion amount is $245. After 2013, the lower monthly exclusion amount (as adjusted for inflation) applies to combined employer-provided transit pass and vanpool benefits. For 2014, the monthly exclusion amount for qualified parking benefits is $250, and the monthly exclusion amount for combined employer-provided transit pass and vanpool benefits is $130.

With respect to any calendar year, a qualified bicycle commuting reimbursement is an employer reimbursement, during the 15-month period beginning with the first day of the calendar year, for reasonable expenses incurred by an employee during the calendar year for the purchase of a bicycle and bicycle improvements, repair, and storage, if such bicycle is regularly used for travel between the employee's residence and place of employment. The exclusion for a qualified bicycle commuting reimbursement for a calendar year is limited to $20 multiplied by the number of months during the year for which the employee regularly uses the bicycle for a substantial portion of the travel between the employee's residence and place of employment and does not receive any other qualified transportation fringe.

 

Description of Proposal

 

 

The proposal repeals the rule under which, for purposes of a no-additional-cost service or a qualified employee discount, use of air transportation by a parent of an employee is treated as use by the employee.

With respect to the qualified transportation fringe exclusion for parking, the proposal applies a permanent monthly limit of $250, which is not adjusted in the future for inflation. With respect to the qualified transportation fringe exclusion for employer-provided transit passes, vanpool benefits or combined transit pass and vanpool benefits, the proposal applies a permanent combined monthly limit of $130, which is not adjusted in the future for inflation. The proposal also repeals the qualified transportation fringe exclusion for qualified bicycle commuting reimbursements.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

21. Repeal of exclusion of net unrealized appreciation in employer securities (sec. 1421 of the discussion draft and sec. 402(e)(4) of the Code)

 

Present Law

 

 

If a qualified retirement plan distributes property, the general rule is that the amount of the distribution is the fair market value of the property on the date of the distribution and amount of the distribution is includible in gross income except to the extent that a portion of the distribution is a return of the employee's investment in the contract.

However, if employer securities are distributed by a qualified retirement plan and either the distribution is a lump sum distribution or the employer securities are attributable to after-tax employee contributions, the net unrealized appreciation in the securities is excluded from the recipient's gross income.170 Net unrealized appreciation is defined as the excess of the market value of the securities at the time of distribution over the cost or other basis of the securities to the trust.171 In other words, it generally is the amount by which the value of the securities increased while held by the trust of the qualified retirement plan. The basis of the employer securities after distribution does not include the amount of net unrealized appreciation excluded from gross income.172

The exclusion for net unrealized appreciation is not available upon subsequent distribution after the securities are contributed to another eligible retirement plan in a tax-free rollover.173 When the securities are received as part of a lump sum distribution, the recipient may elect not to exclude net unrealized appreciation.174

 

Description of Proposal

 

 

The exclusion for net unrealized appreciation with respect to employer securities is repealed.

 

Effective Date

 

 

The proposal applies to distributions of employer securities after December 31, 2014.

22. Consistent basis reporting between estate and person acquiring property from decedent (sec. 1422 of the discussion draft and secs. 6035 and 6724 of the Code)

 

Present Law

 

 

The value of an asset for purposes of the estate tax generally is the fair market value at the time of death or at the alternate valuation date.175 The basis of property acquired from a decedent is the fair market value of the property at the time of the decedent's death or as of an alternate valuation date, if elected by the executor.176 Under regulations, the fair market value of the property at the date of the decedent's death (or alternate valuation date) is deemed to be its value as appraised for estate tax purposes.177 However, the value of property as reported on the decedent's estate tax return provides only a rebuttable presumption of the property's basis in the hands of the heir.178 Unless the heir is estopped by his or her previous actions or statements with regard to the estate tax valuation, the heir may rebut the use of the estate's valuation as his or her basis by clear and convincing evidence. The heir is free to rebut the presumption in two situations: (1) the heir has not used the estate tax value for tax purposes, the IRS has not relied on the heir's representations, and the statute of limitations on assessments has not barred adjustments; and (2) the heir does not have a special relationship to the estate which imposes a duty of consistency.179

 

Description of Proposal

 

 

Under the proposal, if the inclusion of property in an estate increased estate tax liability on such estate, and the value of the property has been finally determined for estate tax purposes, the basis in the hands of the recipient can be no greater than the value of the property as finally determined. If the value of the property is not finally determined for estate tax purposes, then the basis in the hands of the recipient can be no greater than the value reported in a required statement.

An executor of a decedent's estate that is required to file an estate tax return under section 6018(a) is required to report to both the recipient and the IRS the value of each interest in property included in the gross estate. A person that is required to file an estate tax return under section 6018(b) (returns by beneficiaries) is required to report to each other person holding a legal or beneficial interest in property to which the return relates and to the IRS the value of each interest in property included in the gross estate. The required reports must be furnished by the time proscribed by the Secretary, but in no case later than the earlier of 30 days after the return is due under section 6018 or 30 days after the return is filed. In any case where reported information is adjusted after a statement has been filed, a supplemental statement must be filed not later than 30 days after such adjustment is made.

The proposal grants the Secretary authority to prescribe regulations necessary to carry out the proposal, including the application of the proposal when no estate tax return is required to be filed and when the surviving joint tenant or other recipient may have better information than the executor regarding the basis or fair market value of the property.

The proposal applies the penalty for failure to file correct information returns under section 6721, and failure to furnish correct payee statements under section 6722, to failure to file the new information returns required under the proposal. Additionally, the proposal applies the accuracy-related penalty under section 6662 to any inconsistent estate basis. Inconsistent estate basis for purposes of the accuracy-related penalty is the portion of the understatement attributable to a basis determination with respect to property which is not consistent with the value of the property finally determined for estate tax purposes, or if not finally determined, in accordance with the statement provided under the proposal.

 

Effective Date

 

 

The proposal is applicable to transfers for which an estate tax return is filed after the date of enactment.

 

F. Employment Tax Modifications

 

 

1. Modifications of deduction for Social Security taxes in computing net earnings from self-employment (sec. 1501 of the discussion draft and sec. 1402(a)(12) of the Code)

 

Present Law

 

 

FICA taxes

The Federal Insurance Contributions Act ("FICA") imposes tax on employers and employees based on the amount of wages (as defined for FICA purposes) paid to an employee during the year.180 The tax imposed on the employer and on the employee is each composed of two parts: (1) the Social Security or old age, survivors, and disability insurance ("OASDI") tax equal to 6.2 percent of covered wages up to the taxable wage base ($117,000 for 2014); and (2) the Medicare or hospital insurance ("HI") tax equal to 1.45 percent of all covered wages.181 The employee portion of the FICA tax generally must be withheld and remitted to the Federal government by the employer.

The employer portion of the FICA tax is not treated as income or wages to the employee. That is, it is not included in the employee's income and is not subject to FICA tax.

SECA taxes

As a parallel to FICA taxes, taxes under the Self-Employment Contributions Act ("SECA") apply to the self-employment income of self-employed individuals.182 The rate of the OASDI portion of SECA taxes is generally 12.4 percent, which is equal to the combined employee and employer OASDI tax rates, and applies to self-employment income up to the OASDI taxable wage base (reduced by the individual's OASDI wages, if any). Similarly, the rate of the HI portion of SECA tax is 2.9 percent, the same as the combined employer and employee HI rates, and there is no cap on the amount of self-employment income to which the rate applies.183

Self-employment income for SECA purposes means net earnings from self-employment with certain modifications. Net earnings from self-employment generally means the income from a self-employed individual's trade or business less deductions attributable to the trade or business. In determining net earnings from self-employment, a self-employed individual is permitted a deduction equal to the product of the taxpayer's net earnings from self-employment determined without regard to this deduction ("preliminary" net earnings from self-employment or NESE) and one-half of the sum of the rates for OASDI (12.4 percent) and HI (2.9 percent), i.e., 7.65 percent of preliminary NESE.184 This deduction reflects the fact that the FICA rates apply to an employee's wages, which do not include FICA taxes paid by the employer, whereas a self-employed individual's net earnings are economically the equivalent of an employee's wages plus the employer share of FICA taxes. The deduction is intended to provide parity between FICA and SECA taxes.

 

Description of Proposal

 

 

The proposal modifies the deduction from net earnings from self-employment to make SECA taxes economically equivalent to FICA taxes.185 Under the proposal, the deduction is determined as the sum of two amounts, corresponding to the OASDI and HI portions of SECA taxes.

The OASDI portion of the deduction is 7.1064 percent of preliminary net earnings from self-employment up to 1.0765 multiplied by the OASDI taxable wage base (reduced by the individual's OASDI wages, if any). The HI portion of the deduction is 1.4293 percent of preliminary net earnings from self-employment in excess of the amount taken into account in determining the OASDI portion of the deduction (that is, preliminary net earnings from self-employment up to 1.0765 multiplied by the OASDI taxable wage base (reduced by the individual's OASDI wages, if any)).

The calculation is summarized in the following table. For purposes of the table, the OASDI base amount is 1.0765 times the OASDI taxable wage base reduced by the individual's OASDI wages, if any.

             Table 3. -- Calculation of Deduction Allowed

 

                       in Determining SECA Taxes

 

 ____________________________________________________________________

 

 

                                  Amount of deduction in calculating

 

                                  net earnings from self-employment

 

 If preliminary NESE are . . .    is . . .

 

 ____________________________________________________________________

 

 

 Up to the OASDI base amount      7.1064 percent of preliminary NESE.

 

 

 In excess of the OASDI base      7.1064 percent of preliminary NESE

 

                                  up to the OASDI base amount, plus

 

 

                                  1.4293 percent of preliminary NESE

 

                                  in excess of the OASDI base amount

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

2. Determination of net earnings from self-employment (sec. 1502 of the discussion draft and secs. 3101, 3102, 2111, 1401, and 1402 of the Code)

 

Present Law

 

 

In general

As part of the financing for Social Security and Medicare benefits, a tax is imposed on the wages of an individual received with respect to his or her employment under the Federal Insurance Contributions Act ("FICA").186 A similar tax is imposed on the net earnings from self-employment of an individual under the Self-Employment Contributions Act ("SECA").187

FICA
The FICA tax has two components. Under the old-age, survivors, and disability insurance component ("OASDI"), the rate of tax is 12.4 percent, half of which is imposed on the employer, and the other half of which is imposed on the employee.188 The amount of wages subject to this component is capped at $117,000 for 2014. Under the hospital insurance ("HI") component, the rate is 2.9 percent, also split equally between the employer and the employee. The amount of wages subject to the HI component of the tax is not capped.189 The wages of individuals employed by a business in any form (for example, a C corporation) generally are subject to the FICA tax. The employee portion of the FICA tax is collected through withholding from wages.190
SECA
The SECA tax rate is the combined employer and employee rate for FICA taxes. Under the OASDI component, the rate of tax is 12.4 percent and the amount of earnings subject to this component is capped at $117,000 for 2014. Under the HI component, the rate is 2.9 percent, and the amount of self-employment income subject to the HI component is not capped.191

For SECA tax purposes, net earnings from self-employment generally includes the gross income derived by an individual from any trade or business carried on by the individual, less the deductions attributable to the trade or business that are allowed under the self-employment tax rules.192 Net earnings from self-employment generally includes the distributive share of income or loss from any trade or business of a partnership in which the individual is a partner.

Specified types of income or loss are excluded, such as rentals from real estate in certain circumstances, dividends and interest, and gains or loss from the sale or exchange of a capital asset or from timber, certain minerals, or other property that is neither inventory nor held primarily for sale to customers.

S corporation shareholders

An S corporation is treated as a passthrough entity for Federal income tax purposes. Each shareholder takes into account and is subject to Federal income tax on the shareholder's pro rata share of the S corporation's income.193

A shareholder of an S corporation who performs services as an employee of the S corporation is subject to FICA tax on his or her wages from the S corporation.

A shareholder of an S corporation generally is not subject to FICA tax on amounts that are not wages, such as the shareholder's share of the S corporation's income. Unlike a partner's distributive share of income or loss from the partnership's trade or business, which is generally subject to SECA tax, an S corporation shareholder's pro rata share of S corporation income is not subject to SECA tax. Nevertheless, courts have held that an S corporation shareholder is subject to FICA tax on the amount of his or her reasonable compensation, even though the amount may have been characterized by the taxpayer as other than wages. The case law has addressed the issue of whether amounts paid to shareholders of S corporations constitute reasonable compensation and therefore are wages subject to the FICA tax, or rather, are properly characterized as another type of income that is not subject to FICA tax.194

In cases addressing whether payments to an S corporation shareholder were wages for services or were corporate distributions, courts have recharacterized a portion of corporate distributions as wages if the shareholder performing services did not include any amount as wages.195 In cases involving whether reasonable compensation was paid (not exclusively in the S corporation context), courts have applied a multi-factor test to determine reasonable compensation, including such factors as whether the individual's compensation was comparable to compensation paid at comparable firms.196 The Seventh Circuit, however, has adopted an "independent investor" analysis differing from the multi-factor test in that it asks whether an inactive, independent investor would be willing to compensate the employee as he was compensated.197 The independent investor test has been examined and partially adopted in some other Circuits, changing the analysis under the multi-factor test.198

Partners

In general
A partnership is treated as a passthrough entity for Federal income tax purposes. Each partner includes in income its distributive share of partnership items of income, gain and loss.199

A partner's distributive share of partnership items is not treated as wages for FICA tax purposes. Rather, a partner who is an individual is subject to the SECA tax on his or her distributive share of trade or business income of the partnership. The net earnings from self-employment generally include the partner's distributive share (whether or not distributed) of income or loss from any trade or business carried on by the partnership (excluding specified types of income, such as rent, dividends, interest, and capital gains and losses, as described above200 ). This rule applies to individuals who are general partners.

Limited partners
An exclusion from SECA applies in certain circumstances for limited partners of a partnership.201 Under this rule, in determining a limited partner's net earnings from self-employment, an exclusion is generally provided for his or her distributive share of partnership income or loss. The exclusion does not apply with respect to guaranteed payments to the limited partner for services actually rendered to or on behalf of the partnership to the extent that those payments are established to be in the nature of remuneration for those services.202

The owners of a limited liability company that is classified as a partnership for Federal tax purposes are treated as partners for tax purposes. However, under State law, limited liability company owners are not defined as either general partners or limited partners.203

 

Description of Proposal

 

 

In general

The proposal modifies the determination of net earnings from self-employment under the SECA tax by adding the shareholder's pro rata share of income from S corporations, repealing the exception for limited partners, providing a new deduction related to nonlabor income, and providing a new 100-percent deduction for individuals who do not have material participation.

S corporation shareholders

The proposal provides that net earnings from self-employment generally include the income or loss from any trade or business of an S corporation in which the individual is a stockholder. Specifically, the amount included is the individual's pro rata share of nonseparately computed income or loss described in section 1366(a)(2) from any trade or business carried on by an S corporation in which he is a stockholder.

Under the proposal, the same exceptions apply in determining net earnings from self-employment of a stockholder in an S corporation as apply to a partner in a partnership and to an individual carrying on a trade or business. Thus, the same specified types of income or loss are excluded: rentals from real estate in certain circumstances, dividends and interest, and gains or loss from the sale or exchange of a capital asset, or gains or losses from other property that is neither inventory nor held primarily for sale to customers. Consequently, under this rule, an S corporation shareholder is treated in the same manner as a partner in a partnership under the SECA tax.

The proposal does not change the present-law rules applying FICA tax to wages, including wages paid by an S corporation.

Authority is provided to the Treasury Department to provide regulations or other guidance to coordinate for any year to which the proposal applies the application of the cap (which is $117,000 for 2014) on wages of an individual from an S corporation that are subject to the FICA tax with the application of the cap to amounts subject to the SECA tax with respect to that individual's pro rata share of income of that S corporation.

Limited partners

The proposal repeals the present-law exclusion for a limited partner's distributive share of partnership income or loss in determining net earnings from self-employment (including repeal of the exception for partnership guaranteed payments in the nature of remuneration for services). Thus, under the proposal, limited partners are treated the same as other partners for purposes of determining net earnings from self-employment. Any person who is treated for Federal income tax purposes as a partner in any entity that is treated for Federal income tax purposes as a partnership is treated as a partner in a partnership for purposes of the SECA tax. Thus, for example, a member of an LLC who is treated for Federal income tax purposes as a partner in a partnership is treated as a partner for purposes of the SECA tax. A person treated as a partner under the Federal income tax is so treated for purposes of the SECA tax regardless of whether the person is treated as a partner under applicable State, local, or foreign law.

Nonlabor income deduction

The proposal provides a deduction that reduces net earnings from self-employment by a percentage that is derived from the historical portion of U.S. gross domestic product that represents income other than labor income. The deduction does not depend in any case on the type or nature of any particular item of income or earnings, but rather is calculated under a formula derived by reference to historical nonlabor income.

Under the proposal, an individual's net earnings from self-employment are reduced (but not below zero) by the lesser of (1) 30 percent of the sum of his pass-through net earnings from self-employment and his FICA wages paid by an S corporation in which he is a shareholder, or (2) his pass-through net earnings from self-employment. Thus, in determining the deduction, both the FICA wages paid by an S corporation to an individual shareholder, and the individual shareholder's pro rata share of S corporation income (subject to SECA), are taken into account.

For example, assume an individual performs services for or on behalf of an S corporation that pays him wages, and the individual also wholly owns the S corporation. Further assume that the S corporation's income (before any deduction for wages) is $100 for the year, and the individual has wages from the S corporation of $70 and a pro rata share (as shareholder) of $30. Under the proposal, 30 percent of the sum of the individual's pass-through net earnings from self-employment and his FICA wages is $30, and the individual's pass-through net earnings from self-employment are the same amount, $30. The nonlabor income deduction reduces the individual's net earnings from self-employment by $30 to $0. The individual's FICA tax on the $70 of wages is unaffected. Because both FICA wages and pass-through net earnings from self-employment are subject to payroll tax at the same rate and both are taken into account in determining the nonlabor income deduction, application of the judicially-developed reasonable compensation test is not necessary to determine FICA wages. The nonlabor income deduction is applied after application of the present-law exclusions from net earnings from self-employment for rentals from real estate in certain circumstances, dividends and interest, and gains or loss from the sale or exchange of a capital asset or from timber, certain minerals, or other property that is neither inventory nor held primarily for sale to customers.

Pass-through net earnings from self-employment is defined as net earnings from self-employment (computed without regard to the proposal) determined without regard to any trade or business carried on by the individual. Thus, for example, if the individual carries on a widget business as a sole proprietor, and also is a partner in a gadget business carried on by the partnership, pass-through net earnings from self-employment is determined with regard only to the gadget business of the partnership, and does not take into account the widget business the individual conducts as a sole proprietor. The Treasury Department is accorded regulatory authority to reallocate items of income, gain, or loss among businesses in which the taxpayer has an interest in any capacity, to carry out the purposes of the proposal.

100-percent deduction for individuals who do not have material participation

The proposal generally provides a 100-percent deduction from net earnings from self-employment for specified amounts in circumstances in which an individual does not have material participation with respect to an entity.

The rule has the effect that an individual's net earnings from self-employment are separated into items from nonparticipation entities, and items that are not from nonparticipation entities. An individual's net earnings from self-employment generally are reduced (but not below zero) by the sum of (1) the reduction determined above under the nonlabor income deduction, but modified to take account only of items from nonparticipation entities at 100 percent, and (2) the reduction determined above under the nonlabor income deduction, but modified to take account only of items that are not from nonparticipation entities at 30 percent.

For this purpose, a nonparticipation entity with respect to any individual is any entity with respect to which the individual does not have material participation.

An individual does not have material participation with respect to a top-tier entity if the individual demonstrates to the satisfaction of the Treasury Department that he or she does not materially participate in any activity carried on by the top-tier entity, and does not materially participate in any activity carried on by any other entity in which the top-tier entity directly or indirectly holds an interest. For this purpose, material participation has the same meaning as under the passive loss rules (sec. 469(h)). The participation of an individual in any activity is treated as including that of the individual's spouse and the lineal descendants of the individual and the individual's spouse.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

3. Repeal of exemption from FICA taxes for certain foreign workers (sec. 1503 of the discussion draft and secs. 3121(b)(1) and (b)(19) and section 3231(e)(1) of the Code)

 

Present Law

 

 

FICA imposes tax on employers and employees based on the amount of wages (as defined for FICA purposes) paid to an employee during the year.204 The tax imposed on the employer and on the employee is each composed of two parts: (1) the Social Security or old age, survivors, and disability insurance ("OASDI") tax equal to 6.2 percent of covered wages up to the taxable wage base ($117,000 for 2014); and (2) the Medicare or hospital insurance ("HI") tax equal to 1.45 percent of all covered wages.205

Wages as defined for FICA purposes means all remuneration for employment, with certain specified exceptions. Employment as defined for FICA purposes generally means any service, of whatever nature, performed by an employee for an employer within the United States, with certain specified exceptions.206

Exceptions from employment apply to service performed by certain categories of employees who are lawfully admitted to the United States on a temporary basis in order to work, specifically, agricultural workers holding H-2A visas and individuals (for example, certain students, researchers, and cultural exchange participants) holding F-1, J-1, M-1, Q-1 or Q-2 visas.207 Exceptions from employment apply also to certain other types of service, and, in some cases, an employee's service may be eligible for both a FICA exception applicable to certain visa holders and also for another exception.

Instead of FICA taxes, railroad employers and employees are subject, under the Railroad Retirement Tax Act ("RRTA"), to taxes equivalent to the OASDI and HI taxes under FICA with respect to compensation as defined for RRTA purposes ("RRTA compensation").208 An exception applies for individuals holding F-1, J-1, M-1, Q-1 or Q-2 visas.209

 

Description of Proposal

 

 

Under the proposal, the FICA and RRTA exceptions for services performed as employees by agricultural workers holding H-2A visas or individuals holding F-1, J-1, M-1, Q-1 or Q-2 visas are repealed.210 Thus, FICA taxes apply to wages paid to these employees (and RRTA taxes apply to compensation) unless another exception applies.

 

Effective Date

 

 

The proposal is effective with respect to remuneration received for services performed after December 31, 2014.

4. Repeal of exemption from FICA taxes for certain students (sec. 1504 of the discussion draft and sec. 3121(b)(2) and (b)(10) of the Code)

 

Present Law

 

 

FICA imposes tax on employers and employees based on the amount of wages (as defined for FICA purposes) paid to an employee during the year.211 The tax imposed on the employer and on the employee is each composed of two parts: (1) the Social Security or old age, survivors, and disability insurance ("OASDI") tax equal to 6.2 percent of covered wages up to the taxable wage base ($117,000 for 2014); and (2) the Medicare or hospital insurance ("HI") tax equal to 1.45 percent of all covered wages.212

Wages as defined for FICA purposes means all remuneration for employment, with certain specified exceptions. Employment as defined for FICA purposes generally means any service, of whatever nature, performed by an employee for an employer within the United States, with certain specified exceptions.213

An exception from employment for FICA purposes applies in the case of certain services performed by a student in the employ of a school, college, or university.214 Specifically, FICA does not apply to services performed by a student who is enrolled and regularly attending classes at the school, college, or university. A FICA exception applies also to domestic service performed in a local college club, or local chapter of a college fraternity or sorority, by a student who is enrolled and regularly attending classes at a school, college, or university.215 Exceptions from employment apply also to certain other types of service, and, in some cases, an employee's service may be eligible for both a FICA exception applicable to students and also for another exception.

Some FICA exceptions are subject to dollar limits. For example, cash remuneration of less than a specified amount ($1,900 for 2014) paid to an employee in a year for domestic service in a private home is exempt from FICA.216 The FICA rules provide that, in cases in which a FICA exception is subject to a dollar limit, the employer may withhold the employee share of FICA from payments made to the employee even though, at the time of payment, the total amount paid to the employee is less than the limit and, thus, may be exempt from FICA.217

Under the Social Security Act, an individual's wages are credited to the individual's earnings record for purposes of determining an individual's eligibility for Social Security benefits and Medicare coverage and for purposes of determining the amount of an individual's Social Security benefits. Eligibility for Social Security benefits and Medicare coverage is based in part on credits (referred to as "quarters of coverage") received for wages. Up to four quarters of coverage can be earned for a year, depending on total wages for the year and the amount needed to earn each quarter of coverage. For 2014, credit for a quarter of coverage is provided for each $1,200 of wages, with a maximum of four quarters of coverage for $4,800 in wages.

 

Description of Proposal

 

 

The proposal amends the FICA exceptions for students by adding a dollar limit. Specifically, a FICA exception applies to a student for a year only if the student's earnings are less than the amount needed to receive a quarter of FICA coverage for the year ($1,200 for 2014).218 Thus, if a student's earnings exceed the limit, the student's earnings are subject to FICA unless another FICA exception applies. If the limit is exceeded, all of the individual's earnings are subject to FICA, including earnings up to the limit, thus enabling the individual to receive at least one quarter of coverage for the year.

Under the proposal, the rules and procedures relating to the withholding of the employee share of FICA that apply under present law in the case of FICA exceptions that are subject to dollar limits apply also for purposes of the student exception. For example, the employer may withhold the employee share of FICA from payments made to the employee even though, at the time of payment, the total amount paid to the employee is less than the limit.

 

Effective Date

 

 

The proposal is effective for remuneration received for services performed after December 31, 2014.

5. Override of Treasury guidance providing that certain employer-provided supplemental unemployment benefits are not subject to employment taxes (sec. 1505 of the discussion draft and sec. 3402(o)(1)(A) and (o)(2)(A) of the Code)

 

Present Law

 

 

Employment taxes

Employment taxes generally consist of taxes on employee wages under the Federal Insurance Contributions Act ("FICA"), the Railroad Retirement Tax Act ("RRTA") and the Federal Unemployment Tax Act ("FUTA"), and required Income Tax Withholding ("ITW") from employee wages.219 For these purposes, wages is defined broadly to include all remuneration, subject to exceptions specifically provided in the relevant statutory provisions.220 Remuneration does not fail to be subject to employment taxes merely because it is paid after termination of employment.221

Dismissal pay and supplemental unemployment benefits

Income tax withholding is required with respect to dismissal payments, described as any payments made by an employer to an employee on account of dismissal (that is, involuntary separation from the service of the employer), regardless of whether the employer is legally bound by contract, statute, or otherwise to make such payments.222 Dismissal payments are also subject to FICA and FUTA.223 Similarly, lump sum separation and severance allowances paid to laid-off employees in the railway industry are subject to RRTA.224

The IRS has established a limited administrative exception to the application of FICA, RRTA, FUTA and income tax withholding in the case of supplemental unemployment benefit ("SUB") pay meeting certain requirements.225 In order to qualify for the exception, SUB pay benefits must be linked to eligibility for State unemployment compensation and must not be paid in a lump sum.226

Income tax withholding is required with respect to the payment of supplemental unemployment compensation benefits.227 For this purpose, the term supplemental unemployment compensation benefits means amounts paid to an employee, pursuant to a plan to which the employer is a party, because of the employee's involuntary separation from employment (whether or not the separation is temporary), resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions, but only to the extent such benefits are includible in the employee's gross income.

 

Description of Proposal

 

 

Under the proposal, various revenue rulings providing employment tax exclusions for supplemental unemployment benefits are null and void, as are any other Treasury or IRS ruling, regulation or other guidance to the extent that such ruling, regulation or guidance provides that any payment made by reason of involuntary termination of employment, including any supplemental unemployment benefit, is not wages for purposes of any Code provision. Thus, the employment tax exclusions established administratively under IRS guidance for SUB pay no longer apply and all supplemental unemployment benefits are subject to FICA, RRTA and FUTA taxes and income tax withholding. The proposal does not override the application of any statutory employment tax exceptions.

The proposal also repeals the present-law provision requiring income tax withholding on supplemental unemployment compensation benefits. These amounts are subject to income tax withholding as wages.

 

Effective Date

 

 

The proposal making various revenue rulings and other rulings, regulations or other guidance null and void is effective for amounts paid after December 31, 2014. Repeal of the present-law provision requiring income tax withholding on supplemental unemployment compensation benefits is effective for amounts paid after December 31, 2013. Repeal of this income tax withholding requirement is not to be construed to create any inference with respect to the exclusion from wages or compensation of any amounts paid before January 1, 2014.

6. Certified professional employer organizations (sec. 1506 of the discussion draft and new secs. 3511 and 7706 of the Code)

 

Present Law

 

 

In general

Employment taxes generally consist of the taxes under the Federal Insurance Contributions Act ("FICA"), the taxes under the Railroad Retirement Tax Act ("RRTA"), the tax under the Federal Unemployment Tax Act ("FUTA"), and income taxes required to be withheld by employers from wages paid to employees ("income tax withholding").228

FICA tax consists of two parts: (1) old age, survivor, and disability insurance ("OASDI"), which correlates to the Social Security program that provides monthly benefits after retirement, disability, or death; and (2) Medicare hospital insurance ("HI"). The OASDI tax rate is 6.2 percent on both the employee and employer (for a total rate of 12.4 percent). The OASDI tax rate applies to wages up to the OASDI wage base for the calendar year ($117,000 for 2014). The HI tax rate is 1.45 percent on both the employee and the employer (for a total rate of 2.9 percent). Unlike the OASDI tax, the HI tax is not limited to a specific amount of wages, but applies to all wages.229

RRTA taxes consist of tier 1 taxes and tier 2 taxes. Tier 1 taxes parallel the OASDI and HI taxes applicable to employers and employees. Tier 2 taxes consist of employer and employee taxes on railroad compensation up to the tier 2 wage base for the calendar year.

Under FUTA, employers must pay a tax of 6 percent of wages up to the FUTA wage base of $7,000. An employer may take a credit against its FUTA tax liability for its contributions to a State unemployment fund and, in certain cases, an additional credit for contributions that would have been required if the employer had been subject to a higher contribution rate under State law. For purposes of the credit, contributions means payments required by State law to be made by an employer into an unemployment fund, to the extent the payments are made by the employer without being deducted or deductible from employees' remuneration.

Employers are required to withhold income taxes from wages paid to employees. Withholding rates vary depending on the amount of wages paid, the length of the payroll period, and the number of withholding allowances claimed by the employee.

Wages paid to employees, and FICA, RRTA, and income taxes withheld from the wages, are required to be reported on employment tax returns and on Forms W-2.230

Employment taxes generally apply to all remuneration paid by an employer to an employee. However, various exclusions apply to certain types of remuneration or certain types of services, which may depend on the type of employer for whom an employee performs services.231 For example, remuneration (subject to a dollar limit) paid to an employee by a tax-exempt organization is excluded from wages for FICA purposes, and services performed in the employ of certain tax-exempt organizations are excluded from employment for FUTA purposes.232 In addition, various definitions and special rules apply to certain types of employers.233

As discussed above, certain employment taxes apply only on amounts up to a specified wage base. If an employee works for multiple employers during a year, separate wage bases generally apply to each employer. However, a single OASDI, RRTA tier 1 or tier 2, or FUTA wage base applies in certain cases in which an employer (a "successor" employer) takes over the business of another employer (the "predecessor" employer) and employs the employees of the predecessor employer.

Responsibility for employment tax compliance

Employment tax responsibility generally rests with the person who is the employer of an employee under a common-law test that has been incorporated into Treasury regulations.234 Under the regulations, an employer-employee relationship generally exists if the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work, but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer, not only as to what is to be done, but also as to how it is to be done. It is not necessary that the employer actually control the manner in which the services are performed, rather it is sufficient that the employer have a right to control. Whether the requisite control exists is determined on the basis of all the relevant facts and circumstances. The test of whether an employer-employee relationship exists often arises in determining whether a worker is an employee or an independent contractor. However, the same test applies in determining whether a worker is an employee of one person or another.

In some cases, a person other than the common-law employer (a "third party") may be liable for employment taxes. For example, if wages are paid to an employee by a third party and the third party, rather than the employer, has control of the payment of the wages, the third party is the statutory employer responsible for complying with applicable employment tax requirements.235 In addition, an employer may designate a reporting agent to be responsible for FICA tax and income tax withholding compliance,236 including filing employment tax returns and issuing Forms W-2 to employees.237 In that case, the reporting agent and the employer are jointly and severally liable for compliance.238

Professional employer organizations

A professional employer organization (sometimes called an employee leasing company) is a term used for a firm that provides employees to perform services in the businesses of the professional employer organization's customers, generally small and medium-sized businesses. In many cases, before the professional employer organization arrangement is entered into, the employees already work in the customer's business as employees of the customer. The terms of a typical professional employer organization arrangement provide that the professional employer organization is the employer of the employees and is responsible for paying the employees and for the related employment tax compliance. The customer typically pays the professional employer organization a fee based on payroll costs plus an additional amount.239

In some cases, the employees provided to work in the customer's business are legally the employees of the customer, and the customer is legally responsible for employment tax compliance. Nonetheless, customers generally rely on the professional employer organization for employment tax compliance (without designating the professional employer organization as a reporting agent) and treat the employees as employees of the professional employer organization.

Reporting by large food and beverage establishments

Certain reporting requirements relating to tips apply to large food or beverage establishments.240 In the case of such an establishment, an employer is generally required to report the following information to the IRS each calendar year: (1) the gross receipts of the establishment from the provision of food and beverages (other than certain receipts); (2) the aggregate amount of charge receipts (other than certain receipts); (3) the aggregate amount of charged tips on the charge receipts; (4) the sum of the aggregate amount of tips reported to the employer by employees and certain amounts required to be reported by the employer on employees' Form W-2s; and (5) with respect to each employee, the amount of tips allocated to the employee based on the receipts of the establishment. The employer must also provide employees with written statements showing certain information each calendar year, including the amount of tips allocated to the employee for the year.

User fees

User fees apply to requests to the IRS for ruling letters, opinion letters, determination letters, and similar requests.241 The user fees that apply are determined by the IRS and are generally required to be determined after taking into account the average time and difficulty involved in a request.

 

Description of Proposal

 

 

Treatment of certified professional employer organization as employer for employment tax purposes

Under the proposal, if certain requirements are met, for purposes of employment taxes and other obligations under the employment tax rules, a certified professional employer organization is treated as the employer of any work site employee performing services for any customer of the certified professional employer organization, but only with respect to remuneration remitted to the work site employee by the certified professional employer organization. In addition, no other person is treated as the employer for employment tax purposes with respect to remuneration remitted by the certified professional employer organization to a work site employee.

Under the proposal, exceptions, exclusions, definitions, and other rules that are based on the type of employer and that would apply if the certified professional employer organization were not treated as the employer under the proposal continue to apply. Thus, for example, if services performed in the employ of a customer that is a tax-exempt organization would be excluded from employment for FUTA purposes, the fact that a certified professional employer organization is treated as the employer for employment tax purposes does not affect the application of the exclusion.

The proposal provides rules under which, on entering into a service contract with a customer with respect to a work site employee, a certified professional employer organization is treated as a successor employer and the customer is treated as the predecessor employer. Similarly, on termination of a service contract with respect to a worksite employee, the customer is treated as a successor employer and the certified professional employer organization is treated as a predecessor employer. Thus, wages paid by the customer and the certified professional employer organization to a work site employee during a calendar year are subject to a single OASDI, RRTA tier 1 or tier 2, or FUTA wage base.

The proposal does not apply in the case of a customer who is related to the certified professional employer organization.242 In addition, an individual with net earnings from self-employment derived from a customer's trade or business (i.e., a self-employed individual), including a customer who is a sole proprietor or a partner of a customer that is a partnership, is not a work site employee for employment tax purposes with respect to remuneration paid by a certified professional employer organization.

As discussed more fully below, a work site employee is an individual who performs services (1) for a customer pursuant to a contract between the customer and the certified professional employer organization that meets certain requirements and (2) at a work site that meets certain requirements. Thus, if the contract or work site fails to meet these requirements, the individual is not a work site employee. The proposal applies also in the case of an individual (other than a self-employed individual) who is not a work site employee, but who performs services under a contract that meets the specified requirements. In this case, solely for purposes of a certified professional employer organization's liability for employment taxes and other obligations under the employment tax rules, a certified professional employer organization is treated as the employer of such an individual, but only with respect to remuneration remitted to the individual by the certified professional employer organization. With respect to such an individual, exceptions, exclusions, definitions, and other rules that are based on the type of employer and that would apply if the certified professional employer organization were not treated as the employer under the proposal continue to apply.

A certified professional employer organization is eligible for the FUTA credit with respect to contributions made to a State unemployment fund with respect to a work site employee by the certified professional employer organization or a customer. An additional FUTA credit may be claimed by a certified professional employer organization if, under State law, a certified professional employer organization is permitted to collect and remit contributions with respect to a work site employee to the State unemployment fund.

Except to the extent necessary for purposes of the proposal treating a certified professional employer organization as the employer for employment tax purposes, nothing in the proposal is to be construed to affect the determination of who is an employee or employer for purposes of the Code.

Certified professional employer organization

A certified professional employer organization is a person who has been certified by the Secretary of the Treasury ("Secretary"), for purposes of being treated as the employer for employment tax purposes under the proposal, as meeting certain requirements. These requirements are met if the person:

  • demonstrates that the person (and any owner, officer, and such other persons as may be specified in regulations) meets requirements established by the Secretary with respect to tax status, background, experience, business location, and annual financial audits;

  • agrees to satisfy the bond and independent financial review requirements (described below) on an ongoing basis;

  • agrees to satisfy any reporting obligations imposed by the Secretary;

  • computes its taxable income using an accrual method of accounting unless the Secretary approves another method;

  • agrees to verify on such periodic basis as prescribed by the Secretary that it continues to meet the requirements for certification; and

  • agrees to notify the Secretary in writing within such time as prescribed by the Secretary of any change that materially affects the continuing accuracy of any agreement or information that was previously made or provided.

 

Under the bond requirement, a certified professional employer organization must post a bond for the payment of employment taxes in a minimum amount and in a form acceptable to the Secretary. The minimum amount is determined for the period April 1 of any calendar year through March 31 of the following calendar year and is the greater of (1) five percent of the employment taxes for which the certified professional employer organization is liable under the proposal during the preceding calendar year (but not to exceed $1,000,000), or (2) $50,000. However, during the first three full calendar years that a professional employer organization is in existence, the amount described in (1) of the preceding sentence does not apply. For this purpose, under rules provided by the Secretary, an organization is treated as in existence as of the date that it begins providing services to any client that are comparable to the services being provided with respect to work site employees, regardless of whether such date occurred before or after the organization is certified by the IRS. If a certified professional employer organization has employment tax liability of more than $5,000,000 for a calendar year, the exception no longer applies as of April 1 of the following year.

Under the independent financial review requirements, a certified professional employer organization must: (1) have, as of the most recent audit date (that is, six months after the completion of the certified professional employer organization's fiscal year), caused to be prepared and provided to the Secretary an opinion of an independent certified public accountant as to whether the certified professional employer organization's financial statements are presented fairly in accordance with generally accepted accounting principles; and (2) provide to the Secretary, not later than the last day of the second month beginning after the end of each calendar quarter, from an independent certified public accountant an assertion regarding Federal employment tax payments and an examination level attestation on the assertion. The assertion must state that the certified professional employer organization has withheld and made deposits of all required FICA, RRTA, and withheld income taxes for the calendar quarter, and the attestation must state that the assertion is fairly stated in all material respects. If a certified professional employer organization fails to file the required assertion and attestation with respect to any calendar quarter, the independent financial review requirements are treated as not satisfied for the period beginning on the due date for the attestation.

For purposes of the bond and independent financial review requirements, all professional employer organizations that are members of a controlled group of corporations or under common control are treated as a single organization.243 The Secretary may suspend or revoke the certification of a person's certified professional employer organization status if the Secretary determines that the person does not satisfy the representations or other requirements for certification or fails to satisfy the applicable accounting, reporting, payment, or deposit requirements.

Work site employee

A work site employee is an individual who: (1) performs services for a customer of a certified professional employer organization pursuant to a contract between the customer and the certified professional employer organization that meets certain requirements (described below); and (2) performs services at a work site meeting certain requirements (described below).244

The contract between the customer and the certified professional employer organization must be in writing and, with respect to an individual performing services for the customer, must provide that the certified professional employer organization will:

  • assume responsibility for payment of wages to the individual, without regard to the receipt or adequacy of payment from the customer;

  • assume responsibility for reporting, withholding, and paying any employment taxes with respect to the individual's wages, without regard to the receipt or adequacy of payment from the customer;

  • assume responsibility for any employee benefits that the contract may require the certified professional employer organization to provide, without regard to the receipt or adequacy of payment from the customer;

  • assume responsibility for recruiting, hiring and firing workers in addition to the customer's responsibility for recruiting, hiring and firing workers;

  • maintain employee records relating to the individual; and

  • agree to be treated as a certified professional employer organization for employment tax purposes with respect to such individual.

 

For purposes of whether an individual is a work site employee, the work site where the individual performs services meets the applicable requirements if at least 85 percent of the individuals performing services for the customer at the work site are subject to one or more contracts with the certified professional employer organization that meet the above requirements.245

Regulations

The Secretary is directed to prescribe such regulations as may be necessary or appropriate to carry out the purposes of the proposal. The Secretary is also directed to develop reporting and recordkeeping rules, regulations, and procedures to ensure compliance with the proposal with respect to entities applying for and receiving certification as certified professional employer organizations. These are to be designed in a manner to streamline, to the extent possible, the application of the requirements of the proposal, the exchange of information between a certified professional employer organization and its customers, and the reporting and recordkeeping obligations of a certified professional employer organization.

Other rules

 

Reporting by large food and beverage establishments

 

Under the proposal, if a certified professional employer organization is treated for employment tax purposes as the employer of a work site employee, the customer for whom the work site employee performs services is the employer for purposes of the reporting required with respect to a large food or beverage establishment. The certified professional employer organization is required to furnish the customer with any information necessary to complete the required reporting.

 

User fees

 

Under the proposal, the user fee charged under the program for certifying a professional employer organization is an annual fee and may not exceed $1,000.

 

No inference as to effect of proposal

 

Nothing contained in the proposal or the amendments made by the proposal is to be construed to create any inference with respect to the determination of who is an employee or employer (1) for Federal tax purposes (other than the purposes set forth in the proposal), or (2) for purposes of any other provision of law.

 

Effective Date

 

 

The proposal is effective with respect to wages paid for services performed on or after January 1 of the first calendar year beginning more than 12 months after the date of enactment of the proposal. The Secretary is directed to establish the certification program for professional employer organizations not later than six months before the proposal becomes effective.

 

G. Pensions and Retirement

 

 

1. Changes to rules for individual retirement arrangements (secs. 1601 through 1604 of the discussion draft and secs. 219, 408, and 408A of the Code)

 

Present Law

 

 

Individual retirement arrangements

There are two basic types of individual retirement arrangements ("IRAs") under present law: traditional IRAs,246 to which both deductible and nondeductible contributions may be made,247 and Roth IRAs, to which only nondeductible contributions may be made.248 The principal difference between these two types of IRAs is the timing of income tax inclusion. For a traditional IRA, an eligible contributor may deduct the contributions made for the year, but distributions are includible in gross income to the extent attributable to earnings on the account and the deductible contributions. For a Roth IRA, all contributions are after-tax (that is, no deduction is allowed), but qualified distributions are not includible in gross income.

An annual limit applies to contributions to IRAs. The contribution limit is coordinated so that the aggregate maximum amount that can be contributed to all of an individual's IRAs (both traditional and Roth) for a taxable year is the lesser of a certain dollar amount ($5,500 for 2014) or the individual's compensation. In the case of a married couple, contributions can be made up to the dollar limit for each spouse if the combined compensation of the spouses is at least equal to the contributed amount. The dollar limit is increased to reflect increases in the cost-of living using calendar year 2007 as the base year. The index used is the consumer price index for all-urban consumers published by the Department of Labor (CPI-U). However, if the amount of any increase is not a multiple of $500, the increase is rounded down to the nearest multiple of $500.

An individual who has attained age 50 before the end of the taxable year may also make catch-up contributions up to $1,000 to an IRA. The IRA catch-up contribution limit is not indexed.

Traditional IRAs

An individual may make deductible contributions to a traditional IRA up to the IRA contribution limit (reduced by any contributions to Roth IRAs) if neither the individual nor the individual's spouse is an active participant in an employer-sponsored retirement plan. If an individual (or the individual's spouse) is an active participant in an employer-sponsored retirement plan, the deduction is phased out for taxpayers with adjusted gross income ("AGI") for the taxable year over certain indexed levels.249 To the extent an individual cannot or does not make deductible contributions to a traditional IRA or contributions to a Roth IRA for the taxable year, the individual may make nondeductible contributions to a traditional IRA (that is, no AGI limits apply), subject to the same contribution limits as the limits on deductible contributions, including catch-up contributions. An individual who has attained age 70 1/2 prior to the close of a year is not permitted to make contributions to a traditional IRA.

Amounts held in a traditional IRA are includible in income when withdrawn, except to the extent that the withdrawal is a return of the individual's basis.250 All traditional IRAs of an individual are treated as a single contract for purposes of recovering basis in the IRAs.

Roth IRAs

Individuals with AGI below certain levels may make nondeductible contributions to a Roth IRA. The maximum annual contribution that can be made to a Roth IRA is phased out for taxpayers with AGI for the taxable year over certain indexed levels. The AGI phase-out ranges for 2014 for Roth IRA contributions are: (1) for single taxpayers, $114,000 to $129,000; (2) for married taxpayers filing joint returns, $181,000 to $191,000; and (3) for married taxpayers filing separate returns, $0 to $10,000. Contributions to a Roth IRA may be made even after the account owner has attained age 70 1/2.

Amounts held in a Roth IRA that are withdrawn as a qualified distribution are not includible in income. A qualified distribution is a distribution that (1) is made after the five-taxable-year period beginning with the first taxable year for which the individual first made a contribution to a Roth IRA, and (2) is made after attainment of age 59 1/2, on account of death or disability, or is made for first-time homebuyer expenses of up to $10,000.251

Distributions from a Roth IRA that are not qualified distributions are includible in income to the extent attributable to earnings; amounts that are attributable to a return of contributions to the Roth IRA are not includible in income. All Roth IRAs are treated as a single contract for purposes of determining the amount that is a return of contributions.

Separation of traditional and Roth IRA accounts

Contributions to traditional IRAs and to Roth IRAs must be segregated into separate IRAs, meaning arrangements with separate trusts, accounts, or contracts, and separate IRA documents. Except in the case of a conversion or recharacterization, amounts cannot be transferred or rolled over between the two types of IRAs.

Taxpayers generally may convert an amount in a traditional IRA into a Roth IRA.252 The amount converted is includible in the taxpayer's income as if a withdrawal had been made, except that the 10-percent early distribution tax does not apply.253 The conversion is accomplished by a trustee-to-trustee transfer of the amount from the traditional IRA to the Roth IRA, or by a distribution from the traditional IRA and contribution to the Roth IRA within 60 days.

Rollovers to IRAs of distributions from tax-favored employer-sponsored plans (qualified retirement plans, section 403(b) plans, and governmental section 457(b) plans) are also permitted. For tax-free rollovers, distributions from pretax accounts under an employer-sponsored plan must be contributed to a traditional IRA and distributions from a designated Roth account are only permitted to be contributed to a Roth IRA. A distribution from an employer-sponsored plan that is not from a designated Roth account is also permitted to be rolled over into a Roth IRA, subject to the rules that apply to conversions from a traditional IRA into a Roth IRA. Thus, a rollover from an eligible employer plan into a Roth IRA is includible in gross income (except to the extent it represents a return of after-tax contributions), and the 10-percent early distribution tax does not apply.254

Recharacterization

If an individual makes a contribution to an IRA (traditional or Roth) for a taxable year, the individual is permitted to recharacterize (by a trustee-to-trustee transfer to the other type of IRA) the amount of that contribution as a contribution to the other type of IRA (traditional or Roth) before the due date for the individual's income tax return for that year.255 In the case of a recharacterization, the contribution will be treated as having been made to the transferee plan (and not the transferor plan) as of the date of the original contribution. Both regular contributions and conversion contributions to a Roth IRA can be recharacterized as having been made to a traditional IRA. The amount transferred must be accompanied by any net income allocable to the contribution and no deduction is allowed with respect to the contribution to the transferor plan. Even if a recharacterization is accomplished by transferring a specific asset, net income is calculated as a prorata portion of income on the entire account rather than income allocable to the specific asset transferred. However, when doing a Roth conversion of an amount for a year, an individual may divide up the amount being converted and establish multiple Roth IRAs (for example, Roth IRAs with different investment strategies) and select which Roth IRA to recharacterize as a traditional IRA by transferring the entire amount in the account to a traditional IRA (for example, the entire amount in the account of any IRA for which the value of the assets in the account declines during the year).256 The individual may then later convert that traditional IRA to Roth IRA, including the lower value in income. Treasury regulations prevent the conversion from taking place immediately after the recharcterization. The regulations require a minimum period to elapse before a reconversion after a recharacterization (meaning a conversion of an amount previously contributed to a Roth IRA in a Roth conversion and then recharacterized as a contribution to a traditional IRA).257 Generally the reconversion cannot occur sooner than the later of 30 days after the recharacterization or a date during the taxable year following the taxable year of the original conversion.

Simple IRA plans and simplified employee pensions

Simple IRA plans and simplified employee pensions are special types of employer-sponsored retirement plans under which the employer makes contributions to IRAs established for each of its employees in accordance with the Code requirements for each type of plan. Only contributions to traditional IRAs are allowed for these plans.

Rollover contributions from employer sponsored retirement plans

Distributions from tax-favored employer-sponsored plans are permitted to be rolled over tax-free to a traditional IRA or another tax-favored employer-sponsored plan.

 

Description of Proposal

 

 

Under the proposal, the rules for IRAs are changed as described below.

Elimination of income limits on contributions to Roth IRAs

The AGI limits on making contributions to a Roth IRA are eliminated. Thus contributions are permitted to be made to a Roth IRA by a taxpayer for a year regardless of the taxpayer's AGI.

No deductible or nondeductible contributions to traditional IRAs

No deductible or nondeductible contributions are allowed to be made to traditional IRAs. Only rollover contributions of distributions from other traditional IRAs or tax-favored retirement plans and contributions under a SIMPLE IRA plan or a simplified employee pension plan are allowed to be made to a traditional IRA. Nondeductible contributions continue to be allowed to be made to Roth IRAs.

Suspension of inflation adjustment of dollar limit on contributions to Roth IRAs

The proposal suspends cost-of-living adjustments to the dollar limit on contributions to Roth IRAs through 2023. Thus, the 2014 annual limit on contributions to a Roth IRA remains at $5,500 through 2023. Cost-of living adjustments resume beginning with 2024 using calendar year 2022 as the base year, rounding down to the nearest multiple of $500 (as under present law). As under present law, Roth IRA catch-up contributions are not indexed, and thus remain at $1,000 per year even after 2023.

Repeal of special rule permitting recharacterization of IRA contributions

Under the proposal, the special rule that allows IRA contributions to one type of IRA (either traditional or Roth) to be recharacterized as a contribution to the other type of IRA is repealed. Thus, for example, under the proposal, a conversion contribution establishing a Roth IRA during a taxable year can no longer be recharacterized as a contribution to a traditional IRA (thereby unwinding the conversion) because the investment experience of the Roth IRA after the conversion resulted in net losses, rather than net gains, and the individual wanted to be able convert that amount at the lower value, including in income only that lower value.

Effective Date

The proposal is effective for taxable years beginning after December 31, 2014.

2. Repeal of exception to 10-percent penalty for first-time home purchases and elimination of first-time home purchase as a qualified distribution from a Roth IRA (sec. 1605 of the discussion draft and secs. 72(t) and 408A of the Code)

 

Present Law

 

 

Early distribution tax

The Code imposes an early distribution tax on distributions made from qualified retirement plans, 403(b) plans, and IRAs before an employee (or an IRA owner) attains age 59 1/2 unless an exception applies.258 The tax is equal to 10 percent of the amount of the distribution that is includible in gross income.259 One of the exceptions is for qualified first-time homebuyer distributions which are distributions from IRAs used for first-time homebuyer expenses that meet certain requirements and are limited to $10,000.260

Qualified distributions from Roth IRAs

There are two basic types of individual retirement arrangements ("IRAs") under present law: traditional IRAs,261 to which both deductible and nondeductible contributions may be made,262 and Roth IRAs, to which only nondeductible contributions may be made.263 The principal difference between these two types of IRAs is the timing of income tax inclusion. For a traditional IRA, an eligible contributor may deduct the contributions made for the year, but distributions are includible in gross income to the extent attributable to earnings on the account and the deductible contributions. For a Roth IRA, all contributions are after-tax (that is, no deduction is allowed) but, qualified distributions from the Roth IRA are not includible in gross income.

A qualified distribution from a Roth IRA is a distribution that (1) is made after the five-taxable-year period beginning with the first taxable year for which the individual first made a contribution to a Roth IRA, and (2) is made after attainment of age 59 1/2, on account of death or disability of the IRA owner, or is a qualified first-time home buyer distribution.264 Distributions from a Roth IRA that are not qualified distributions are includible in income to the extent attributable to earnings; amounts that are attributable to a return of contributions to the Roth IRA are not includible in income.

 

Description of Proposal

 

 

The proposal repeals the exception from the 10 percent early distribution tax for qualified first-time homebuyer distributions from IRAs. The proposal also eliminates qualified first-time home buyer distributions as a basis for a distribution from a Roth IRA being a qualified distribution (and thus not includible in gross income).

 

Effective Date

 

 

The proposal is effective for distributions after December 31, 2014.

3. Termination of new simplified employee pensions (sec. 1611 of the discussion draft and sec. 408(k) of the Code)

 

Present Law

 

 

A simplified employee pension ("SEP") is a type of tax-favored employer-sponsored retirement plan under which an employer may make contributions to a SEP IRA for each eligible employee up to the lesser of 25 percent of the employee's compensation or the dollar limit applicable to contributions to a qualified defined contribution plan ($52,000 for 2014).265 All contributions must be fully vested. Any employee must be eligible to participate in the SEP if the employee has (1) attained age 21, (2) performed services for the employer during at least three of the immediately preceding five years, and (3) received at least $550 (for 2014) in compensation from the employer for the year. Contributions to a SEP generally must bear a uniform relationship to compensation.

Effective for taxable years beginning before January 1, 1997, certain employers with no more than 25 employees could maintain a salary reduction SEP ("SARSEP") under which employees could make elective deferrals. However, contributions may continue to be made to SARSEPs that were established before 1997. Elective deferrals under a SARSEP are subject to the same limit that applies to elective deferrals under a section 401(k) plan ($17,500 for 2014). An individual who has attained age 50 before the end of the taxable year may also make catch-up contributions under a SARSEP up to a limit of $5,500 (for 2014).

 

Description of Proposal

 

 

Under the proposal, a new SEP plan is not permitted to be established by an employer after December 31, 2014. However, contributions are permitted to continue to any SEP plan of an employer maintaining a SEP plan for its employees as of December 31, 2014 if such SEP plan and the terms thereof satisfy the requirements for SEPs on and after December 31, 2014. Thus, under the SEP plan of the employer, contributions may be made to a SEP IRA of an employee of the employer even if the employee did not participate in the plan on that date and the SEP IRA for the employee is established after that date.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

4. Termination for new SIMPLE 401(k) plans (sec. 1612 of the discussion draft and sec. 401(k)(11) of the Code)

 

Present Law

 

 

A small employer that employs no more than 100 employees who earned $5,000 or more during the prior calendar year can establish a simplified tax-favored retirement plan, which is called a simple retirement plan. There are two types of simple retirement plans, one that is a form of section 401(k) plan ("SIMPLE 401(k) plan") and the other is a plan under which contributions are made to an individual retirement arrangement for each employee (a "SIMPLE IRA plan"). A simple retirement plan allows employees to make elective deferrals, subject to a limit of $12,000 (for 2014). An individual who has attained age 50 before the end of the taxable year may also make catch-up contributions under a simple retirement plan up to a limit of $2,500 (for 2014). A SIMPLE 401(k) plan is deemed to satisfy the nondiscrimination tests that otherwise apply to elective deferrals and matching contributions.

Employer contributions to a simple retirement plan generally must satisfy one of two contribution formulas. Under the matching contribution formula, the employer generally is required to match employee elective deferrals on a dollar-for-dollar basis up to three percent of the employee's compensation. Alternatively, for any year, an employer is permitted to elect, in lieu of making matching contributions, to make a nonelective contribution of two percent of compensation on behalf of each eligible employee whether or not the employee makes elective deferrals. No contributions other than employee elective deferrals, required employer matching contributions, or employer nonelective contributions can be made to a simple retirement plan.

 

Description of Proposal

 

 

Under the proposal, a new SIMPLE 401(k) plan is not permitted to be established by an employer for plan years beginning after December 31, 2014. However, contributions are permitted to continue to any SIMPLE 401(k) plan in existence for the last plan year beginning before January 1, 2015, but only if the arrangement meets the requirements for being a SIMPLE 401(k) plan for such plan year and each plan year thereafter.

 

Effective Date

 

 

The proposal applies to plan years beginning after December 31, 2014.

5. Rules related to designated Roth contributions (sec. 1613 of the discussion draft and secs. 401(a)(30), 402(g), 402A, and 408(p) of the Code)

 

Present Law

 

 

Section 401(k) plans, section 403(b) plans, and governmental section 457(b) plans

 

In general

 

A qualified retirement plan that is a profit-sharing plan or stock bonus plan (and certain money purchase pension plans) may allow an employee to make an election between cash and an employer contribution to the plan pursuant to a qualified cash or deferred arrangement.266 A plan with this feature is generally referred to as a section 401(k) plan. A section 403(b) plan may allow a similar salary reduction agreement under which an employee may make an election between cash and an employer contribution to the plan.267

Amounts contributed pursuant to these qualified cash or deferred arrangements and salary reduction agreements generally are referred to as elective deferrals. The elective deferrals generally are excludable from gross income (pretax elective deferrals) and only taxed along with attributable earnings upon distribution from the plan. Alternatively the plan may include a qualified Roth contribution program under which eligible employees are offered a choice of either making pretax elective deferrals or making elective deferrals that are not excluded from income and are designated as Roth contributions.268 However, the plan is not permitted to only allow employees to make designated Roth contributions; pretax elective deferrals must also be permitted.269 If certain requirements are satisfied, distributions of designated Roth contributions and attributable earnings are excluded from gross income. The employer may also make nonelective and matching contributions for employees under a section 401(k) or 403(b) plan. These are not permitted to be designated as Roth contributions and generally are pretax contributions.

A dollar limit applies to the aggregate amount of elective deferrals (both pretax elective deferrals and designated Roth contributions) that an employee is permitted to contribute to section 401(k) and section 403(b) plans for a taxable year, which is $17,500 for 2014.270 An employee age 50 or over is allowed to contribute an additional catch up amount of $5,500 for 2014.271

If an individual's total elective deferrals for a taxable year under section 401(k) plans and section 403(b) plans exceed the $17,500 limit plus, if applicable, the catch-up contributions limit, and the plan distributes the excess (plus allocable income) by April 15 following the taxable year, the excess amount is includable in the individual's gross income.272 If the excess is not distributed by April 15, the excess is includable in gross income but the individual receives no basis in the account for the amount included in gross income. Thus, that amount will be taxed again when distributed. In the case of an excess in the form of designated Roth contributions that is not distributed by April 15, any distribution attributable to the excess cannot be a qualified distribution, and the individual is not entitled to basis to reflect that the excess amount is an after-tax contribution.

A governmental section 457(b) plan may also provide for elective deferrals. Contributions to a governmental section 457(b) plan are subject to a dollar limit of $17,500 (for 2014) plus an additional $5,500 catch-up contribution limit (for 2014) for participants at least age 50 (or the participant's compensation, if less).273 This limit is separate from the limit on elective deferrals to section 401(k) and section 403(b) plans.274 As in the case of a section 401(k) plan or a section 403(b) plan, the plan may include a qualified Roth contribution program under which employees are given the choice between making pretax elective deferrals and designated Roth contributions.

Designated Roth accounts

All designated Roth contributions made under the plan must be maintained in a separate account (a designated Roth account). A qualified distribution from a designated Roth account is excludable from gross income. A qualified distribution is a distribution that is made after (1) an employee's completion of a specified 5-year period and (2) the employee's attainment of age 59 1/2, death, or disability.

A distribution from a designated Roth account (other than a qualified distribution) is included in the distributee's gross income to the extent allocable to income under the contract and excluded from gross income to the extent allocable to investment in the contract (commonly referred to as basis), taking into account only the designated Roth contributions as basis.

SIMPLE IRA plan

An eligible employer can establish a simplified tax-favored retirement plan, which is called a SIMPLE IRA plan. An eligible employer is an employer which had no more than 100 employees who received at least $5,000 of compensation from the employer for the preceding year. Compensation for this purpose is wages reported on the employees Form W-2 plus elective pretax deferrals. An employer that maintains a SIMPLE IRA plan for one or more years and then exceeds this limit may remain an eligible employer for 2 years following the year in which the employer last satisfied the limit.

A SIMPLE IRA under a SIMPLE IRA plan is not permitted to be a Roth IRA. Under a SIMPLE IRA plan, contributions are made only to a traditional IRA (not a Roth IRA) for each employee (a "SIMPLE IRA"). A SIMPLE IRA plan allows employees to make pretax elective deferrals to a SIMPLE IRA, subject to a limit of $12,000 (for 2014). An individual who has attained age 50 before the end of the taxable year may also make catch-up contributions under a SIMPLE IRA plan up to a limit of $2,500 (for 2014). The employer is required to make certain specified matching or nonelective contributions to the SIMPLE IRA for each eligible employee. In the case of a SIMPLE IRA plan, the group of eligible employees generally must include any employee who has received at least $5,000 in compensation from the employer in any two preceding years and is reasonably expected to receive $5,000 in the current year.275

 

Description of Proposal

 

 

Limit on pretax elective deferrals

Except as described below for plans of eligible employers, under the proposal, the combined limit on pretax elective deferrals under section 401(k) plans and 403(b) plans, and pretax deferrals under a governmental section 457(b) plan is reduced to one half the dollar limits on total elective deferrals and catch-up contributions (the aggregate amount of pretax elective deferrals and designated Roth contributions). Thus, the general limit on pretax elective deferrals is $8,750 (one half of $17,500), and the catch-up contribution limit is $2,750 (one half of $5,500). As a result, for an employee over age 50, the general elective contribution limit applicable to the aggregate amount of pretax elective deferrals and designated Roth contributions is $23,000, but the pretax elective deferrals cannot exceed one half that amount or $11,500.

Qualified Roth contribution program

The limit on designated Roth contributions is the full $17,500 limit, plus (if applicable) the full $5,500 catch up contribution limit, reduced by the amount of any pretax elective deferrals. Under the proposal, section 401(k) plans, section 403(b) plans, and governmental section 457(b) plans are permitted to offer only a qualified Roth contribution program with respect to elective deferrals (both with respect to the $17,500 limit and the $5,500 catch-up contribution limit), and are not required to also offer employees the opportunity to make pretax elective deferrals.276

Plan maintained by an eligible employer

The rule reducing the limit on pretax elective deferrals to one half the elective deferral limit and, if applicable, the catch-up contribution limit does not apply to a section 401(k) plan, section 403(b) plan, or governmental section 457(b) plan, maintained by an eligible employer. Under the proposal, the only change to the present-law rules applicable to one of these types of plans maintained by an eligible employer is that the plan is permitted to only allow designated Roth contributions (under a qualified Roth contribution program) and is not required to also allow pretax elective deferrals. Otherwise the rules remain unchanged. Thus, the employer may maintain a plan that only allows pretax elective deferrals and the limit remains the maximum limit of $17,500 (plus $5,500 catch up, if applicable). Reporting will be required on the employee's Form W-2 to identify that the elective deferrals are under a plan of an eligible employer.

The definition of an eligible employer for this purpose is the definition of an eligible employer under the SIMPLE IRA plan rules, generally an employer that had no more than 100 employees who received at least $5,000 of compensation from the employer for the preceding year with a 2-year grace period for an employer with employees that exceed this limit.

SIMPLE IRA plans

The proposal permits a SIMPLE IRA to be a Roth IRA. The proposal also allows a SIMPLE IRA plan to permit employees to choose to make after-tax elective deferrals to Roth IRAs in lieu of elective deferrals to traditional IRAs, subject to the combined limit of $12,000 (plus $2,500 for catch-up contributions, if applicable). However, a SIMPLE IRA plan is also permitted to continue to only allow pretax elective deferrals to traditional IRAs.

The proposal also provides a new option for a SIMPLE IRA plan under which the plan may provide for elective deferrals up to the full limit of $17,500 plus catch-up contributions of $5,500 (applicable to elective deferrals under section 401(k) and 403(b) plans, and governmental section 457(b) plans), but only if the plan allows after-tax elective deferrals to be made to a SIMPLE IRA that is a Roth IRA and does not allow pretax elective deferrals to be made to traditional IRAs in excess of one half the applicable limit, $8,750 plus catch-up contributions, if applicable of $2,750.277

 

Effective Date

 

 

The proposal is effective for plan years and taxable years beginning after December 31, 2014. With respect to SIMPLE IRA plans, the proposal is effective for calendar year beginning after December 31, 2014.

6. Modification of required distribution rules for pension plans (sec. 1614 of the discussion draft and sec. 401(a)(9) of the Code)

 

Present Law

 

 

Minimum distribution rules278 apply to employer sponsored tax-favored retirement plans279 and individual retirement arrangements ("IRAs"). In general, under these rules, distribution of minimum benefits must begin no later than a required beginning date and a minimum amount must be distributed each year.280 Minimum distribution rules also apply to benefits payable with respect to an employee (or IRA owner) who has died. The regulations provide a methodology for calculating the required minimum distribution from an individual account under a defined contribution plan or from an IRA.281 In the case of annuity payments under a defined benefit plan or an annuity contract, the regulations provide requirements that the stream of annuity payments must satisfy. Failure to comply with the minimum distribution requirement results in an excise tax imposed on the individual who was required to take the distributions equal to 50 percent of the required minimum amount not distributed for the year. The excise tax may be waived in certain cases. For qualified retirement plans, satisfying the minimum distribution requirement under the plan terms and operation is also a qualification requirement for the trust of the plan to remain tax-exempt.

Required beginning date

For traditional IRAs, the required beginning date is April 1 following the calendar year in which the employee (or IRA owner) attains age 70 1/2. For employer-sponsored tax-favored retirement plans, for an employee other than an employee who is a five-percent owner in the year the employee attains age 70 1/2, the required beginning date is April 1 after the later of the calendar year in which the employee attains age 70 1/2 or retires. For an employee who is a five-percent owner under an employer-sponsored tax-favored retirement plan in the year the employee attains age 70 1/2, the required beginning date is the same as for IRAs even if the employee continues to work past age 70 1/2.

Lifetime rules

While an employee (or IRA owner) is alive, distributions of the individual's interest are required to be made (in accordance with regulations) over the life or life expectancy of the employee (or IRA owner), or over the joint lives or joint life expectancy of the employee (or IRA owner) and a designated beneficiary.282 For defined contribution plans and IRAs, the required minimum distribution for each year is determined by dividing the account balance as of the end of the prior year by a distribution period which, while the employee (or IRA owner) is alive, is the factor for the employee (or IRA owner's) age from the uniform lifetime table included in the Treasury regulations.283 This table is based on the joint life and last survivor expectancy of the individual and a hypothetical beneficiary 10 years younger. The distribution period for annuity payments under a defined benefit plan or annuity contract (to the extent not limited to the life of the employee (or IRA owner) or the joint lives of the employee (or IRA owner) and a designated beneficiary) is generally subject to the same limitations as apply to individual accounts.

Distributions after death

 

Payments over a distribution period

 

The after-death minimum distributions rules vary depending on (1) whether an employee (or IRA owner) dies on or after the required beginning date or before the required beginning date, and (2) whether there is a designated beneficiary for the benefit.284 Under the regulations, a designated beneficiary is an individual designated as a beneficiary under the plan or IRA.285 Similar to the lifetime rules, for defined contribution plans and IRAs ("individual accounts"), the required minimum distribution for each year after the death of the employee (or IRA owner) is generally determined by dividing the account balance as of the end of the prior year by a distribution period.

If an employee (or IRA owner) dies on or after the required beginning date, the basic statutory rule is that the remaining interest must be distributed at least as rapidly as under the method of distribution being used before death.286 Under the regulations, for individual accounts, this rule is also interpreted as requiring the minimum required distribution to be calculated using a distribution period. If there is no designated beneficiary, the distribution period is equal to the remaining years of the employee's (or IRA owner's) life, as of the year of death.287 If there is a designated beneficiary, the distribution period (if longer) is the beneficiary's life expectancy calculated using the life expectancy table in the regulations, calculated in the year after the year of death.288

If an employee (or IRA owner) dies before the required beginning date and any portion of the benefit is payable to a designated beneficiary, the statutory rule is that distributions are generally required to begin within one year of the employee's (or IRA owner's) death (or such later date as prescribed in regulations) and are permitted to be paid (in accordance with regulations) over the life or life expectancy of the designated beneficiary. If the beneficiary of the employee (or IRA owner) is the individual's surviving spouse, distributions are not required to commence until the year in which the employee (or IRA owner) would have attained age 70 1/2. If the surviving spouse dies before the employee (or IRA owner) would have attained age 70 1/2, the after-death rules apply after the death of the spouse as though the spouse were the employee (or IRA owner). Under the regulations, for individual accounts, the required minimum distribution for each year is determined using a distribution period and the period is measured by the designated beneficiary's life expectancy, calculated in the same manner as if the individual died on or after the required beginning date.289

In cases where distribution after death is based on life expectancy (either the remaining life expectancy of the employee (or IRA owner) or a designated beneficiary), the distribution period generally is fixed at death and then reduced by one for each year that elapses after the year in which it is calculated. If the designated beneficiary dies during the distribution period, distributions continue to the subsequent beneficiaries over the remaining years in the distribution period.290

The distribution period for annuity payments under a defined benefit plan or annuity contract (to the extent not limited to the life of a designated beneficiary) is generally subject to the same limitations as apply to individual accounts.

 

Five-year rule

 

If an employee (or IRA owner) dies before the required beginning date and there is no designated beneficiary, then the entire remaining interest of the employee (or IRA owner) must generally be distributed by the end of the fifth year following the individual's death.291

Defined benefit plans and annuity distribution

The regulations provide rules for the amount of annuity distributions from a defined benefit plan or an annuity purchased from an insurance company paid over life or life expectancy. Annuity distributions are generally required to be nonincreasing with certain exceptions, which include, for example, increases to the extent of certain specified cost of living indexes, a constant percentage increase (for a qualified plan, the constant percentage cannot exceed five-percent per year), certain accelerations of payments, increases to reflect when an annuity is converted to a single life annuity after the death of the beneficiary under a joint and survivor annuity or after termination of the survivor annuity under a QDRO.292 If distributions are in the form of a joint and survivor annuity and the survivor annuitant both is not the surviving spouse and is younger than the employee (or IRA owner), the survivor annuitant is limited to a percentage of the life annuity benefit for the employee (or IRA owner). The survivor benefit as a percentage of the benefit of the primary annuitant is required to be smaller (but not required to be less than 52 percent) as the difference in the ages of the primary annuitant and the survivor annuitant become greater.

 

Description of Proposal

 

 

Required beginning date

Under the proposal, if an employee becomes a five-percent owner after age 70 1/2 but before retiring and thus before the employee's required beginning date with respect to tax-favored retirement plans of the employee's employer, the required beginning date for that employee becomes April 1 of the year following the year that the employee becomes a five-percent owner.

Other than the modification to the required beginning date for five-percent owners, the proposal makes no changes to the required minimum distribution rules during the lifetime of the employee (or IRA owner). Thus, for example, the proposal is not expected to result in a change to the regulations under section 401(a)(9) for required minimum distributions during the lifetime of the employee (or IRA owner) under which the required minimum distribution for each year is generally determined by dividing the account balance as of the end of the prior year by a distribution period which is the number corresponding to the employee's (or IRA owner's) age for the year from the uniform lifetime table included in the Treasury regulations.

After death rules

 

General rule

 

Under the proposal, the five-year rule is the general rule for all distributions after death (regardless of whether the employee (or IRA owner) dies before, on, or after the required beginning date) unless the designated beneficiary is an eligible beneficiary as defined in the proposal.

 

Eligible beneficiaries

 

For eligible beneficiaries, the exception to the five-year rule (for death before the required beginning date under present law) applies whether or not the employee (or IRA owner) dies before, on, or after the required beginning date. The exception generally allows distributions over life or life expectancy of an eligible beneficiary beginning in the year following the year of death. Eligible beneficiaries includes any beneficiary who, as of the date of death, is the surviving spouse of the employee (or IRA owner), is disabled, is a chronically ill individual, is an individual who is not more than 10 years younger than the employee (or IRA owner), or is a child of the employee (or IRA owner) who has not reached the age 22. In the case of a child who has not reached the age 22, under the exception to the five-year rule, calculation of the minimum required distribution under this exception is only allowed through the year that the child reaches age 22.

However, unlike present law, under the proposal, the five-year rule also applies after the death of an eligible beneficiary or after a child reaches age 22. Thus for example, if a disabled child of an employee (or IRA owner) is an eligible beneficiary of a parent who dies when the child is age 20 and the child dies at age 30, even though 52.1 years remain in the life expectancy of the child calculated for the child's age (21) in the year after the employee's (or IRA owner's) death, the disabled child's remaining beneficiary interest must be distributed by the end of the fifth year following the death of the disabled child. If a child is an eligible beneficiary based on having not reached the age 22 before the employee's (or IRA owner's) death, the five-year rule applies beginning with the earlier of date of the child's death or the date that the child reaches age 22. The child's entire interest must be distributed by the end of the fifth year following that date.

As under present law, if the surviving spouse is the beneficiary, there is a special rule that allows the commencement of distribution to be delayed until end of the year that the employee (or IRA owner) would have been age 70 1/2. If the spouse dies before distributions were required to begin to the spouse, the surviving spouse is treated as the employee (or IRA owner) in determining the required distributions to beneficiaries of the surviving spouse.

 

Definition of disabled and chronically ill individual

 

Under the proposal, the definition of disabled in section 72(m)(7) is incorporated by reference. Under this definition, disabled means unable to engage in any substantial gainful activity by reason of any medically determinable physical or mental impairment which can be expected to end in death or to be for long-continued and indefinite duration. Under section 72(m)(7), an individual is not considered to be disabled unless proof of the disability is furnished in such form and manner as the Secretary may require. The substantial gainful activity to which section 72(m)(7) refers is the activity, or a comparable activity, in which the individual customarily engaged prior to the arising of the disability (or prior to retirement if the individual was retired at the time the disability arose).293

Under the proposal, the definition of a chronically ill individual for qualified long-term care insurance under section 7702B(c)(2) is incorporated by reference with a modification. Under this definition, a chronically ill individual is any individual who (1) is unable to perform (without substantial assistance from another individual) at least two activities of daily living for an indefinite period (expected to be lengthy in nature)294 due to a loss of functional capacity, (2) has a level of disability similar (as determined under regulations prescribed by the Secretary in consultation with the Secretary of Health and Human Services) to the level of disability described above requiring assistance with daily living based on loss of functional capacity, or (3) requires substantial supervision to protect the individual from threats to health and safety due to severe cognitive impairment. The activities of daily living for which assistance is needed for purposes of determining loss of functional capacity are eating, toileting, transferring, bathing, dressing, and continence.

 

Defined benefit plans and annuities

 

The new general rule under the proposal applies to all after-death distributions under all retirement plans subject to the required minimum distribution requirements, including annuity distributions under defined benefit plans and distributions under qualified annuity contracts distributed by individual accounts. Thus, for example, under the proposal, after the death of an employee (or IRA owner), distribution in the form of the survivor life annuity (including a distribution that began before death as a joint and survivor annuity) is only permitted to an eligible beneficiary.

 

Plan amendments to comply with the proposal

 

It is intended that Treasury and IRS will provide sponsors of qualified retirement plans relief from the anti-cut back rules for amendments to eliminate forms of benefit with respect to benefits already accrued to the extent necessary to comply with the proposal295 and provide all plans a remedial amendment period that provides sufficient time to amend the terms of their plans to reflect this change to the minimum distributions requirements.296

 

Effective Date

 

 

Required beginning date change for five-percent owners

For the proposal changing the definition of required beginning date for employees who become five-percent owners after age 70 1/2, the proposal applies to any employee who becomes five-percent owner with respect to plan years ending in calendar years beginning before, on, or after the date of the enactment. If an employee became a five percent owner with respect to a plan year ending in a calendar year before January 1, 2014, and the employee has not retired before the calendar year 2014, the employee's required beginning date is April 1, 2015. However if under present law, an employee's required beginning date occurred before April 1, 2015 because the employee retired during a year before 2014, the proposal does not cause the employee to have an earlier required beginning date.

Required distributions after death

For determining minimum required distributions after the death of an employee (or IRA owner), the proposal is generally effective for distributions with respect to employees (or IRA owners) who die after December 31, 2014.

In the case of an employee (or IRA owner) who dies before January 1, 2015, if the designated beneficiary of the employee (or IRA owner) dies after December 31, 2014, the proposal applies to any beneficiary of the designated beneficiary as though the designated beneficiary were an eligible beneficiary. Thus, the entire interest must be distributed by the end of the fifth year after the death of the designated beneficiary.

In the case of an employee (or IRA owner) who dies after December 31, 2014, the proposal does not apply to a qualified annuity that is a binding annuity contract in effect on the date of the enactment and at all times thereafter. To be a qualified annuity, the annuity must be a commercial annuity (as defined in section 3405(e)(6)) or an annuity payable by a defined benefit plan, and (2) an annuity under which the annuity payments are substantially equal periodic payments (not less frequently than annually) over the lives of such employee (or IRA owner) and a designated beneficiary (or over a period not extending beyond the life expectancy of such employee (or IRA owner) or the life expectancy of such employee (or IRA owner) and a designated beneficiary) in accordance with the required minimum distribution regulations for annuity payments (as in effect before enactment of this proposal). In addition to these requirements, to be a qualified annuity, annuity payments to the employee (or IRA owner) must begin before January 1, 2015 and the employee (or IRA owner) must have made an irrevocable election before that date as to the method and amount of the annuity payments to the employee or any designated beneficiaries. Alternatively, if an annuity is not a qualified annuity solely based on annuity payments not having begun irrevocably before January 1, 2015, an annuity can be a qualified annuity if the employee (or IRA owner) has made an irrevocable election before the date of enactment as to the method and amount of the annuity payments to the employee (or IRA owner) or any designated beneficiaries.

7. Reduction in age for allowable in-service distributions (sec. 1615 of the discussion draft and secs. 401(a)(36) and sec. 457(d)(1) of the Code)

 

Present Law

 

 

Overview

There are three basic types of funded tax-favored employer-sponsored defined contribution plans: qualified retirement plans, section 403(b) plans, and governmental section 457(b) plans. These tax-favored employer-sponsored retirement plans are accorded special tax treatment under present law. Most contributions, earnings on contributions, and benefits are not included in gross income until amounts are distributed, even if the arrangement is funded and benefits are vested. Additionally, many distributions can be rolled over to another plan for further deferral of income inclusion. Defined contribution plans may provide for nonelective contributions and matching contributions by employers and elective deferrals or after-tax contributions by employees. Elective deferrals are contributions made pursuant to an election by an employee between cash compensation and a contribution to the plan.

Elective deferrals under a qualified retirement plan may only be made under a section 401(k) plan. A section 401(k) plan legally is not a separate type of plan, but is a profit-sharing or stock bonus plan that contains a qualified cash or deferred arrangement.297 Thus, such arrangements are subject to the rules generally applicable to qualified defined contribution plans. In addition, special rules apply to such arrangements. One requirement is that no distributions prior to severance from employment generally are permitted for amounts attributable to elective deferrals unless the employee has attained age 59 1/2.

Section 403(b) plans are another form of tax-favored employer-sponsored plan that provide tax benefits similar to qualified retirement plans. Section 403(b) plans may be maintained only by (1) charitable organizations tax-exempt under section 501(c)(3), and (2) educational institutions of State or local governments (i.e., public schools, including colleges and universities). Elective deferrals are also permitted under section 403(b) plans and are subject to the same requirement that generally no distributions are permitted prior to severance from employment unless the employee has attained age 59 1/2.

Governmental section 457(b) plans

In the case of a State or local government employer, a section 457(b) plan is generally limited to elective deferrals and provides tax benefits similar to a section 401(k) or 403(b) plan in that deferrals are contributed to a trust or custodial account for the exclusive benefit of participants, but are not included in income until distributed (and may be rolled over to another tax-favored plan).298 However distributions from a governmental section 457(b) plan prior to severance from employment are generally not permitted until the employee attains age 70 1/2.299

Pension plans

For purposes of the qualification requirements applicable to pension plans, stock bonus plans, and profit-sharing plans under the Code, a pension plan is a plan established and maintained primarily to provide systematically for the payment of definitely determinable benefits to employees over a period of years, usually life, after retirement.300 A pension plan (i.e., a defined benefit plan or money purchase pension plan) generally may not provide for distributions before the attainment of the normal retirement age under the plan to participants who have not separated from employment. However, a pension plan is not treated as failing to be a qualified retirement plan solely because the plan provides that a distribution may be made to an employee who has attained age 62 (even if earlier than the normal retirement age under the plan) and who is not separated from employment at the time of the distribution.301

 

Description of Proposal

 

 

The proposal changes the age at which distributions are permitted prior to termination of employment to age 59 1/2 for both pension plans and governmental section 457(b) plans, thus making the rules for these plans consistent with the rules for section 401(k) plans and section 403(b) plans. Under the proposal, a pension plan does not fail to be a qualified retirement plan solely because the plan provides that a distribution may be made to an employee who has attained age 59 1/2 and who is not separated from employment at the time of the distribution.

 

Effective Date

 

 

The proposal is effective for distributions made after December 31, 2014.

8. Modification of rules governing hardship distributions (sec. 1616 of the discussion draft and sec. 401(k)(2) of the Code)

 

Present Law

 

 

Elective deferrals under a qualified cash or deferred arrangement (a "section 401(k) plan") may not be distributable prior to the occurrence of one or more specified events.302 One event upon which distribution is permitted is the financial hardship of the employee.303 The amount allowed to be distributed on account of hardship is limited to the dollar amount of elective deferrals reduced for the amount of elective deferrals previously distributed on account of hardship. Applicable Treasury regulations provide that a distribution is made on account of hardship only if the distribution is made on account of an immediate and heavy financial need of the employee and is necessary to satisfy the heavy need.304

The Treasury regulations provide a safe harbor under which a distribution may be deemed necessary to satisfy an immediate and heavy financial need. One requirement of this safe harbor is that the employee be prohibited from making elective deferrals and employee contributions to the plan and all other plans maintained by the employer for at least six months after receipt of the hardship distribution. The same rules apply to hardship distributions of elective deferrals from section 403(b) plans.

 

Description of Proposal

 

 

The Secretary of the Treasury is directed to revise the applicable regulations within one year of the date of enactment to eliminate the requirement that an employee be prohibited from making elective deferrals and employee contributions for six months after the receipt of a hardship distribution in order for the distribution to be deemed necessary to satisfy an immediate and heavy financial need. It is intended that an employee not be prevented for any period after the receipt of a hardship distribution from continuing to make elective deferrals and employee contributions.

 

Effective Date

 

 

The proposal applies to plan years beginning after December 31, 2014.

9. Extended rollover period for the rollover of plan loan offset amounts in certain cases (sec. 1617 of the discussion draft and sec. 402(c) of the Code)

 

Present Law

 

 

Taxation of retirement plan distributions

 

General rule

 

A distribution from a tax-favored retirement plan is generally includible in gross income, except to the extent that the distribution is a recovery of basis under the plan, or the amount of distribution is contributed to another eligible retirement plan in a tax-free rollover. In the case of a distribution from a retirement plan to a participant under age 59 1/2, the distribution (other than a distribution from certain governmental plans) is also subject to a 10-percent early distribution tax, unless an exception applies.

 

Rollovers

 

A distribution from a qualified retirement plan, section 403(b) plan, or a governmental section 457(b) plan that is an eligible rollover distribution may be rolled over to another such plan or an IRA. The rollover generally can be achieved by direct rollover (direct payment from the distributing plan to the recipient plan) or by contributing the distribution to the eligible retirement plan within 60 days of receiving the distribution ("60-day rollover"). Amounts that are rolled over are usually not included in gross income.305 Generally, any distribution of the balance to the credit of a participant is an eligible rollover distribution with exceptions, for example, certain periodic payments, required minimum distributions, and hardship distributions.306

Qualified retirement plans, section 403(b) plans, and governmental section 457(b) plans are required to offer a direct rollover with respect to any eligible rollover distribution before paying the amount to the participant or beneficiary.307 If an eligible rollover distribution is not directly rolled over into an eligible retirement plan, the taxable portion of the distribution generally is subject to mandatory 20-percent income tax withholding.308 Participants who do not elect a direct rollover but who roll over eligible distributions within 60 days of receipt also defer tax on the rollover amounts; however, the 20 percent withheld will remain taxable unless the participant substitutes funds within the 60-day period.

Plan loan as a deemed distribution

Tax-favored employer-sponsored retirement plans may provide loans to participants. Unless the loan satisfies certain requirements in both form and operation, the amount of a retirement plan loan is a deemed distribution from the retirement plan.309 These requirements include the following: the amount of the loan must not exceed the lesser of 50 percent of the participant's account balance or $50,000; the terms of the loan must provide for a repayment period of not more than five years and provide for level amortization of loan payments (with payments not less frequently than quarterly); and the terms of the loan must be legally enforceable. Loans specifically for home purchases may be repaid over a longer period. Thus if a plan participant ceases to make payments on a loan before it is repaid, a deemed distribution of the outstanding loan balance generally occurs.

A deemed distribution of an unpaid loan balance is generally taxed as though an actual distribution occurred, including being subject to a 10-percent early distribution tax, if applicable. However, a deemed distribution is not eligible for rollover to another eligible retirement plan.

Loan offset amount

A plan may also provide that, in certain circumstances (for example, upon a participant's termination of employment with the employer), a participant's obligation to repay a loan is accelerated and, if the loan is not repaid, the loan is cancelled and the amount in participant's account balance is offset by the amount attributable to the loan (the amount of the unpaid loan balance). In the case of a loan offset, an actual distribution equal to the unpaid loan balance (as opposed to a deemed distribution under section 72(p)) occurs, and (unlike a deemed distribution) the amount of the distribution is eligible for tax-free rollover to another eligible retirement plan. However, the plan is not required to offer a direct rollover with respect to a plan loan offset amount that is an eligible rollover distribution and the plan loan offset amount is generally not subject to 20-percent income tax withholding.

 

Description of the Proposal

 

 

Under the proposal, the period during which a qualified plan loan offset amount may be contributed to an eligible retirement plan as a rollover contribution is extended from 60 days after the date of the offset to the due date (including extensions) for filing the Federal income tax return for the taxable year in which the plan loan offset occurs (meaning the taxable year in which such amount is treated as distributed from a qualified employer plan). Under the proposal, a qualified plan loan offset amount is a plan loan offset amount which is treated as distributed from a qualified retirement plan, a section 403(b) plan or a governmental section 457(b) plan to a participant or beneficiary solely by reason of either the termination of the plan, or the failure to meet the repayment terms of the loan from such plan because of the separation from service of the participant (whether due to layoff, cessation of business, termination of employment, or otherwise). As under present law, a loan offset amount under the proposal is the amount by which a participant's accrued benefit under the plan is reduced to repay a loan from the plan.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

10. Coordination of contribution limitations for 403(b) plans and governmental 457(b) plans (sec. 1618 of the discussion draft and secs. 402(g), 403(b), 415 and 457(b) of the Code)

 

Present Law

 

 

There are three types of account-based tax-favored employer-sponsored retirement plans: a qualified defined contribution plan, a tax-sheltered annuity plan (referred to as a section 403(b) plan), and an eligible deferred compensation plan of a State or local government (referred to as a governmental section 457(b) plan). A qualified defined contribution plan may include a qualified cash or deferred arrangement (referred to as a section 401(k) plan), under which an employee elects to have contributions made to the plan (referred to as elective deferrals) rather than receiving the same amount as cash compensation. Elective deferrals are generally made on a pretax basis unless designated by the participant as Roth contributions, which are made on an after-tax basis. A defined contribution plan may also provide for after-tax employee contributions and for employer nonelective contributions and matching contributions. A section 403(b) plan may also provide for these different types of contributions. Although a governmental section 457(b) plan may provide for employer contributions, these plans generally provide only for elective deferrals.

In the case of a section 401(k) plan or a section 403(b) plan, specific annual limits apply to elective deferrals by a participant and additional annual limits apply to aggregate contributions for the participant. For 2014, elective deferrals are generally limited to the lesser of (1) $17,500 plus an additional $5,500 catch-up contribution limit for participants at least age 50 and (2) the participant's compensation. If an employee participates in both a section 401(k) plan and a section 403(b) plan of the same employer,310 a single limit applies to elective deferrals under both plans. However, under a special rule, in the case of employees who have completed 15 years of service, additional elective deferrals are permitted under a section 403(b) plan maintained by an educational organization, hospital, home health service agency, health and welfare service agency, church, or convention or association of churches. In this case, the annual limit is increased by the least of (1) $3,000, (2) $15,000 reduced by the employee's additional elective deferrals for previous years, and (3) $5,000 multiplied by the employee's years of service and reduced by the employee's elective deferrals for previous years.

For 2014, the limit on aggregate contributions to a qualified defined contribution plan (including a section 401(k) plan) or a section 403(b) plan is the lesser of (1) $52,000 and (2) the participant's compensation.311 Because employees generally do not receive compensation for years after they have terminated employment, contributions generally cannot be made for former employees. However, under a special rule, employer contributions to a section 403(b) plan can be made for up to five years after termination of employment. In addition, under special rules, certain contribution amounts are permitted for church employees and foreign missionaries.

The limit described above on aggregate contributions to a qualified defined contribution plan applies to contributions for a participant to any defined contribution plans maintained by the same employer, defined generally to include any members of a controlled group (using an ownership standard of more than 50 percent, rather than at least 80 percent) or affiliated service group. Similarly, the limit on aggregate contributions to a section 403(b) plan applies to contributions for a participant to any section 403(b) plan maintained by the same employer, including any members of a controlled group or affiliated service group. However, contributions to a qualified defined contribution plan and to a section 403(b) plan maintained by the same employer are subject to separate limits unless the participant in the section 403(b) plan is in control of the employer maintaining the qualified defined contribution plan. This could occur, for example, if the participant in the section 403(b) plan owns a separate business that maintains a qualified defined contribution plan. In that case, a single limit applies to the contributions for the participant to the section 403(b) plan and the defined contribution plan. However, deferrals under a governmental section 457(b) plan are not taken into account in applying this limit.

In the case of a governmental section 457(b) plan, all contributions are subject to a single limit, generally for 2014, the lesser of (1) $17,500 plus an additional $5,500 catch-up contribution limit for participants at least age 50 and (2) the participant's compensation. This limit is separate from the limit on elective deferrals to section 401(k) and section 403(b) plans. Thus, for example, if an employee participates in both a section 403(b) plan and a governmental section 457(b) plan of the same employer, the employee may contribute up to $17,500 (plus $5,500 catch-up contributions if at least age 50) to the section 403(b) plan and up to $17,500 (plus $5,500 catch-up contributions if at least age 50) to the section 457(b) plan. In addition, under a special rule, catch-up contributions may be made by a participant to a governmental section 457(b) for the last three years before attainment of normal retirement age. Additional contributions may be made up to the lesser of (1) two times the otherwise applicable dollar limit for the year (two times $17,500 for 2014, or $35,000) and (2) the participant's otherwise applicable limit for the year plus the amount by which the limit applicable to the participant for previous years exceeded the participant's deferrals for the previous years. If a higher limit applies to a participant for a year under this special rule than under the general catch-up rule, the general catch-up rule does not apply for the year.

 

Description of Proposal

 

 

The proposal applies a single aggregate limit to contributions for a participant in a governmental section 457(b) plan and elective deferrals for the same participant under a section 401(k) plan or a 403(b) plan of the same employer. Thus, the limit for governmental section 457(b) plans is coordinated with the limit for section 401(k) and 403(b) plans in the same manner as the limits are coordinated under present law for elective deferrals to section 401(k) and section 403(b) plans.

The proposal repeals the special rules allowing additional elective deferrals and catch-up contributions under section 403(b) plans and governmental section 457(b) plans. Thus, the same limits apply to elective deferrals and catch-up contributions under section 401(k) plans, section 403(b) plans and governmental section 457(b) plans.

The proposal repeals the special rules allowing employer contributions to section 403(b) plans for up to five years after termination of employment and the special contribution rules for church employees and foreign missionaries.

The proposal also revises application of the limit on aggregate contributions to a qualified defined contribution plan or a section 403(b) plan (that is, the lesser of (1) $52,000 (for 2014) and (2) the participant's compensation). As revised, a single aggregate limit applies to contributions for a participant to any defined contribution plans, any section 403(b) plans, and any governmental section 457(b) plans maintained by the same employer, including any members of a controlled group or affiliated service group.312

 

Effective Date

 

 

The proposal is effective for plan years and taxable years beginning after December 31, 2014.

11. Application of 10-percent early distribution tax to governmental 457 plans (sec. 1619 of the discussion draft and sec. 72(t) of the Code)

Governmental section 457(b) plans

Special rules apply with respect to deferred compensation arrangements of State and local government and tax-exempt employers.313 Amounts deferred under an eligible deferred compensation plan, i.e., a section 457(b) plan, are not currently included in income. In the case of a State or local government employer, a section 457(b) plan is generally limited to elective deferrals and provides tax benefits similar to a section 401(k) or 403(b) plan in that deferrals are contributed to a trust or custodial account for the exclusive benefit of participants, but are not included in income until distributed (and may be rolled over to another tax-favored plan).314

Deferrals under a governmental section 457(b) plan are subject to the same limits as elective deferrals ($17,500 for 2014) and catch-up contributions ($5,500 for 2014) under a section 401(k) plan or a section 403(b) plan, or, if less, the employee's compensation.315 As of 2011, a governmental section 457(b) plan may include a qualified Roth contribution program, allowing a participant to elect to have all or a portion of the participant's deferrals under the plan be treated as designated Roth contributions.

Early distribution tax

The Code imposes provides an early distribution tax on distributions made from qualified retirement plans, 403(b) plans and IRAs before employee or an IRA owner attains age 59 1/2 unless an exception applies.316 The tax is equal to 10 percent of the amount of the distribution that is includible in gross income. The 10-percent tax is in addition to the taxes that would otherwise be due on distribution. This early distribution tax does not apply to distributions from governmental section 457(b) plans.

 

Description of Proposal

 

 

The proposal imposes the 10-percent early distribution tax on distributions from governmental section 457(b) plans.

 

Effective Date

 

 

The proposal is effective for distributions on or after February 26, 2014.

12. Inflation adjustments for employer-sponsored retirement plan dollar limitations on benefits and contributions (secs. 1620 to 1624 of the discussion draft and secs. 402(g), 415(d), and 408(p) of the Code)

 

Present Law

 

 

In general

There are several types of funded tax-favored employer-sponsored retirement plans: qualified retirement plans, section 403(b) plans, governmental section 457(b) plans, simplified employee pensions, and simple retirement plans. Tax-favored retirement plans are of two general types: defined benefit plans, under which benefits are determined under a plan formula and paid from general plan assets, rather than individual accounts; and defined contribution plans, under which benefits are based on a separate account for each participant, to which are allocated contributions, earnings and losses. Defined contribution plans generally may provide for nonelective contributions and matching contributions by employers and elective deferrals or after-tax contributions by employees. Elective deferrals are contributions made pursuant to an election by an employee between cash compensation and a contribution to the plan. Among the requirements that apply to tax-favored qualified retirement plans are dollar limits on the benefits and contributions that are permitted to be provided under the plan.317

The dollar limits generally are indexed to reflect cost-of-living increases. The index used for adjusting the dollar limits is generally the same index used for cost-of-living increases in Social Security benefits. An adjustment with respect to any calendar year is based on the index for the calendar quarter ending September 30 of the preceding calendar year over such index for the base period which starts from the base calendar quarter. However for each limit, there is a rounding rule under which any increase that is not a multiple of a specified dollar amount (such as $500) is rounded down to the next lowest multiple for that dollar amount.

Qualified retirement plans and annuities

 

Limits on defined benefit plans

 

In the case of a qualified defined benefit plan, a dollar limit applies on the amount of benefits payable with respect to a participant. The dollar limit is expressed in terms of a benefit commencing at age 65 in the form of a straight life annuity for the life of the participant. The dollar limit on the annual payments under the annuity is $210,000 a year (for 2014).318 The limit applies to the aggregate of all benefits accrued by an employee under all defined benefit plans maintained by the same employer.319 This limit is only increased for cost-of-living in multiples of $5,000.

 

Limits on Contribution to Defined Contribution Plans

 

In the case of a qualified defined contribution plan, a dollar limit applies on the amount of contributions that can be made for each employee for a year under all defined contribution plans of the same employer. The dollar limit is $52,000 (for 2014), and generally applies to allocations to a participant's account under the terms of the plan as of any date during the year.320 The limit is only increased for cost-of-living in multiples of $1,000.

 

Elective deferrals

 

Certain qualified defined contribution plans ("section 401(k)" plans) include a feature under which an employee may elect to have elective deferrals made to the plan, subject to a dollar maximum. The dollar limit is $17,500 (for 2014) and is applied to the amount of deferrals for the employee's taxable year (which is generally the calendar year).321 Additional elective deferrals ("catch-up contributions") are allowed for employees aged 50 or older, up to a dollar limit of $5,500 (for 2014). Both limits are only increased for cost-of-living in multiples of $500.

Elective deferrals up to these limits are either not includable in gross income (but then subsequent distributions attributable to the contributions are includable in gross income) or are designated Roth contributions (in which case the contributions are includable in gross income but then subsequent qualified distributions attributable to the Roth contributions are excludible from gross income).

The amount of elective deferrals (but not catch up contributions) is also included in the contributions subject to the general limit ($52,000 for 2014).

Section 403(b) plans

Section 403(b) plans may be maintained only by (1) tax-exempt charitable organizations,322 and (2) educational institutions of State or local governments (i.e., public schools, including colleges and universities). Many of the rules that apply to section 403(b) plans are similar to the rules applicable to qualified retirement plans, including section 401(k) plans. Employers may make nonelective or matching contributions to such plans on behalf of their employees, and the plan may provide for employees to make pretax elective deferrals, designated Roth contributions or other after-tax contributions.

Contributions to a section 403(b) plan are generally subject to the same contribution limits applicable to qualified defined contribution plans, including the general limit on contributions ($52,000 for 2014) and the special limits for elective deferrals ($17,500 for 2014) and catch-up contributions ($5,500 for 2014) under a section 401(k) plan. If elective deferral and catch-up contributions are made to both a section 401(k) plan and a section 403(b) plan for the same employee, a single limit applies to the elective deferrals under both plans.323

Governmental section 457(b) plans

Deferrals under a governmental section 457(b) plan are generally subject to the same limits as elective deferrals ( $17,500 for 2014) and catch-up contributions ($5,500 for 2014) under a section 401(k) plan or a section 403(b) plan. However, the section 457(b) plan limits apply separately from the combined limit applicable to section 401(k) and 403(b) plan contributions, so that an employee covered by a governmental section 457(b) plan and a section 401(k) or 403(b) plan can contribute the full amount to each plan.324

Employer-sponsored retirement plans using IRAs

 

SIMPLE IRA plan

 

An employer that employs no more than 100 employees who earned $5,000 or more during the prior calendar year can establish a simple retirement plan, under which an IRA is established for each employee (that is, a SIMPLE IRA). A SIMPLE IRA plan allows employees to make elective deferrals, but is subject to a special limit, $12,000 (for 2014).325 The catch-up contribution limit for an individual age 50 or over is $2,500 (for 2014). Both limits are only increased for cost-of-living in multiples of $500.

 

Simplified employee pension plan

 

A simplified employee pension ("SEP") is a type of employer-sponsored retirement plan under which an employer may make contributions to a SEP IRA for each eligible employee up to the lesser of 25 percent of the employee's compensation or the dollar limit applicable to contributions to a qualified defined contribution plan ($52,000 for 2014).

Certain SEP plans established before 1997 may include a salary reduction feature ("SARSEP") under which employees can make elective deferrals. Elective deferrals under a SARSEP are subject to the same limit that applies to elective deferrals under a section 401(k) plan ($17,500, plus catch-up contribution up to $5,500 for a participant age 50 or over, for 2014).

 

Description of Proposal

 

 

The proposal suspends the adjustments for cost of living on tax-favored retirement plan dollar limits and holds these limits at the 2014 level through 2023. Thus, through 2023, the defined benefit plan dollar limit remains at an annuity with annual payments equal to $210,000 commencing at age 65; the defined contribution plan dollar limit remains at $52,000; the elective deferral dollar limit remains at $17,500; and the catch-up contribution dollar limit remains at $5,500. The dollar limit on deferral limits under section 457(b) plans also remains at $17,500 and the limit on catch-up contributions for these plans remains at $5,500. Similarly, the limit on elective deferrals under simple retirement plans remains at $12,000 and the limit on catch up contributions for simple retirement plans remains at $2,500. Adjustments resume in 2024 using the quarter beginning July 1, 2022 as the base calendar quarter.

 

Effective Date

 

 

The suspension of adjustments to the defined benefit plan dollar limit and the defined contribution plan dollar limit applies to years ending with or within a calendar year beginning after 2014. The suspension of the adjustment to the elective deferral dollar limit applies to plan years and taxable years beginning after December 31, 2014. The suspension of the adjustments to dollar limit on elective deferrals under simple retirement plans is effective for calendar years beginning after 2014. The proposal otherwise applies to taxable years beginning after December 31, 2014.

 

H. Certain Provisions Related to Members of Indian Tribes

 

1. Indian general welfare benefits (secs. 1701-1703 of the discussion draft and new sec. 139E of the Code)

 

Present Law

 

 

Except as otherwise provided, gross income means all income from whatever source derived. The general welfare doctrine is an IRS administrative rule that operates to exclude certain payments from gross income. Excludable payments generally consist of payments: (i) made from a governmental fund, (ii) for the promotion of general welfare (on the basis of the need of the recipient), and (iii) which do not represent compensation for services. Examples of excludable benefits include disaster relief, adoption assistance, housing and utility subsidies for low income persons, and government benefits paid to the blind.

Prior to IRS Notice 2012-75 (the "Notice"),326 there was some uncertainty concerning the application of the general welfare doctrine to certain benefits provided by Indian tribes to their members. Benefits that have been scrutinized by the IRS include payments for housing, cultural, education, and elder programs provided by Indian tribal governments. The issue is whether the tribal governments can provide such benefits tax-free to their members because they are addressing a social welfare need, without considering the financial need of the members.

In response to requests from tribes to provide guidance on this issue, the IRS has issued the Notice, which provides safe harbors under which the IRS presumes that the individual need requirement of the general welfare exclusion is met for benefits provided under certain Indian tribal governmental programs.

 

Description of Proposal

 

 

The proposal contains similar requirements to the Notice under which benefits would qualify for exclusion from income under the general welfare doctrine, including that the benefits (i) are provided pursuant to a specific Indian tribal government program, (ii) are available to any tribal member who meets certain guidelines, (iii) are for the promotion of general welfare, (iv) are not lavish or extravagant, and (v) are not compensation for services.

The proposal requires the Secretary of the Treasury ("Secretary") to establish a Tribal Advisory Committee to advise on matters relating to the taxation of Indians. In consultation with the Committee, the proposal requires the Secretary to establish and require training of IRS agents on Federal Indian law and training of tribal financial officers about the proposal. The proposal also requires the Secretary to suspend audits and examinations of Indian tribal governments and tribe members relating to the general welfare exclusion until this education has been completed. The proposal allows the Secretary to waive interest and penalties to the extent those penalties relate to excluding a payment under the general welfare exclusion.

The proposal applies to years for which the tribal member's refund statute of limitation period has not expired and provides a one-year waiver of the refund statute of limitations period in the event that the period expires before the end of the one-year period beginning on the date of enactment of the Act.

 

Effective Date

 

 

The proposal is effective on the date of enactment.

 

TITLE II -- REPEAL OF ALTERNATIVE MINIMUM TAX

 

 

Present Law

 

 

Individual alternative minimum tax

 

In general

 

An alternative minimum tax ("AMT") is imposed on an individual, estate, or trust in an amount by which the tentative minimum tax exceeds the regular income tax for the taxable year. For taxable years beginning in 2014, the tentative minimum tax is the sum of (1) 26 percent of so much of the taxable excess as does not exceed $182,500 ($91,250 in the case of a married individual filing a separate return) and (2) 28 percent of the remaining taxable excess. The breakpoints are indexed for inflation. The taxable excess is so much of the alternative minimum taxable income ("AMTI") as exceeds the exemption amount. The maximum tax rates on net capital gain and dividends used in computing the regular tax are used in computing the tentative minimum tax. AMTI is the taxable income adjusted to take account of specified tax preferences and adjustments.

The exemption amounts for taxable years beginning in 2014 are: (1) $82,100 in the case of married individuals filing a joint return and surviving spouses; (2) $52,800 in the case of other unmarried individuals; (3) $41,050 in the case of married individuals filing separate returns; and (4) $23,500 in the case of an estate or trust. For taxable years beginning in 2014, the exemption amounts are phased out by an amount equal to 25 percent of the amount by which the individual's AMTI exceeds (1) $156,500 in the case of married individuals filing a joint return and surviving spouses, (2) $117,300 in the case of other unmarried individuals, and (3) $78,250 in the case of married individuals filing separate returns or an estate or a trust. The amounts are indexed for inflation.

Alternative minimum taxable income is the taxpayer's taxable income increased by certain preference items and adjusted by determining the tax treatment of certain items in a manner that negates the deferral of income resulting from the regular tax treatment of those items.

 

Preference items in computing AMTI

 

The minimum tax preference items are:

 

1. The excess of the deduction for percentage depletion over the adjusted basis of each mineral property (other than oil and gas properties) at the end of the taxable year.

2. The amount by which excess intangible drilling costs (i.e., expenses in excess the amount that would have been allowable if amortized over a 10-year period) exceed 65 percent of the net income from oil, gas, and geothermal properties. This preference applies to independent producers only to the extent it reduces the producer's AMTI (determined without regard to this preference and the net operating loss deduction) by more than 40 percent.

3. Tax-exempt interest income on private activity bonds (other than qualified 501(c)(3) bonds, certain housing bonds, and bonds issued in 2009 and 2010) issued after August 7, 1986.

4. Accelerated depreciation or amortization on certain property placed in service before January 1, 1987.

5. Seven percent of the amount excluded from income under section 1202 (relating to gains on the sale of certain small business stock).

 

In addition, losses from any tax shelter farm activity or passive activities are not taken into account in computing AMTI.

 

Adjustments in computing AMTI

 

The adjustments that individuals must make to compute AMTI are:

 

1. Depreciation on property placed in service after 1986 and before January 1, 1999, is computed by using the generally longer class lives prescribed by the alternative depreciation system of section 168(g) and either (a) the straight-line method in the case of property subject to the straight-line method under the regular tax or (b) the 150-percent declining balance method in the case of other property. Depreciation on property placed in service after December 31, 1998, is computed by using the regular tax recovery periods and the AMT methods described in the previous sentence. Depreciation on property acquired after September 10, 2001, which is allowed an additional allowance under section 168(k) for the regular tax is computed without regard to any AMT adjustments.

2. Mining exploration and development costs are capitalized and amortized over a 10-year period.

3. Taxable income from a long-term contract (other than a home construction contract) is computed using the percentage of completion method of accounting.

4. The amortization deduction allowed for pollution control facilities placed in service before January 1, 1999 (generally determined using 60-month amortization for a portion of the cost of the facility under the regular tax), is calculated under the alternative depreciation system (generally, using longer class lives and the straight-line method). The amortization deduction allowed for pollution control facilities placed in service after December 31, 1998, is calculated using the regular tax recovery periods and the straight-line method.

5. Miscellaneous itemized deductions are not allowed.

6. Itemized deductions for State, local, and foreign real property taxes; State and local personal property taxes; State, local, and foreign income, war profits, and excess profits taxes; and State and local sales taxes are not allowed.

7. Medical expenses are allowed only to the extent they exceed ten percent of the taxpayer's adjusted gross income.

8. Deductions for interest on home equity loans are not allowed.

9. The standard deduction and the deduction for personal exemptions are not allowed.

10. The amount allowable as a deduction for circulation expenditures is capitalized and amortized over a 3-year period.

11. The amount allowable as a deduction for research and experimentation expenditures from passive activities is capitalized and amortized over a 10-year period.

12. The regular tax rules relating to incentive stock options do not apply.

Other rules

 

The taxpayer's net operating loss deduction generally cannot reduce the taxpayer's AMTI by more than 90 percent of the AMTI (determined without the net operating loss deduction).

The alternative minimum tax foreign tax credit reduces the tentative minimum tax.

The various nonrefundable business credits allowed under the regular tax generally are not allowed against the AMT. Certain exceptions apply.

If an individual is subject to AMT in any year, the amount of tax exceeding the taxpayer's regular tax liability is allowed as a credit (the "AMT credit") in any subsequent taxable year to the extent the taxpayer's regular tax liability exceeds his or her tentative minimum tax liability in such subsequent year. The AMT credit is allowed only to the extent that the taxpayer's AMT liability is the result of adjustments that are timing in nature. The individual AMT adjustments relating to itemized deductions and personal exemptions are not timing in nature, and no minimum tax credit is allowed with respect to these items.

An individual may elect to write off certain expenditures paid or incurred with respect of circulation expenses, research and experimental expenses, intangible drilling and development expenditures, development expenditures, and mining exploration expenditures over a specified period (three years in the case of circulation expenses, 60 months in the case of intangible drilling and development expenditures, and 10 years in case of other expenditures). The election applies for purposes of both the regular tax and the alternative minimum tax.

Corporate alternative minimum tax

 

In general

 

Present law imposes an alternative minimum tax ("AMT") on a corporation to the extent the corporation's tentative minimum tax exceeds its regular tax. This tentative minimum tax is computed at the rate of 20 percent on the alternative minimum taxable income ("AMTI") in excess of a $40,000 exemption amount that phases out. The exemption amount is phased out by an amount equal to 25 percent of the amount that the corporation's AMTI exceeds $150,000.

AMTI is the taxpayer's taxable income increased by certain preference items and adjusted by determining the tax treatment of certain items in a manner that negates the deferral of income resulting from the regular tax treatment of those items.

A corporation with average gross receipts of less than $7.5 million for the prior three taxable years is exempt from the corporate minimum tax. The $7.5 million threshold is reduced to $5 million for the corporation's first 3-taxable year period.

 

Preference items in computing AMTI

 

The corporate minimum tax preference items are:

 

1. The excess of the deduction for percentage depletion over the adjusted basis of the property at the end of the taxable year. This preference does not apply to percentage depletion allowed with respect to oil and gas properties.

2. The amount by which excess intangible drilling costs arising in the taxable year exceed 65 percent of the net income from oil, gas, and geothermal properties. This preference does not apply to an independent producer to the extent the preference would not reduce the producer's AMTI by more than 40 percent.

3. Tax-exempt interest income on private activity bonds (other than qualified 501(c)(3) bonds, certain housing bonds, and bonds issued in 2009 and 2010) issued after August 7, 1986.

4. Accelerated depreciation or amortization on certain property placed in service before January 1, 1987.

Adjustments in computing AMTI

 

The adjustments that corporations must make in computing AMTI are:

 

1. Depreciation on property placed in service after 1986 and before January 1, 1999, must be computed by using the generally longer class lives prescribed by the alternative depreciation system of section 168(g) and either (a) the straight-line method in the case of property subject to the straight-line method under the regular tax or (b) the 150-percent declining balance method in the case of other property. Depreciation on property placed in service after December 31, 1998, is computed by using the regular tax recovery periods and the AMT methods described in the previous sentence. Depreciation on property which is allowed "bonus depreciation" for the regular tax is computed without regard to any AMT adjustments.

2. Mining exploration and development costs must be capitalized and amortized over a 10-year period.

3. Taxable income from a long-term contract (other than a home construction contract) must be computed using the percentage of completion method of accounting.

4. The amortization deduction allowed for pollution control facilities placed in service before January 1, 1999 (generally determined using 60-month amortization for a portion of the cost of the facility under the regular tax), must be calculated under the alternative depreciation system (generally, using longer class lives and the straight-line method). The amortization deduction allowed for pollution control facilities placed in service after December 31, 1998, is calculated using the regular tax recovery periods and the straight-line method.

5. The special rules applicable to Merchant Marine construction funds are not applicable.

6. The special deduction allowable under section 833(b) for Blue Cross and Blue Shield organizations is not allowed.

7. The adjusted current earnings adjustment applies, as described below.

Adjusted current earning ("ACE") adjustment

 

The adjusted current earnings adjustment is the amount equal to 75 percent of the amount by which the adjusted current earnings of a corporation exceed its AMTI (determined without the ACE adjustment and the alternative tax net operating loss deduction). In determining ACE the following rules apply:

 

1. For property placed in service before 1994, depreciation generally is determined using the straight-line method and the class life determined under the alternative depreciation system.

2. Amounts excluded from gross income under the regular tax but included for purposes of determining earnings and profits are generally included in determining ACE.

3. The inside build-up of a life insurance contract is included in ACE (and the related premiums are deductible).

4. Intangible drilling costs of integrated oil companies must be capitalized and amortized over a 60-month period.

5. The regular tax rules of section 173 (allowing circulation expenses to be amortized) and section 248 (allowing organizational expenses to be amortized) do not apply.

6. Inventory must be calculated using the FIFO, rather than LIFO, method.

7. The installment sales method generally may not be used.

8. No loss may be recognized on the exchange of any pool of debt obligations for another pool of debt obligations having substantially the same effective interest rates and maturities.

9. Depletion (other than for oil and gas properties) must be calculated using the cost, rather than the percentage, method.

10. In certain cases, the assets of a corporation that has undergone an ownership change must be stepped down to their fair market values.

Other rules

 

The taxpayer's net operating loss carryover generally cannot reduce the taxpayer's AMT liability by more than 90 percent of AMTI determined without this deduction.

The various nonrefundable business credits allowed under the regular tax generally are not allowed against the AMT. Certain exceptions apply.

If a corporation is subject to AMT in any year, the amount of AMT is allowed as a credit ("AMT credit") in any subsequent taxable year to the extent the taxpayer's regular tax liability exceeds its tentative minimum tax in the subsequent year. Corporations are allowed to claim a limited amount of AMT credits in lieu of bonus depreciation.

A corporation may elect to write off certain expenditures paid or incurred with respect of circulation expenses, research and experimental expenses, intangible drilling and development expenditures, development expenditures, and mining exploration expenditures over a specified period (three years in the case of circulation expenses, 60 months in the case of intangible drilling and development expenditures, and 10 years in case of other expenditures). The election applies for purposes of both the regular tax and the alternative minimum tax.

 

Description of Proposal

 

 

The proposal repeals the individual and corporate alternative minimum tax.

The proposal allows the AMT credit to offset the taxpayer's regular tax liability for any taxable year. In addition, the AMT credit is refundable for any taxable year beginning after 2015 and before 2020 in an amount equal to 50 percent (100 percent in the case of taxable years beginning in 2019) of the excess of the minimum tax credit for the taxable year over the amount of the credit allowable for the year against regular tax liability. Thus, full amount of the minimum tax credit will be allowed in taxable years beginning before 2020.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

In determining the alternative minimum taxable income for taxable years beginning before January 1, 2015, the net operating loss deduction carryback from taxable years beginning on December 31, 2014, are determined without regard to any AMT adjustments or preferences.

The repeal of the election to write off certain expenditures over a specified period applies to amounts paid or incurred after December 31, 2014.

 

TITLE III -- BUSINESS TAX REFORM

 

 

A. Tax Rates

 

 

1. 25-percent corporate tax rate (sec. 3001 of the discussion draft and sec. 11 of the Code)

 

Present Law

 

 

Corporate taxable income is subject to tax under a four-step graduated rate structure. The top corporate tax rate is 35 percent on taxable income in excess of $10 million. The corporate taxable income brackets and tax rates are as set forth in the table below:

                Table 4. -- Corporate Income Tax Rates

 

 ______________________________________________________________________

 

 

      Taxable Income                          Tax rate (percent)

 

 ______________________________________________________________________

 

 

      Not over $50,000                               15

 

      Over $50,000 but not over $75,000              25

 

      Over $75,000 but not over $10,000,000          34

 

      Over $10,000,000                               35

 

 

An additional five-percent tax is imposed on a corporation's taxable income in excess of $1 million. The maximum additional tax is $11,750. Also, a second additional three-percent tax is imposed on a corporation's taxable income in excess of $15 million. The maximum second additional tax is $100,000.

Certain personal service corporations pay tax on their entire taxable income at the rate of 35 percent.

Present law provides if the maximum corporate tax rate exceeds 35 percent, the maximum rate on a corporation's net capital gain will be 35 percent.

 

Description of Proposal

 

 

The proposal reduces the maximum corporate tax rate from 35 percent to 25 percent for taxable years beginning after December 31, 2018.

The proposal is phased-in. For taxable years beginning in 2015 the maximum rate is 33 percent; for taxable years beginning in 2016 the maximum rate is 31 percent; for taxable years beginning in 2017 the maximum rate is 29 percent; and for taxable years beginning in 2018 the maximum rate is 27 percent.327 For each of these taxable years the 25-percent rate applies to so much of the taxable income as does not exceed $75,000.

Personal service corporations are taxed at the same tax rates as other corporations.

The proposal repeals the maximum corporate tax rate on net capital gain as obsolete.

The proposal provides a withholding rate on certain foreign income equal to the maximum corporate tax rate.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

 

B. Reform of Business-Related Exclusions and Deductions

 

 

1. Revision of treatment of contributions to capital (sec. 3101 of the discussion draft, new sec. 76 of the Code, and sec. 118 of the Code)

 

Present Law

 

 

The gross income of a corporation does not include any contribution to its capital.328 For purposes of this rule, a contribution to the capital of a corporation does not include any contribution in aid of construction or any other contribution from a customer or potential customer.329 A special rule allows certain contributions in aid of construction received by a regulated public utility that provides water or sewerage disposal services to be treated as a tax-free contribution to the capital of the utility.330 No deduction or credit is allowed for, or by reason of, any expenditure that constitutes a contribution that is treated as a tax-free contribution to the capital of the utility.331

If property is acquired by a corporation as a contribution to capital and is not contributed by a shareholder as such, the adjusted basis of the property is zero.332 If the contribution consists of money, the corporation must first reduce the basis of any property acquired with the contributed money within the following 12-month period, and then reduce the basis of other property held by the corporation.333 Similarly, a utility's adjusted basis of any property acquired with a contribution in aid of construction will be zero.334

 

Description of Proposal

 

 

The proposal repeals section 118.

Further, the proposal provides that a contribution to capital, other than a contribution of money or property made in exchange for stock of a corporation or any interest in an entity, is included in gross income of a taxpayer.335

For example, a contribution of municipal land by a municipality that is not in exchange for stock (or for a partnership interest or other interest) of equivalent value is considered a contribution to capital that is includable in gross income. By contrast, a municipal tax abatement for locating a business in a particular municipality is not considered a contribution to capital.

 

Effective Date

 

 

The proposal applies to contributions made, and transactions entered into, after the date of enactment.

2. Repeal of deduction for local lobbying expenses (sec. 3102 of the discussion draft and sec. 162(e) of the Code)

 

Present Law

 

 

In general

 

 

A taxpayer generally is allowed a deduction for ordinary and necessary expenses paid or incurred in carrying on any trade or business.336 However, section 162(e) denies a deduction for amounts paid or incurred in connection with (1) influencing legislation,337 (2) participation in, or intervention in, any political campaign on behalf of (or in opposition to) any candidate for public office, (3) any attempt to influence the general public, or segments thereof, with respect to elections, legislative matters, or referendums, or (4) any direct communication with a covered executive branch official338 in an attempt to influence the official actions or positions of such official. Expenses paid or incurred in connection with lobbying and political activities (such as research for, or preparation, planning, or coordination of, any previously described activity) also are not deductible.339

Exceptions

 

Local legislation

 

Notwithstanding the above, a deduction is allowed for ordinary and necessary expenses incurred in connection with any legislation of any local council or similar governing body (collectively, "local legislation").340 With respect to local legislation, the exception permits a deduction for amounts paid or incurred in carrying on any trade or business (1) in direct connection with appearances before, submissions to, or sending communications to the committees, or individual members, of such local legislation with respect to legislation or proposed legislation of direct interest to the taxpayer, or (2) in direct connection with communication of information between the taxpayer and an organization of which the taxpayer is a member with respect to any such legislation or proposed legislation which is of direct interest to the taxpayer and such organization, and (3) that portion of the dues so paid or incurred with respect to any organization of which the taxpayer is a member which is attributable to the expenses of the activities described in (1) or (2) carried on by such organization.341

For purposes of this exception, legislation of an Indian tribal government is treated in the same manner as local legislation.342

 

De minimis

 

For taxpayers with $2,000 or less of in-house expenditures related to lobbying and political activities, a de minimis exception is provided that permits a deduction.343

 

Description of Proposal

 

 

The proposal repeals the exception for amounts paid or incurred related to lobbying local councils or similar governing bodies, including Indian tribal governments. Thus, the general disallowance rules applicable to lobbying and political expenditures will apply to costs incurred related to such local legislation.

 

Effective Date

 

 

The proposal applies to amounts paid or incurred after December 31, 2014.

3. Expenditures for repairs in connection with casualty losses (sec. 3103 of the discussion draft and sec. 165 of the Code)

 

Present Law

 

 

In general, a taxpayer may claim a deduction for any loss sustained during the taxable year and not compensated by insurance or otherwise.344 The amount of any loss is limited to the adjusted basis of the property.345 For individual taxpayers, deductible losses must be incurred in a trade or business or other profit-seeking activity or consist of property losses arising from fire, storm, shipwreck, or other casualty, or from theft.346 Personal casualty or theft losses for the taxable year are allowable only if they exceed a $100 limitation per casualty or theft.347 In addition, aggregate net casualty and theft losses are deductible only to the extent they exceed 10 percent of an individual taxpayer's adjusted gross income.348 If the disaster occurs in a Presidentially declared disaster area, the taxpayer may elect to take into account the casualty loss in the taxable year immediately preceding the taxable year in which the disaster occurs.349

With respect to restoration of a unit of property, a taxpayer generally must capitalize as an improvement amounts paid to restore a unit of property, including an amount paid to make good the exhaustion for which an allowance is or has been made.350 A restoration includes, in relevant part, an amount paid for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment either as a result of a casualty loss or relating to a casualty event.351 However, with respect to amounts paid or incurred for repairs in connection with casualty losses or events, the regulations limit the amount required to be capitalized to the excess (if any) of (1) the taxpayer's basis adjustments resulting from the casualty, over (2) the amount paid for the restoration of damage to the unit of property as a result of the casualty that also constitutes an improvement.352 Amounts paid in excess of such limitation are analyzed under the applicable provisions of the Internal Revenue Code and regulations353 to determine if capitalization is required.354

 

Description of Proposal

 

 

The proposal amends the rules for repairs incurred in connection with a casualty loss. Specifically, the proposal requires the capitalization of any expenditure made for any repair of damage to property in connection with a casualty loss where a casualty loss deduction for such property is allowed under section 165. The proposal provides an election to expense repair costs in lieu of deducting the casualty loss. If the taxpayer makes such election, no deduction is allowed for a casualty loss under section 165 and the requirement to capitalize repair expenditures shall not apply. When an election is made to forego the casualty loss deduction, it is intended that costs incurred to improve or better the property beyond the state of such property prior to the casualty loss355 will continue to be capitalized.

 

Effective Date

 

 

The proposal applies to losses sustained after December 31, 2014.

4. Reform of accelerated cost recovery system (sec. 3104 of the discussion draft and sec. 168 of the Code)

 

Present Law

 

 

Overview

For Federal income tax purposes, a taxpayer is allowed to recover through annual depreciation deductions the cost of certain property used in a trade or business or for the production of income.356 Under the modified accelerated cost recovery system ("MACRS"), adopted in 1986, the amount of the depreciation deduction allowed with respect to tangible property for a taxable year is determined for different types of property based on an assigned applicable depreciation method, recovery period, and convention.357

Recovery periods and depreciation methods

The applicable recovery period for an asset is determined in part by statute and in part by historic Treasury guidance.358 The "type of property" of an asset is used to determine the "class life" of the asset, which in turn dictates the applicable recovery period for the asset.

The MACRS recovery periods applicable to most tangible personal property range from three to 20 years. The depreciation methods generally applicable to tangible personal property are the 200 -- percent and 150-percent declining balance methods,359 switching to the straight-line method for the first taxable year where using the straight-line method with respect to the adjusted basis as of the beginning of that year will yield a larger depreciation allowance. The recovery periods for most real property are 39 years for nonresidential real property and 27.5 years for residential rental property. Table 5 provides general rules for class lives and recovery periods as provided in sections 168(c) and (e).

    Table 5. -- General Rules for Class Lives and Recovery Periods

 

 ______________________________________________________________________

 

 

                                                       MACRS Applicable

 

 Type of Property         General Rule-Class Life      Recovery Period

 

 ______________________________________________________________________

 

 

 3-year property              4 years or less              3 years

 

 

 5-year property              More than 4 but              5 years

 

                              less than 10 years

 

 

 7-year property              10 or more but               7 years

 

                              less than 16 years;

 

                              also, property

 

                              (other than real

 

                              property) without

 

                              a class life

 

 

 10-year property             16 or more but less          10 years

 

                              than 20 years

 

 

 15-year property             20 or more but less          15 years

 

                              than 25 years

 

 

 20-year property             25 or more years             20 years

 

 

 Water utility property       50 years                     25 years

 

 

 Residential rental

 

 property                     40 years                   27.5 years

 

 

 Nonresidential real

 

 property                     40 years                     39 years

 

 

 Any railroad grading

 

 or tunnel bore               50 years                     50 years

 

 

Placed-in-service conventions

Depreciation of an asset begins when the asset is deemed to be placed in service under the applicable convention.360 Under MACRS, nonresidential real property, residential rental property, and any railroad grading or tunnel bore generally are subject to the mid-month convention, which treats all property placed in service during any month (or disposed of during any month) as placed in service (or disposed of) on the mid-point of such month.361 All other property generally is subject to the half-year convention, which treats all property placed in service during any taxable year (or disposed of during any taxable year) as placed in service (or disposed of) on the mid-point of such taxable year.362 However, if substantial property is placed in service during the last three months of a taxable year, a special rule requires use of the mid-quarter convention,363 designed to prevent the recognition of disproportionately large amounts of first-year depreciation under the half-year convention.

Alternative depreciation system

The alternative depreciation system ("ADS") is required to be used for property used predominantly outside the United States, tax-exempt bond financed property, and certain tax-exempt use property.364 An election to use ADS is available to taxpayers for any class of property for any taxable year.365 Under ADS, all property is depreciated using the straight-line method, over recovery periods which generally are equal to the class life of the property, with certain exceptions.366

 

Description of Proposal

 

 

Depreciation

 

In general

 

Under the proposal, the depreciation method for tangible property is the straight line method and the applicable recovery period generally is the class life of the property.367 A recovery period is specifically assigned for the following property:
  • Property with no class life (12 years);

  • Any race horse, and any horse other than a race horse that is more than 12 years old at the time it is placed in service (3 years);

  • Semi-conductor manufacturing equipment (5 years);

  • Qualified technological equipment (5 years);

  • Automobile or light general purpose truck (5 years);

  • Qualified rent-to-own property (9 years);

  • Certain telephone switching equipment (9.5 years);

  • Railroad track (10 years);

  • Smart electric distribution property (10 years);

  • Airplanes (12 years);368

  • Natural gas gathering line (14 years);

  • Tree or vine bearing fruit or nuts (20 years);

  • Telephone distribution plant (24 years);

  • Real property, including nonresidential real property and residential rental property (40 years);

  • Water treatment and utility property (50 years);

  • Clearing and grading improvements, and tunnel bore (50 years); and

  • Tax-exempt use property subject to lease (recovery period shall be no less than 125 percent of the lease term).

 

Under the proposal, the Secretary is required to develop a schedule of class lives for all tangible property, except for property with a recovery period that was specifically assigned. One year following the delivery of the schedule of class lives, the revised class lives will take effect, replacing Revenue Procedure 87-56.

 

Inflation adjustment

 

The proposal provides an election for taxpayers to increase their depreciation deductions to take into account inflation. The election is made annually and applies to all property (except for specified property used outside the United States, real property, water treatment and utility property, and any clearing and grading land improvements or tunnel bore) placed in service during such taxable year.369 With respect to property for which an election has been made, the taxpayer increases the depreciation deductions associated with such property by applying an inflation adjustment percentage to the modified adjusted basis of such property.370 The term "modified adjusted basis" means the taxpayer's adjusted basis in such property determined as if the inflation adjustment had not been applied. The term "inflation adjustment percentage" means the cost-of-living adjustment for such calendar year, which is the percentage (if any) by which the Chained Consumer Price Index for all Urban Consumers ("C-CPI-U")371 for the preceding calendar year exceeds the C-CPI-U for the second preceding calendar year. The overall depreciation allowance (including the inflation adjustment) for a taxable year with respect to any property may not exceed such property's adjusted basis as of the beginning of such taxable year.

The below table illustrates depreciation for an asset with a cost of $1,000 and a seven-year recovery period under the straight-line method using the half-year convention with and without the election to apply the inflation adjustment. For purposes of the inflation adjustment, an inflation rate of three percent is assumed in the below table.

                              Table 6. -- Example

 

 ______________________________________________________________________________

 

 

                                                Straight line

 

        Straight       Straight line with the   beginning year   Adjusted basis

 

 Year   line method    inflation adjustment     basis            end of year

 

 ______________________________________________________________________________

 

 

 1        71.40               86.40               1,000.00          913.60

 

 2       142.90              170.76                 928.60          742.84

 

 3       142.90              166.47                 785.70          576.37

 

 4       142.80              162.08                 642.80          414.29

 

 5       142.90              157.90                 500.00          256.39

 

 6       142.80              153.51                 357.10          102.87

 

 7       142.90              102.87                 214.30            0.00

 

 8        71.40                0.00                  71.40            0.00

 

 

Normalization

The proposal continues the rule that the tax benefits of public utility property may be normalized in setting rates charged by utilities to customers and in reflecting operating results in regulated books of account. In addition to requiring the normalization of depreciation deductions, the proposal provides for the normalization of excess deferred tax reserves resulting from the reduction of corporate income tax rates (with respect to prior depreciation or recovery allowances taken on assets placed in service before the date of enactment).

If an excess deferred tax reserve is reduced more rapidly or to a greater extent than such reserve would be reduced under the average rate assumption method, the taxpayer will not be treated as using a normalization method of accounting with respect to any of its assets. Thus, if the excess deferred tax reserve is not normalized, the taxpayer must compute its depreciation allowances using the depreciation method, useful life determination, averaging convention, and salvage value limitation used for purposes of setting rates and reflecting operating results in regulated books of account.

The excess deferred tax reserve is the reserve for deferred taxes computed under prior law over what the reserve for deferred taxes would be if the tax rate in effect under the proposal had been in effect for all prior periods. The average rate assumption method is the method that reduces the excess deferred tax reserve over the remaining regulatory lives of the property that gave rise to the reserve for deferred taxes. Under this method, the excess deferred tax reserve is reduced as the timing differences (i.e., differences between tax depreciation and regulatory depreciation with respect to each asset or group of assets in the case of vintage accounts) reverse over the life of the asset. The reversal of timing differences generally occurs when the amount of the tax depreciation taken with respect to an asset is less than the amount of the regulatory depreciation taken with respect to the asset. The excess deferred tax reserve is multiplied by a formula that is designed to insure that the excess is reduced to zero at the end of the regulatory life of the asset that generated the reserve.

 

Effective Date

 

 

The amendments made by this proposal apply to property placed in service after December 31, 2016.

5. Repeal of amortization of pollution control facilities (sec. 3105 of the discussion draft and sec. 169 of the Code)

 

Present Law

 

 

In general, a taxpayer may elect to recover the cost of any certified pollution control facility over a period of 60 months.372 A certified pollution control facility is defined as a new, identifiable treatment facility which (1) is used in connection with a plant in operation before January 1, 1976, to abate or control water or atmospheric pollution or contamination by removing, altering, disposing, storing, or preventing the creation or emission of pollutants, contaminants, wastes, or heat; and (2) does not lead to a significant increase in output or capacity, a significant extension of useful life, a significant reduction in total operating costs for such plant or other property (or any unit thereof), or a significant alteration in the nature of a manufacturing production process or facility.373 A certified air pollution control facility placed in service after April 11, 2005 used in connection with an electric generation plant which is primarily coal fired is eligible for 84-month amortization if the associated plant or other property was not in operation prior to January 1, 1976.374

For a pollution control facility with a useful life greater than 15 years, only the portion of the basis attributable to the first 15 years is eligible to be amortized over a 60-month or 84-month period.375 In addition, a corporation must reduce the amount of basis otherwise eligible for the 60-month or 84-month recovery period by 20 percent.376 The amount of basis not eligible for 60-month or 84-month amortization is depreciable under the regular tax rules for depreciation.377

 

Description of Proposal

 

 

The proposal repeals section 169 such that the costs of certified pollution control facilities must be capitalized and amortized in accordance with the general cost recovery provisions under sections 167 and 168.

 

Effective Date

 

 

The proposal applies to facilities placed in service after December 31, 2014.

6. Net operating loss deduction (sec. 3106 of the discussion draft and sec. 172 of the Code)

 

Present Law

 

 

Under present law, a net operating loss ("NOL") generally means the amount by which a taxpayer's business deductions exceed its gross income. In general, an NOL may be carried back two years and carried over 20 years to offset taxable income in such years.378 NOLs offset taxable income in the order of the taxable years to which the NOL may be carried.379

Different carryback periods apply with respect to NOLs arising in different circumstances. Extended carryback periods are allowed for NOLs attributable to specified liability losses and casualty and certain disaster losses. Limitations are placed on the carryback of excess interest losses attributable to corporate equity reduction transactions. Extended carrybacks for bank bad debt losses, 2008 and 2009 net operating losses, losses where investment in transmission property and pollution control investments, and losses attributable to federally declared disasters were provided but have expired.

 

Description of Proposal

 

 

In the case of a corporation, the proposal limits the NOL deduction to 90 percent of taxable income (determined without regard to the deduction). Carryovers to other years are adjusted to take account of this limitation.

The proposal repeals the special carryback provisions other than the provision relating to certain casualty and disaster losses.

 

Effective Date

 

 

The proposal limiting the NOL deduction for corporations applies to taxable years beginning after December 31, 2014.

The repeal of the special carryback rules generally applies to losses arising in taxable years beginning after December 31, 2014. The repeal of the extended carryback provisions which have expired is effective on the date of enactment.

7. Circulation expenditures (sec. 3107 of the discussion draft and sec. 173 of the Code)

 

Present Law

 

 

Business expenses associated with the development or creation of an asset having a useful life extending beyond the current year generally must be capitalized and depreciated over such useful life.380 However, section 173 allows a deduction for expenditures to establish, maintain, or increase the circulation of a newspaper, magazine, or other periodical. In lieu of a current deduction, a taxpayer may elect to amortize such costs over a three-year period.381

 

Description of Proposal

 

 

The proposal requires that specified circulation expenditures be capitalized and amortized over the 36-month period beginning with the mid-point of the month in which the expenditures are paid or incurred.

In the case of retired, abandoned, or disposed property with respect to which specified circulation expenditures are paid or incurred, any remaining basis may not be recovered in the year of retirement, abandonment, or disposal, but instead must continue to be amortized over the remaining amortization period.

The proposal provides transition relief allowing 75 percent of specified circulation expenditures made in taxable years beginning in 2016, 50 percent of specified circulation expenditures made in taxable years beginning in 2017, and 25 percent of specified circulation expenditures made in taxable years beginning in 2018, to be deducted, with the remaining percentage of the specified circulation expenditures to be capitalized and amortized over 36 months. The taxpayer may make an irrevocable election not to apply the transition rule.

 

Effective Date

 

 

The proposal applies to amounts paid or incurred in taxable years beginning after December 31, 2015.

8. Amortization of research and experimental expenditures (sec. 3108 of the discussion draft and sec. 174 of the Code)

 

Present Law

 

 

Business expenses associated with the development or creation of an asset having a useful life extending beyond the current year generally must be capitalized and depreciated over such useful life.382 Taxpayers, however, may elect to deduct currently the amount of certain reasonable research or experimentation expenditures paid or incurred in connection with a trade or business.383 Taxpayers may choose to forgo a current deduction, capitalize their research expenditures, and recover them ratably over the useful life of the research, but in no case over a period of less than 60 months.384 Taxpayers, alternatively, may elect to amortize their research expenditures over a period of 10 years.385

Amounts defined as research or experimental expenditures under section 174 generally include all costs incurred in the experimental or laboratory sense related to the development or improvement of a product.386 In particular, qualifying costs are those incurred for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.387 Uncertainty exists when information available to the taxpayer is not sufficient to ascertain the capability or method for developing, improving, and/or appropriately designing the product.388 The determination of whether expenditures qualify as deductible research expenses depends on the nature of the activity to which the costs relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents. Examples of qualifying costs include salaries for those engaged in research or experimentation efforts, amounts incurred to operate and maintain research facilities (e.g., utilities, depreciation, rent), and expenditures for materials and supplies used and consumed in the course of research or experimentation (including amounts incurred in conducting trials).389 In addition, under administrative guidance, the costs of developing computer software have been accorded treatment similar to research expenditures.390

However, generally no current deduction under section 174 is allowable for expenditures for the acquisition or improvement of land or of depreciable or depletable property used in connection with any research or experimentation.391 In addition, no current deduction is allowed for research expenses incurred for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore or other mineral, including oil and gas.392

 

Description of Proposal

 

 

Under the proposal, amounts defined as specified research or experimental expenditures are required to be capitalized and amortized over a five-year period, beginning with the midpoint of the taxable year in which the specified research or experimental expenditures were paid or incurred. Specified research or experimental expenditures which are attributable to research that is conducted outside of the United States393 are required to be capitalized and amortized over a period of 15 years, beginning with the midpoint of the taxable year in which such expenditures were paid or incurred. Specified research or experimental expenditures subject to capitalization include expenditures for software development.

In the case of retired, abandoned, or disposed property with respect to which specified research or experimental expenditures are paid or incurred, the remaining basis may not be recovered in the year of retirement, abandonment, or disposal, but instead must continue to be amortized over the remaining amortization period.

As a conforming amendment to the repeal of the alternative minimum tax,394 taxpayers may no longer elect to amortize their research expenditures over a period of 10 years.

A transition rule is provided for domestic research or experimental expenditures395 paid or incurred during any taxable year beginning before 2021. For taxable years beginning in 2015, 60 percent of domestic research or experimental expenditures are allowed as a deduction and the remainder are capitalized and amortized over a two-year period. For taxable years beginning in 2016 and 2017, 40 percent of domestic research or experimental expenditures are allowed as a deduction and the remainder are capitalized and amortized over a three-year period. For taxable years beginning in 2018, 2019, and 2020, 20 percent of domestic research or experimental expenditures are allowed as a deduction and the remainder are capitalized and amortized over a four-year period. The taxpayer may make an irrevocable election not to apply the transition rule.

 

Effective Date

 

 

The proposal applies to amounts paid or incurred in taxable years beginning after December 31, 2014.

9. Repeal of deductions for soil and water conservation expenditures and endangered species recovery expenditures (sec. 3109 of the discussion draft and sec. 175 of the Code)

 

Present Law

 

 

Under present law, a taxpayer engaged in the business of farming may treat expenditures that are paid or incurred by him during the taxable year for the purpose of soil or water conservation in respect of land used in farming, for the prevention of erosion of land used in farming, or made pursuant to a recovery plan under the Endangered Species Act of 1973396 as expenses that are not chargeable to capital account. Such expenditures are allowed as a deduction, not to exceed 25 percent of the gross income derived from farming during the taxable year.397 Any excess above such percentage is deductible for succeeding taxable years, not to exceed 25 percent of the gross income derived from farming during each succeeding taxable year.

 

Description of Proposal

 

 

The proposal repeals section 175 such that soil and water conservation expenditures and endangered species recovery expenditures must be capitalized in accordance with general tax principles.398

 

Effective Date

 

 

The proposal applies to amounts paid or incurred after December 31, 2014.

10. Amortization of certain advertising expenses (sec. 3110 of the discussion draft and new sec. 177 of the Code)

 

Present Law

 

 

Advertising expenses generally are deductible as ordinary and necessary business expenses in the year in which they are paid or incurred.399 Business expenses associated with the development or creation of an asset having a useful life extending beyond the current year generally must be capitalized and recovered over such useful life.400

 

Description of Proposal

 

 

Under the proposal, a taxpayer must capitalize and amortize 50 percent of its specified advertising expenses over a 10-year period, beginning with the midpoint of the tax year in which the expenses are paid or incurred. The remaining 50 percent of a taxpayer's specified advertising expenses may continue to be deducted in the year paid or incurred (as under present law).

The proposal provides an exemption from the capitalization requirement for taxpayers with advertising expenses for the taxable year of $1 million or less. However, if the taxpayer's otherwise deductible advertising expenses for any taxable year exceed $1.5 million, the $1 million amount is reduced (but not below zero) by twice such excess amount. The $1 million and $1.5 million amounts are adjusted for inflation in taxable years beginning after 2015.

A "specified advertising expense" is defined as any amount paid or incurred for the development, production, or placement (including any form of transmission, broadcast, publication, display, or distribution) of any communication to the general public (or portions thereof) which is intended to promote the taxpayer or a trade of business of the taxpayer, including any service, facility, or product provided as part of such trade or business. Specified advertising expense includes only deductions that would (but for this section) be deductible by the taxpayer for the taxable year under other provisions of the Code. Thus, the determination of amounts that are capitalizable under section 263 or other Code sections is not affected by this proposal.

The proposal provides certain exclusions from the definition of a specified advertising expense: (1) wages paid to the taxpayer's employees unless the employee's services are primarily related to specified advertising activities (including supervision of such employees); (2) depreciation expense allowed under section 167 for tangible property; (3) amortization deductions allowable under section 197;401 (4) any discount, coupon, rebate, slotting allowance, sample, prize, loyalty reward point, or any other item determined by the Secretary to be similar; (5) amounts paid or incurred with respect to any communications appearing on the taxpayer's tangible property subject to depreciation or treated as inventory;402 (6) amounts paid or incurred for the creation of any logo, trademark, or trade name; (7) amounts paid or incurred for package design;403 (8) amounts paid or incurred for marketing research; (9) amounts paid or incurred for business meals; and (10) amounts paid or incurred as qualified sponsorship payments (as defined in section 513(i)(2)) with respect to an organization subject to the tax imposed by section 511.

In the case of retired, abandoned, or disposed property with respect to which specified advertising expenses are paid or incurred, the remaining basis may not be recovered in the year of retirement, abandonment, or disposal, but instead must continue to be amortized over the remaining amortization period.

A transition rule is provided for specified advertising expenses paid or incurred during any taxable year beginning before 2018. For taxable years beginning in 2015, 20 percent of specified advertising expenses are required to be capitalized and amortized over the 10-year period. For taxable years beginning in 2016, 30 percent of specified advertising expenses are required to be capitalized and amortized over the 10-year period. For taxable years beginning in 2017, 40 percent of specified advertising expenses are required to be capitalized and amortized over the 10-year period. The taxpayer may make an irrevocable election not to apply the transition rule.

While package design expenses are excluded from capitalization under new section 177, the proposal requires such costs to be treated as allocable indirect costs for purposes of section 263A with respect to packages which utilize such design.404

 

Effective Date

 

 

The proposal applies to amounts paid or incurred in taxable years beginning after December 31, 2014.

11. Expensing certain depreciable business assets for small business (sec. 3111 of the discussion draft and sec. 179 of the Code)

 

Present Law

 

 

A taxpayer may elect under section 179 to deduct (or "expense") the cost of qualifying property, rather than to recover such costs through depreciation deductions, subject to limitation.405 For taxable years beginning in 2013, the maximum amount a taxpayer may expense is $500,000 of the cost of qualifying property placed in service for the taxable year.406 The $500,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $2,000,000.407 The $500,000 and $2,000,000 amounts are not indexed for inflation.

In general, qualifying property is defined as depreciable tangible personal property that is purchased for use in the active conduct of a trade or business. For taxable years beginning before 2014, qualifying property also includes off-the-shelf computer software and qualified real property (i.e., qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property).408 Of the $500,000 expense amount available under section 179, the maximum amount available with respect to qualified real property is $250,000 for each taxable year.409

For taxable years beginning in 2014 and thereafter, a taxpayer may elect to deduct up to $25,000 of the cost of qualifying property placed in service for the taxable year, subject to limitation. The $25,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $200,000. The $25,000 and $200,000 amounts are not indexed for inflation. In general, qualifying property is defined as depreciable tangible personal property (not including off-the-shelf computer software or qualified real property) that is purchased for use in the active conduct of a trade or business.

The amount eligible to be expensed for a taxable year may not exceed the taxable income for such taxable year that is derived from the active conduct of a trade or business (determined without regard to this provision).410 Any amount that is not allowed as a deduction because of the taxable income limitation may be carried forward to succeeding taxable years (subject to limitations). However amounts attributable to qualified real property that are disallowed under the trade or business income limitation may only be carried over to taxable years in which the definition of eligible section 179 property includes qualified real property.411 Thus, if a taxpayer's section 179 deduction for 2012 with respect to qualified real property is limited by the taxpayer's active trade or business income, such disallowed amount may be carried over to 2013. Any such carryover amounts that are not used in 2013 are treated as property placed in service in 2013 for purposes of computing depreciation. That is, the unused carryover amount from 2012 is considered placed in service on the first day of the 2013 taxable year.412

No general business credit under section 38 is allowed with respect to any amount for which a deduction is allowed under section 179.413 An expensing election is made under rules prescribed by the Secretary.414 In general, any election or specification made with respect to any property may not be revoked except with the consent of the Commissioner. However, an election or specification under section 179 may be revoked by the taxpayer without consent of the Commissioner for taxable years beginning after 2002 and before 2014.415

 

Description of Proposal

 

 

The proposal provides that the maximum amount a taxpayer may expense, for taxable years beginning after 2013, is $250,000 of the cost of qualifying property placed in service for the taxable year. The $250,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $800,000. The $250,000 and $800,000 amounts are indexed for inflation for taxable years beginning after 2014.

In addition, the proposal makes permanent, for taxable years beginning after 2013, the treatment of off-the-shelf computer software as qualifying property. The proposal also makes permanent the treatment of qualified real property as eligible section 179 property for taxable years beginning after 2013.

The proposal permits the taxpayer to revoke any election and any specification contained therein, made under section 179 after 2002.

Further, the proposal strikes the flush language in section 179(d)(1) that excludes air conditioning and heating units from the definition of qualifying property.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2013.

12. Repeal of election to expense certain refineries (sec. 3112 of the discussion draft and sec. 179C of the Code)

 

Present Law

 

 

Section 179C provides a temporary election to expense 50 percent of qualified refinery property. The remaining 50 percent is recovered as under present law.416 Qualified refinery property includes assets, located in the United States, used in the refining of liquid fuels: (1) with respect to the construction of which there is a binding construction contract before January 1, 2010; (2) which are placed in service before January 1, 2014; (3) which increase the capacity of an existing refinery by at least five percent or increase the percentage of total throughput attributable to qualified fuels (as defined in section 45K(c)) such that it equals or exceeds 25 percent; and (4) which meet all applicable environmental laws in effect when the property is placed in service.

 

Description of Proposal

 

 

The proposal repeals section 179C.

 

Effective Date

 

 

The proposal is effective for property placed in service after December 31, 2013.

13. Repeal of deduction for energy efficient commercial buildings (sec. 3113 of the discussion draft and sec. 179D of the Code)

 

Present Law

 

 

Section 179D provides a deduction equal to energy-efficient commercial building property expenditures made by the taxpayer.417 The deduction is limited to an amount equal to $1.80 per square foot of the property for which such expenditures are made.418 The deduction is allowed in the year in which the property is placed in service.419

If a deduction is allowed under this section, the basis of the property is reduced by the amount of the deduction.420 The deduction is effective for property placed in service after December 31, 2005, and prior to January 1, 2014.421

If a corporation makes an election under section 179D to deduct expenditures, the full amount of the deduction does not reduce earnings and profits. Rather, the expenditures that are deducted reduce corporate earnings and profits ratably over a five-year period.422

 

Description of Proposal

 

 

The proposal repeals section 179D. The proposal also repeals the related earnings and profits rule.

 

Effective Date

 

 

The proposal is effective for property placed in service after December 31, 2013.

14. Repeal of election to expense advanced mine safety equipment (sec. 3114 of the discussion draft and sec. 179E of the Code)

 

Present Law

 

 

A taxpayer may elect to treat 50 percent of the cost of any qualified advanced mine safety equipment property as an expense in the taxable year in which the equipment is placed in service.423 "Qualified advanced mine safety equipment property" means any advanced mine safety equipment property for use in any underground mine located in the United States the original use of which commences with the taxpayer and which is placed in service after December 20, 2006, and before January 1, 2014.424

Advanced mine safety equipment property means any of the following: (1) emergency communication technology or devices used to allow a miner to maintain constant communication with an individual who is not in the mine; (2) electronic identification and location devices that allow individuals not in the mine to track at all times the movements and location of miners working in or at the mine; (3) emergency oxygen-generating, self-rescue devices that provide oxygen for at least 90 minutes; (4) pre-positioned supplies of oxygen providing each miner on a shift the ability to survive for at least 48 hours; and (5) comprehensive atmospheric monitoring systems that monitor the levels of carbon monoxide, methane and oxygen that are present in all areas of the mine and that can detect smoke in the case of a fire in a mine.425

 

Description of Proposal

 

 

The proposal repeals section 179E.

 

Effective Date

 

 

The proposal applies to property placed in service after December 31, 2013.

15. Repeal of deduction for expenditures by farmers for fertilizer, etc. (sec. 3115 of the discussion draft and sec. 180 of the Code)

 

Present Law

 

 

A taxpayer engaged in the business of farming may elect to deduct expenses (otherwise chargeable to capital account) which are paid or incurred during the taxable year for the purchase or acquisition of fertilizer, lime, ground limestone, marl, or other materials to enrich, neutralize, or condition land used in farming.426

 

Description of Proposal

 

 

The proposal repeals section 180 such that amounts paid or incurred during the taxable year for the purchase or acquisition of fertilizer, lime, ground limestone, marl, or other materials to enrich, neutralize, or condition land used in farming are subject to the general capitalization principles.427

 

Effective Date

 

 

The proposal applies to expenses paid or incurred in taxable years beginning after December 31, 2014.

16. Repeal of special treatment of certain qualified film and television productions (sec. 3116 of the discussion draft and sec. 181 of the Code)

 

Present Law

 

 

Under section 181, taxpayers may elect428 to deduct the cost of any qualifying film and television production, commencing prior to January 1, 2014, in the year the expenditure is incurred in lieu of capitalizing the cost and recovering it through depreciation allowances.429 Taxpayers may elect to deduct up to $15 million of the aggregate cost of the film or television production under this section.430 The threshold is increased to $20 million if a significant amount of the production expenditures are incurred in areas eligible for designation as a low-income community or eligible for designation by the Delta Regional Authority as a distressed county or isolated area of distress.431

A qualified film or television production means any production of a motion picture (whether released theatrically or directly to video cassette or any other format) or television program if at least 75 percent of the total compensation expended on the production is for services performed in the United States by actors, directors, producers, and other relevant production personnel.432 The term "compensation" does not include participations and residuals (as defined in section 167(g)(7)(B)).433 With respect to property which is one or more episodes in a television series, each episode is treated as a separate production and only the first 44 episodes qualify under the provision.434 Qualified property does not include sexually explicit productions as defined by section 2257 of title 18 of the U.S. Code.435

For purposes of recapture under section 1245, any deduction allowed under section 181 is treated as if it were a deduction allowable for amortization.436

 

Description of Proposal

 

 

The proposal repeals section 181 such that amounts paid or incurred to produce any film or television program are subject to the general capitalization principles and cost recovery rules.437

 

Effective Date

 

 

The proposal applies to productions commencing after December 31, 2013.

17. Repeal of special rules for recoveries of damages of antitrust violations, etc. (sec. 3117 of the discussion draft and sec. 186 of the Code)

 

Present Law

 

 

In the case of losses resulting from a patent infringement, a breach of fiduciary duty, or antitrust injury for which there is a recovery under section 4 of the Clayton Act,438 a special deduction is allowed which has the effect of reducing the amounts required to be included in income to the extent that the losses to which they relate did not give rise to a tax benefit.439

When a compensatory amount is received or accrued during a year for a compensable injury, a deduction is allowed for the compensatory amount or, if smaller, the unrecovered losses sustained as a result of the compensable injury.440 Compensable injuries are those sustained as a result of a patent infringement, a breach of contract, or a breach of fiduciary duty or an antitrust injury for which there is a recovery under section 4 of the Clayton Act.441

The compensatory amount is the amount received or accrued as damages either as an award in or settlement of a civil action for recovery of a compensable injury.442 This is to be reduced by the expenses in securing the award or settlement. The provision applies only to recoveries for actual injury and not for any additional amounts.

The unrecovered losses are the net operating losses attributable to the compensatory injury reduced by those allowed as a deduction as a loss carryback or carryover.443 These net operating losses are also reduced by the amount (if any) of a recovery of a compensatory amount in any other years against which these losses were offset.

 

Description of Proposal

 

 

The proposal repeals section 186 such that compensatory amounts are includable in income in accordance with generally applicable income and revenue recognition principles.444

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

18. Treatment of reforestation expenditures (sec. 3118 of the discussion draft and sec. 194 of the Code)

 

Present Law

 

 

A taxpayer may elect to expense up to $10,000 ($5,000 in the case of a separate return by a married individual) of qualifying reforestation expenditures incurred during the taxable year with respect to qualifying timber property.445 The remaining expenditures are amortized over 84 months (seven years) subject to a mandatory half-year convention.446 In the case of an individual, the amortization deduction is allowed in determining adjusted gross income (i.e., an "above-the-line deduction") rather than as an itemized deduction.447

Qualifying reforestation expenditures are the direct costs a taxpayer incurs in connection with the forestation or reforestation of a site by planting or seeding, and include costs for the preparation of the site, the cost of the seed or seedlings, and the cost of the labor and tools (including depreciation of long lived assets such as tractors and other machines) used in the reforestation activity.448 Qualifying reforestation expenditures do not include expenditures that would otherwise be deductible and do not include costs for which the taxpayer has been reimbursed under a governmental cost sharing program, unless the amount of the reimbursement is also included in the taxpayer's gross income.449

Qualifying timber property means a woodlot or other site located in the United States which will contain trees in significant commercial quantities and which is held by the taxpayer for the planting, cultivating, caring for, and cutting of trees for sale or use in the commercial production of timber products.450 Qualified timber property does not include either property on which the taxpayer has planted shelter beds (for which section 175 deductions are allowed) or ornamental trees.451

Reforestation amortization is subject to recapture as ordinary income on the sale of qualifying timber property within 10 years of the year in which the qualifying reforestation expenditures were incurred.452

 

Description of Proposal

 

 

The proposal eliminates the election to expense up to $10,000 ($5,000 in the case of a separate return by a married individual) of qualified reforestation expenditures. Thus, all qualified reforestation expenditures are required to be capitalized and amortized over seven years. The term "qualified reforestation expenditures" means the reforestation expenditures453 paid or incurred by the taxpayer during the taxable year with respect to qualified timber property.

The proposal changes the definition of qualified timber property to include only property held by the taxpayer for the planting, cultivating, caring for, and cutting of evergreen trees (that are more than six years old when cut) for sale for ornamental purposes. It is intended that costs related to property that no longer meets the definition of qualified timber property shall be included in basis and recovered using cost depletion.454

 

Effective Date

 

 

The proposal applies to expenditures paid or incurred in taxable years beginning after December 31, 2014.

19. 20-year amortization of goodwill and certain other intangibles (sec. 3119 of the discussion draft and sec. 197 of the Code)

 

Present Law

 

 

Under section 197, when a taxpayer acquires intangible assets held in connection with a trade or business, any value properly attributable to a "section 197 intangible" is amortizable on a straight-line basis over 15 years.455 Such intangibles include goodwill; going concern value; workforce in place including its composition and terms and conditions (contractual or otherwise) of its employment; business books and records, operating systems, or other information base; any patent, copyright, formula, process, design, pattern, knowhow, format, or similar item; customer-based intangibles; supplier-based intangibles; and any other similar item.456 The definition of a section 197 intangible also includes any license, permit, or other rights granted by governmental units (even if the right is granted for an indefinite period or is reasonably expected to be renewed indefinitely);457 any covenant not to compete; and any franchise, trademark, or trade name.458

However, interests in land, including leases, easements, grazing rights, and mineral rights granted by a government, may not be amortized over the 15-year period provided in section 197, but instead must be amortized over the period of the grant of the right.459 Certain financial interests,460 certain computer software readily available for purchase by the general public,461 and certain rights acquired separately from the acquisition of assets constituting a trade or business (or substantial portion thereof)462 are not subject to the 15-year amortization. Certain interests under leases and debt instruments,463 any right to service indebtedness which is secured by residential real property (unless such right is acquired as part of the acquisition of a trade or business, or substantial portion thereof) ("mortgage servicing rights"),464 and certain transaction costs465 are not section 197 intangibles. In addition, certain self-created intangibles, such as goodwill created through advertising and other expenses, are not subject to section 197.466

While mortgage servicing rights are explicitly excluded from section 197, section 167 provides that mortgage servicing rights are depreciated using the straight-line method over a 108-month period.467 Similarly, section 167 provides that computer software excluded from section 197 is depreciated using the straight-line method over a 36-month period.468 With respect to certain interests or rights not acquired as part of a purchase of a trade or business that are excluded from section 197, the regulations under section 167 prescribe the amortization method and period based on the type of interest or right separately acquired.469

 

Description of Proposal

 

 

The proposal provides that section 197 intangibles are amortized ratably over a 20-year period beginning with the month in which such intangible was acquired. Under the proposal, the exception to the definition of section 197 intangibles for mortgage servicing rights is repealed.470

 

Effective Date

 

 

The proposal applies to property acquired after December 31, 2014.

20. Treatment of environmental remediation costs (sec. 3120 of the discussion draft and sec. 198 of the Code)

 

Present Law

 

 

Present law allows a deduction for ordinary and necessary expenses paid or incurred in carrying on any trade or business.471 Treasury regulations provide that a taxpayer may deduct the repair and maintenance costs of tangible property if such amounts are not otherwise required to be capitalized.472 Section 263(a)(1) limits the scope of section 162 by prohibiting a current deduction for certain capital expenditures. Treasury regulations generally require taxpayers to capitalize amounts paid or incurred that are for a betterment to a unit of property, restore a unit of property, or adapt a unit of property to a new or different use.473 Amounts paid for repairs and maintenance generally do not constitute capital expenditures. The determination of whether an expense is deductible or capitalizable is based on all relevant facts and circumstances.

Taxpayers may elect to treat certain environmental remediation expenditures paid or incurred before January 1, 2012, that would otherwise be chargeable to capital account as deductible in the year paid or incurred.474 The deduction applies for both regular and alternative minimum tax purposes. The expenditure must be incurred in connection with the abatement or control of hazardous substances at a qualified contaminated site.475 In general, any expenditure for the acquisition of depreciable property used in connection with the abatement or control of hazardous substances at a qualified contaminated site does not constitute a qualified environmental remediation expenditure.476 However, depreciation deductions allowable for such property that would otherwise be allocated to the site under the principles set forth in Commissioner v. Idaho Power Co.477 and section 263A are treated as qualified environmental remediation expenditures.478

A "qualified contaminated site" (a so-called "brownfield") generally is any property that is held for use in a trade or business, for the production of income, or as inventory and is certified by the appropriate State environmental agency to be an area at or on which there has been a release (or threat of release) or disposal of a hazardous substance.479 Both urban and rural property may qualify. However, sites that are identified on the national priorities list under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 ("CERCLA")480 cannot qualify as targeted areas. Hazardous substances generally are defined by reference to sections 101(14) and 102 of CERCLA, subject to additional limitations applicable to asbestos and similar substances within buildings, certain naturally occurring substances such as radon, and certain other substances released into drinking water supplies due to deterioration through ordinary use, as well as petroleum products defined in section 4612(a)(3).481

In the case of property to which a qualified environmental remediation expenditure otherwise would have been capitalized, any deduction allowed under section 198 is treated as a depreciation deduction and the property is treated as section 1245 property.482 Thus, deductions for qualified environmental remediation expenditures are subject to recapture as ordinary income upon a sale or other disposition of the property. In addition, sections 280B (demolition of structures) and 468 (special rules for mining and solid waste reclamation and closing costs) do not apply to amounts that are treated as expenses under section 198.483

 

Description of Proposal

 

 

The proposal requires qualified environmental remediation expenditures484 to be capitalized and amortized over a 40-year period.

 

Effective Date

 

 

The proposal is effective for expenditures paid or incurred after December 31, 2014.

21. Repeal of expensing of qualified disaster expenses (sec. 3121 of the discussion draft and sec. 198A of the Code)

 

Present Law

 

 

Under present law, a taxpayer may elect to treat any qualified disaster expense that is paid or incurred by the taxpayer as a deduction for the taxable year in which paid or incurred.485 For purposes of the provision, a qualified disaster expense is any otherwise capitalizable expenditure paid or incurred in connection with a trade or business or with business-related property that is: (1) for the abatement or control of hazardous substances that were released on account of a Federally declared disaster486 occurring before January 1, 2010; (2) for the removal of debris from, or the demolition of structures on, real property damaged or destroyed as a result of a Federally declared disaster occurring before January 1, 2010; or (3) for the repair of business-related property damaged as a result of a Federally declared disaster occurring before January 1, 2010.487

For purposes of this provision, "business-related property" is property held by the taxpayer for use in a trade or business, for the production of income, or as inventory.488 In addition, for purposes of recapture as ordinary income, any deduction allowed under this provision is treated as a deduction for depreciation and the property to which the amount would have been capitalized is treated as section 1245 property for purposes of depreciation recapture.489

This provision does not apply to any disaster that has been declared by the President on or after May 20, 2008, and before August 1, 2008, under section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act (the "Act") by reason of severe storms, tornados, or flooding occurring during 2008 in any of the States of Arkansas, Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Nebraska, and Wisconsin.490

 

Description of Proposal

 

 

The proposal repeals section 198A such that amounts properly chargeable to capital account generally are not permitted a current deduction.

 

Effective Date

 

 

The proposal is effective for amounts paid or incurred after December 31, 2014.

22. Phaseout and repeal of deduction for income attributable to domestic production activities (sec. 3122 of the discussion draft and sec. 199 of the Code)

 

Present Law

 

 

Present law provides a deduction from taxable income (or, in the case of an individual, adjusted gross income491) that is equal to nine percent (six percent in the case of oil related qualified production activities income) of the lesser of the taxpayer's qualified production activities income or taxable income for the taxable year.492 For taxpayers subject to the 35-percent corporate income tax rate, the nine-percent deduction effectively reduces the corporate income tax rate to just under 32 percent on qualified production activities income.493

In general, qualified production activities income is equal to domestic production gross receipts reduced by the sum of: (1) the costs of goods sold that are allocable to those receipts; and (2) other expenses, losses, or deductions which are properly allocable to those receipts.494

Domestic production gross receipts generally are gross receipts of a taxpayer that are derived from: (1) any sale, exchange, or other disposition, or any lease, rental, or license, of qualifying production property495 that was manufactured, produced, grown or extracted by the taxpayer in whole or in significant part within the United States496 (2) any sale, exchange, or other disposition, or any lease, rental, or license, of qualified film497 produced by the taxpayer; (3) any lease, rental, license, sale, exchange, or other disposition of electricity, natural gas, or potable water produced by the taxpayer in the United States; (4) construction of real property performed in the United States by a taxpayer in the ordinary course of a construction trade or business; or (5) engineering or architectural services performed in the United States for the construction of real property located in the United States.498

The amount of the deduction for a taxable year is limited to 50 percent of the W-2 wages paid by the taxpayer, and properly allocable to domestic production gross receipts, during the calendar year that ends in such taxable year.499

 

Description of Proposal

 

 

The proposal repeals section 199 for taxable years beginning after December 31, 2016. However, the repeal is phased in: for taxable years beginning in 2015, the deduction is reduced to 6 percent and for taxable years beginning in 2016 the deduction is reduced to 3 percent. The proposal repeals the limitation for oil related qualified production activities income for taxable years beginning after December 31, 2014, such that for oil-related qualified production activities income, the percentage deduction allowed for taxable years beginning in 2015 and 2016 is the same percentage generally allowed for all other qualified production activities income.

 

Effective Date

 

 

For the phase-out of present law section 199, the proposal applies to taxable years beginning after December 31, 2014. For the repeal of section 199, the proposal applies to taxable years beginning after December 31, 2016.

23. Unification of deduction for organizational expenditures (sec. 3123 of the discussion draft and secs. 195, 248, and 709 of the Code)

 

Present Law

 

 

A taxpayer may elect to deduct up to $5,000 of start-up expenditures in the taxable year in which the active trade or business begins.500 A corporation or a partnership may elect to deduct up to $5,000 of organizational expenditures in the taxable year in which the active trade or business begins.501 However, in each case, the $5,000 amount is reduced (but not below zero) by the amount by which the cumulative cost of start-up or organizational expenditures exceeds $50,000.502 Pursuant to such election, the remainder of such start-up expenditures and organizational expenditures may be amortized over a period of not less than 180 months, beginning with the month in which the trade or business begins.503 A taxpayer is deemed to make an election to deduct and amortize start-up or organizational expenditures for the applicable taxable year, unless the taxpayer affirmatively elects to capitalize such amounts on a timely-filed (including extensions) Federal income tax return.504 Capitalized amounts are recovered when the business is sold, exchanged, or otherwise disposed.505

Start-up expenditures are amounts that would have been deductible as trade or business expenses had they not been paid or incurred before business began.506 Organizational expenditures are expenditures that are incident to the creation of a corporation or the organization of a partnership, are chargeable to capital, and that would be eligible for amortization had they been paid or incurred in connection with the organization of a corporation or partnership with a limited or ascertainable life.507

 

Description of Proposal

 

 

Under the proposal, the rules for start-up expenditures (section 195) and organizational expenditures (sections 248 and 709) are consolidated into a single provision.508 A taxpayer may elect to deduct up to $10,000 of the sum of start-up and organizational expenditures in the taxable year in which the active trade or business begins. The $10,000 amount is reduced (but not below zero) by the amount by which the cumulative cost of the sum of start-up and organizational expenditures exceeds $60,000. Pursuant to such election, the remainder of such start-up expenditures and organizational expenditures may be amortized over a period of not less than 15 years, beginning with the midpoint of the taxable year in which the trade or business begins.

 

Effective Date

 

 

The proposal applies to expenses paid or incurred in taxable years beginning after December 31, 2014.

24. Prevention of arbitrage of deductible interest expense and tax-exempt interest income (sec. 3124 of the discussion draft and sec. 265 of the Code)

 

Present Law

 

 

Expenses and interest relating to tax-exempt income

Present law disallows a deduction for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is exempt from tax.509 In general, an interest deduction is disallowed only if the taxpayer has a purpose of using borrowed funds to purchase or carry tax-exempt obligations; a determination of the taxpayer's purpose in borrowing funds is made based on all of the facts and circumstances.510

 

Two-percent rule for individuals and certain nonfinancial corporations

 

In the absence of direct evidence linking an individual taxpayer's indebtedness with the purchase or carrying of tax-exempt obligations, the Internal Revenue Service takes the position that it ordinarily will not infer that a taxpayer's purpose in borrowing money was to purchase or carry tax-exempt obligations if the taxpayer's investment in tax-exempt obligations is "insubstantial."511 An individual's holdings of tax-exempt obligations are presumed to be insubstantial if during the taxable year the average adjusted basis of the individual's tax-exempt obligations is two percent or less of the average adjusted basis of the individual's portfolio investments and assets held by the individual in the active conduct of a trade or business.

Similarly, in the case of a corporation that is not a financial institution or a dealer in tax-exempt obligations, where there is no direct evidence of a purpose to purchase or carry tax-exempt obligations, the corporation's holdings of tax-exempt obligations are presumed to be insubstantial if the average adjusted basis of the corporation's tax-exempt obligations is two percent or less of the average adjusted basis of all assets held by the corporation in the active conduct of its trade or business.

 

Financial institutions

 

In the case of a financial institution, the Code generally disallows that portion of the taxpayer's interest expense that is allocable to tax-exempt interest.512 The amount of interest that is disallowed is an amount that bears the same ratio to such interest expense as the taxpayer's average adjusted bases of tax-exempt obligations acquired after August 7, 1986, bears to the average adjusted bases for all assets of the taxpayer.

 

Exception for certain obligations of qualified small issuers

 

The general rule denying financial institutions' interest expense deductions allocable to tax-exempt obligations does not apply to qualified tax-exempt obligations. Instead, only 20 percent of the interest expense allocable to qualified tax-exempt obligations is disallowed.513 A qualified tax-exempt obligation is a tax-exempt obligation that (1) is issued after August 7, 1986, by a qualified small issuer, (2) is not a private activity bond, and (3) is designated by the issuer as qualifying for the exception from the general rule of section 265(b).514

A qualified small issuer is an issuer that reasonably anticipates that the amount of tax-exempt obligations that it will issue during the calendar year will be $10 million or less. The Code specifies the circumstances under which an issuer and all subordinate entities are aggregated. For purposes of the $10 million limitation, an issuer and all entities that issue obligations on behalf of such issuer are treated as one issuer. All obligations issued by a subordinate entity are treated as being issued by the entity to which it is subordinate. An entity formed (or availed of) to avoid the $10 million limitation and all entities benefiting from the device are treated as one issuer.

Composite issues (i.e., combined issues of bonds for different entities) qualify for the qualified tax-exempt obligation exception only if the requirements of the exception are met with respect to (1) the composite issue as a whole (determined by treating the composite issue as a single issue) and (2) each separate lot of obligations that is part of the issue (determined by treating each separate lot of obligations as a separate issue). Thus a composite issue may qualify for the exception only if the composite issue itself does not exceed $10 million, and if each issuer benefitting from the composite issue reasonably anticipates that it will not issue more than $10 million of tax-exempt obligations during the calendar year, including through the composite arrangement.

Investment interest expense

In the case of a taxpayer other than a corporation, the deduction allowable for investment interest for any taxable year may not exceed the investment income for the year.515 Investment interest means interest paid or accrued on indebtedness incurred to purchase or carry property held for investment. Net investment income includes gross income from property held for investment reduced by investment expenses (other than interest) directly connected with the production of investment income.

The two-percent floor on miscellaneous itemized deductions allows taxpayers to deduct investment expenses connected with investment income only to the extent such deductions exceed two percent of the taxpayer's adjusted gross income ("AGI").516 Miscellaneous itemized deductions517 that are not investment expenses are disallowed first before any investment expenses are disallowed.518

 

Description of Proposal

 

 

Pro rata allocation of interest expense for corporations

The proposal applies the present-law financial institution rules to all C corporations. That is, in the case of a C corporation or financial institution, no deduction is allowed for that portion of the taxpayer's interest expense that is allocable to tax-exempt interest. The amount of interest that is disallowed is an amount that bears the same ratio to such interest expense as the taxpayer's average adjusted bases of tax-exempt obligations acquired on or after February 26, 2014 (August 7, 1986, in the case of a financial institution), bears to the average adjusted bases for all assets of the taxpayer.

The proposal repeals the special exception for any qualified tax-exempt obligation of a qualified small issuer and the special exception for certain bonds issued during 2009 or 2010. The proposal also repeals the tracing rule of section 265(a) with respect to interest.

Investment interest expense

In the case of a taxpayer other than a corporation or financial institution, the amount otherwise allowed as a deduction for investment interest for a taxable year is reduced by the amount of tax-exempt interest received by the taxpayer during the year. The amount of investment interest after the reduction is limited to the amount of investment income as under present law, with the excess (if any) carried over and treated as investment interest in the succeeding taxable year.

Under the proposal, tax-exempt debt is treated as property held for investment so that any interest expense properly allocable to tax-exempt debt is treated as investment interest subject to the limitations described above.

The following examples illustrate the application of the proposal in the case of a taxpayer other than a corporation or financial institution:

Example 1. -- Assume an individual has $100 taxable interest income, $100 tax-exempt interest income, and $20 interest expense properly allocable to the property that produced that income. Under the proposal, $20 of the interest expense is not allowed as a deduction in any taxable year.

Example 2. -- Assume the same facts except that the interest expense is $120. $100 is not allowed as a deduction, $20 is allowed as a deduction currently.

Example 3. -- Assume the same facts except that the interest expense is $220. $100 is not allowed as a deduction, $100 is allowed as a deduction currently, and $20 is carried forward to the next succeeding taxable year.

 

Effective Date

 

 

The pro rata allocation of interest expense to tax-exempt interest for corporations and financial institutions applies to taxable years ending on or after February 26, 2014.

The repeal of the special exceptions for any qualified tax-exempt obligation of a qualified small issuer and the special exception for certain bonds issued during 2009 or 2010 applies for obligations issued on or after February 26, 2014.

The limitation on investment interest for a taxpayer other than a corporation or financial institution applies to taxable years beginning after December 31, 2014.

25. Prevention of transfer of certain losses from tax indifferent parties (sec. 3125 of the discussion draft and sec. 267 of the Code)

 

Present Law

 

 

Related party sales

Sections 267(a)(1) and 707(b) generally disallow a deduction for a loss on the sale or exchange of property, directly or indirectly, to certain related parties or controlled partnerships. Section 267(d)519 provides that if a loss has been disallowed under either of such provisions, the transferee may reduce any gain that the transferee later recognizes on a disposition of the asset by the amount of loss disallowed to the transferor. Thus, section 267(d) shifts the benefit of the loss to the transferee to the extent of post-sale appreciation.

In the case of a sale or exchange between two corporations that are members of the same controlled group,520 section 267(f) provides a rule different from that of sections 267(a)(1), 707(b), and 267(d). Under section 267(f), the loss to the transferor is not denied entirely, but rather is deferred until such time as the property is transferred outside the controlled group and there would be recognition of loss under consolidated return principles, or such other time as may be prescribed in regulations. While the loss is deferred, it is not transferred to another party.

Sections 267 and 707 generally operate on an item-by item basis, so that if a transferor sells several items of separately acquired property to a related or controlled party in a single transaction, the disallowance at the time of the sale applies to each loss regardless of any gains recognized on other property in the same transfer.521

Transferee basis in gift cases

In the case of property acquired by gift, the basis generally is the basis in the hands of the transferor except that if the basis exceeds the fair market value at the time of the gift, the basis for purposes of determining loss is the fair market value at that time.522 This rule has the same effect as the rule in section 267(d) which in effect allows the loss at the time of the transfer to offset post-transfer appreciation.

Transferee basis in certain nontaxable corporate organizations and reorganizations

In the case of certain nontaxable organizations and reorganizations, section 362(a) generally provides that the transferee takes the same basis in property that the property had in the hands of the transferor, increased by the amount of any gain (or dividend) recognized by the transferor. However, section 362(e)(1) provides that in cases involving the importation of a net built-in loss, the transferee's aggregate adjusted basis may not exceed the fair market value of the property immediately after the transaction. This rule applies to a transfer of property if (i) gain or loss with respect to such property is not subject to Federal income tax in the hands of the transferor immediately before the transfer and (ii) gain or loss with respect to such property is subject to such tax in the hands of the transferee immediately after such transfer.

 

Description of Proposal

 

 

The proposal provides that the principles of section 267(d) do not apply to the extent gain or loss with respect to property that has been sold or exchanged is not subject to Federal income tax in the hands of the transferor immediately before the transfer but any gain or loss with respect to the property is subject to Federal income tax in the hands of the transferee immediately after the transfer. Thus, the basis of the property in the hands of the transferee will be its cost for purposes of determining gain or loss, thereby precluding a loss importation result.

 

Effective Date

 

 

The proposal applies to sales and exchanges after December 31, 2014.

26. Entertainment, etc. expenses (sec. 3126 of the discussion draft and sec. 274 of the Code)

 

Present Law

 

 

In general

Under present law, no deduction is allowed with respect to (1) an activity generally considered to be entertainment, amusement or recreation (referred to collectively as "entertainment"), unless the taxpayer establishes that the item was directly related to (or, in certain cases, associated with) the active conduct of the taxpayer's trade or business, or (2) a facility (e.g., an airplane) used in connection with such activity.523 If the taxpayer establishes that entertainment expenses are directly related to (or associated with) the active conduct of its trade or business, the deduction generally is limited to 50 percent of the amount otherwise deductible under the Code.524 Similarly, a deduction for any expense for food or beverages generally is limited to 50 percent of the amount otherwise deductible under the Code.525 In addition, no deduction is allowed for membership dues with respect to any club organized for business, pleasure, recreation or other social purpose.526

The Code includes a number of exceptions to the general rule disallowing deductions of entertainment expenses and the rules limiting deductions to 50 percent of the otherwise deductible amount. Under one such exception, these rules do not apply to expenses for goods, services, and facilities to the extent that the expenses are reported by the taxpayer as compensation and wages to an employee.527 The deduction disallowance rules also do not apply to expenses paid or incurred by the taxpayer for goods, services, and facilities to the extent that the expenses are includible in the gross income of a recipient who is not an employee (e.g., a nonemployee director) as compensation for services rendered or as a prize or award.528 The exceptions apply only to the extent that amounts are properly reported by the company as compensation and wages or otherwise includible in income. In no event can the amount of the deduction exceed the amount of the taxpayer's actual cost, even if a greater amount (i.e., fair market value) is includible in income.529

These rules also do not apply to expenses paid or incurred by the taxpayer, in connection with the performance of services for another person (other than an employee) under a reimbursement or other expense allowance arrangement if the taxpayer accounts for the expenses to such person.530 Another exception applies for expenses for recreational, social or similar activities primarily for the benefit of employees other than certain owners and highly compensated employees.531 An exception applies also to the 50 percent deduction limit for food and beverages provided to crew members of certain commercial vessels and certain oil or gas platform or drilling rig workers.532

Expenses treated as compensation

Except as otherwise provided, gross income includes compensation for services, including fees, commissions, fringe benefits, and similar items.533 In general, an employee or other service provider must include in gross income the amount by which the fair market value of a fringe benefit exceeds the amount paid by the individual (plus the amount, if any excluded from gross income).534 Treasury regulations provide rules regarding the valuation of fringe benefits, including flights on an employer-provided aircraft.535 In general, the value of a non-commercial flight generally is determined under the base aircraft valuation formula, also known as the Standard Industry Fare Level formula or "SIFL."536 If the SIFL valuation rules do not apply, the value of a flight on a company-provided aircraft generally is equal to the amount that an individual would have to pay in an arm's-length transaction to charter the same or a comparable aircraft for that period for the same or a comparable flight.537

In the context of an employer providing an aircraft to employees for nonbusiness (e.g., vacation) flights, the exception for expenses treated as compensation was interpreted as not limiting the company's deduction for expenses attributable to the operation of the aircraft to the amount of compensation reportable to its employees, which can result in a deduction many times larger than the amount required to be included in income.538 In many cases, the individual including amounts attributable to personal travel in income directly benefits from the enhanced deduction, resulting in a net deduction for the personal use of the company aircraft.

The exceptions were subsequently modified in the case of specified individuals such that the exceptions to the general entertainment expense disallowance rule for expenses treated as compensation or includible in income apply only to the extent of the amount of expenses treated as compensation or includible in income of the specified individual.539 Specified individuals are individuals who, with respect to an employer or other service recipient (or a related party), are subject to the requirements of section 16(a) of the Securities Exchange Act of 1934, or would be subject to such requirements if the employer or service recipient (or related party) were an issuer of equity securities referred to in section 16(a).540

As a result, in the case of specified individuals, no deduction is allowed with respect to expenses for (1) a nonbusiness activity generally considered to be entertainment, amusement or recreation, or (2) a facility (e.g., an airplane) used in connection with such activity to the extent that such expenses exceed the amount treated as compensation or includible in income to the specified individual. For example, a company's deduction attributable to aircraft operating costs and other expenses for a specified individual's vacation use of a company aircraft is limited to the amount reported as compensation to the specified individual. However, in the case of other employees or service providers, the company's deduction is not limited to the amount treated as compensation or includible in income.541

Excludable fringe benefits

Certain employer-provided fringe benefits are excluded from an employee's gross income and wages for employment tax purposes, including de minimis fringes and qualified transportation fringes.542 A de minimis fringe generally means any property or services the value of which is (taking into account the frequency with which similar fringes are provided by the employer) so small as to make accounting for it unreasonable or administratively impracticable.543 Qualified transportation fringes include qualified parking (i.e., on or near the employer's business premises or on or near a location from which the employee commutes to work by public transit), transit passes, vanpool benefits, and qualified bicycle commuting reimbursements.544

 

Description of Proposal

 

 

The proposal provides that no deduction is allowed with respect to (1) an activity generally considered to be entertainment, amusement or recreation, (2) membership dues with respect to any club organized for business, pleasure, recreation or other social purposes, (3) a de minimis fringe that is primarily personal in nature and involving property or services that are not directly related to the taxpayer's trade or business, (4) a facility or portion thereof used in connection with any of the above items, or (5) a qualified transportation fringe, including costs of operating a facility used for qualified parking. Thus, the proposal repeals the present law exception to the deduction disallowance for entertainment, amusement, or recreation that is directly related to (or, in certain cases, associated with) the active conduct of the taxpayer's trade or business (and the related rule applying a 50 percent limit to such deductions). The proposal also repeals the present law exception for recreational, social, or similar activities primarily for the benefit of employees. However, taxpayers may still, generally, deduct 50 percent of the food and beverage expenses associated with operating their trade or business (e.g., meals consumed by employees on work travel).

Under the proposal, in the case of all individuals (not just specified individuals), the exceptions to the general entertainment expense disallowance rule for expenses treated as compensation or includible in income apply only to the extent of the amount of expenses treated as compensation or includible in income. Thus, under those exceptions, no deduction is allowed with respect to expenses for (1) a nonbusiness activity generally considered to be entertainment, amusement or recreation, or (2) a facility (e.g., an airplane) used in connection with such activity to the extent that such expenses exceed the amount treated as compensation or includible in income. As under present law, the exceptions apply only if amounts are properly reported by the company as compensation and wages or otherwise includible in income.

The proposal amends the present-law exception for reimbursed expenses. The proposal disallows a deduction for amounts paid or incurred by a taxpayer in connection with the performance of services for another person (other than an employee) under a reimbursement or other expense allowance arrangement if the person for whom the services are performed is a tax-exempt entity545 or the arrangement is designated by the Secretary as having the effect of avoiding the 50 percent deduction disallowance.

The proposal clarifies that the exception to the 50 percent deduction limit for food or beverages applies to any expense excludible from the gross income of the recipient related to meals furnished for the convenience of the employer. The proposal thereby repeals as deadwood the special exceptions for food or beverages provided to crew members of certain commercial vessels and certain oil or gas platform or drilling rig workers.

 

Effective Date

 

 

The proposal applies to amounts paid or incurred after December 31, 2014.

27. Repeal of limitation on corporate acquisition indebtedness (sec. 3127 of the discussion draft and sec. 279 of the Code)

 

Present Law

 

 

The Code contains several provisions that limit corporate interest deductions in certain circumstances.

One provision, enacted in 1969, denies a corporate interest deduction for interest in excess of five million dollars on corporate acquisition indebtedness. Corporate acquisition indebtedness is debt under certain subordinated obligations546 issued to provide consideration for the acquisition of stock or assets of another corporation. The conditions under which the provision applies are further limited. Also, the provision does not apply unless, as of the last day of the taxable year of the issuing corporation in which it issues an obligation, the debt to equity ratio of the issuing corporation exceeds two to one and the projected earnings (as defined)547 do not exceed three times the annual interest to be paid or incurred. Also, the obligation must be either convertible directly or indirectly into stock of the issuing corporation, or part of an investment unit or other arrangement which includes, in addition to such bond or other evidence of indebtedness, an option to acquire, directly or indirectly, stock in the issuing corporation. Special rules apply to banks and lending or finance companies.

 

Description of Proposal

 

 

The proposal repeals the corporate acquisition indebtedness interest limitation

 

Effective Date

 

 

The proposal applies to interest paid or incurred with respect to indebtedness incurred after December 31, 2014.

28. Denial of deductions and credits for expenditures in illegal businesses (sec. 3128 of the discussion draft and sec. 280E of the Code)

 

Present Law

 

 

Under present law, ordinary and necessary expenses of carrying on a trade or business generally are deductible.548 However, the Code expressly provides that certain business expenses that otherwise might be treated as ordinary and necessary are nondeductible.

These nondeductible expenses include bribes, kickbacks, and other payments that are illegal under Federal or State law.549 Specified types of payments that are not illegal, but are of such nature that the Congress has determined that deductibility would frustrate a public policy objective, also are made nondeductible.

One such specified type of nondeductible payment that would frustrate public policy relates to illegal sales of drugs. Specifically, section 280E disallows deductions in connection with the trade or business of trafficking in controlled substances.

 

Description of Proposal

 

 

The proposal expands the section 280E definition of nondeductible expenses to include amounts paid or incurred in carrying on a trade or business if such trade or business is a felony under Federal law or the law of any State in which such trade or business is conducted.

 

Effective Date

 

 

The proposal applies to amounts paid or incurred after the date of the enactment in taxable years ending after the date of the enactment.

29. Limitation on Deduction for FDIC Premiums (sec. 3129 of the discussion draft and sec. 162 of the Code)

 

Present Law

 

 

Corporations generally

Corporations organized under the laws of any of the 50 States (and the District of Columbia) generally are subject to the U.S. corporate income tax on their worldwide taxable income. The taxable income of a C corporation550 generally is comprised of gross income less allowable deductions. A taxpayer generally is allowed a deduction for ordinary and necessary expenses paid or incurred in carrying on any trade or business.551

Corporations that make a valid election pursuant to section 1362 of subchapter S of Chapter 1 of the Code, referred to as S corporations, are taxed differently. In general, an S corporation is not subject to corporate-level income tax on its items of income and loss. Instead, an S corporation passes through to shareholders its items of income and loss. The shareholders separately take into account their shares of these items on their individual income tax returns.

Banks, thrifts, and credit unions

 

In general

 

Financial institutions are subject to the same Federal income tax rules and rates as are applied to other corporations or entities, with specified exceptions

 

C corporation banks and thrifts

 

A bank is generally taxed for Federal income tax purposes as a C corporation. For this purpose a bank generally means a corporation, a substantial portion of whose business is receiving deposits and making loans and discounts, or exercising certain fiduciary powers.552 A bank for this purpose generally includes domestic building and loan associations, mutual stock or savings banks, and certain cooperative banks that are commonly referred to as thrifts.553

 

S corporation banks

 

A bank is generally eligible to elect S corporation status under section 1362, provided it meets the other requirements for making this election and it does not use the reserve method of accounting for bad debts as described in section 585.554

 

Special bad debt loss rules for small banks

 

Section 166 provides a deduction for any debt that becomes worthless (wholly or partially) within a taxable year. The reserve method of accounting for bad debts was repealed in 1986555 for most taxpayers, but is allowed under section 585 for any bank (as defined in section 581) other than a large bank. For this purpose, a bank is a large bank if for the taxable year (or for any preceding taxable year after 1986) the average adjusted basis of all its assets (or the assets of the controlled group of which it was a member) exceeds $500 million. Deductions for reserves are taken in lieu of a worthless debt deduction under section 166. Accordingly, a small bank is able to take deductions for additions to a bad debt reserve. Additions to the reserve are determined under an experience method that looks to the ratio of (1) total bad debts sustained during a taxable year to (2) the total bad debts over the five preceding taxable years. A large bank is allowed a deduction for specific bad debts charged off during a taxable year.

 

Credit unions

 

Credit unions are exempt from Federal income taxation.556 The exemption is based on their status as not-for-profit mutual or cooperative organizations (without capital stock) operated for the benefit of their members, who generally must share a common bond. The definition of common bond has been expanded to permit greater utilization of credit unions.557 While significant differences between the rules under which credit unions and banks operate have existed in the past, most of those differences have disappeared over time.558

FDIC premiums

The Federal Deposit Insurance Corporation ("FDIC") provides deposit insurance for banks and savings institutions. To maintain its status as an insured depository institution, a bank must pay semiannual assessments into the deposit insurance fund. Assessments for deposit insurance are treated as ordinary and necessary business expenses. These assessments, also known as premiums, are deductible once the all events test for the premium is satisfied.559

 

Description of Proposal

 

 

No deduction is allowed for the applicable percentage of any FDIC premium paid or incurred by the taxpayer. For taxpayers with total consolidated assets of $50 billion or more, the applicable percentage is 100 percent. Otherwise, the applicable percentage is the ratio of the excess of total consolidated assets over $10 billion to $40 billion. For example, for a taxpayer with total consolidated assets of $20 billion, no deduction is allowed for 25 percent of FDIC premiums. The proposal does not apply to taxpayers with total consolidated assets (as of the close of the taxable year) that do not exceed $10 billion.

FDIC premium means any assessment imposed under section 7(b) of the Federal Deposit Insurance Act.560 The term total consolidated assets has the meaning given such term under section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.561

For purposes of determining a taxpayer's total consolidated assets, members of an expanded affiliated group are treated as a single taxpayer. An expanded affiliated group means an affiliated group as defined in section 1504(a) (related to consolidated returns) determined by substituting "more than 50 percent" for "at least 80 percent" each place it appears and without regard to the exceptions from the definition of includible corporation for insurance companies and foreign corporations. A partnership or any other entity other than a corporation is treated as a member of an expanded affiliated group if such entity is controlled by members of such group.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

30. Repeal of percentage depletion (sec. 3130 of the discussion draft and secs. 613 and 613A of the Code)

 

Present Law

 

 

In general

Depletion, like depreciation, is a form of capital cost recovery. In both cases, the taxpayer is allowed a deduction in recognition of the fact that an asset is being expended to produce income.562 Certain costs incurred prior to drilling an oil or gas property or extracting minerals are recovered through the depletion deduction.563 These include the cost of acquiring the lease or other interest in the property. In certain instances, the cost of land used in production also is recovered through the depletion deduction.564

Depletion is available to any person having an economic interest in a producing property.565 An economic interest is possessed in every case in which the taxpayer has acquired by investment any interest in minerals in place, and secures, by any form of legal relationship, income derived from the extraction of the mineral, to which it must look for a return of its capital.566 Thus, for example, both working interests and royalty interests in an oil- or gas-producing property constitute economic interests, thereby qualifying the interest holders for depletion deductions with respect to the property. A taxpayer who has no capital investment in the mineral deposit, however, does not acquire an economic interest merely by possessing an economic or pecuniary advantage derived from production through a contractual relation.567

Two methods of depletion are currently allowable under the Code: (1) the cost depletion method, and (2) the percentage depletion method.568 Under the cost depletion method, the taxpayer deducts that portion of the adjusted basis of the depletable property which is equal to the ratio of units sold from that property during the taxable year to the number of units remaining as of the end of taxable year plus the number of units sold during the taxable year.569 Thus, the amount recovered under cost depletion may never exceed the taxpayer's basis in the property.570

Under the percentage depletion method, a percentage, varying from five percent to 22 percent, of the taxpayer's gross income from a producing property is allowed as a deduction in each taxable year.571 The Code generally limits the percentage depletion method for oil and gas properties to independent producers and royalty owners.572 Such producers and royalty owners generally may claim percentage depletion at a rate of 15 percent.573

The amount deducted generally may not exceed 50 percent (100 percent in the case of oil and gas properties) of the taxable income from the property in any taxable year.574 Additionally, the percentage depletion deduction for all oil and gas properties may not exceed 65 percent of the taxpayer's overall taxable income for the year (determined before such deduction, as well as before any deduction allowable under section 199, and adjusted for certain loss carrybacks and trust distributions).575 Because percentage depletion, unlike cost depletion, is computed without regard to the taxpayer's basis in the depletable property, cumulative depletion deductions may be greater than the amount expended by the taxpayer to acquire and/or develop the property.576

A taxpayer is required to determine the depletion deduction for each property under both the percentage depletion method (if the taxpayer is entitled to use this method) and the cost depletion method. If the cost depletion deduction is larger, the taxpayer must utilize that method for the taxable year in question.577

Limitation on oil and gas percentage depletion to independent producers and royalty owners

As stated above, percentage depletion of oil and gas properties generally is not permitted, except for independent producers and royalty owners, certain fixed-price gas contracts, and natural gas from geopressured brine. For purposes of the percentage depletion allowance, an independent producer is any producer that is not a "retailer" or "refiner." A retailer is any person that directly, or through a related person, sells oil or natural gas (or a derivative thereof): (1) through any retail outlet operated by the taxpayer or related person, or (2) to any person that is obligated to market or distribute such oil or natural gas (or a derivative thereof) under the name of the taxpayer or the related person, or that has the authority to occupy any retail outlet owned by the taxpayer or a related person.578

Bulk sales of crude oil and natural gas to commercial or industrial users, and bulk sales of aviation fuel to the Department of Defense, are not treated as retail sales.579 Further, if the combined gross receipts of the taxpayer and all related persons from the retail sale of oil, natural gas, or any product derived therefrom do not exceed $5 million for the taxable year, the taxpayer will not be treated as a retailer.580

A refiner is any person that directly or through a related person engages in the refining of crude oil in excess of an average daily refinery run of 75,000 barrels during the taxable year.581

Percentage depletion for eligible taxpayers is allowed for up to 1,000 barrels of average daily production of domestic crude oil or an equivalent amount of domestic natural gas.582 For producers of both oil and natural gas, this limitation applies on a combined basis. All production owned by businesses under common control and members of the same family must be aggregated;583 each group is then treated as one producer in applying the 1,000-barrel limitation.

In addition to independent producers and royalty owners, certain sales of natural gas under a fixed contract in effect on February 1, 1975, and certain natural gas from geopressured brine, are eligible for percentage depletion, at rates of 22 percent and 10 percent, respectively. These exceptions apply without regard to the 1,000-barrel-per-day limitation and regardless of whether the producer is an independent producer or an integrated oil company.

Prior to the enactment of the Omnibus Budget Reconciliation Act of 1990 (the "1990 Act"), if an interest in a proven oil or gas property was transferred (subject to certain exceptions), the production from such interest did not qualify for percentage depletion.584 The 1990 Act repealed the limitation on claiming percentage depletion on transferred properties effective for property transfers occurring after October 11, 1990.

Percentage depletion on marginal production

The 1990 Act also created a special percentage depletion provision for oil and gas production from so-called marginal properties held by independent producers or royalty owners.585 Under this provision, the statutory percentage depletion rate is increased (from the general rate of 15 percent) by one percent for each whole dollar that the average price of crude oil for the immediately preceding calendar year is less than $20 per barrel. In no event may the rate of percentage depletion under this provision exceed 25 percent for any taxable year. The increased rate applies for the taxpayer's taxable year that immediately follows a calendar year for which the average crude oil price falls below the $20 floor. To illustrate the application of this provision, the average price of a barrel of crude oil for calendar year 1999 was $15.56.586 Thus, the percentage depletion rate for production from marginal wells was increased to 19 percent for taxable years beginning in 2000. Since the price of oil currently is above the $20 floor, there is no increase in the statutory depletion rate for marginal production (and has not been since 2000).587

The Code defines the term "marginal production" for this purpose as domestic crude oil or domestic natural gas which is produced during any taxable year from a property which (1) is a stripper well property for the calendar year in which the taxable year begins, or (2) is a property substantially all of the production from which during such calendar year is heavy oil (i.e., oil that has a weighted average gravity of 20 degrees API or less, corrected to 60 degrees Fahrenheit).588 A stripper well property is any oil or gas property that produces a daily average of 15 or fewer equivalent barrels of oil and gas per producing oil or gas well on such property in the calendar year during which the taxpayer's taxable year begins.589

The determination of whether a property qualifies as a stripper well property is made separately for each calendar year. The fact that a property is or is not a stripper well property for one year does not affect the determination of the status of that property for a subsequent year. Further, a taxpayer makes the stripper well property determination for each separate property interest (as defined under section 614) held by the taxpayer during a calendar year. The determination is based on the total amount of production from all producing wells that are treated as part of the same property interest of the taxpayer. A property qualifies as a stripper well property for a calendar year only if the wells on such property were producing during that period at their maximum efficient rate of flow.590

If a taxpayer's property consists of a partial interest in one or more oil- or gas-producing wells, the determination of whether the property is a stripper well property or a heavy oil property is made with respect to total production from such wells, including the portion of total production attributable to ownership interests other than the taxpayer's interest.591 If the property satisfies the requirements of a stripper well property, then the benefits of this provision apply with respect to the taxpayer's allocable share of the production from the property.592 The deduction is allowed for the taxable year that begins during the calendar year in which the property so qualifies.

The allowance for percentage depletion on production from marginal oil and gas properties is subject to the 1,000-barrel-per-day limitation discussed above. Unless a taxpayer elects otherwise, marginal production is given priority over other production for purposes of utilization of that limitation.

Percentage depletion for hard mineral fossil fuel properties

Percentage depletion is available for taxpayers with an economic interest in a coal mine or other hard mineral fossil fuel property such as lignite or oil shale properties. The depletion rate for coal and lignite is 10 percent.593 For oil shale, the rate generally is 15 percent, but the rate drops to 7.5 percent for shale used or sold for use in the manufacture of sewer pipe or brick or as sintered or burned lightweight aggregates.594

As noted above, the percentage depletion deduction is limited to 50 percent of the taxable income from the property (determined before depletion and the deduction under section 199). Additionally, a corporation's percentage depletion deduction with respect to coal or lignite properties is reduced by 20 percent of the excess of the percentage depletion deduction over the adjusted basis of the property at the close of the taxable year (determined without regard to the depletion deduction for the taxable year).595

The excess of percentage depletion over cost depletion is a tax preference in computing a taxpayer's alternative minimum taxable income.596

 

Description of Proposal

 

 

The proposal repeals percentage depletion under sections 613 and 613A. Cost depletion, however, remains available under section 611.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

31. Repeal of passive activity exception for working interests in oil and gas property (sec. 3131 of the discussion draft and sec. 469 of the Code)

 

Present Law

 

 

The passive loss rules generally limit deductions and credits from passive trade or business activities.597 A passive activity for this purpose is a trade or business activity in which the taxpayer owns an interest, but in which the taxpayer does not materially participate.598 A taxpayer is treated as materially participating in an activity only if the taxpayer is involved in the operation of the activity on a basis that is regular, continuous, and substantial.599 Deductions attributable to passive activities, to the extent they exceed income from passive activities, generally may not be deducted against other income.600 Deductions and credits that are suspended under these rules are carried forward and treated as deductions and credits from passive activities in the next year.601 The suspended losses from a passive activity are allowed in full when a taxpayer disposes of his entire interest in the passive activity to an unrelated person.602

Losses from certain working interests in oil and gas property are not limited under the passive loss rule.603 Thus, losses and credits from such interests can be used to offset other income of the taxpayer without limitation under the passive loss rule. Specifically, a passive activity does not include a working interest in any oil or gas property that the taxpayer holds directly or through an entity that does not limit the liability of the taxpayer with respect to the interest.604 This rule applies without regard to whether the taxpayer materially participates in the activity.605 If the taxpayer has a loss from a working interest in any oil or gas property that is treated as not from a passive activity, then net income from the property for any succeeding taxable year is treated as income of the taxpayer that is not from a passive activity.606

In general, a working interest is an interest with respect to an oil and gas property that is burdened with the cost of development and operation of the property.607 Rights to overriding royalties, production payments, and the like, do not constitute working interests, because they are not burdened with the responsibility to share expenses of drilling, completing, or operating oil and gas property. Similarly, contract rights to extract or share in oil and gas, or in profits from extraction, without liability to share in the costs of production, do not constitute working interests. Income from such interests generally is considered to be portfolio (i.e., passive) income.

When the taxpayer's form of ownership limits the liability of the taxpayer, the interest possessed by such taxpayer is not a working interest for purposes of the passive loss provision.608 Thus, for purposes of the passive loss rules, an interest owned by a limited partnership is not treated as a working interest with regard to any limited partner, and an interest owned by an S corporation is not treated as a working interest with regard to any shareholder.609 The same result follows with respect to any form of ownership that is substantially equivalent in its effect on liability to a limited partnership interest or interest in an S corporation, even if different in form.

When an interest is not treated as a working interest because the taxpayer's form of ownership limits his liability, the general rules regarding material participation apply to determine whether the interest is treated as a passive activity.610 Thus, for example, a limited partner's interest generally is treated as a passive activity. In the case of a shareholder in an S corporation, the general facts and circumstances test for material participation applies and the working interest exception does not apply, because the form of ownership limits the taxpayer's liability.

A special rule applies in any case where, for a prior taxable year, net losses from a working interest in a property were treated by the taxpayer as not from a passive activity.611 In such a case, any net income realized by the taxpayer from the property (or from any substituted basis property, e.g., property acquired in a section 1031 like kind exchange for such property) in a subsequent year also is treated as active. Under this rule, for example, if a taxpayer claims losses for a year with regard to a working interest and then, after the property to which the interest relates begins to generate net income, transfers the interest to an S corporation in which he is a shareholder, or to a partnership in which he has an interest as a limited partner, his interest with regard to the property continues to be treated as not passive.612

 

Description of Proposal

 

 

The proposal repeals the exception for passive losses from working interests in oil and gas properties. Thus, working interests in oil and gas properties are fully subject to the passive loss rules.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

32. Repeal of special rules for gain or loss on timber, coal, or domestic iron ore (sec. 3132 of the discussion draft and sec. 631 of the Code)

 

Present Law

 

 

Timber

In general, proceeds from the sale of inventoriable goods are taxed as ordinary income for Federal income tax purposes.613 However, a taxpayer disposing of timber held for more than one year is eligible to elect capital gains treatment in the following situations. First, if the taxpayer sells or exchanges timber that is a capital asset614 or property used in the trade or business,615 the gain generally is long-term capital gain; however, if the timber is held for sale to customers in the taxpayer's business, the gain will be ordinary income. Second, if the taxpayer disposes of the timber and either retains an economic interest in such timber or makes an outright sale of such timber, the gain is eligible for capital gain treatment.616 Third, if the taxpayer cuts standing timber, the taxpayer may elect to treat the cutting as a sale or exchange eligible for capital gains treatment.617

Coal or domestic iron ore

Similar to proceeds from the sale of inventoriable goods, royalties generally are taxed as ordinary income for Federal income tax purposes. However, the Code provides a special rule that treats royalties from certain dispositions of coal or domestic iron ore as capital gains. Specifically, in the case of the disposal of coal (including lignite), or iron ore mined in the United States, held for more than one year prior to disposal by the owner in a form under which the owner retains an economic interest in such coal or iron ore, the excess of the amount realized from the sale over the adjusted depletable basis of the coal or iron ore plus certain disallowed deductions is treated as the sale of depreciable property used in the owner's trade or business (i.e., the sale of section 1231 property).618 For these purposes, an owner means any person who owns an economic interest in coal or iron ore in place, including a lessee or sublessor thereof.619The exception does not apply to income realized by any owner as a co-adventurer, partner, or principal in the mining of such coal or iron ore.620

Section 1231 generally provides that if recognized gains on the sale or exchange of property used in a taxpayer's trade or business,621 plus certain gains on involuntary conversions, exceed losses from such sales, exchanges, or conversions, the gain is long-term capital gain.622 If losses exceed gains, the losses are treated as ordinary losses. The net ordinary losses are subject to certain recapture provisions. Thus, if the owner's section 1231 gains, including royalties from coal or iron ore disposals described in section 631(c), exceed its section 1231 losses, the royalties will be treated as long-term capital gains.

Section 631(c) is not elective. Thus, if a taxpayer meets the requirements of the section, royalties from the disposal of coal or iron ore will be treated as the disposition of section 1231 property. An owner may not claim percentage depletion with respect to coal or iron ore that is subject to section 631(c) if for the taxable year of the sale the maximum tax rate for capital gains or losses is less than the maximum tax rate for ordinary income.623

 

Description of Proposal

 

 

This proposal repeals section 631 such that gains or losses from the sale or exchange of timber, coal, or domestic iron ore will not receive capital gain treatment.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

33. Repeal of like-kind exchanges (sec. 3133 of the discussion draft and sec. 1031 of the Code)

 

Present Law

 

 

An exchange of property, like a sale, generally is a taxable event. However, no gain or loss is recognized if property held for productive use in a trade or business or for investment is exchanged for property of a "like-kind" which is to be held for productive use in a trade or business or for investment.624 In general, section 1031 does not apply to any exchange of stock in trade or other property held primarily for sale; stocks, bonds or notes; other securities or evidences of indebtedness or interest; interests in a partnership; certificates of trust or beneficial interests; or choses in action.625 Section 1031 also does not apply to certain exchanges involving livestock626 or involving foreign property.627

The nonrecognition of gain in a like-kind exchange applies only to the extent that like-kind property is received in the exchange. Thus, if an exchange of property would meet the requirements of section 1031, but for the fact that the property received in the transaction consists not only of the property that would be permitted to be exchanged on a tax-free basis, but also other property or money, then the gain to the recipient of the other property or money is to be recognized, but not in an amount exceeding the fair market value of such other property or money.628 Additionally, any gain realized on a section 1031 exchange must be recognized to the extent that the gain is subject to the recapture provisions of sections 1245 and 1250.629 No losses may be recognized from a like-kind exchange.630

If section 1031 applies to an exchange of properties, the basis of the property received in the exchange631 is equal to the basis of the property transferred. This basis is increased to the extent of any gain recognized due to the receipt of other property or money in the like-kind exchange, and decreased to the extent of any money received by the taxpayer.632 The holding period of qualifying property received includes the holding period of the qualifying property transferred, but the nonqualifying property received is required to begin a new holding period.633

 

Description of Proposal

 

 

The proposal repeals the provision providing for nonrecognition of gain in the case of like-kind exchanges.

 

Effective Date

 

 

The proposal generally applies to transfers after December 31, 2014. However, an exception to repeal is provided for any transfer subject to a written binding contract entered into before January 1, 2015, where such transfer is completed before January 1, 2017.

34. Restriction on trade or business property treated as similar or related in service to involuntarily converted property in disaster areas (sec. 3134 of the discussion draft and sec. 1033 of the Code)

 

Present Law

 

 

Generally, a taxpayer realizes gain to the extent the sales price (and any other consideration received) exceeds the taxpayer's basis in the property.634 The realized gain is subject to current income tax unless the recognition of the gain is deferred or excluded from income under a special tax provision.

Section 1033 provides an exception to this rule in the case of certain involuntary conversions of property.635 Under section 1033, gain realized by a taxpayer from an involuntary conversion of property is deferred to the extent the taxpayer purchases property similar or related in service or use to the converted property within the applicable period.636 If the taxpayer receives money (e.g., insurance proceeds) and acquires qualified replacement property within the prescribed time period, the taxpayer's basis in the replacement property generally is the cost of such property, reduced by the amount of gain not recognized.637

The applicable period for the taxpayer to replace the converted property begins with the date of the disposition of the converted property (or if earlier, the earliest date of the threat or imminence of requisition or condemnation of the converted property) and ends two years after the close of the first taxable year in which any part of the gain upon conversion is realized (the "replacement period").638

Special rules extend the replacement period for certain real property639 and principal residences damaged by a Federally declared disaster640 to three years and four years, respectively, after the close of the first taxable year in which gain is realized. Similarly, the replacement period for livestock sold on account of drought, flood, or other weather-related conditions is extended from two years to four years after the close of the first taxable year in which any part of the gain on conversion is realized.641

 

Description of Proposal

 

 

With respect to property held for productive use in a trade or business or for investment located in a disaster area, the proposal modifies the rules related to property compulsorily or involuntarily converted as a result of a Federally declared disaster. Specifically, the proposal provides gain deferral for such trade or business or investment property that was compulsorily or involuntarily converted as a result of a Federally declared disaster only in instances where the replacement property has a class life equal to, or less than, the property that was involuntarily converted.

 

Effective Date

 

 

The proposal applies to disasters declared after December 31, 2014.

35. Repeal of rollover of publicly traded securities gain into specialized small business investment companies (sec. 3135 of the discussion draft and sec. 1044 of the Code)

 

Present Law

 

 

Under present law, a corporation or individual may elect to roll over tax-free any capital gain realized on the sale of publicly-traded securities to the extent of the taxpayer's cost of purchasing common stock or a partnership interest in a specialized small business investment company ("SSBIC") within 60 days of the sale. The amount of gain that an individual may elect to roll over under this provision for a taxable year is limited to $50,000 or (2) $500,000 reduced by the gain previously excluded under this provision. For corporations, these limits are $250,000 and $1 million, respectively.

 

Description of Proposal

 

 

The proposal repeals this provision.

 

Effective Date

 

 

The proposal applies to sales after December 31, 2014.

36. Termination of special rules for gain from certain small business stock (sec. 3136 of the discussion draft and secs. 1045 and 1202 of the Code)

 

Present Law

 

 

Exclusion of gain on sale of small business stock

 

In general

 

Individuals generally may exclude 50 percent (60 percent for certain empowerment zone businesses) of the gain from the sale of certain small business stock acquired at original issue and held for at least five years.642 The amount of gain eligible for the exclusion by an individual with respect to any corporation is the greater of (1) ten times the taxpayer's basis in the stock or (2) $10 million. To qualify as a small business, when the stock is issued, the gross assets of the corporation may not exceed $50 million. The corporation also must meet certain active trade or business requirements.

The portion of the gain includible in taxable income is taxed at a maximum rate of 28 percent under the regular tax.643 Seven percent of the excluded gain is an alternative minimum tax preference;644 the portion of the gain includible in alternative minimum taxable income is taxed at a maximum rate of 28 percent under the alternative minimum tax.

 

Temporary increases in exclusion

 

The percentage exclusion for qualified small business stock acquired after February 17, 2009, and on or before September 27, 2010, is increased to 75 percent.

For stock acquired after September 27, 2010, and before January 1, 2014, the percentage exclusion for qualified small business stock sold by an individual is increased to 100 percent and the minimum tax preference does not apply.

Rollover of gain from sale of small business stock

An individual may elect to rollover gain from the sale of qualified small business stock held more than six months where other qualified small business stock is purchased during the 60 day period beginning on the date of sale.645

 

Description of Proposal

 

 

The proposal repeals the exclusion for gain on the sale of small business stock and repeals the rollover provision.

 

Effective Date

 

 

The repeal of the exclusion applies to stock issued after the date of enactment.

The repeal of the rollover provision applies to sales and exchanges after that date.

37. Certain self-created property not treated as a capital asset (sec. 3137 of the discussion draft and sec. 1221 of the Code)

 

Present Law

 

 

In general, property held by a taxpayer (whether or not connected with his trade or business) is considered a capital asset.646 Certain assets, however, are specifically excluded from the definition of capital asset. Such excluded assets are: inventory property, property of a character subject to depreciation (including real property),647 certain self-created intangibles, accounts or notes receivable acquired in the ordinary course of business (e.g., for providing services or selling property), publications of the U.S. Government received by a taxpayer other than by purchase at the price offered to the public, commodities derivative financial instruments held by a commodities derivatives dealer unless clearly identified as a capital asset, hedging transactions clearly identified as such, and supplies regularly used or consumed by the taxpayer in the ordinary course of business.648

Self-created intangibles subject to the exception are copyrights, literary, musical, or artistic compositions, letters or memoranda, or similar property which is held either by the taxpayer who created the property, or (in the case of a letter, memorandum, or similar property) a taxpayer for whom the property was produced. For the purpose of determining gain, a taxpayer with a substituted or transferred basis from the taxpayer who created the property, or for whom the property was created, also is subject to the exception.649 However, a taxpayer may elect to treat musical compositions and copyrights in musical works as capital assets.650

Since the intent of Congress is that profits and losses arising from everyday business operations be characterized as ordinary income and loss, the general definition of capital asset is narrowly applied and the categories of exclusions are broadly interpreted.651

 

Description of Proposal

 

 

This proposal amends section 1221(a)(3), resulting in the exclusion of a patent, invention, model or design (whether or not patented), a secret formula or process which is held either by the taxpayer who created the property or a taxpayer with a substituted or transferred basis from the taxpayer who created the property (or for whom the property was created) from the definition of a "capital asset." Thus, gains or losses from the sale or exchange of a patent, invention, model or design (whether or not patented), or a secret formula or process which is held either by the taxpayer who created the property or a taxpayer with a substituted or transferred basis from the taxpayer who created the property (or for whom the property was created) will not receive capital gain treatment.

The proposal also repeals the elective capital treatment for musical compositions and copyrights in musical works. Thus, gains or losses from the sale or exchange of musical compositions and copyrights in musical works will not receive capital gain treatment.

 

Effective Date

 

 

The proposal applies to dispositions after December 31, 2014.

38. Repeal special rule for sale or exchange of patents (sec. 3138 of the discussion draft and sec. 1235 of the Code)

 

Present Law

 

 

Section 1235 provides that a transfer652 of all substantial rights to a patent, or an undivided interest therein which includes a part of all of such rights, by any holder shall be considered the sale or exchange of a capital asset held for more than one year, regardless of whether or not payments in consideration of such transfer are (1) payable periodically over a period generally conterminous with the transferee's use of the patent or (2) contingent upon the productivity, use, or disposition of the property transferred.653

A holder is defined as (1) any individual whose efforts created such property, or (2) any other individual who has acquired his interest in such property in exchange for consideration in money or money's worth paid to such creator prior to actual reduction to practice of the invention covered by the patent, if such individual is neither the employer of such creator nor related (as defined) to such creator.654

 

Description of Proposal

 

 

The proposal repeals section 1235. Thus, the holder of a patented invention may not transfer his or her rights to the patent and treat amounts received as proceeds from the sale of a capital asset. It is intended that the determination of whether a transfer is a sale or exchange of a capital asset that produces capital gain, or a transaction that produces ordinary income, will be determined under generally applicable principles.655

 

Effective Date

 

 

The proposal applies to dispositions after December 31, 2014.

39. Depreciation recapture on gain from disposition of certain depreciable realty (sec. 3139 of the discussion draft and sec. 1250 of the Code)

 

Present Law

 

 

Upon disposition of most property used in a business on which depreciation or amortization deductions were taken, the treatment of the resulting gain or loss as ordinary or capital depends on whether there is a net gain or a net loss under section 1231. If the netting of gains and losses results in a net gain, then, subject to the depreciation recapture rules, long-term capital gain treatment results.656 If the netting of gains and losses results in a loss, the loss is fully deductible against ordinary income.657

The depreciation recapture rules require taxpayers to recognize ordinary income in an amount equal to all or a portion of the gain realized as a result of the disposition of property. The purpose of the rules is to limit a taxpayer's ability to reduce ordinary income via depreciation deductions and then receive capital gain treatment for the portion of any gain on the disposition of the depreciated property that resulted from the taking of depreciation deductions. There are two regimes that dictate depreciation recapture, sections 1245 and 1250.658

Depreciable personal property, whether tangible or intangible, and certain depreciable real property (typically real property that performs specific functions in a business, but not buildings or structural components of buildings) disposed of at a gain are known as section 1245 property.659 When a taxpayer disposes of section 1245 property, the taxpayer must recapture the gain on disposition of the property as ordinary income to the extent of earlier depreciation or amortization deductions taken with respect to the asset.660 Any remaining gain recognized upon the sale of section 1245 property is treated as section 1231 gain.

Depreciable real property, other than that included within the definition of section 1245 property, disposed of at a gain is known as section 1250 property.661 Gain on the disposition of section 1250 property is treated as ordinary income, rather than capital gain, only to the extent of the excess of post-1969 depreciation allowances over the depreciation that would have been available under the straight-line method.662 However, if section 1250 property is held for one year or less, all depreciation is recaptured, regardless of whether it exceeds the depreciation that would have been available under the straight-line method. Special rules phase out the recapture for certain types of property held over a specified period of time.663 Further, for corporations, the amount treated as ordinary income on the disposition of section 1250 property is increased by 20 percent of the additional amount that would be treated as ordinary income if the property were subject to recapture under the rules for section 1245 property.664

 

Description of Proposal

 

 

Under the proposal, a taxpayer must recapture the gain on disposition of section 1250 property as ordinary income to the extent of earlier depreciation deductions taken with respect to the asset. Recapture of depreciation attributable to periods before January 1, 2015, is limited to the depreciation adjustments only to the extent that they exceed the depreciation that would have been available under the straight-line method. However, if section 1250 property is held for one year or less, all depreciation is recaptured, regardless of whether it exceeds the depreciation that would have been available under the straight-line method.

 

Effective Date

 

 

The proposal applies to dispositions after December 31, 2014.

 

C. Reform of Business Credits

 

 

1. Repeal credit for alcohol used as a fuel, etc. (sec. 3201 of the discussion draft and sec. 40 of the Code)

 

Present Law

 

 

Section 40 of the Internal Revenue Code consists of the sum of four income tax credits: (1) the alcohol mixture credit, (2) the alcohol credit, (3) in the case of an eligible small producer, the small ethanol producer credit, plus (4) the second generation biofuel producer credit. All but the second generation biofuel producer credit, expired on December 31, 2011. The second generation biofuel producer credit expired on December 31, 2013.

The alcohol mixture credit also was available as an excise tax credit or payment. The excise tax credits and payments were coordinated with the Section 40 income tax credit, so that the income tax credit was reduced by any benefit received as an excise tax credit or payment. The excise tax credit and payment incentives for alcohol fuel also expired December 31, 2011.

 

Description of Proposal

 

 

The proposal repeals all of section 40 (the alcohol mixture credit, the alcohol credit, the small ethanol producer credit, plus the second generation biofuel producer credit). The proposal also removes from the Code the related excise tax credit and payment provisions and makes conforming amendments.

 

Effective Date

 

 

The proposal is effective for fuel sold or used after December 31, 2013.

2. Repeal of credit for biodiesel and renewable diesel used as fuel (sec. 3202 of the discussion draft and sec. 40A, 6426 and 6427(e) of the Code)

 

Present Law

 

 

The biodiesel fuels credit is the sum of three credits: (1) the biodiesel mixture credit ($1.00 per gallon of biodiesel used by the taxpayer in the production of a qualified biodiesel mixture), (2) the biodiesel credit ($1.00 per gallon of biodiesel that is not in a mixture with diesel fuel), and (3) the small agri-biodiesel producer credit (10 cents per gallon for up to 15 million gallons of agri-biodiesel produced by small producers). The credits may be taken as income tax credits and the biodiesel mixture credit also may be taken as an excise tax payment or credit. The excise tax credits and payments were coordinated with the income tax credit for biodiesel mixture, so that the income tax credit was reduced by any benefit received as an excise tax credit or payment.

For purposes of the Code, renewable diesel generally is afforded the same incentives as biodiesel, except there is no small producer credit for renewable diesel.

The income tax, excise tax and payment provisions related to biodiesel and renewable diesel expired on December 31, 2013.

 

Description of Proposal

 

 

The proposal repeals all biodiesel and renewable diesel incentives (income tax, excise tax and payment provisions665) and makes related conforming amendments.

 

Effective Date

 

 

The proposal is effective for fuel sold or used after December 31, 2013.

3. Research credit modified and made permanent (sec. 3203 of the discussion draft and sec. 41 of the Code)

 

Present Law

 

 

General rule

For general research expenditures, a taxpayer may claim a research credit equal to 20 percent of the amount by which the taxpayer's qualified research expenses for a taxable year exceed its base amount for that year.666 Thus, the research credit is generally available with respect to incremental increases in qualified research. An alternative simplified research credit (with a 14 percent rate and a different base amount) may be claimed in lieu of this credit.667

A 20-percent research tax credit also is available with respect to the excess of (1) 100 percent of corporate cash expenses (including grants or contributions) paid for basic research conducted by universities (and certain nonprofit scientific research organizations) over (2) the sum of (a) the greater of two minimum basic research floors plus (b) an amount reflecting any decrease in nonresearch giving to universities by the corporation as compared to such giving during a fixed-base period, as adjusted for inflation.668 This separate credit computation commonly is referred to as the basic research credit.669

Finally, a research credit is available for a taxpayer's expenditures on research undertaken by an energy research consortium.670 This separate credit computation commonly is referred to as the energy research credit. Unlike the other research credits, the energy research credit applies to all qualified expenditures, not just those in excess of a base amount.

The research credit, including the basic research credit and the energy research credit, expired for amounts paid or incurred after December 31, 2013.671

Computation of allowable credit

Except for energy research payments, the research tax credit applies only to the extent that the taxpayer's qualified research expenses for the current taxable year exceed its base amount. In general, the base amount for the current year generally is computed by multiplying the taxpayer's fixed-base percentage by the average amount of the taxpayer's gross receipts for the four preceding years. If a taxpayer both incurred qualified research expenses and had gross receipts during each of at least three years from 1984 through 1988, then its fixed-base percentage is the ratio that its total qualified research expenses for the 1984-1988 period bears to its total gross receipts for that period (subject to a maximum fixed-base percentage of 16 percent). Special rules apply to all other taxpayers (so called start-up firms).672 In computing the research credit, a taxpayer's base amount cannot be less than 50 percent of its current-year qualified research expenses. Slightly different rules apply in calculating the basic research credit, which generally has a base period that extends from 1981 through 1983.

To prevent artificial increases in research expenditures by shifting expenditures among commonly controlled or otherwise related entities, a special aggregation rule provides that all members of the same controlled group of corporations are treated as a single taxpayer.673 Under regulations prescribed by the Secretary, special rules apply for computing the credit when a major portion of a trade or business (or unit thereof) changes hands. Under these rules, qualified research expenses and gross receipts for periods prior to the change of ownership of a trade or business are treated as transferred with the trade or business that gave rise to those expenses and receipts for purposes of recomputing a taxpayer's fixed-base percentage.674

Alternative simplified credit

The alternative simplified research credit is equal to 14 percent of qualified research expenses that exceed 50 percent of the average qualified research expenses for the three preceding taxable years.675 The rate is reduced to six percent if a taxpayer has no qualified research expenses in any one of the three preceding taxable years.676 An election to use the alternative simplified credit applies to all succeeding taxable years unless revoked with the consent of the Secretary.677

Eligible expenses

Qualified research expenses eligible for the research tax credit consist of: (1) in-house expenses of the taxpayer for wages and supplies attributable to qualified research; (2) certain time-sharing costs for computer use in qualified research; and (3) 65 percent of amounts paid or incurred by the taxpayer to certain other persons for qualified research conducted on the taxpayer's behalf (so-called contract research expenses).678 Notwithstanding the limitation for contract research expenses, qualified research expenses include 100 percent of amounts paid or incurred by the taxpayer to an eligible small business, university, or Federal laboratory for qualified energy research.

To be eligible for the credit, the research not only has to satisfy the requirements of section 174,679 but also must be undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and substantially all of the activities of which constitute elements of a process of experimentation for functional aspects, performance, reliability, or quality of a business component. Research does not qualify for the credit if substantially all of the activities relate to style, taste, cosmetic, or seasonal design factors.680 In addition, research does not qualify for the credit if: (1) conducted after the beginning of commercial production of the business component; (2) related to the adaptation of an existing business component to a particular customer's requirements; (3) related to the duplication of an existing business component from a physical examination of the component itself or certain other information; (4) related to certain efficiency surveys, management function or technique, market research, market testing, or market development, routine data collection or routine quality control; (5) related to software developed primarily for internal use by the taxpayer; (6) conducted outside the United States, Puerto Rico, or any U.S. possession; (7) in the social sciences, arts, or humanities; or (8) funded by any grant, contract, or otherwise by another person (or government entity).681

Relation to deduction

Deductions allowed to a taxpayer under section 174 (or any other section) are reduced by an amount equal to 100 percent of the taxpayer's research tax credit determined for the taxable year.682 Taxpayers may alternatively elect to claim a reduced research tax credit amount under section 41 in lieu of reducing deductions otherwise allowed.683

 

Description of Proposal

 

 

The proposal makes permanent the alternative simplified method684 for calculating the research credit and increases the rate to 15 percent. That is, the research credit is equal to 15 percent of qualified research expenses that exceed 50 percent of the average qualified research expenses for the three preceding taxable years. The rate is reduced to 10 percent if a taxpayer has no qualified research expenses in any one of the three preceding taxable years. The proposal repeals the traditional 20-percent research credit calculation method.

The proposal also makes permanent the basic research credit, but reduces the credit rate to 15 percent and changes the base period from a fixed period to a three-year rolling average. The proposal repeals the energy research credit.

The proposal eliminates the research credit with respect to research related to computer software. In addition, the proposal removes from the definition of qualified research expenses amounts paid for supplies in the conduct of qualified research. The proposal also eliminates the special rules in the research credit that allow, in certain cases, for contract research expenses to exceed 65 percent of the amount actually paid for such expenses.

Finally, the proposal eliminates a taxpayer's ability to claim a reduced research credit amount in lieu of reducing research and development deductions otherwise allowed.

 

Effective Date

 

 

The proposal to make various components of the research credit permanent is effective for amounts paid or incurred after December 31, 2013. The other elements of the proposal are effective for taxable years beginning after December 31, 2013.

4. Modification of low-income housing tax credit (sec. 3204 of the discussion draft and sec. 42 of the Code)

 

Present Law

 

 

In general

The low-income housing tax credit ("LIHTC") may be claimed over a 10-year period for the cost of building rental housing occupied by tenants having incomes below specified levels.685 The amount of the credit for any taxable year in the credit period is the applicable percentage of the qualified basis of each qualified low-income building. The applicable percentage is designed to produce a credit with a present value equal to a fixed percentage of the qualified basis of the building. The qualified basis of any qualified low-income building for any taxable year equals the applicable fraction of the eligible basis of the building. Eligible basis is generally adjusted basis at the close of the first taxable year of the credit period.

Qualified low-income housing project

To qualify for the low-income housing tax credit, the incomes of the tenants must satisfy certain targeting rules. Under the LIHTC rules, a project is a qualified low-income housing project if 20 percent or more of the residential units in such project are occupied by individuals whose income is 50 percent or less of area median gross income (the "20-50 test"). Alternatively, a project is a qualified low-income housing project if 40 percent or more of the residential units in such project are occupied by individuals whose income is 60 percent or less of area median gross income (the "40-60 test"). The owner must elect to apply either the 20-50 test or the 40-60 test. Operators of qualified low-income housing projects must annually certify that such project meets the requirements for qualification, including meeting the 20-50 test or the 40-60 test. In practice, many projects have every unit satisfy the income targeting rules so that the entire project qualifies for the credit.

Present value credit

 

In general

 

The calculation of the applicable percentage is designed to produce a credit with a present value equal to: (1) 70 percent of the building's qualified basis in the case of newly constructed or substantially rehabilitated housing that is not Federally subsidized (the "70-percent credit"); or (2) 30 percent of the building's qualified basis in the case of newly constructed or substantially rehabilitated housing that is Federally subsidized and existing housing that is substantially rehabilitated (the "30-percent credit"). For example, in a zero-interest-rate environment, a building eligible for a 70-percent credit has an annual applicable percentage of seven percent for each of the ten years of the credit period. As interest rates rise, the seven-percent applicable percentage also rises to preserve the present value of the credit.

Where existing housing is substantially rehabilitated, the existing housing is eligible for the 30-percent credit and the qualified rehabilitation expenses (if not Federally subsidized) are eligible for the 70-percent credit.

 

Special rule

 

Under a special rule the applicable percentage is set at a minimum of nine percent for newly constructed non-Federally subsidized buildings placed in service after July 30, 2008 with respect to credit allocations made before January 1, 2014.

Calculation of the applicable percentage

The credit percentage for a low-income building is set for the earlier of: (1) the month the building is placed in service; or (2) at the election of the taxpayer, (a) the month the taxpayer and the housing credit agency enter into a binding agreement with respect to such building for a credit allocation, or (b) in the case of a tax-exempt bond-financed project for which no credit allocation is required, the month in which the tax-exempt bonds are issued.

These credit percentages (used for the 70-percent credit and 30-percent credit) are adjusted monthly by the IRS on a discounted after-tax basis (assuming a 28-percent tax rate) based on the average of the applicable Federal rates for mid-term and long-term obligations for the month the building is placed in service.686 The discounting formula assumes that each credit is received on the last day of each year and that the present value is computed on the last day of the first year. In a project consisting of two or more buildings placed in service in different months, a separate credit percentage may apply to each building.

Substantial rehabilitation requirement

Rehabilitation expenditures paid or incurred by a taxpayer with respect to a low-income building are treated as a separate building and may be eligible for the 70-percent credit if they satisfy the otherwise applicable credit rules. To qualify for the credit, the rehabilitation expenditures must equal the greater of an amount that is (1) at least 20 percent of the adjusted basis of the building being rehabilitated; or (2) at least $6,000 per low-income unit in the building being rehabilitated. The $6,000 amount is indexed for inflation, so it is $6,500 in 2014.

At the election of the taxpayer, a special rule applies allowing the 30-percent credit to both existing buildings and rehabilitation expenditures if the second prong (i.e., at least $6,000 of rehabilitation expenditures per low-income unit) of the rehabilitation expenditures test is satisfied. This special rule applies only in the case where the taxpayer acquired the building and immediately prior to that acquisition the building was owned by or on behalf of a government unit.

Enhanced credit for buildings in high-cost areas

Generally, buildings located in three types of high-cost areas (i.e., qualified census tracts, difficult development areas and buildings designated by the State housing credit agency as requiring the enhanced credit in order for such buildings to be financially feasible) are eligible for an enhanced credit. Under the enhanced credit, the 70-percent and 30-percent credits are increased to a 91-percent and 39-percent credit, respectively. The mechanism for this increase is through an increase from 100 to 130 percent of the otherwise applicable eligible basis of a new building or the rehabilitation expenditures of an existing building. A further requirement for the enhanced credit in qualified census tracts and difficult development areas is that the portions of each metropolitan statistical area or nonmetropolitan statistical area designated as difficult to develop areas cannot exceed an aggregate area having 20 percent of the population of such statistical area. Buildings designated by the State housing credit agency as requiring the enhanced credit in order for such buildings to be financially feasible are not subject to the limitation limiting high cost areas to 20 percent of the population of each metropolitan statistical area or nonmetropolitan statistical area.

Recapture

The compliance period for any building is the period beginning on the first day of the first taxable year of the credit period of such building and ending 15 years from such date.

The penalty for any building subject to the 15-year compliance period failing to remain part of a qualified low-income project (due, for example, to noncompliance with the minimum set aside requirement, or the gross rent requirement, or other requirements with respect to the units comprising the set aside) is recapture of the accelerated portion of the credit, with interest, for all prior years.

Allocation of credits

A low-income housing tax credit is allowable only if the owner of a qualified building receives a housing credit allocation from the State or local housing credit agency. Generally, the aggregate credit authority provided annually to each State for calendar year 2014 is $2.30 per resident, with a minimum annual cap of $2,635,000 for certain small population States.687 These amounts are indexed for inflation. Projects that also receive financing with proceeds of tax-exempt bonds issued subject to the private activity bond volume limit do not require an allocation of the low-income housing credit, but the related use of tax-exempt bonds is subject to limitation.

 

Description of Proposal

 

 

Allocation of qualified basis rather than credits

Under the proposal, a low-income housing tax credit is only allowed if the owner of a qualified building receives an allocation of qualified basis, as opposed to housing credits under present law, from the State or local housing credit agency. Generally, the aggregate basis authority provided annually to each State for calendar year 2015 is $31.20 per resident, with a minimum annual cap of $36.3 million for certain small population States. These amounts are indexed annually for inflation in increments of $0.20 and $100,000, respectively.

The enhanced credits for 130 percent of the otherwise applicable basis of buildings in high-cost areas are repealed.

The proposal repeals the part of the calculation of the State housing credit ceiling that allows unused housing credit carryovers to be allocated among certain States (the so called national reallocation pool).

The proposal repeals the special rule for States with constitutional home rule cities.

Credit period

The proposal changes the credit period from 10 years to 15 years. The credit recapture rules are repealed. As the credit period and compliance period are both 15 years, there is no accelerated portion of the credit to recapture.

Applicable percentage

As a result of the lengthening of the credit period, the applicable percentage for determining the 70-percent credit is reduced relative to present law. However, the applicable percentage is determined in such a way as to maintain a credit with a present value equal to 70 percent of the building's qualified basis. The discount rate used to determine the applicable percentage is the applicable discount percentage of the average of the mid-term and long-term applicable Federal rates. The applicable discount percentage is the number of percentage points by which 100 percent exceeds the highest corporate income tax rate for a taxable year which begins in such month.688

The proposal repeals the 30-percent credit, and related rules, for qualified basis of a building that is not a new building or any building that is Federally subsidized.689 Rehabilitation expenditures that are substantial are treated as a separate new building as under present law and are eligible for the 70-percent credit.

Modification of rules against preferential treatment

The proposal repeals the exception to the general public use requirement for preferences that favor tenants who are involved in artistic or literary activities and adds an exception for veterans.

Selection criteria

The proposal modifies the selection criteria that a qualified allocation plan must include to remove the energy efficiency and historic nature criteria.

 

Effective Date

 

 

The proposal applies to allocations after December 31, 2014.

5. Repeal of enhanced oil recovery credit (sec. 3205 of the discussion draft and sec. 43 of the Code)

 

Present Law

 

 

A 15-percent credit is available for expenses associated with an enhanced oil recovery ("EOR") project. Qualified EOR costs consist of the following designated expenses associated with an EOR project: (1) amounts paid for depreciable tangible property; (2) intangible drilling and development expenses; (3) tertiary injectant expenses; and (4) construction costs for certain Alaskan natural gas treatment facilities. An EOR project is generally a project that involves increasing the amount of recoverable domestic crude oil through the use of one or more tertiary recovery methods (as defined in section 193(b)(3)), such as injecting steam or carbon dioxide into a well to effect oil displacement. The credit is reduced as the price of oil exceeds a certain threshold and is currently phased-out.

 

Description of Proposal

 

 

The proposal repeals the enhanced oil recovery credit.

 

Effective Date

 

 

The proposal is effective on the date of enactment.

6. Modification and repeal of electricity produced from certain renewable resources (sec. 3206 of the discussion draft and sec. 45 of the Code)

 

Present Law

 

 

Renewable electricity production credit

A production credit is available for electricity produced from certain renewable resources during the 10-year period beginning after the renewable power facility has been placed in service. The full credit rate is 1.5 cents per kilowatt-hour (adjusted for inflation; 2.3 cents per kilowatt-hour for 2013) and is available for power produced at qualified wind, closed-loop biomass, and geothermal facilities. A credit equal to one-half the full credit rate (1.1 cents per kilowatt hour for 2013) is available for power produced at open-loop biomass, small irrigation power, landfill gas, trash combustion, marine/hydrokinetic, and certain hydropower facilities. The credit expired for facilities the construction of which began after December 31, 2013.

Election to claim energy credit in lieu of renewable electricity production credit

A taxpayer may make an irrevocable election to have certain property which is part of a qualified renewable power facility be treated as energy property eligible for a 30-percent investment credit under section 48. For this purpose, qualified renewable power facilities are facilities otherwise eligible for the renewable electricity production credit with respect to which no credit under section 45 has been allowed. A taxpayer electing to treat a facility as energy property may not claim the renewable electricity production credit. The eligible basis for the investment credit for taxpayers making this election is the basis of the depreciable (or amortizable) property that is part of a facility capable of generating electricity eligible for the renewable electricity production credit. No credit is available for facilities the construction of which began after December 31, 2013.

Refined coal production credit

A production credit of $4.375 per ton (adjusted for inflation; $6.59 per ton for 2013) is available for refined coal produced at a qualified facility during the 10-year period beginning on the date such facility has been placed in service. Refined coal is defined as a synthetic fuel produced from coal (including lignite) or high-carbon fly ash that when burned emits 20 percent less nitrogen oxide and 40 percent less sulfur dioxide or mercury compared to feedstock coal predominantly available in the marketplace as of January 1, 2003. The refined coal must be sold to a third party with the reasonable expectation that it will be used for the purpose of producing steam. Qualified refined coal facilities must be placed in service before January 1, 2010.

Description of Proposal

The proposal eliminates the credit rate inflation adjustments for the renewable electricity and refined coal production tax credits. Thus, for renewable electricity, the full credit rate is 1.5 cents per kilowatt-hour and the half credit rate is 0.75 cents per kilowatt-hour. For refined coal, the credit rate reverts to $4.375 per ton.

The proposal also clarifies that for purposes of determining whether the construction of a qualified renewable power facility (including modifications, improvements, additions, or the construction of other related property) is treated as beginning before January 1, 2014, there must be a continuous program of construction that begins before such date and ends on the date such property is placed in service.

Finally, the proposal repeals the section 45 credit (including the credits for renewable electricity and refined coal) in its entirety for electricity and coal produced and sold after December 31, 2024.

 

Effective Date

 

 

With respect to the inflation adjustment, the proposal is effective for electricity and refined coal produced and sold after December 31, 2014. The clarification of the rules for determining whether construction has begun is effective for taxable years beginning before on or after the date of enactment. The repeal of the credit is effective for electricity and coal produced and sold after December 31, 2024.

7. Indian employment credit (sec. 3207 of the discussion draft and sec. 45A of the Code)

 

Present Law

 

 

In general, a credit against income tax liability is allowed to employers for the first $20,000 of qualified wages and qualified employee health insurance costs paid or incurred by the employer with respect to certain employees.690 The credit is equal to 20 percent of the excess of eligible employee qualified wages and health insurance costs during the current year over the amount of such wages and costs incurred by the employer during 1993. The credit is an incremental credit, such that an employer's current-year qualified wages and qualified employee health insurance costs (up to $20,000 per employee) are eligible for the credit only to the extent that the sum of such costs exceeds the sum of comparable costs paid during 1993. No deduction is allowed for the portion of the wages equal to the amount of the credit.

Qualified wages means wages paid or incurred by an employer for services performed by a qualified employee. A qualified employee means any employee who is an enrolled member of an Indian tribe or the spouse of an enrolled member of an Indian tribe, who performs substantially all of the services within an Indian reservation, and whose principal place of abode while performing such services is on or near the reservation in which the services are performed. An "Indian reservation" is a reservation as defined in section 3(d) of the Indian Financing Act of 1974691 or section 4(10) of the Indian Child Welfare Act of 1978.692 For purposes of the preceding sentence, section 3(d) is applied by treating "former Indian reservations in Oklahoma" as including only lands that are (1) within the jurisdictional area of an Oklahoma Indian tribe as determined by the Secretary of the Interior, and (2) recognized by such Secretary as an area eligible for trust land status under 25 C.F.R. Part 151 (as in effect on August 5, 1997).

An employee is not treated as a qualified employee for any taxable year of the employer if the total amount of wages paid or incurred by the employer with respect to such employee during the taxable year exceeds an amount determined at an annual rate of $30,000, as adjusted for inflation in the manner described (which is $45,000 for 2013). In addition, an employee will not be treated as a qualified employee under certain specific circumstances, such as where the employee is related to the employer (in the case of an individual employer) or to one of the employer's shareholders, partners, or grantors. Similarly, an employee will not be treated as a qualified employee where the employee has more than a five percent ownership interest in the employer. Finally, an employee will not be considered a qualified employee to the extent the employee's services relate to gaming activities or are performed in a building housing such activities.

The wage credit is available for wages paid or incurred in taxable years that begin on or before December 31, 2013.

 

Description of Proposal

 

 

This proposal repeals the Indian employment credit and provides conforming amendments to preserve the definition of the term "Indian tribe."

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2013.

8. Repeal of credit for portion of employer Social Security taxes paid with respect to employee cash tips (sec. 3208 of the discussion draft and sec. 45B of the Code)

 

Present Law

 

 

Employee tip income is treated as employer-provided wages subject to taxes under the Federal Insurance Contributions Act ("FICA").693 Employees are required to report the amount of tips received.

A business tax credit is provided equal to an employer's FICA taxes paid on tips in excess of those treated as wages for purposes of meeting the minimum wage requirements of the Fair Labor Standards Act (the "FLSA") as in effect on January 1, 2007.694 The credit applies only with respect to FICA taxes paid on tips received from customers in connection with the providing, delivering, or serving of food or beverages for consumption if the tipping of employees delivering or serving food or beverages by customers is customary. The credit is available whether or not the employee reports the tips on which the employer FICA taxes were paid. No deduction is allowed for any amount taken into account in determining the tip credit. A taxpayer may elect not to have the credit apply for a taxable year.

 

Description of Proposal

 

 

The proposal repeals the credit for FICA taxes an employer pays on tips.

 

Effective Date

 

 

The proposal is effective for tips received for services performed after December 31, 2014.

9. Repeal of credit for clinical testing expenses for certain drugs for rare diseases or conditions (sec. 3209 of the discussion draft and sec. 45C of the Code)

 

Present Law

 

 

Present law provides a 50-percent business tax credit for qualified clinical testing expenses incurred in testing of certain drugs for rare diseases or conditions, generally referred to as "orphan drugs."695 Qualified clinical testing expenses are costs incurred to test an orphan drug after the drug has been approved for human testing by the Food and Drug Administration ("FDA") but before the drug has been approved for sale by the FDA.696 A rare disease or condition is defined as one that (1) affects less than 200,000 persons in the United States, or (2) affects more than 200,000 persons, but for which there is no reasonable expectation that businesses could recoup the costs of developing a drug for such disease or condition from sales in the United States of the drug.697

Amounts included in computing the credit under this section are excluded from the computation of the research credit under section 41.698

 

Description of Proposal

 

 

This proposal repeals the credit for qualified clinical testing expenses.

 

Effective Date

 

 

The proposal applies to amounts paid or incurred in taxable years beginning after December 31, 2014.

10. Repeal of credit for small employer pension plan startup costs (sec. 3210 of the discussion draft and sec. 45E of the Code)

 

Present Law

 

 

Present law provides a nonrefundable income tax credit for qualified start-up costs of an eligible small employer that adopts a new qualified retirement plan, SIMPLE IRA plan, or simplified employee pension plan, provided that the plan covers at least one nonhighly compensated employee. Qualified start-up costs are expenses connected with the establishment or administration of the plan or retirement-related education for employees with respect to the plan. The credit is the lesser of $500 per year or 50 percent of the qualified start-up costs. The credit applies for up to three years beginning with the year the plan is first effective, or, at the election of the employer, the preceding year.

An eligible employer is an employer that, for the preceding year, had no more than 100 employees with compensation of $5,000 or more. In addition, the employer must not have had a plan covering substantially the same employees as the new plan during the three years preceding the first year for which the credit would apply. Members of controlled groups and affiliated service groups are treated as single employers for purposes of these requirements.

 

Description of Proposal

 

 

The proposal repeals the credit for qualified start-up costs of an eligible small employer.

 

Effective Date

 

 

The proposal is effective for costs paid or incurred after December 31, 2014, with respect to plans first effective after that date.

11. Repeal of credit for employer-provided childcare (sec. 3211 of the discussion draft and section 45F of the Code)

 

Present Law

 

 

Taxpayers are eligible for a tax credit equal to 25 percent of qualified expenses for employee child care and 10 percent of qualified expenses for child care resource and referral services. The maximum total credit that may be claimed by a taxpayer may not exceed $150,000 per taxable year. The credit is part of the general business credit.

Qualified child care expenses include costs paid or incurred: (1) to acquire, construct, rehabilitate or expand property that is to be used as part of the taxpayer's qualified child care facility;699 (2) for the operation of the taxpayer's qualified child care facility, including the costs of training and certain compensation for employees of the child care facility, and scholarship programs; or (3) under a contract with a qualified child care facility to provide child care services to employees of the taxpayer. To be a qualified child care facility, the principal use of the facility must be for child care (unless it is the principal residence of the taxpayer), and the facility must meet all applicable State and local laws and regulations, including any licensing laws.

 

Description of Proposal

 

 

The proposal repeals the credit for qualified child care expenditures.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

12. Repeal of railroad track maintenance credit (sec. 3212 of the discussion draft and sec. 45G of the Code)

 

Present Law

 

 

Present law provides a 50-percent business tax credit for qualified railroad track maintenance expenditures paid or incurred by an eligible taxpayer during taxable years beginning before January 1, 2014.700 The credit is limited to the product of $3,500 times the number of miles of railroad track (1) owned or leased by an eligible taxpayer as of the close of its taxable year, and (2) assigned to the eligible taxpayer by a Class II or Class III railroad that owns or leases such track at the close of the taxable year.701 Each mile of railroad track may be taken into account only once, either by the owner of such mile or by the owner's assignee, in computing the per-mile limitation. The credit also may reduce a taxpayer's tax liability below its tentative minimum tax.702 Basis of the railroad track must be reduced (but not below zero) by an amount equal to 100 percent of the taxpayer's qualified railroad track maintenance tax credit determined for the taxable year.703

Qualified railroad track maintenance expenditures are defined as gross expenditures (whether or not otherwise chargeable to capital account) for maintaining railroad track (including roadbed, bridges, and related track structures) owned or leased as of January 1, 2005, by a Class II or Class III railroad (determined without regard to any consideration for such expenditure given by the Class II or Class III railroad which made the assignment of such track).704

An eligible taxpayer means any Class II or Class III railroad, and any person who transports property using the rail facilities of a Class II or Class III railroad or who furnishes railroad-related property or services to a Class II or Class III railroad, but only with respect to miles of railroad track assigned to such person by such railroad under the provision.705

The terms Class II or Class III railroad have the meanings given by the Surface Transportation Board.706

 

Description of Proposal

 

 

This proposal repeals the credit for qualified railroad track maintenance expenditures.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2013.

13. Repeal of credit for production of low sulfur diesel fuel (sec. 3213 of the discussion draft and sec. 45H of the Code)

 

Present Law

 

 

A small business refiner may claim a credit of five cents per gallon for each gallon of low sulfur diesel fuel produced during the taxable year that is in compliance with the Highway Diesel Fuel Sulfur Control Requirements of the EPA. A small business refiner is a crude oil refiner that has no more than 1,500 individuals engaged in refinery operations on any given day and that had an average daily domestic refinery run or average retained production of not more than 205,000 barrels for the one-year period ending on December 31, 2002.

The total production credit claimed by the taxpayer is limited to 25 percent of the capital costs incurred to come into compliance with the EPA diesel fuel requirements. The percentage limitation phases down pro rata for refiners that had runs in 2002 exceeding 155,000 barrels but less than 205,000 barrels.

Costs qualifying for the credit are those costs paid or incurred with respect to any facility of a small business refiner during the period beginning on January 1, 2003 and ending on the earlier of the date that is one year after the date on which the taxpayer must comply with the applicable EPA regulations or December 31, 2009. The taxpayer's basis in property with respect to which the credit applies is reduced by the amount of the production credit claimed. Although the period for incurring qualified expenditures ended on December 31, 2009, a taxpayer may claim the production credit until the 25 percent limit is reached.

 

Description of Proposal

 

 

The proposal repeals the credit for production of low sulfur diesel fuel.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

14. Repeal of credit for producing oil and gas from marginal wells (sec. 3214 of the discussion draft and sec. 45I of the Code)

 

Present Law

 

 

The Code provides a $3-per-barrel credit for the production of crude oil and a $0.50 credit per 1,000 cubic feet of qualified natural gas production. In both cases, the credit is available only for production from a "qualified marginal well."

A qualified marginal well is defined as domestic well: (1) production from which is treated as marginal production for purposes of the Code percentage depletion rules; or (2) that during the taxable year had average daily production of not more than 25 barrel equivalents and produces water at a rate of not less than 95 percent of total well effluent. The maximum amount of production on which credit could be claimed is 1,095 barrels or barrel equivalents.

The credit is not available to production occurring if the reference price of oil exceeds $18 ($2.00 for natural gas). The credit is reduced proportionately as for reference prices between $15 and $18 ($1.67 and $2.00 for natural gas). Currently the credit is totally phased out.

In the case of production from a qualified marginal well which is eligible for the credit allowed under section 45K for the taxable year, no marginal well credit is allowable unless the taxpayer elects not to claim the credit under section 45K with respect to the well. The credit is treated as a general business credit. Unused credits can be carried back for up to five years rather than the generally applicable carryback period of one year. The credit is indexed for inflation.

 

Description of Proposal

 

 

The proposal repeals the credit for producing oil from marginal wells.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014.

15. Repeal of credit for production from advanced nuclear power facilities (sec. 3215 of the discussion draft and sec. 45J of the Code)

 

Present Law

 

 

A production tax credit available for the production of nuclear power from new facilities that use modern designs and have received an allocation from the Secretary (who may allocate up 6,000 megawatts of credit-eligible capacity). The credit rate is 1.8 cents per kilowatt-hour for the eight year period starting when the facility was placed in service. Qualified facilities must be placed in service by December 31, 2020.

 

Description of Proposal

 

 

The proposal repeals the advanced nuclear power production tax credit.

 

Effective Date

 

 

The proposal is effective for electricity produced and sold after December 31, 2014.

16. Repeal of credit for producing fuel from a nonconventional source (sec. 3216 of the discussion draft and sec. 45K of the Code)

 

Present Law

 

 

Certain fuels produced in the United States from "non-conventional sources" and sold to unrelated parties are eligible for an income tax credit equal to $3 (generally adjusted for inflation)707 per barrel or Btu oil barrel equivalent ("non-conventional source fuel credit"). Qualified fuels include: oil produced from shale and tar sands; gas produced from geopressured brine, Devonian shale, coal seams, tight formations, or biomass; and liquid, gaseous, or solid synthetic fuels produced from coal (including lignite). The non-conventional source fuel credit provision also includes a credit for certain coke or coke gas produced at qualified facilities. The credit has expired, except for coke or coke gas produced before December 30, 2013, at certain qualified facilities.

 

Description of Proposal

 

 

The proposal repeals the credit for nonconventional source fuel.

 

Effective Date

 

 

The proposal is effective for fuel produced and sold after December 31, 2013.

17. Repeal of energy efficient new homes credit (sec. 3217 of the discussion draft and sec. 45l of the Code)

 

Present Law

 

 

A credit is available through 2013 for homes placed in service that exceed certain efficiency standards. The credit is $1,000 for homes that exceed the standard by 30 percent and $2,000 for homes that exceed the standard by 50 percent.

 

Description of Proposal

 

 

The proposal repeals the credit for energy efficient new homes.

 

Effective Date

 

 

The proposal is effective for new homes acquired after December 31, 2013.

18. Repeal of energy efficient appliance credit (sec. 3218 of the discussion draft and sec. 45M of the Code)

 

Present Law

 

 

Credits are available through 2013 for certain energy-efficient consumer appliances, such as dishwashers, clothes washers, and refrigerators. Credit amounts vary between $50 and $225 depending on the type and efficiency of the eligible appliance.

 

Description of Proposal

 

 

The proposal repeals the credit for energy efficient appliances.

 

Effective Date

 

 

The proposal is effective for appliances produced after December 31, 2013.

19. Repeal of mine rescue team training credit (sec. 3219 of the discussion draft and sec. 45N of the Code)

 

Present Law

 

 

An eligible employer may claim a general business credit against income tax with respect to each qualified mine rescue team employee equal to the lesser of: (1) 20 percent of the amount paid or incurred by the taxpayer during the taxable year with respect to the training program costs of the qualified mine rescue team employee (including the wages of the employee while attending the program); or (2) $10,000.708 A qualified mine rescue team employee is any full-time employee of the taxpayer who is a miner eligible for more than six months of a taxable year to serve as a mine rescue team member by virtue of either having completed the initial 20 hour course of instruction prescribed by the Mine Safety and Health Administration's Office of Educational Policy and Development, or receiving at least 40 hours of refresher training in such instruction.709

An eligible employer is any taxpayer which employs individuals as miners in underground mines in the United States.710 The term "wages" has the meaning given to such term by section 3306(b)711 (determined without regard to any dollar limitation contained in that section).712

No deduction is allowed for the portion of the expenses otherwise deductible that is equal to the amount of the credit.713 The credit does not apply to taxable years beginning after December 31, 2013.714 Additionally, the credit is not allowable for purposes of computing the alternative minimum tax.715

 

Description of Proposal

 

 

This proposal repeals the credit for qualified mine rescue team training expenses.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2013.

20. Repeal of agricultural chemicals security tax credit (sec. 3220 of the discussion draft and sec. 45O of the Code)

 

Present Law

 

 

The Code provides a 30-percent credit for qualified chemical security expenditures for the taxable year with respect to eligible agricultural businesses. The credit is a component of the general business credit.716

The credit is limited to $100,000 per facility; this amount is reduced by the aggregate amount of the credits allowed for the facility in the prior five years. In addition, each taxpayer's annual credit is limited to $2,000,000.717 The credit only applies to expenditures paid or incurred before December 31, 2012. The taxpayer's deductible expense is reduced by the amount of the credit claimed.

 

Description of Proposal

 

 

The proposal repeals the agriculture chemicals security credit.

 

Effective Date

 

 

The proposal is effective for amounts paid or incurred after December 31, 2012.

21. Repeal of credit for carbon dioxide sequestration (sec. 3221 of the discussion draft and section 45Q of the Code)

 

Present Law

 

 

A credit is available for the sequestration of industrial source carbon dioxide produced at qualified U.S. facilities. Qualified facilities must capture at least 500,000 metric tons of carbon dioxide per year. The credit rate is $10 per ton for carbon dioxide used first as a tertiary injectant and then disposed of in secure geological storage and $20 per ton for carbon dioxide disposed of in secure geological storage without being first used as tertiary injectant. The credit expires at the end of the year in which the Secretary determines that 75 million tons of carbon dioxide have been captured and sequestered.

 

Description of Proposal

 

 

The proposal repeals the credit for carbon dioxide sequestration.

 

Effective Date

 

 

The proposal is effective for credits determined for taxable years beginning after December 31, 2014.

22. Repeal of credit for employee health insurance expenses of small employers (sec. 3222 of the discussion draft and sec. 45R of the Code)

 

Present Law

 

 

In general

An eligible small employer may be eligible for a tax credit for nonelective contributions to purchase health insurance for its employees.718 An eligible small employer for this purpose generally is an employer with no more than 25 full-time equivalent employees ("FTEs") during the employer's taxable year, whose average annual wages do not exceed $50,000.719 However, the full amount of the credit is available only to an employer with 10 or fewer FTEs whose average annual wages do not exceed $25,000.

An employer's FTEs are calculated by dividing the total hours worked by all employees during the employer's tax year (up to 2,080 for any employee) by 2,080 (and rounding down to the nearest whole number of FTEs) . Average annual wages are determined by dividing the total wages paid by the employer by the number of FTEs (and rounding down to the nearest $1,000).

For purposes of the credit, the employer is determined by applying the aggregation rules for controlled groups, groups under common control, and affiliated service groups.720 In addition, for purposes of the credit, the term "employee" includes a leased employee, i.e., an individual who is not an employee of the employer, who provides services to the employer pursuant to an agreement between the employer and another person (a "leasing organization") and under the primary direction or control of the employer, and who has performed such services on a substantially full-time basis for at least one year.721

Self-employed individuals (including partners and sole proprietors), two-percent shareholders of an S corporation, and five-percent owners of the employer are not employees for purposes of the credit with the result that they are disregarded in determining number of FTEs, average annual wages, and nonelective contributions for employees' health insurance. Family members of these individuals and any member of the individual's household who is a dependent for tax purposes are also not employees for purposes of the credit. In addition, the hours of service worked by and wages paid to a seasonal worker of an employer are not taken into account in determining number of FTEs and average annual wages unless the worker works for the employer on more than 120 days during the taxable year.

The employer contributions must be provided under an arrangement that requires the eligible small employer to make, on behalf of each employee who enrolls in qualifying health insurance offered by the employer, a nonelective contribution equal to a uniform percentage (not less than 50 percent) of the premium cost of the qualifying health insurance (described below).

The credit is available only to offset actual tax liability and is claimed on the employer's tax return. The credit is a general business credit and generally can be carried back for one year and carried forward for 20 years. The credit is available for tax liability under the alternative minimum tax. The dollar amount of the credit reduces the amount of employer contributions the employer may deduct as a business expense.

Years credit available and qualifying health insurance

An initial credit is available for any taxable year beginning in 2010, 2011, 2012, or 2013. Qualifying health insurance for claiming the credit for this first phase of the credit is health insurance coverage as defined for purposes of the group health plan requirements under the Code, which is generally health insurance coverage offered by an insurance company licensed under State law.

For taxable years beginning after 2013, the credit is available only for nonelective contributions for premiums for qualified health plans offered by the employer through an American Health Benefit Exchange and is available for a maximum credit period of two consecutive taxable years beginning with the first taxable year in which the employer (or any predecessor) offers one or more qualified health plans to its employees through an American Health Benefit Exchange. The maximum two-year credit period does not take into account any taxable years beginning before 2014.

Calculation of credit amount

Only nonelective contributions by the employer are taken into account in calculating the credit. The credit is equal to the lesser of the following two amounts multiplied by an applicable credit percentage: (1) the amount of contributions the employer made on behalf of the employees during the taxable year for the qualifying health insurance and (2) the amount of contributions the employer would have made during the taxable year if each employee with the qualifying health insurance had enrolled in insurance with a benchmark premium (as described below). As discussed above, the credit is available only if nonelective contributions are a uniform percentage of at least 50 percent of the premium cost of the qualifying health insurance.

For the first phase of the credit (taxable years beginning in 2010, 2011, 2012, or 2013), the applicable credit percentage is generally 35 percent, and the benchmark premium is the average premium for the small group market (i.e., insurance coverage provided by small employers) in the employer's State, as determined by the Secretary of Health and Human Services ("HHS"). For taxable years beginning after 2013, the applicable credit percentage is generally 50 percent, and the benchmark premium is the average premium for the small group market in the rating area in which the employee enrolls for coverage, as determined by the Secretary of HHS.

The credit is reduced for an employer with between 10 and 25 FTEs ("FTE phase-out"). The credit is also reduced for an employer for whom the average annual wages per FTE is between $25,000 and $50,000 ("average annual wages phase-out"). For an employer with both more than 10 FTEs and average annual wages in excess of $25,000, the reduction is the sum of the amount of the two reductions.

Tax-exempt organizations

For tax-exempt organizations, the applicable credit percentage during the first phase of the credit (taxable years beginning in 2010, 2011, 2012, or 2013) is limited to 25 percent and the applicable credit percentage during the second phase (taxable years beginning after 2013) is limited to 35 percent. In addition, instead of a general business credit, the credit is a refundable credit limited to the amount of the payroll taxes of the employer during the calendar year in which the taxable year begins.722

 

Description of Proposal

 

 

The proposal repeals the credit for a small employer that pays health insurance premiums for its employees.

 

Effective Date

 

 

The proposal is effective for amounts paid or incurred for taxable years beginning after December 31, 2014.

23. Repeal of rehabilitation credit (sec. 3223 of the discussion draft and sec. 47 of the Code)

 

Present Law

 

 

Present law provides a two-tier tax credit for rehabilitation expenditures.723

A 20-percent credit is provided for qualified rehabilitation expenditures with respect to a certified historic structure. For this purpose, a certified historic structure means any building that is listed in the National Register, or that is located in a registered historic district and is certified by the Secretary of the Interior to the Secretary of the Treasury as being of historic significance to the district.

A 10-percent credit is provided for qualified rehabilitation expenditures with respect to a qualified rehabilitated building, which generally means a building that was first placed in service before 1936. The pre-1936 building must meet requirements with respect to retention of existing external walls and internal structural framework of the building in order for expenditures with respect to it to qualify for the 10-percent credit. A building is treated as having met the substantial rehabilitation requirement under the 10-percent credit only if the rehabilitation expenditures during the 24-month period selected by the taxpayer and ending within the taxable year exceed the greater of (1) the adjusted basis of the building (and its structural components), or (2) $5,000.

The provision requires the use of straight-line depreciation or the alternative depreciation system in order for rehabilitation expenditures to be treated as qualified under the provision.

 

Description of Proposal

 

 

The proposal repeals the rehabilitation credit.

 

Effective Date

 

 

The proposal generally is effective for amounts paid after December 31, 2014. A transition rule provides that in the case of qualified rehabilitation expenditures (within the meaning of present law), with respect to any building acquired by the taxpayer before January 1, 2015, and with respect to which the 24-month period selected by the taxpayer (under section 47(c)(1)(C)) begins before January 1, 2015, the provision is effective for amounts paid after December 31, 2016.

24. Repeal of energy credit (sec. 3224 of the discussion draft and sec. 48 of the Code)

 

Present Law

 

 

A business tax credit ranging from 10 to 30 percent of the basis of property placed in service is allowed for certain solar, geothermal, wind, fuel cell, microturbine, and combined heat and power property. The 30 percent credit expires for property placed in service after December 31, 2016. Beginning in 2017, the credit is 10 percent, and is available only for certain geothermal and solar property.

 

Description of Proposal

 

 

The proposal repeals the energy credit.

 

Effective Date

 

 

The proposal is effective for property placed in service after December 31, 2016.

25. Repeal of qualifying advanced coal project credit (sec. 3225 of the discussion draft and sec. 48A of the Code)

 

Present Law

 

 

An investment credit is available for projects that use integrated gasification combined cycle (IGCC) or other advanced coal-based electricity generation technologies. Credits are allocated by the Secretary. First round allocations are capped at $800 million for IGCC projects and $500 million for other projects. Second round allocations are capped at $1.25 billion. Second round projects must generally sequester 65 percent of total carbon dioxide emissions (70 percent in the case of reallocated credits). The credit rate is 20 percent for first round IGCC projects, 15 percent for other first round projects, and 30 percent for second round projects. All credits have been fully allocated.

 

Description of Proposal

 

 

The proposal repeals the credit for qualifying advanced coal projects.

 

Effective Date

 

 

The proposal is effective for credit allocations and reallocations occurring after December 31, 2014.

26. Repeal of qualifying gasification project credit (sec. 3226 of the discussion draft and section 48B of the Code)

 

Present Law

 

 

An investment credit is available for qualified projects that use gasification technology. Qualified projects convert coal, petroleum residue, biomass, or other materials recovered for their energy content into a synthesis gas for direct use or subsequent chemical or physical conversion. Credits are allocated by the Secretary. First round allocations are capped at $350 million. Second round allocations are capped at $250 million. First round projects are generally limited to industrial applications; second round projects include projects designed to produce motor fuels. Second round projects must generally sequester 65 percent of total carbon dioxide emissions. The credit rate is 20 percent for first round projects and 30 percent for second round projects. All credits have been fully allocated.

 

Description of Proposal

 

 

The proposal repeals the qualifying gasification project credit.

 

Effective Date

 

 

The proposal is effective for credit allocations and reallocations occurring after December 31, 2014.

27. Repeal of qualifying advanced energy project credit (sec. 3227 of the discussion draft and section 48C of the Code)

 

Present Law

 

 

A 30-percent investment credit is available for qualifying advanced energy projects. A qualifying advanced energy project is a project that re-equips, expands, or establishes a manufacturing facility for the production: (1) property designed to be used to produce energy from the sun, wind, or geothermal deposits (within the meaning of section 613(e)(2)), or other renewable resources; (2) fuel cells, microturbines, or an energy storage system for use with electric or hybrid-electric motor vehicles; (3) electric grids to support the transmission of intermittent sources of renewable energy, including storage of such energy; (4) property designed to capture and sequester carbon dioxide; (5) property designed to refine or blend renewable fuels (but not fossil fuels) or to produce energy conservation technologies (including energy-conserving lighting technologies and smart grid technologies); (6) new qualified plug-in electric drive motor vehicles, qualified plug-in electric vehicles, or components which are designed specifically for use with such vehicles, including electric motors, generators, and power control units, or (7) other advanced energy property designed to reduce greenhouse gas emissions as may be determined by the Secretary. Qualified property does not include property designed to manufacture equipment for use in the refining or blending of any transportation fuel other than renewable fuels.

Credits are allocated by the Secretary and are capped at $2.3 billion. All credits have been fully allocated. Credits for projects that fail to meet certain benchmarks may be reallocated by the Secretary.

 

Description of Proposal

 

 

The proposal repeals the qualifying advanced energy project credit.

 

Effective Date

 

 

The proposal is effective for credit allocations and reallocations occurring after December 31, 2014.

28. Repeal of qualifying therapeutic discovery project credit (sec. 3228 of the discussion draft and sec. 48D of the Code)

 

Present Law

 

 

In general

Under present law, a taxpayer is eligible for a 50 percent nonrefundable investment tax credit for qualified investments in qualifying therapeutic discovery projects.724 Qualified investments must be made in a taxable year beginning in 2009 and 2010 and the total amount of credits allocated for the program for the two-year period 2009 through 2010 is $1 billion.725 The Secretary, in consultation with the Secretary of Health and Human Services, awards certifications for qualified investments.726 The credit is available only to companies having 250 or fewer employees.727

A "qualifying therapeutic discovery project" is a project which is designed to develop a product, process, or therapy to diagnose, treat, or prevent diseases and afflictions by: (1) conducting pre-clinical activities, clinical trials, clinical studies, and research protocols, or (2) by developing technology or products designed to diagnose diseases and conditions, including molecular and companion drugs and diagnostics, or to further the delivery or administration of therapeutics.728

The qualified investment for any taxable year is the aggregate amount of the costs paid or incurred in such year for expenses necessary for, and directly related to, the conduct of a qualifying therapeutic discovery project.729 The qualified investment for any taxable year with respect to any qualifying therapeutic discovery project does not include any cost for: (1) remuneration for an employee described in section 162(m)(3), (2) interest expense, (3) facility maintenance expenses, (4) a service cost identified under Treas. Reg. sec. 1.263A-1(e)(4), or (5) any other expenditure as determined by the Secretary as appropriate to carry out the purposes of the provision.730

Companies must apply to the Secretary to obtain certification for qualifying investments.731 The Secretary, in determining qualifying projects, will consider only those projects that show reasonable potential to: (1) result in new therapies to treat areas of unmet medical need or to prevent, detect, or treat chronic or acute disease and conditions; (2) reduce long-term health care costs in the United States; or (3) significantly advance the goal of curing cancer within a 30-year period.732 Additionally, the Secretary will take into consideration which projects have the greatest potential to: (1) create and sustain (directly or indirectly) high quality, high paying jobs in the United States; and (2) advance the United States' competitiveness in the fields of life, biological, and medical sciences.733

Qualified therapeutic discovery project expenditures do not qualify for the research credit, orphan drug credit, or bonus depreciation.734 If a credit is allowed for an expenditure related to property subject to depreciation, the basis of the property is reduced by the amount of the credit.735 Additionally, expenditures taken into account in determining the credit are nondeductible to the extent of the credit claimed that is attributable to such expenditures.

Election to receive grant in lieu of tax credit

Taxpayers may elect to receive credits that have been allocated to them in the form of Treasury grants equal to 50 percent of the qualifying investment.736 Any such grant is not includible in the taxpayer's gross income.

In making grants under this section, the Secretary is to apply rules similar to the rules of section 50.737 In applying such rules, if an investment ceases to be a qualified investment, the Secretary shall provide for the recapture of the appropriate percentage of the grant amount in such manner as the Secretary determines appropriate. The Secretary shall not make any grant under this section to: (1) any Federal, State, or local government (or any political subdivision, agency, or instrumentality thereof); (2) any organization described in section 501(c) and exempt from tax under section 501(a); (3) any entity referred to in section 54(j)(4); or (4) any partnership or other pass-thru entity any partner (or other holder of an equity or profits interest) of which is described in paragraph (1), (2), or (3).

 

Description of Proposal

 

 

This proposal repeals the credit for qualified therapeutic discovery projects.

 

Effective Date

 

 

The proposal applies to allocations and reallocations after December 31, 2014.

29. Repeal of the work opportunity tax credit (sec. 3229 of the discussion draft and sec. 51 of the Code)

 

Present Law

 

 

In general

The work opportunity tax credit is available on an elective basis for employers hiring individuals from one or more of nine targeted groups. The amount of the credit available to an employer is determined by the amount of qualified wages paid by the employer. Generally, qualified wages consist of wages attributable to service rendered by a member of a targeted group during the one-year period beginning with the day the individual begins work for the employer (two years in the case of an individual in the long-term family assistance recipient category).

Targeted groups eligible for the credit

Generally, an employer is eligible for the credit only for qualified wages paid to members of a targeted group.

 

(1) Families receiving TANF

 

An eligible recipient is an individual certified by a designated local employment agency (e.g., a State employment agency) as being a member of a family eligible to receive benefits under the Temporary Assistance for Needy Families Program ("TANF") for a period of at least nine months part of which is during the 18-month period ending on the hiring date. For these purposes, members of the family are defined to include only those individuals taken into account for purposes of determining eligibility for the TANF.

 

(2) Qualified veteran

 

There are five subcategories of qualified veterans: (1) veterans who were eligible to receive assistance under a supplemental nutritional assistance program (for at least a three month period during the year prior to the hiring date) ; (2) veterans who are entitled to compensation for a service connected disability, who are hired within one year of discharge; (3) veterans who are entitled to compensation for a service connected disability, and who have been unemployed for an aggregate of at least six months during the one year period ending on the hiring date; (4) veterans who were unemployed for at least four weeks but less than six months (whether or not consecutive) during the one-year period ending on the date of hiring; and (5) veterans who were unemployed for at least six months (whether or not consecutive) during the one-year period ending on the date of hiring.

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

 

(3) Qualified ex-felon

 

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

 

(4) Designated community residents

 

A designated community resident is an individual certified as being at least age 18 but not yet age 40 on the hiring date and as having a principal place of abode within an empowerment zone, enterprise community, renewal community or a rural renewal community. For these purposes, a rural renewal county is a county outside a metropolitan statistical area (as defined by the Office of Management and Budget) which had a net population loss during the five-year periods 1990-1994 and 1995-1999. Qualified wages do not include wages paid or incurred for services performed after the individual moves outside an empowerment zone, enterprise community, renewal community or a rural renewal community.

 

(5) Vocational rehabilitation referral

 

A vocational rehabilitation referral is an individual who is certified by a designated local agency as an individual who has a physical or mental disability that constitutes a substantial handicap to employment and who has been referred to the employer while receiving, or after completing: (a) vocational rehabilitation services under an individualized, written plan for employment under a State plan approved under the Rehabilitation Act of 1973; (b) under a rehabilitation plan for veterans carried out under Chapter 31 of Title 38, U.S. Code; or (c) an individual work plan developed and implemented by an employment network pursuant to subsection (g) of section 1148 of the Social Security Act. Certification will be provided by the designated local employment agency upon assurances from the vocational rehabilitation agency that the employee has met the above conditions.

 

(6) Qualified summer youth employee

 

A qualified summer youth employee is an individual: (1) who performs services during any 90-day period between May 1 and September 15; (2) who is certified by the designated local agency as being 16 or 17 years of age on the hiring date; (3) who has not been an employee of that employer before; and (4) who is certified by the designated local agency as having a principal place of abode within an empowerment zone, enterprise community, or renewal community. As with designated community residents, no credit is available on wages paid or incurred for service performed after the qualified summer youth moves outside of an empowerment zone, enterprise community, or renewal community. If, after the end of the 90-day period, the employer continues to employ a youth who was certified during the 90-day period as a member of another targeted group, the limit on qualified first-year wages will take into account wages paid to the youth while a qualified summer youth employee.

 

(7) Qualified food and nutrition recipient

 

A qualified food and nutrition recipient is an individual at least age 18 but not yet age 40 certified by a designated local employment agency as being a member of a family receiving assistance under a food and nutrition program under the Food and Nutrition Act of 2008 for a period of at least six months ending on the hiring date. In the case of families that cease to be eligible for food and nutrition assistance under section 6(o) of the Food and Nutrition Act of 2008, the six-month requirement is replaced with a requirement that the family has been receiving food and nutrition assistance for at least three of the five months ending on the date of hire. For these purposes, members of the family are defined to include only those individuals taken into account for purposes of determining eligibility for a food and nutrition assistance program under the Food and Nutrition Act of 2008.

 

(8) Qualified SSI recipient

 

A qualified SSI recipient is an individual designated by a local agency as receiving supplemental security income ("SSI") benefits under Title XVI of the Social Security Act for any month ending within the 60-day period ending on the hiring date.

 

(9) Long-term family assistance recipients

 

A qualified long-term family assistance recipient is an individual certified by a designated local agency as being: (1) a member of a family that has received family assistance for at least 18 consecutive months ending on the hiring date; (2) a member of a family that has received such family assistance for a total of at least 18 months (whether or not consecutive) after August 5, 1997 (the date of enactment of the welfare-to-work tax credit)738 if the individual is hired within two years after the date that the 18-month total is reached; or (3) a member of a family who is no longer eligible for family assistance because of either Federal or State time limits, if the individual is hired within two years after the Federal or State time limits made the family ineligible for family assistance.

Qualified wages

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

For purposes of the credit, generally, wages are defined by reference to the FUTA definition of wages contained in section 3306(b) (without regard to the dollar limitation therein contained). Special rules apply in the case of certain agricultural labor and certain railroad labor.

Calculation of the credit

The credit available to an employer for qualified wages paid to members of all targeted groups except for long-term family assistance recipients equals 40 percent (25 percent for employment of 400 hours or less) of qualified first-year wages. Generally, qualified first-year wages are qualified wages (not in excess of $6,000) attributable to service rendered by a member of a targeted group during the one-year period beginning with the day the individual began work for the employer. Therefore, the maximum credit per employee is $2,400 (40 percent of the first $6,000 of qualified first-year wages). With respect to qualified summer youth employees, the maximum credit is $1,200 (40 percent of the first $3,000 of qualified first-year wages). Except for long-term family assistance recipients, no credit is allowed for second-year wages.

In the case of long-term family assistance recipients, the credit equals 40 percent (25 percent for employment of 400 hours or less) of $10,000 for qualified first-year wages and 50 percent of the first $10,000 of qualified second-year wages. Generally, qualified second-year wages are qualified wages (not in excess of $10,000) attributable to service rendered by a member of the long-term family assistance category during the one-year period beginning on the day after the one-year period beginning with the day the individual began work for the employer. Therefore, the maximum credit per employee is $9,000 (40 percent of the first $10,000 of qualified first-year wages plus 50 percent of the first $10,000 of qualified second-year wages).

In the case of a qualified veterans, the credit is calculated as follows: (1) in the case of a qualified veteran who was eligible to receive assistance under a supplemental nutritional assistance program (for at least a three month period during the year prior to the hiring date) the employer is entitled to a maximum credit of 40 percent of $6,000 of qualified first-year wages; (2) in the case of a qualified veteran who is entitled to compensation for a service connected disability, who is hired within one year of discharge, the employer is entitled to a maximum credit of 40 percent of $12,000 of qualified first-year wages; (3) in the case of a qualified veteran who is entitled to compensation for a service connected disability, and who has been unemployed for an aggregate of at least six months during the one year period ending on the hiring date, the employer is entitled to a maximum credit of 40 percent of $24,000 of qualified first-year wages; (4) in the case of a qualified veteran unemployed for at least four weeks but less than six months (whether or not consecutive) during the one-year period ending on the date of hiring, the maximum credit equals 40 percent of $6,000 of qualified first-year wages; and (5) in the case of a qualified veteran unemployed for at least six months (whether or not consecutive) during the one-year period ending on the date of hiring, the maximum credit equals 40 percent of $14,000 of qualified first-year wages.

Expiration

The work opportunity tax credit is not available with respect to wages paid to individuals who begin work for an employer after December 31, 2013.

 

Description of Proposal

 

 

This proposal repeals the work opportunity tax credit.

 

Effective Date

 

 

The proposal is effective for amounts paid or incurred to individuals who begin work for the employer after December 31, 2013.

30. Repeal of deduction for certain unused business credits (sec. 3230 of the discussion draft and sec. 196 of the Code)

 

Present Law

 

 

The general business credit ("GBC") consists of various individual tax credits allowed with respect to certain qualified expenditures and activities.739 In general, the various individual tax credits contain provisions that prohibit "double benefits," either by denying deductions in the case of expenditure-related credits or by requiring income inclusions in the case of activity-related credits. Unused credits may be carried back one year and carried forward 20 years.740

Section 196 allows a deduction to the extent that certain portions of the GBC expire unused after the end of the carry forward period. In general, 100 percent of the unused credit is allowed as a deduction in the taxable year after such credit expired. However, with respect to the investment credit determined under section 46 (other than the rehabilitation credit) and the research credit determined under section 41(a) (for a taxable year beginning before January 1, 1990), section 196 limits the deduction to 50 percent of such unused credits.741

 

Description of Proposal

 

 

This proposal repeals the deduction for certain unused business credits.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

 

D. Accounting Methods

 

 

1. Limitation on use of cash method of accounting (sec. 3301 of the discussion draft and secs. 448 and 451 of the Code)

 

Present Law

 

 

Taxpayers using the cash receipts and disbursements method of accounting (the "cash method") generally recognize items of income when actually or constructively received and items of expense when paid. Taxpayers using an accrual method of accounting generally accrue items of income when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy.742 Taxpayers using an accrual method of accounting generally may not deduct items of expense prior to when all events have occurred that fix the right to pay the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred.743 An accrual method taxpayer may deduct the amount of any receivable that was previously included in income that becomes worthless during the year.744

A C corporation, a partnership that has a C corporation as a partner, or a tax-exempt trust with unrelated business income generally may not use the cash method of accounting. Exceptions are made for farming businesses, qualified personal service corporations, and the aforementioned entities to the extent their average annual gross receipts do not exceed $5 million for all prior years (including the prior taxable years of any predecessor of the entity) (the "gross receipts test"). The cash method of accounting may not be used by any tax shelter. In addition, the cash method generally may not be used if the purchase, production, or sale of merchandise is an income producing factor.745 Such taxpayers generally are required to keep inventories and use an accrual method of accounting with respect to inventory items.746

A farming business is defined as a trade or business of farming, including operating a nursery or sod farm, or the raising or harvesting of trees bearing fruit, nuts, or other crops, timber, or ornamental trees.747 Such farming businesses are not precluded from using the cash method regardless of whether they meet the gross receipts test.748

A qualified personal service corporation is a corporation: (1) substantially all of whose activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting and (2) substantially all of the stock of which is owned by current or former employees performing such services, their estates, or heirs. Qualified personal service corporations are allowed to use the cash method without regard to whether they meet the gross receipts test.

Accrual method taxpayers are not required to include in income that portion of any amounts to be received for the performance of services in the fields of health, law, engineering, architecture, accounting actuarial science, performing arts, or consulting, that, on the basis of experience, will not be collected (the "nonaccrual experience method").749 The availability of this method is conditioned on the taxpayer not charging interest or a penalty for failure to timely pay the amount charged.

 

Description of Proposal

 

 

The proposal both expands and restricts the universe of taxpayers that may use the cash method of accounting.

Under the proposal, the cash method of accounting may only be used by natural persons (i.e., sole proprietors) and taxpayers other than tax shelters that satisfy the gross receipts test. The gross receipts test allows taxpayers with annual average gross receipts that do not exceed $10 million for the three prior taxable-year period to use the cash receipts and disbursements method, so long as use of such method clearly reflects income.750

The proposal eliminates the exceptions for qualified personal service corporations. Thus, personal service corporations generally are precluded from using the cash method unless such personal service corporation satisfies the gross receipts test. However, the proposal retains the exception for farming business such that farming businesses are not precluded from using the cash method regardless of whether they meet the gross receipts test.

Under the proposal, the rules for the nonaccrual experience method are retained and are moved from section 448 to new subsection (j) under section 451.

In the case of any taxpayer required by this section to change its method of accounting for any taxable year, such change is treated as initiated by the taxpayer and made with the consent of the Secretary.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014. Application of these rules is a change in the taxpayer's method of accounting for purposes of section 481. Any resulting increase in income is taken into account over four taxable years beginning with the earlier of the taxpayer's elected taxable year751 or the taxpayer's first taxable year beginning after December 31, 2018, using the following schedule: (1) first taxable year in such period, 10 percent; (2) second such taxable year, 15 percent; (3) third such taxable year, 25 percent; and (4) fourth such taxable year, 50 percent. For taxpayers with a final taxable year beginning before December 31, 2018, the present-law operative rules of section 481 apply (e.g., the full amount of the section 481 adjustment required to be included under this proposal is included with the final return).

2. Rules for determining whether taxpayer has adopted a method of accounting (sec. 3302 of the discussion draft and sec. 446 of the Code)

 

Present Law

 

 

Section 446 generally allows a taxpayer to select the method of accounting to be used to compute taxable income, provided that such method clearly reflects the income of the taxpayer. The term "method of accounting" includes not only the overall method of accounting used by the taxpayer, but also the accounting treatment of any one item.752 Permissible overall methods of accounting include the cash receipts and disbursements method ("cash method"), an accrual method, or any other method (including a hybrid method) permitted under regulations prescribed by the Secretary of the Treasury.753 Examples of any one item for which an accounting method may be adopted include cost recovery,754 revenue recognition,755 and timing of deductions.756 For each separate trade or business, a taxpayer is entitled to adopt any permissible method, subject to certain restrictions.757

A taxpayer filing its first return may adopt any permissible method of accounting in computing taxable income for such year.758 Except as otherwise provided, section 446(e) requires taxpayers to secure consent of the Secretary before changing a method of accounting. The regulations under this section provide rules for determining: (1) what a method of accounting is, (2) how an adoption of a method of accounting occurs, and (3) how a change in method of accounting is effectuated.759

A change in method of accounting includes a change in the overall plan of accounting for gross income or deductions (e.g., cash method or an accrual method) or a change in the treatment of any material item used in such overall plan (e.g., timing of deduction of prepaid insurance). A material item is any item that involves the proper time for the inclusion of the item in income or taking of a deduction.760 A change in method of accounting does not include a correction of a mathematical or posting error, or an error in the computation of tax liability.761 Also, a change in method of accounting does not include adjustment of any item of income or deduction that does not involve the proper time for the inclusion of the item of income or the taking of a deduction. A change in method of accounting also does not include a change in treatment resulting from a change in underlying facts.

There are instances where taxpayers change their method of accounting without securing consent of the Secretary. Additionally, there are instances where taxpayers adopt an impermissible method of accounting. In such instances, the IRS has taken the position that a taxpayer's method of accounting is adopted (1) when a permissible method of accounting is used on a single tax return or (2) when the same impermissible method of accounting has been used on two or more consecutive tax returns.762

 

Description of Proposal

 

 

The proposal codifies the current IRS position and provides that a method of accounting is considered as adopted by the taxpayer (1) when a permissible method of accounting is used on a single tax return or (2) when the same impermissible method of accounting has been used on two or more consecutive tax returns. No inference is intended as to present law.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

3. Certain special rules for taxable year of inclusion (sec. 3303 of the discussion draft and sec. 451 of the Code)

 

Present Law

 

 

In general

A taxpayer generally is required to include an item in income no later than the time of its actual or constructive receipt, unless the item properly is accounted for in a different period under the taxpayer's method of accounting.763 If a taxpayer has an unrestricted right to demand the payment of an amount, the taxpayer is in constructive receipt of that amount whether or not the taxpayer makes the demand and actually receives the payment.764

In general, for a cash basis taxpayer, an amount is included in income when actually or constructively received.765 For an accrual basis taxpayer, an amount generally is recognized (and included in income) the earlier of when such amount is earned by, due to, or received by the taxpayer, unless an exception permits deferral or exclusion.766

A number of exceptions that exist to permit deferral of income relate to advance payments. Advance payment situations arise when amounts are received by the taxpayer in advance of when goods or services are provided by the taxpayer to its customer. The exceptions often allow tax deferral to mirror financial accounting deferral (e.g., income is recognized as the goods are provided or the services are performed).767

Special rule for crop insurance proceeds or disaster payments

Under a special rule, in the case of insurance proceeds received as a result of destruction or damage to crops, a cash method taxpayer may elect to include such proceeds in income for the taxable year following the taxable year of destruction or damage, if the taxpayer establishes that the income from such crops would have been reported in the following taxable year.768 For this purpose, payments for which these elections are available include disaster assistance received as a result of destruction or damage to crops caused by drought, flood, or other natural disaster, or the inability to plant crops because of such a disaster, under any Federal law (including payments received under the Agricultural Act of 1949, as amended, or title II of the Disaster Assistance Act of 1988).

Special rule for proceeds from livestock sold on account of drought, flood, or other weather-related conditions

A similar special provision exists for a cash method taxpayer whose principal trade or business is farming who is forced to sell livestock due to drought, flood, or other weather-related conditions in excess of the number the taxpayer would sell if the taxpayer followed its usual business practices. Such a taxpayer may elect to include income from the sale of the livestock in the taxable year following the taxable year of the sale.769 This elective deferral of income is available only if the taxpayer establishes that, under the taxpayer's usual business practices, the sale would not have occurred but for drought, flood, or weather-related conditions that resulted in the area being designated as eligible for Federal assistance.

Special rule for sales or dispositions to implement Federal Energy Regulatory Commission or State electric restructuring policy

Another such special tax provision permits taxpayers to elect to recognize gain from qualifying electric transmission transactions ratably over an eight-year period beginning in the year of sale if the amount realized from such sale is used to purchase exempt utility property within the applicable period770 (the "reinvestment property").771 If the amount realized exceeds the amount used to purchase reinvestment property, any realized gain is recognized to the extent of such excess in the year of the qualifying electric transmission transaction.

A qualifying electric transmission transaction is the sale or other disposition of property used by a qualified electric utility to an independent transmission company prior to January 1, 2014.772 A qualified electric utility is defined as an electric utility, which as of the date of the qualifying electric transmission transaction, is vertically integrated in that it is both (1) a transmitting utility (as defined in the Federal Power Act773) with respect to the transmission facilities to which the election applies, and (2) an electric utility (as defined in the Federal Power Act774).775

In general, an independent transmission company is defined as: (1) an independent transmission provider776 approved by the Federal Energy Regulatory Commission ("FERC"); (2) a person (i) who the FERC determines under section 203 of the Federal Power Act777 (or by declaratory order) is not a "market participant" and (ii) whose transmission facilities are placed under the operational control of a FERC-approved independent transmission provider no later than four years after the close of the taxable year in which the transaction occurs; or (3) in the case of facilities subject to the jurisdiction of the Public Utility Commission of Texas, (i) a person which is approved by that Commission as consistent with Texas State law regarding an independent transmission organization, or (ii) a political subdivision, or affiliate thereof, whose transmission facilities are under the operational control of an organization described in (i).778

Exempt utility property is defined as: (1) property used in the trade or business of (i) generating, transmitting, distributing, or selling electricity or (ii) producing, transmitting, distributing, or selling natural gas; or (2) stock in a controlled corporation whose principal trade or business consists of the activities described in (1).779 Exempt utility property does not include any property that is located outside of the United States.780

If a taxpayer is a member of an affiliated group of corporations filing a consolidated return, the reinvestment property may be purchased by any member of the affiliated group (in lieu of the taxpayer).781

 

Description of Proposal

 

 

The proposal revises the rules associated with the recognition of income. Specifically, the proposal requires a taxpayer to recognize income no later than the taxable year in which such income is taken into account as income on an audited financial statement or another financial statement under rules specified by the Secretary,782 but provides an exception for long-term contract income to which section 460 applies.783

The proposal also codifies the current deferral method of accounting for advance payments for goods and services provided by the IRS under Revenue Procedure 2004-34.784 That is, the proposal allows taxpayers to defer the inclusion of income associated with certain advance payments to the end of the tax year following the tax year of receipt if such income also is deferred for financial statement purposes.785

The proposal repeals the special rule for crop insurance proceeds or disaster payments. Similar to insurance proceeds or disaster payments received by taxpayers unrelated to destruction or damage of crops, taxpayers that use the cash method of accounting must include crop insurance proceeds and disaster payments in income when received.

The proposal also repeals the special rule for proceeds from livestock sold on account of drought, flood, or other weather-related conditions. As a result of repealing the special rule, taxpayers using the cash method of accounting are required to include amounts received from the sale of livestock in income when received.

Further, the proposal repeals the special rule for sales or dispositions to implement FERC or State electric restructuring policy. That is, gains resulting from a qualifying electric transmission transaction must be recognized in accordance with generally applicable revenue recognition principles.

 

Effective Date

 

 

The proposal repealing the special rule for crop insurance proceeds and disaster payments generally applies to destruction and damage to crops or natural disasters occurring after December 31, 2014. However, in the case of inability to plant crops because of a natural disaster, the proposal applies to natural disasters occurring after December 31, 2014.

The proposal repealing the special rule for proceeds from livestock sold on account of drought, flood, or other weather-related conditions applies to sales and exchanges after December 31, 2014.

The proposal repealing the special rule for sales or dispositions to implement FERC or State electric restructuring policy applies to sales and dispositions after December 31, 2013.

The remaining proposals apply to taxable years beginning after December 31, 2014 and application of these rules is a change in the taxpayer's method of accounting for purposes of section 481.

4. Installment sales (sec. 3304 of the discussion draft and secs. 453 and 453A of the Code)

 

Present Law

 

 

An accrual method taxpayer generally is required to recognize income when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy.786 However, taxpayers are permitted to recognize as gain on a disposition of property only that proportion of payments received in a taxable year which is the same as the proportion that the gross profit bears to the total contract price (the "installment method").787 That is, the installment method of accounting generally allows a taxpayer to defer the recognition of income from the disposition of certain property until payment is received. Sales to customers in the ordinary course of business ("dealer dispositions") and sales in which the taxpayer receives indebtedness that is readily tradeable are not eligible for the installment method. However, exceptions from the prohibition to use the installment method for dealer dispositions are available for sales of timeshares and residential lots (if an election to pay interest under section 453(l)(2)(B) is made) and for sales of property that is used or produced in the trade or business of farming.788

A pledge rule provides that if an installment obligation is pledged as security for any indebtedness, the net proceeds789 of such indebtedness are treated as a payment on the obligation, triggering the recognition of income.790 Actual payments received on the installment obligation subsequent to the receipt of the loan proceeds are not taken into account until such subsequent payments exceed the loan proceeds that were treated as payments. The pledge rule does not apply to sales by an individual of personal use property,791 to sales of property used or produced in the trade or business of farming, to sales of timeshares and residential lots where the taxpayer elects to pay interest under section 453(l)(2)(B), or to dispositions where the sales price does not exceed $150,000.

The amount of benefit that may be obtained through the use of the installment method is limited by the imposition of an interest charge on the tax deferral attributable to the portion of the installment obligations that arise during and remain outstanding at the close of the taxable year that exceed $5 million.792 Dispositions where the sales price does not exceed $150,000 are not taken into account for the purpose of this $5 million threshold. Interest accrues at the same rate as applies to underpayments of income tax and is treated as interest expense for other Federal income tax purposes.793 An exception from the imposition of an interest charge is provided for installment obligations arising from the disposition by an individual of personal use property or of any property used or produced in the trade or business of farming.794 Another exception applies to obligations arising from sales of timeshares and residential lots; however, a separate interest charge applies as described above.795

 

Description of Proposal

 

 

The proposal repeals the present law exceptions to the dealer disposition rules for farm property and timeshares and residential lots. Thus, under the proposal, installment method treatment is not available for any dealer disposition of real or personal property.

The proposal also repeals the present law $5 million floor for the imposition of the special rule for interest payments under section 453A such that interest is imposed on the tax deferral attributable to obligations outstanding at year-end where the sales price for such disposition exceeds $150,000.

Further, the proposal repeals the exception from interest on installment obligations related to the sales of farm property. The proposal also repeals the special interest rules for timeshares and residential lots.

 

Effective Date

 

 

The proposal applies to sales and other dispositions after December 31, 2014.

5. Repeal of special rule for prepaid subscription income (sec. 3305 of the discussion draft and sec. 455 of the Code)

 

Present Law

 

 

An accrual method taxpayer generally is required to recognize income when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy.796 However, eligible taxpayers using an accrual method of accounting for subscription income797 may elect to recognize income associated with prepaid subscriptions798 in the year during which the liability exists. For this purpose, "liability" means a liability to furnish or deliver a newspaper, magazine, or other periodical.799 Thus, if elected,800 prepaid subscription income may be allocated over the subscription's term.

 

Description of Proposal

 

 

The proposal repeals the special rules for prepaid subscription income. Thus, any prepayment received by a taxpayer associated with a subscription to a newspaper, magazine, or other periodical is included in income in accordance with the generally applicable rules for taxable year of inclusion.801

 

Effective Date

 

 

The proposal applies to payments received after December 31, 2014.

6. Repeal of special rule for prepaid dues income of certain membership organizations (sec. 3306 of the discussion draft and sec. 456 of the Code)

 

Present Law

 

 

An accrual method taxpayer generally is required to recognize income when all the events have occurred that fix the right to receive the income and the amount of the income can be determined with reasonable accuracy.802 However, accrual method taxpayers803 qualifying as membership organizations804 may elect805 to recognize income associated with prepaid dues806 in the year during which the liability exists. For this purpose, "liability" means a liability to render services or make available membership privileges over a period of time which does not exceed 36 months.807 Thus, a qualifying taxpayer may elect to include prepaid dues in income ratably over the period over which the taxpayer is obligated to render services or provide membership privileges, up to a maximum of 36 months.

 

Description of Proposal

 

 

The proposal repeals the special rule for prepaid dues income of certain membership organizations. Thus, any prepayment received by a taxpayer (qualifying as a membership organization) in connection with, and directly attributable to, a liability to render services or make available membership privileges is included in accordance with the generally applicable rules for taxable year of inclusion.808

 

Effective Date

 

 

The proposal applies to payments received after December 31, 2014.

7. Repeal of special rule for magazines, paperbacks, and records returned after the close of the taxable year (sec. 3307 of the discussion draft and sec. 458 of the Code)

 

Present Law

 

 

A taxpayer generally is required to include an item in income no later than the time of its receipt, unless the item properly is accounted for in a different period under the taxpayer's method of accounting.809 Taxpayers selling merchandise who use an accrual method of accounting generally must include sales proceeds in income for the taxable year when all events have occurred which fix the right to receive income and the amount can be determined with reasonable accuracy.810

In some cases, the seller expects that accrued sales income will be reduced on account of events subsequent to the date of sale, such as returns of unsold merchandise for credit or refund pursuant to a preexisting agreement or understanding between the seller and the purchaser. In these instances, the reduction in sales income generally may be recognized only in the taxable year during which the subsequent event, such as the return of unsold merchandise, occurs.811 Deductions or exclusions based on estimates of future losses, expenses, or reductions in income ordinarily generally are not allowed for Federal income tax purposes.812

Publishers and distributors of magazines, paperbacks, and records often sell more copies of their merchandise than it is anticipated will be sold to consumers. This overstocking is part of a mass-marketing promotion technique, which relies in part on conspicuous display of the merchandise and the ability of the retailer promptly to satisfy consumer demand. Publishers usually bear the cost of such mass-marketing promotion by agreeing to repurchase unsold copies of merchandise from distributors, who in turn agree to repurchase unsold copies from retailers. These unsold items commonly are referred to as returns.

For taxpayers who account for sales of magazines, paperbacks, or records on an accrual method, section 458 provides an election to exclude from gross income for a taxable year the income attributable to unsold merchandise returned within a certain time (the "merchandise return period") after the close of the taxable year.813 In the case of magazines, the merchandise return period extends for two months and 15 days after the close of the taxable year in which the sales were made.814 In the case of paperbacks and records, the merchandise return period extends for four months and 15 days after the close of the taxable year in which the sales were made.815 Once an election is made, a taxpayer's use of section 458 is treated as a method of accounting816 and must be continued until the taxpayer secures the consent of the Secretary to revoke such election.817

 

Description of Proposal

 

 

The proposal repeals the special rule for the recognition of income attributable to magazines, paperbacks, and records returned after close of the taxable year in which the sales were made. Thus, taxpayers must recognize revenue for the sale of magazines, paperbacks, and records in accordance with section 451. Further, taxpayers may claim a deduction for any returned items in accordance with section 461.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014. Application of these rules is a change in the taxpayer's method of accounting for purposes of section 481.

8. Modification of rules for long-term contracts (sec. 3308 of the discussion draft and sec. 460 of the Code)

 

Present Law

 

 

Percentage-of-completion method

In general, in the case of a long-term contract, the taxable income from the contract is determined under the percentage-of-completion method.818 Under this method, the taxpayer must include in gross income for the taxable year an amount equal to the product of (1) the gross contract price and (2) the percentage of the contract completed during the taxable year.819 The percentage of completed during the taxable year is determined by comparing costs allocated to the contract and incurred before the end of the taxable year with the estimated total contract costs.820 Costs allocated to the contract typically include all costs (including depreciation) that directly benefit or are incurred by reason of the taxpayer's long-term contract activities.821 The allocation of costs to a contract is made in accordance with regulations.822 Costs incurred with respect to the long-term contract are deductible in the year incurred, subject to general accrual method of accounting principles and limitations.823

Upon the completion of a long-term contract, a taxpayer must pay (or receive as a refund) interest computed under the look-back method to the extent that taxes in a prior contract year were underpaid (or overpaid) due to the use of estimated contract price and costs rather than the actual contract price and costs.824

A long-term contract is defined as any contract for the manufacture, building, installation, or construction of property when such contract is not completed within the same taxable year in which the contract was entered into.825 However, a contract for the manufacture of property is not considered a long-term contract unless the contract involves the manufacture of (1) any unique item of a type which is not normally included in the finished goods inventory of the taxpayer, or (2) any item which normally requires more than 12 calendar months to complete.826

Exceptions to the percentage-of-completion method

There are a number of types of long-term contracts excepted from the requirement to use the percentage-of-completion method to compute taxable income: (1) home and residential construction contracts; (2) small construction contracts; and (3) ship construction contracts. For the portion of the long-term contract income excluded from the percentage-of-completion method, taxable income is determined under the taxpayer's exempt contract method. Permissible exempt contract methods include the completed contract method, the exempt-contract percentage-of-completion method, the percentage-of-completion method, or any other permissible method.827

 

Home and residential construction contracts

 

One exception from the requirement to use the percentage-of-completion method is provided for home construction contracts.828 For this purpose, a home construction contract means any construction contract if 80 percent or more of the estimated total contract costs (as of the close of the taxable year in which the contract was entered into) are reasonably expected to be attributable to the building, construction, reconstruction, or rehabilitation of, or the installation of any integral component to, or improvements of, real property with respect to dwelling units829 contained in buildings containing four or fewer dwelling units,830 and improvements to real property directly related to (and located on the site of) such dwelling units.831 Thus, long-term contract income from home construction contracts must be reported consistently using the taxpayer's exempt contract method.

A partial exception is provided that allows residential construction contracts to use the 70/30 percentage-of-completion/capitalized cost method ("PCCM").832 Residential construction contracts are home construction contracts, as defined above, except that the building or buildings being constructed contain more than four dwelling units.833 Under the 70/30 PCCM, 70 percent of a taxpayer's long-term contract income is required to be computed using the percentage-of-completion method while the remaining 30 percent is exempt from the requirement.834 The exempt 30 percent of long-term contract income must be reported by consistently using the taxpayer's exempt contract method.835

 

Small construction contracts

 

Another exception from the requirement to use the percentage-of-completion method is provided for certain construction contracts ("small construction contracts"). Contracts within this exception are those contracts for the construction or improvement of real property if the contract: (1) is expected (at the time such contract is entered into) to be completed within two years of commencement of the contract and (2) is performed by a taxpayer whose average annual gross receipts for the prior three taxable years do not exceed $10 million.836 Thus, long-term contract income from small construction contracts must be reported consistently using the taxpayer's exempt contract method.837

 

Ship construction contracts

 

Additional exceptions from the requirement to use the percentage-of-completion method are provided for qualified ship construction contracts and qualified naval ship contracts, as defined below. The taxable income from those contracts are allowed to be determined using the 40/60 PCCM.838 Under the 40/60 PCCM, 40 percent of a taxpayer's long-term contract income is required to be computed using the percentage-of-completion method while the remaining 60 percent is exempt from the requirement.839 The exempt 60 percent of long-term contract income must be reported consistently using the taxpayer's exempt contract method.

A qualified ship construction contract is defined as any contract for the construction in the United States of not more than five ships if such ships will not be constructed (directly or indirectly) for the Federal government and the taxpayer reasonably expects to complete such contract within five years of the contract commencement date.840

A qualified naval ship contract is defined as any contract or portion thereof that is for the construction in the United States of one ship or submarine for the Federal Government if the taxpayer reasonably expects the acceptance date841 will occur no later than nine years after the construction commencement date (the date on which the physical fabrication of any section or component of the ship or submarine begins in the taxpayer's shipyard).842

 

Description of Proposal

 

 

The proposal repeals the exception from the required use of the percentage-of-completion method for determining taxable income from home construction contracts, as well as the partial exception for residential construction contracts (i.e., the 70/30 PCCM). However, the exception for certain small construction contracts is retained. Thus, taxable income for home construction contracts generally must be accounted for using the percentage-of-completion method, unless the taxpayer meets the present-law exception for small construction contracts.

The proposal also repeals the 40/60 PCCM exception for qualified ship construction contracts and qualified naval ship contracts. Thus, the taxable income under these contracts generally must be accounted for using the percentage-of-completion method.

 

Effective Date

 

 

The proposal applies to contracts entered into after December 31, 2014.

9. Nuclear decommissioning reserve funds (sec. 3309 of the discussion draft and sec. 468A of the Code)

 

Present Law

 

 

In general

Under general tax accounting rules, taxpayers using an accrual method of accounting generally may not deduct items of expense before all events have occurred that fix the right to pay the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred.843 However, the Deficit Reduction Act of 1984844 contains an exception under which a taxpayer responsible for decommissioning a nuclear powerplant may elect845 to deduct contributions made to a Nuclear Decommissioning Reserve Fund (hereinafter referred to as a "Fund") for future decommissioning costs when such amounts are paid into the Fund.846 Taxpayers who do not elect this provision are subject to the general tax accounting rules for timing of the deduction.

Nuclear Decommissioning Reserve Fund

To qualify as a Fund, two requirements must be met. First, the taxpayer must establish a separate Fund with respect to each nuclear powerplant to which such election applies.847 Second, the Fund must be used exclusively for the payment of decommissioning costs, taxes on Fund income, administrative costs of the Fund, and for making investments (to the extent that a portion of the Fund is not currently needed to pay the aforementioned costs).848

Accumulations in a Fund are limited to the amount required to fund decommissioning costs of a nuclear powerplant for the period during which the Fund is in existence. For this purpose, decommissioning costs are considered to accrue ratably over a nuclear powerplant's estimated useful life. To prevent accumulations of funds over the remaining life of a nuclear powerplant in excess of those required to pay future decommissioning costs of such nuclear powerplant and to ensure that contributions to a Fund are not deducted more rapidly than level funding (taking into account an appropriate discount rate), taxpayers must obtain a ruling from the IRS to establish the maximum annual contribution that may be made to a Fund (the "ruling amount").849 In certain instances (e.g., change in estimate), a taxpayer is required to obtain a new ruling amount to reflect updated information.

Contributions to a Fund are deductible in the year paid into the Fund, to the extent such amounts do not exceed the ruling amount.850 A taxpayer is permitted to make contributions to a Fund in excess of the ruling amount in one circumstance. Specifically, a taxpayer is permitted to contribute up to the present value of total nuclear decommissioning costs with respect to a nuclear powerplant previously excluded under section 468A(d)(2)(A).851 An amount that is permitted to be contributed under this special rule is determined using the estimate of total decommissioning costs used for purposes of determining the taxpayer's most recent ruling amount.852 Any amount transferred to the qualified fund under this special rule is allowed as a deduction over the remaining useful life of the nuclear powerplant.853 If a qualified fund that has received amounts under this rule is transferred to another person, the transferor is permitted a deduction for any remaining deductible amounts at the time of transfer.854

This provision requires that a taxpayer apply for a new ruling amount with respect to a nuclear powerplant in any tax year in which the powerplant is granted a license renewal, extending its useful life.855

The Fund is treated as a corporation, and income of the Fund is taxed at a reduced rate of 20 percent for taxable years beginning after December 31, 1995.856 Amounts withdrawn from a Fund by a taxpayer to pay for decommissioning costs are included in such taxpayer's income, but the taxpayer also is entitled to a deduction for decommissioning costs as economic performance for such costs occurs.857

A Fund may be transferred in connection with the sale, exchange, or other transfer of the nuclear powerplant to which it relates. If the transferee meets certain requirements,858 the transfer is treated as a nontaxable transaction. No gain or loss is recognized on the transfer of the Fund and the transferee takes the transferor's basis in the Fund.859 The transferee generally is required to obtain a new ruling amount from the IRS.860

Nonqualified nuclear decommissioning funds

Federal and State regulators may require utilities to set aside funds for nuclear decommissioning costs in excess of the amount allowed as a deductible contribution to a Fund. In addition, taxpayers may have set aside funds prior to the effective date of the qualified fund rules.861 The treatment of amounts set aside for decommissioning costs prior to 1984 varies. Some taxpayers may have received no tax benefit while others may have deducted such amounts or excluded such amounts from income. Since 1984, taxpayers have been required to include in gross income customer charges for decommissioning costs,862 and a current deduction has not been allowed for amounts set aside to pay for decommissioning costs except through the use of a Fund. Income earned in a nonqualified fund is taxable to such fund's owner as it is earned.

Description of Proposal

The proposal eliminates the preferential rate for Nuclear Decommissioning Reserve Funds such that earnings of a Fund are taxed at the maximum rate under section 11 (i.e., the maximum rate for corporations).

The proposal also requires that, if any distribution is made from the Fund and not used in accordance with the rules prescribed in section 468A(e)(4), the balance of the Fund is to be included in gross income for such year.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

10. Repeal of last-in, first-out method of inventory (sec. 3310 of the discussion draft and secs. 471, 472, 473 and 474 of the Code)

 

Present Law

 

 

In general

In general, for Federal income tax purposes, taxpayers must account for inventories if the production, purchase, or sale of merchandise is a material income-producing factor to the taxpayer.863 In those circumstances in which a taxpayer is required to account for inventory, the taxpayer must maintain inventory records to determine the cost of goods sold during the taxable period. Cost of goods sold generally is determined by adding the taxpayer's inventory at the beginning of the period to the purchases made during the period and subtracting from that sum the taxpayer's inventory at the end of the period.

Because of the difficulty of accounting for inventory on an item-by-item basis, taxpayers often use conventions that assume certain item or cost flows. Among these conventions are the first-in, first-out ("FIFO") method, which assumes that the items in ending inventory are those most recently acquired by the taxpayer, and the last-in, first-out ("LIFO") method, which assumes that the items in ending inventory are those earliest acquired by the taxpayer.

LIFO

 

In general

 

Under the LIFO method, it is assumed that the last items entered into the inventory are the first items sold. Because the most recently acquired or produced units are deemed to be sold first, cost of goods sold is valued at the most recent costs; the effect of cost fluctuations is reflected in the ending inventory, which is valued at the historical costs rather than the most recent costs.864 Compared to FIFO, LIFO produces net income that more closely reflects the difference between sale proceeds and current market cost of inventory. When costs are rising, the LIFO method results in a higher measure of cost of goods sold and, consequently, a lower measure of income when compared to the FIFO method. The inflationary gain experienced by the business in its inventory generally is not reflected in income, but rather, remains in ending inventory as a deferred gain until a future period in which the quantity of items sold exceeds purchases.865

 

Dollar-value LIFO

 

Under a variation of the LIFO method, known as dollar-value LIFO, inventory is measured not in terms of number of units but rather in terms of a dollar-value relative to a base cost. Dollar-value LIFO allows the pooling of dissimilar items into a single inventory calculation. Thus, depending upon the taxpayer's method for defining an item, LIFO may be applied to a taxpayer's entire inventory in a single calculation even if the inventory is made up of different physical items. For example, a single dollar-value LIFO calculation can be performed for an inventory that includes both yards of fabric and sewing needles. This effectively permits the deferral of inflationary gain to continue even as the inventory mix changes or certain goods previously included in inventory are discontinued by the business.

 

Simplified rules for certain small businesses

 

In 1986, Congress enacted a simplified dollar-value LIFO method for certain small businesses.866 In doing so, Congress acknowledged that the LIFO method generally is considered to be an advantageous method of accounting, and that the complexity and greater cost of compliance associated with LIFO, including dollar-value LIFO, discouraged smaller taxpayers from using LIFO.867

To qualify for the simplified method, a taxpayer must have average annual gross receipts of $5 million or less for the three preceding taxable years.868 Under the simplified method, taxpayers are permitted to calculate inventory values by reference to changes in published price indexes rather than comparing actual costs to base period costs.

 

Special rules for qualified liquidations of LIFO inventories

 

In certain circumstances, reductions in inventory levels may be beyond the control of the taxpayer. Section 473 mitigates the adverse effects in certain specified cases by allowing a taxpayer to claim a refund of taxes paid on LIFO inventory profits resulting from the liquidation of LIFO inventories if the taxpayer purchases replacement inventory within a defined replacement period. The provision generally applies when a decrease in inventory is caused by reduced supply due to government regulation or supply interruptions due to the interruption of foreign trade.

 

Description of Proposal

 

 

The proposal repeals the LIFO inventory accounting method. Taxpayers that currently use a LIFO method are required to revalue their beginning LIFO inventory using the FIFO (or other permissible) method in the first taxable year beginning after December 31, 2014.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014. Application of these rules is a change in the taxpayer's method of accounting for purposes of section 481. Any resulting increase in income is taken into account over four taxable years beginning with the earlier of the taxpayer's elected taxable year869 or the taxpayer's first taxable year beginning after December 31, 2018, using the following schedule: (1) first taxable year in such period, 10 percent; (2) second such taxable year, 15 percent; (3) third such taxable year, 25 percent; and (4) fourth such taxable year, 50 percent. For taxpayers with a final taxable year beginning before December 31, 2018, the present-law operative rules of section 481 apply (e.g., the full amount of the section 481 adjustment required to be included under this proposal is included with the final return).

For closely-held entities, only 20 percent (28 percent in the case of a C corporation) of the net positive section 481 adjustment is required to be included in income beginning with the same taxable year using the same schedule described above. A closely-held entity is any domestic corporation or domestic partnership that (1) is not a financial institution which uses the reserve method of accounting for bad debts in accordance with section 585, an insurance company subject to tax under subchapter L, a corporation or partnership to which an election under section 936 applies, or a DISC or former DISC; (2) does not have more than 100 shareholders or partners; and (3) does not have as a shareholder or partner a person (other than an estate, a trust described in section 1361(c)(2), or an exempt organization described in section 1361(c)(6)) who is not an individual. Special rules apply for tiered structures. Anti-abuse rules are provided to prevent transfers of inventory from non-closely-held entities to closely-held entities.

11. Repeal of lower of cost or market method of inventory (sec. 3311 of the discussion draft and sec. 471 of the Code)

 

Present Law

 

 

In general, for Federal income tax purposes, taxpayers must account for inventories if the production, purchase, or sale of merchandise is a material income-producing factor to the taxpayer.870 In those circumstances in which a taxpayer is required to account for inventory, the taxpayer must maintain inventory records to determine the cost of goods sold during the taxable period. Cost of goods sold generally is determined by adding the taxpayer's inventory at the beginning of the period to the purchases made during the period and subtracting from that sum the taxpayer's inventory at the end of the period.

Because of the difficulty of accounting for inventory on an item-by-item basis, taxpayers often use conventions that assume certain item or cost flows. Among these conventions are the first-in, first-out ("FIFO") method, which assumes that the items in ending inventory are those most recently acquired by the taxpayer, and the last-in, first-out ("LIFO") method, which assumes that the items in ending inventory are those earliest acquired by the taxpayer.

Treasury regulations provide that taxpayers that maintain inventories under section 471 may determine the value of ending inventory under the cost method or the lower-of-cost-or-market ("LCM") method.871 Under the LCM method, the value of each article in ending inventory is written down if its market value is less than its cost.872 Additionally, subnormal goods, defined as goods that are unsalable at normal prices or in the normal way because of damage, imperfections, shop wear, changes of style, odd or broken lots, or similar causes, may be written down to bona fide net selling price, under either the cost or LCM method.873

 

Description of Proposal

 

 

The proposal repeals the LCM method. The proposal also prohibits any write down for subnormal goods. Thus, taxpayers valuing their inventory under section 471 generally are not permitted to value their inventory below cost.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014. Application of these rules is a change in the taxpayer's method of accounting for purposes of section 481. Any resulting increase in income is taken into account over four taxable years beginning with the earlier of the taxpayer's elected taxable year874 or the taxpayer's first taxable year beginning after December 31, 2018, using the following schedule: (1) first taxable year in such period, 10 percent; (2) second such taxable year, 15 percent; (3) third such taxable year, 25 percent; and (4) fourth such taxable year, 50 percent. For taxpayers with a final taxable year beginning before December 31, 2018, the present-law operative rules of section 481 apply (e.g., the full amount of the section 481 adjustment required to be included under this proposal is included with the final return).

12. Modification of rules for capitalization and inclusion in inventory costs of certain expenses (sec. 3312 of the discussion draft and sec. 263A of the Code)

 

Present Law

 

 

In general

The uniform capitalization ("UNICAP") rules, which were enacted as part of the Tax Reform Act of 1986,875 require certain direct and indirect costs allocable to real or tangible personal property produced by the taxpayer to be included in either inventory or capitalized into the basis of such property, as applicable.876 For real or personal property acquired by the taxpayer for resale, section 263A generally requires certain direct and indirect costs allocable to such property to be included in inventory.

Exceptions from UNICAP

Section 263A provides a number of exceptions to the general capitalization requirements. One such exception exists for certain small taxpayers who acquire property for resale and have $10 million or less of average annual gross receipts for the preceding three-taxable year period;877 such taxpayers are not required to include additional section 263A costs in inventory.

Another exception exists for taxpayers who raise, harvest, or grow trees.878 Under this exception, section 263A does not apply to trees raised, harvested, or grown by the taxpayer (other than trees bearing fruit, nuts, or other crops, or ornamental trees) and any real property underlying such trees. Similarly, the UNICAP rules do not apply to taxpayers in certain farming businesses (unless the taxpayer is required to use an accrual method of accounting under sec. 447 or 448(a)(3)).879

Freelance authors, photographers, and artists also are exempt from section 263A for any qualified creative expenses.880 Qualified creative expenses are defined as amounts paid or incurred by an individual in the trade or business of being a writer, photographer, or artist. However, such term does not include any expense related to printing, photographic plates, motion picture files, video tapes, or similar items.

 

Description of Proposal

 

 

The proposal expands the exception from the UNICAP rules for certain small taxpayers. Specifically, a taxpayer that produces or acquires real or tangible personal property and satisfies the average annual gross receipts test also is not subject to section 263A. Thus, taxpayers with average annual gross receipts of $10 million or less for the preceding three-taxable year period are exempt from the UNICAP rules, regardless of whether they produce real or tangible personal property or acquire real or personal property for resale.

Additionally, the proposal eliminates certain exceptions from section 263A. The proposal repeals the exception for taxpayers who raise, harvest, or grow trees such that the trees and real property underlying the trees are subject to the UNICAP rules under section 263A. Further, the proposal repeals the exception for freelance authors, photographers, and artists such that their qualified creative expenses are subject to capitalization under section 263A.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014. Application of these rules is a change in the taxpayer's method of accounting for purposes of section 481.

13. Modification of income forecast method (sec. 3313 of the discussion draft and sec. 167 of the Code)

 

Present Law

 

 

In general

Section 167, in general, allows as a depreciation deduction a reasonable allowance for the exhaustion, wear and tear, and obsolescence of property used in the trade or business or held for the production of income. Specifically, section 167 provides special rules for some tangible and intangible assets including the cost of motion picture films, sound recordings, copyrights, books, and patents.881

Certain interests or rights acquired separately

The recovery period for certain interests or rights ( e.g., a patent or copyright), not acquired in a transaction (or series of related transactions) involving the acquisition of assets constituting a trade or business or substantial portion thereof,882 generally is determined by the usefulness of the asset to the taxpayer. To the extent a certain interest or right is known to be of use for only a limited period of time, the length of which can be estimated with reasonable accuracy, such an intangible asset may be recovered over the useful life of the asset.883 For certain interests or rights with an undeterminable useful life, a 15-year safe harbor amortization period may be available.884

Income forecast method

The cost of motion picture films or video tapes, sound recordings, copyrights, books, and patents are eligible to be recovered using the income forecast method of depreciation.885 In the case of certain musical works and copyrights with respect to musical compositions placed in service during taxable years beginning after December 31, 2005 and before January 1, 2011, a temporary election was available which provided a 5-year amortization period (beginning with the month in which the property was placed in service).886 Under the income forecast method, a property's depreciation deduction for a taxable year is determined by multiplying the adjusted basis of the property by a fraction, the numerator of which is the gross income generated by the property during the year, and the denominator of which is the total forecasted or estimated gross income expected to be generated prior to the close of the tenth taxable year after the year the property is placed in service.887 Any costs that are not recovered by the end of the tenth taxable year after the property is placed in service may be taken into account as depreciation in that year.888

In general, the adjusted basis of property that may be taken into account under the income forecast method only includes amounts that satisfy the economic performance standard of section 461(h).889 An exception to this rule applies to participations and residuals.890 Solely for purposes of computing the allowable deduction for property under the income forecast method of depreciation, participations and residuals may be included in the adjusted basis of the property beginning in the year such property is placed in service (even if economic performance has not yet occurred) if such participations and residuals relate to income to be derived from the property before the close of the tenth taxable year following the year the property is placed in service. For this purpose, participations and residuals are defined as costs the amount of which, by contract, varies with the amount of income earned in connection with such property.

The inclusion of participations and residuals in adjusted basis beginning in the year the property is placed in service applies only for purposes of calculating the allowable depreciation deduction under the income forecast method. For all other purposes, the general basis rules of sections 1011 and 1016 apply. Thus, in calculating the adjusted basis for determining gain or loss on the sale of income forecast property, participations and residuals are treated as increasing the taxpayer's basis only when such items are properly taken into account under the taxpayer's method of accounting.891

Alternatively, rather than accounting for participations and residuals as a cost of the property under the income forecast method of depreciation, the taxpayer may deduct those payments as they are paid, consistent with the Associated Patentees892 decision.893 This may be done on a property-by-property basis and must be applied consistently with respect to a given property thereafter.894

In addition, taxpayers that claim depreciation deductions under the income forecast method are required to pay (or receive) interest based on a recalculation of depreciation under a "look-back" method.895

The look-back method is applied in any recomputation year by (1) comparing depreciation deductions that had been claimed in prior periods to depreciation deductions that would have been claimed had the taxpayer used actual, rather than estimated, total income from the property; (2) determining the hypothetical overpayment or underpayment of tax based on this recalculated depreciation; and (3) applying the overpayment rate of section 6621 of the Code. Except as provided in Treasury regulations, a recomputation year is the third and tenth taxable year after the taxable year the property is placed in service, unless the actual income from the property for each taxable year ending with or before the close of such years was within 10 percent of the estimated income from the property for such years.

 

Description of Proposal

 

 

This proposal amends various aspects of the income forecast method. Specifically, the income forecast recovery period is extended from 10 years to 20 years, and the recomputation years are modified to be the fifth, tenth, fifteenth, and twentieth (previously, the third and tenth).

This proposal also modifies the rules regarding the treatment of participations and residuals. The previously elective treatment for participations and residuals is repealed. Instead, participations and residuals are explicitly excluded from the basis of the related property and generally deductible in the year paid.

The proposal includes a new safe harbor. Under new section 167(g)(8), a taxpayer may elect to recover the costs of qualifying property ratably over 20 years, instead of calculating annual depreciation amounts using the income forecast method.

The proposal repeals the expired special five-year amortization rule for certain musical works and copyrights with respect to musical compositions.

The proposal also directs the Secretary of the Treasury to revise Treasury Regulation section 1.167(a)-3(b), the 15-year safe-harbor for certain intangibles, to allow taxpayers to treat qualifying assets as having a useful life equal to 20 years (and not 15 years).

 

Effective Date

 

 

The proposal applies to property placed in service after December 31, 2014.

14. Repeal of averaging of farm income (sec. 3314 of the discussion draft and sec. 1301 of the Code)

 

Present Law

 

 

Section 1301 provides special income averaging rules for individuals896 engaged in a farming business897 or fishing business.898 Under section 1301, such an individual may elect to average the taxable income attributable to the farming or fishing business over a three-year period.

 

Description of Proposal

 

 

This proposal repeals the special rule allowing the averaging of farming or fishing income under section 1301.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

15. Treatment of patent or trademark infringement awards (sec. 3315 of the discussion draft and new sec. 91 of the Code)

 

Present Law

 

 

Gross income

Taxable income of a business generally is comprised of gross income less allowable deductions.899 Gross income generally is income derived from any source, including gross profit from the sale of goods and services to customers, rents, royalties, interest (other than interest from certain indebtedness issued by State and local governments), dividends, gains from the sale of business and investment assets, and other income.900 Gross income does not, however, include return of capital (to the extent of the taxpayer's basis in such capital).901

"Origin of the claim"

The tax treatment of amounts received for infringement of any patent or trademark (whether by reason of judgment or settlement) is determined with respect to the "nature of the claims involved and the basis of the recovery."902 Courts have developed an "origin of the claim" test to determine whether the amounts are compensation for a loss of profits or damage done to a capital asset. For cases in which a taxpayer receives an award based on a loss of profits, the damages replace profits that would have been ordinary income and likewise are treated as ordinary income. On the other hand, for cases in which the amount represents damages for injury to capital, the money received is treated as conversion of capital assets into cash (often resulting in a reduction in the basis of the capital asset and/or capital gain treatment).903 However, when the award amount represents loss of profits as well as injury to capital assets, such amount is bifurcated and each portion is treated accordingly (e.g., the portion associated with loss of profits is included as ordinary income, and the portion associated with injury to capital assets generally reduces the basis of the injured assets and/or is capital gain).904

In most infringement cases, the award is compensation for the taxpayer's loss of profits.905 The Mathy court concluded that "[w]hat a patent owner loses from infringement is the acquisition of 'a just and deserved gain' from the exploitation of the invention embodied in his patent."906 The "just and deserved gains," if earned by the taxpayer in the absence of infringement, would be taxed as ordinary income. Therefore, in cases where damages are calculated on the basis of loss of profits, the award generally is treated as ordinary income to the taxpayer.907

Where damages are awarded for injury to the taxpayer's patent or trademark, or to the goodwill of the taxpayer's business, the award is treated as a conversion of capital assets into cash.908 As a preliminary matter, the taxpayer bears the burden of establishing that gain from a judgment or settlement amounts to a "sale or exchange" or "from the compulsory or involuntary conversion" of the asset.909 In such instances where the burden of proof is met, the taxpayer may exclude from income amounts received up to the taxpayer's basis in the property.910 The basis of the property then must be reduced (but not below zero) for any amounts excluded from income.911 To the extent amounts received for damages exceed the basis of the property, such amounts are treated as long-term capital gain under section 1235,912 or as section 1231 gain, subject to the recapture provisions of section 1245.

 

Description of Proposal

 

 

This proposal clarifies the treatment of patent and trademark infringement awards received by a taxpayer. The proposal states, in general, that amounts received for infringement of any patent or trademark (whether by reason of judgment or settlement) shall be included in gross income as ordinary income.

In certain instances, the proposal permits a taxpayer to impair its capital, instead of including amounts in income. However, the taxpayer is required to demonstrate, to the satisfaction of the Secretary, that the amounts constitute damages received by reason of the reduction in the value of the taxpayer's property caused by the infringement. In such instances where the burden of proof is met, the taxpayer may exclude from income amounts received up to the taxpayer's basis in the property. The basis of the property then must be reduced (but not below zero) for any amounts excluded from income. To the extent amounts received for damages exceed the basis of the property, such amounts must be included in gross income as ordinary income.

 

Effective Date

 

 

The proposal applies to payments received pursuant to judgments and settlements after December 31, 2014.

16. Repeal of redundant rules with respect to carrying charges (sec. 3316 of the discussion draft and sec. 266 of the Code)

 

Present Law

 

 

Section 162 generally allows a deduction for ordinary and necessary expenses paid or incurred in carrying on any trade or business. A capital expenditure, however, generally is not currently deductible, but rather, recovered over an appropriate period. Section 263(a)(1) defines a capital expenditure as any amount paid for new buildings or for permanent improvements or betterments made to increase the value of any property or estate. A capital expenditure also includes any amount expended for restoring property or in making good the exhaustion thereof for which an allowance (for depreciation, amortization, or depletion) is or has been made.913

Section 266 permits a taxpayer to elect to charge certain taxes and carrying charges to capital account.914 The regulations under section 266 enumerate the items, which are otherwise expressly deductible under subtitle A of the Code, which may be charged to capital under this section and included either in the original basis or as an adjustment to basis.915 Such items chargeable to capital account include: (1) in the case of unimproved and unproductive real property: annual taxes, interest on a mortgage, and other carrying charges; (2) in the case of real property, whether improved or unimproved and whether productive or unproductive: interest on a loan, taxes of the owner of such real property measured by compensation paid to his employees, taxes of such owner imposed on the purchase of materials (or on the storage, use, or other consumption of materials), and other necessary expenditures; (3) in the case of personal property: taxes of an employer measured by compensation for services rendered in transporting machinery or other fixed assets to the plant or installing them therein, interest on a loan to purchase such property or to pay for transporting or installing the same, and taxes of the owner thereof imposed on the purchase of such property (or on the storage, use, or other consumption of such property) paid or incurred up to the later of the date of installation or the date when such property is first put into use by the taxpayer; and (4) any other otherwise deductible taxes and carrying charges with respect to property, which in the opinion of the Commissioner are, under sound accounting principles, chargeable to capital account.916

 

Description of Proposal

 

 

This proposal repeals the rules related to the optional capitalization of carrying charges under section 266.

 

Effective Date

 

 

The proposal applies to amounts paid or incurred after December 31, 2014.

17. Repeal of recurring item exception for spudding of oil and gas wells (sec. 3317 of the discussion draft and sec. 461(i) of the Code)

 

Present Law

 

 

Under general tax accounting rules, taxpayers using an accrual method of accounting generally may not deduct items of expense prior to when all events have occurred that fix the right to pay the liability, the amount of the liability can be determined with reasonable accuracy, and economic performance has occurred.917 Section 461 sets forth various principles to be followed in determining the time when economic performance occurs. In general, for liabilities arising out of the provision of services or property to a taxpayer by another person, economic performance occurs as such person provides such services or property.918 For liabilities arising out of the use of property by a taxpayer, economic performance occurs ratably over the period of time during which the taxpayer is entitled to use the property.919 For liabilities arising out of goods or services provided by a taxpayer to another person, economic performance occurs as the taxpayer incurs costs in connection with the satisfaction of the liability.920 For liabilities arising out of workers compensation, tort, breach of contract, and other liabilities designated in regulations,921 economic performance occurs when and to the extent that payment is made to the person to whom the liability is owed.922

There is an exception for recurring items generally expected to be incurred from one taxable year to the next.923 A taxpayer may take a recurring item into account in the taxable year during which the all events test is met if economic performance occurs on or before the earlier of the date the taxpayer files a timely return for such taxable year (including extensions) or the 15th day of the ninth calendar month following the close of such taxable year.924 The exception applies where either the amount of the liability is not material, or the application of the exception results in a better matching of the liability with the income to which it relates.925 The exception generally is not available to tax shelters.926

However, economic performance with respect to amounts paid for drilling an oil or gas well by a tax shelter during a taxable year is treated as having occurred within such taxable year if the drilling of the well commences before the close of the 90th day following the close of the taxable year.927 For tax shelters which are partnerships, the section 704(d) limitation on the deduction is computed as if the taxpayer's adjusted basis in his partnership interest is determined without regard to any liability of the partnership and any amount borrowed by the partner with respect to such partnership where the borrowing is secured by any asset of the partnership or is arranged by the partnership or certain other persons.928

 

Description of Proposal

 

 

The proposal repeals the special economic performance rule with respect to amounts paid for drilling an oil and gas well by a tax shelter under section 461(i).

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

 

E. Financial Instruments

 

 

1. Treatment of certain derivatives (sec. 3401 of the discussion draft and new secs. 485 and 486 of the Code)

 

Present Law

 

 

In general

A derivative is a contract in which the amount of at least one contractual payment is calculated from the value of something (or a combination of things) that is fixed only after the contract is entered into. The thing that fixes the payment amount(s) and hence the derivative's value is called the underlying; examples include assets, liabilities, indices, and events. The most common forms of derivative are options, forwards, futures, and swaps. The taxation of derivatives has developed over a long period without consistent underlying policy. The tax rules apply differently depending on the form of the derivative, the type of taxpayer entering into it, the purpose of the transaction, and other factors. The rules are complex and may be uncertain in their application.

Options

An option is a derivative in which one party purchases the right to deliver or receive a specified thing to or from another party on a fixed date or over a fixed period of time in exchange for a payment whose value is fixed when the contract is entered into. The purchaser of the option is also called the holder; the seller of the option is also called the writer or issuer. When the option purchaser gives or receives the specified thing to the other party in exchange for the payment, the purchaser is said to exercise its right. The latest time the purchaser can exercise its right is called the expiration date. The thing that is delivered or that fixes the amount of payment at the expiration date is called the underlying. The payment by the purchaser for the option is called the premium, and the payment made for the thing at expiration is called the strike price. A European-style option is an option that can only be exercised at the expiration date. An American-style option is an option that can be exercised at any time prior to the expiration date.

A call option is an option in which the option purchaser has the right to buy a specified thing. A put option is an option in which the option purchaser has the right to sell a specified thing. Payment at the expiration date can take many forms. An option is called "physically settled" when the underlying is delivered from one party to the other. An option is called "cash settled" when one party pays cash equal to the difference between the strike price and the value of the underlying at the expiration date.

In general,929 no tax consequences are recognized upon entering into an option contract, even though option premiums are paid without any possibility for recovery or return. The option purchaser's premium payment is nondeductible, and the option seller does not include the premium payment in income.930 If an option is sold, the premium is accounted for in calculating gain or loss on sale. For the purchaser of a put option, if the option is exercised, the premium reduces the amount received in the sale of the underlying. For the purchaser of a call option, if the option is exercised, the premium is part of the basis in the property acquired.

For an option purchaser, gain or loss attributable to the sale or exchange, or loss from failure to exercise an option, is gain or loss from property of the same character as the option's underlying.931 An option is treated as sold or exchanged on the day it expires without exercise in determining whether the loss is short term or long term.932 A seller of an option has ordinary income if the option is not exercised,933 but if the option is with respect to "property," any gain or loss from closing or lapse is short term capital gain.934 For this purpose, "property" includes stocks, securities, commodities, and commodity futures.935 If an option purchaser exercises a cash settled option, then gain or loss is short term or long term depending on whether the option purchaser has held the option for more than one year.936 If an option purchaser exercises a physically settled option, the holding period for the property delivered is calculated from the date the option is exercised.937 Option purchasers may be treated differently depending on whether they hold cash settled or physically settled options, even though their economic positions may be similar.938

Timing and character results for options and the other derivatives described below may be different depending on the type of taxpayer entering into the option (for example, whether a dealer in securities), on the use of the option (for example, as a hedge), the underlying, the type of option (for example, whether governed by section 1256), or the application of other overriding rules (for example, the straddle rules).

Forwards

A forward is a derivative in which one party agrees to deliver a specified thing to another party on a fixed date in exchange for a payment whose value is fixed when the contract is entered into. The party agreeing to deliver the thing is called the short party; the party agreeing to pay is called the long party. The date on which the short party must deliver is called the delivery or expiration date. The thing that is delivered or that fixes the amount of payment at the expiration date is called the underlying. The payment by the long party at delivery is called the forward price. For most forwards, no payment is made when the contract is signed. For a prepaid forward, the long party pays the short party the forward price (discounted to present value on the date of the payment) at the time the parties enter into the contract.939 A variable forward requires the short party to deliver an amount of property that varies according to a formula agreed to when the contract is signed.940

A forward is called "physically settled" if the underlying is delivered from one party to the other. A forward is called "cash settled" if one party pays cash equal to the difference between the forward price and the value of the underlying on the delivery date.

In general, no tax consequences are recognized on entering into a forward.941 If a forward is physically settled, the short party recognizes gain or loss in the amount of the difference between the forward price and the short party's basis in the property in the year in which the delivery takes place.942 The long party reflects the forward price as the basis in the property acquired; any gain or loss is deferred until a subsequent realization event.

In general, the character of the gain or loss with respect to a forward is the same as the character of the property delivered.943 Gain or loss on the sale or exchange of a forward is long term capital gain or loss if the contract has been held for longer than the requisite holding period.944 Cash settlement of a forward is treated as a sale or exchange.945

If a forward qualifies as a commodity futures contract not subject to section 1256,946 the long party's holding period of the underlying includes the period in which the party held the contract.947 For other physically settled forwards, the holding period of the underlying begins when the burdens and benefits of ownership are transferred from the short to the long party.948 For short parties to physically settled securities forwards and commodities futures, section 1233 and the accompanying regulations provide rules regarding holding period determinations,949 although these rules have been partially supplanted by section 1234B (governing certain securities futures contracts) and section 1256 (governing regulated commodities futures contracts). For transactions to which section 1233 still applies, a short party that physically delivers property to close a contract recognizes capital gain or loss on the transaction as short term or long term depending on the period for which the short party holds the property prior to delivery.950 If a short party closes out a physically settled contract by purchasing the underlying asset and immediately delivering it to fulfill its contractual obligations, any capital gain or loss to the short party is short term capital gain or loss.951

Forwards for the sale of a single security or a narrow-based security index952 are subject to a separate regime under section 1234B. Gain or loss attributable to the sale, exchange, or termination of a securities futures contract is considered gain or loss from the sale or exchange of property which has the same character as the property to which the contract relates has (or would have) in the taxpayer's hands. Section 1234B also provides that gain or loss on a securities futures contract, if capital, is treated as short term capital gain or loss regardless of the taxpayer's holding period.

Swaps and notional principal contracts

"Notional principal contract" is the term in the tax law closest to what is colloquially known as "swap." The tax term covers a narrower range of contracts than the colloquial term.953 Treasury regulations define a notional principal contract as a financial instrument that provides for the payment of amounts by one party to another party at specified intervals calculated by reference to a specified index upon a notional principal amount in exchange for specified consideration or a promise to pay similar amounts.954 A specified index is defined as a fixed rate, price, or amount that must be based on objective financial information not in control of either party. A notional principal amount is defined as a specified amount of money or property that, when multiplied by a specified index, measures a party's rights and obligations under the contract but is not borrowed or loaned between the parties.

Examples of notional principal contracts include interest rate swaps, currency swaps, and equity swaps.955 Treasury regulations exclude certain instruments from the definition of notional principal contract including: (1) section 1256 contracts, (2) futures contracts, (3) forwards, (4) options, and (5) instruments or contracts that constitute indebtedness for Federal tax purposes.

For purposes of calculating the inclusion of income or expense flowing from a notional principal contract, the regulations divide payments exchanged by the parties to the contract into: (1) periodic payments (made at least annually); (2) termination payments (made at the end of the contract's life); and (3) nonperiodic payments (neither (1) nor (2)).956 Taxpayers must recognize periodic and nonperiodic payments using a specified accrual method for the taxable year to which the payment relates, and must recognize a termination payment in the year the notional principal contract is extinguished, assigned, or terminated.957 A swap with a significant958 nonperiodic payment is treated as two transactions: an on-market level payment swap and a loan.959 The loan must be accounted for independently of the swap. Treasury regulations proposed in 2004 under section 1234A, contingent nonperiodic payments (such as a single payment at termination tied to the change in value of the underlying) are accrued over the life of the swap based on an estimate of the amount of the payment.960 The amount of a taxpayer's accrual is redetermined periodically as more information becomes available.961

Final Treasury regulations do not address the character of notional principal contract payments. However, the 2004 proposed regulations provide that any periodic or nonperiodic payment generally constitutes ordinary income or expense.962 The preamble to the 2004 proposed regulations explains that ordinary income treatment is warranted because neither periodic nor nonperiodic payments involve the sale or exchange of a capital asset. The 2004 proposed regulations provide that gain or loss attributable to the termination of a notional principal contract is capital if the contract is a capital asset of the taxpayer but do not specify whether a taxpayer who holds a notional principal contract for more than one year should recognize capital gain or loss on account of a termination payment as short term or long term. Those regulations do provide that final settlement payments with respect to a notional principal contract are not termination payments under section 1234A.963

Section 1256 contracts

Section 1256 provides timing and character rules for defined types of derivatives. Any section 1256 contract held by a taxpayer at the close of a taxable year is marked to market, that is, the contract is treated as having been sold by the taxpayer for its fair market value on the last business day of the taxable year.964 The character of gain or loss on the mark to market, or if the contract is terminated or transferred,965 is 60 percent long term capital gain or loss, and 40 percent short term capital gain or loss, regardless of the taxpayer's holding period.966 Different character rules apply to foreign currency contracts that come within both sections 1256 and 988.967

A section 1256 contract is defined as: (1) a regulated futures contract,968 (2) a foreign currency contract, (3) a nonequity option traded on or subject to the rules of a qualified board or exchange,969 (4) an equity option purchased or granted by an options dealer that is listed on a qualified board or exchange on which the dealer is registered,970 and (5) a securities futures contract entered into by a dealer that is traded on a qualified board or exchange. Excluded from the definition of section 1256 contracts are (1) any securities futures contract or option on such a contract unless such contract or option is a dealer securities futures contract and (2) any interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreement.971

Mark to market accounting for dealers and traders

Section 475 requires that securities dealers ? taxpayers that regularly purchase securities from or sell securities to customers in the ordinary course of business ? recognize gain and loss on a mark to market basis. The term "security" is defined to include stocks, interests in widely held or publicly traded partnerships and trusts, debt instruments, interest rate swaps, currency swaps, and equity swaps, as well as options, forwards, and short positions on any of the above-mentioned financial instruments, and other positions identified as hedges with respect to any of the above-mentioned instruments.972 The statute also allows traders in securities to elect into mark to market, and it allows traders in commodities to opt into the mark to market regime and to have their commodity holdings treated analogously to securities under section 475.973

For taxpayers required to follow the mark to market rules or who elect into those rules, securities or commodities in the hands of the taxpayer at the close of a tax year must be treated as if they were sold for their fair market value on the last business day of the year. All resulting mark to market gains or losses with respect to such securities or commodities are treated as ordinary.974 However, mark to market accounting is neither required nor permitted for: (1)securities held for investment; (2) debt instruments acquired in the ordinary course of a trade or business (unless those debt instruments are held for sale, in which case they must be marked to market); and (3) for securities that are held as hedges (unless the security is a hedge for another security that is inventory in the hands of the dealer, in which case the hedge must be marked to market as well).975

Straddles

Section 1092 defines a "straddle" as offsetting positions with respect to actively traded property.976 Positions are offsetting if there is a substantial diminution of risk of loss from holding any position in actively traded property by holding one or more other positions with respect to actively traded property.977 Section 1092(a) provides that a taxpayer's loss with respect to one position that is part of a straddle may only be taken into account to the extent that the loss exceeds the taxpayer's unrecognized gain with respect to any offsetting position that is part of the straddle. The taxpayer may carry forward any disallowed loss into succeeding taxable years and may take such loss into account once the taxpayer disposes of the offsetting position.978

Exceptions from the straddle rules are provided for hedging transactions,979 straddles composed entirely of section 1256 contracts,980 and qualified covered calls.981 Special rules apply for mixed straddles (generally, straddles comprised of both section 1256 contracts and non-section 1256 contracts)982 and for identified straddles.983

Identification of hedges

Several provisions governing the taxation of derivatives grant special treatment to "identified" hedges. The mark to market requirement under section 475 does not apply to any security which is identified as a hedge with respect to a position, right, or liability that is not itself subject to the mark to market rule.984 Likewise, the mark to market requirement under section 1256 does not apply to a transaction that the taxpayer identifies as a hedging transaction.985

Hedges must be identified by the close of the day on which a taxpayer enters into the hedging transaction.986 The identification must be made on, and retained as part of, the taxpayer's books and records.987 The identification of a hedging transaction for financial accounting or regulatory purposes does not satisfy this requirement unless the taxpayer's books and records indicate that the nontax identification is also being made for tax purposes.988

Treatment of convertible debt instruments

Treasury Regulations provide for the treatment of debt instruments with contingent payments.989 In the case of debt instruments issued for money or publicly traded property, the noncontingent bond method applies for accruing original issue discount ("OID").990 Under this method, interest accrues assuming a comparable yield to maturity "at which the issuer would issue a fixed rate debt instrument with terms and conditions similar to those of the contingent payment debt instrument . . ., including the level of subordination, term, timing of payments, and general market conditions."991 This method does not apply to a debt instrument merely because it provides for an option to convert the debt instrument into stock of the issuer (or of stock or debt of a related party), or into cash or other property equal to the approximate value of the stock or debt.992 It does apply to a debt instrument that is convertible into the corporation's stock and provides for one or more cash contingent payments.993

In the case of a convertible debt instrument which is not treated as a contingent debt instrument, no allocation of value is made to the conversion feature. When a convertible debt instrument is repurchased by a corporation, no deduction is allowed for amounts paid in excess of the sum of the adjusted issue price plus a normal call premium for a nonconvertible bond.994

 

Description of Proposal

 

 

In general

The proposal requires all taxpayers to mark their derivatives to market, recognizing gain or loss as if the derivatives were sold for fair market value on the last business day of the taxpayers' taxable year. Gain and loss from the mark to market is treated as ordinary income or loss attributable to a trade or business of the taxpayer for purposes of determining the amount of nonbusiness deductions which are allowed in computing a net operating loss. The proposal does not require stocks or bonds to be marked to market. However, if a taxpayer has a straddle of derivative and a non-derivative offsetting positions, then both the derivative and the non-derivative positions are required to be marked to market. Upon entering into such a straddle, the taxpayer must recognize any built-in gain (and defer any built-in loss) on the non-derivative.

Definition of derivative

 

In general

 

A derivative is any contract the value of which, or any payment or other transfer with respect to which, is (directly or indirectly) determined by reference to one or more of the following: (1) any share of stock in a corporation, (2) any partnership or beneficial ownership interest in a partnership or trust, (3) any note, bond, debenture, or other evidence of indebtedness, (4) any real property (other than real property for which an exclusion is available), (5) any commodity that is actively traded within the meaning of section 1092(d)(1), (6) any currency, (7) any rate, price, amount, index, formula, or algorithm, and (8) any other item prescribed by the Secretary. The term derivative does not include an item described in (1) through (8).

The term "derivative" includes an embedded derivative component. If a contract has derivative and non-derivative components, then each derivative component is treated as a derivative. If an embedded derivative component cannot be separately valued, the entire contract that includes the embedded derivative component is treated as a derivative. A debt instrument is not treated as having an embedded derivative component merely because the debt instrument is denominated in, or specifies payments by reference to, a nonfunctional currency or is a convertible debt instrument, a contingent payment debt instrument, a variable rate debt instrument, an integrated debt instrument, an investment unit, a debt instrument with alternative payment schedules, or another debt instrument with respect to which the regulations under section 1275(d) apply.

 

Exclusions

 

The proposal has a number of exclusions.

If a derivative is with respect to a tract of real property as defined in section 1237(c), or real property which would be inventory if held directly by the taxpayer, then the proposal's timing and character rules do not apply to such derivatives. The Secretary is directed to prescribe regulations or other guidance under which multiple tracts of real property may be treated as a single tract of real property if the contract is of a type designed to facilitate the acquisition or disposition of such real property.995

The proposal excludes from the definition of a derivative any contract that is part of a hedging transaction within the meaning of section 1221(b) as amended or section 988(d)(1).

To the extent provided by the Secretary, the proposal excludes financing transactions such as securities lending, sale-repurchase and similar financing transactions from the definition of a derivative. The types of transactions that are intended to be excluded from the definition of a derivative are financing transactions, not those transactions that provide payments or other transfers determined by reference to: (1) any share of stock in a corporation, (2) any partnership or beneficial ownership interest in a partnership or trust, (3) any note, bond, debenture, or other evidence of indebtedness, (4) any real property (other than real property for which an exclusion is available), (5) any commodity that is actively traded within the meaning of section 1092(d)(1), (6) any currency, (7) any rate, price, amount, index, formula, or algorithm, and (8) any other item prescribed by the Secretary.

It is intended that the types of securities lending, sale-repurchase and similar financing transactions excluded from the definition of derivative by the Secretary reflect current market practice and be flexible enough to accommodate future developments in the market but not be so broad as to undermine the general rule.

The proposal excludes from the definition of a derivative an option described in section 83(e)(3) received in connection with the performance of services. It also excludes an insurance, annuity, or endowment contract issued by an insurance company to which subchapter L applies (or, in the case of a foreign corporation, would apply if the foreign corporation were domestic). A contract that is otherwise within the definition of a derivative is not treated as a derivative if it is with respect to stock issued by any member of the same worldwide affiliated group (within the meaning of section 864(f)) of which the taxpayer is a member. A contract with respect to a commodity that is otherwise within the definition of derivative is not treated as a derivative if the contract requires physical delivery, the contract contains the option of cash settlement only in unusual and exceptional circumstances, the commodity is used in the normal course of the taxpayer's trade or business, and the derivative relates to quantities normally used in the normal course of that business.

American depositary receipts and similar instruments with respect to shares of stock in foreign corporations are treated as shares of stock of foreign corporations and not as derivatives.

Mark-to-market of certain offsetting positions

If a taxpayer has a straddle of derivative and a non-derivative offsetting positions, the non-derivative position is treated as a derivative for both timing and character purposes. A straddle is defined in section 1092(c), applied by treating all offsetting positions as being with respect to personal property. Upon establishing such a straddle, a taxpayer must treat any built-in gain position as if it were sold for its fair market value, but the proposal's character and net operating loss rules do not apply to any gain taken into account as a result of the deemed sale. A built-in gain position is any position (other than a derivative) with respect to which gain would be realized if the position were sold for its fair market value at the time that the straddle is established with respect to the position.

Built-in gain need not be recognized for any position with respect to debt if the interest payments or similar amounts with respect to the position meet the rate calculation requirements of section 860G(a)(1)(B)(i) and the position is not directly or indirectly convertible into stock of the issuer or a related person. Built-in gain need not be recognized for any position that is part of a straddle if: (1) all the offsetting positions which are part of the straddle consist of one or more qualified covered call options and the stock to be purchased from the taxpayer under such options, and (2) the straddle is not part of a larger straddle. A qualified covered call option means any option granted by the taxpayer to purchase stock held by the taxpayer (or acquired in connection with granting of the option) but only if the option is traded on a national securities exchange registered with the Securities and Exchange Commission ("SEC") or other market which the Secretary designates, the option is granted more than 30 days and not more than 90 days before the day the option expires, and the option is not granted by an options dealer in connection with its activity of dealing in options.

Upon establishing a straddle, a taxpayer may not treat any built-in loss position as if it were sold, and the amount of the built-in loss is not taken into account in determining the amount that is marked-to-market while the straddle is in place. Rather, the built-in loss position is deferred until such position is sold or otherwise terminated. A built-in loss position is any position (other than a derivative) with respect to which a loss would be realized if the position were sold for its fair market value at the time that the straddle is established with respect to the position.

The holding period for any position to which the proposal's mark to market provision applies does not include the period during which the position is part of a straddle, or, in the case of a built-in gain position, the period before the position was deemed sold.

The timing and character rules in the proposal also apply to the termination or transfer during the taxable year of a taxpayer's rights or obligations with respect to a derivative. At the time the derivative is terminated, all positions that are part of a straddle with the derivative are treated as the derivative is treated. Fair market value for such terminations or transfers is determined at the time of the termination or transfer.

Fair market value

It is expected that taxpayers and the Internal Revenue Service will use general tax principles in determining the fair market value of a derivative (including an embedded derivative component) and non-derivatives in a straddle that includes a derivative. In determining fair market value, it is intended that taxpayers use sources of information and valuation methods consistently from period to period, incorporating developments in financial markets and advances in financial engineering in a reasonable and fair manner. It is expected that non-tax reports and statements will provide evidence of a mark to market value for purposes of the proposal. Non-tax reports and statements will be preferred in the following order: (1) statements required to be filed with the SEC prepared in accordance with U.S. generally accepted accounting principles ("GAAP"); (2) statements filed with a Federal agency other than the Internal Revenue Service prepared in accordance with U.S. GAAP; (3) certified audited financial statements prepared in accordance with U.S. GAAP given to creditors to make lending decisions; (4) statements prepared in accordance with International Financial Reporting Standards required to be filed with agencies equivalent to the SEC in jurisdictions that have equivalent stringent reporting standards as those in the U.S.; (5) statements provided to other regulatory and governmental bodies as provided by the Secretary.

Treatment of convertible debt instruments

The proposal provides that the Treasury regulations shall be modified to provide that convertible debt instruments are treated in a manner similar to contingent payment debt instruments.

Coordination rules; repeal of certain existing rules

The proposal provides a number of rules for coordinating the new mark-to-market regime with present law rules related to financial instruments taxation.

The proposal repeals sections 1233, 1234, 1234A, 1234B, 1236, 1256, 1258, 1259, and 1260.

 

Effective Date

 

 

The proposal applies to taxable years ending after December 31, 2014 with respect to property acquired and positions established after December 31, 2014, and taxable years ending after December 31, 2019 in case of any other property or position.

2. Modification of certain rules related to hedges (sec. 3402 of the discussion draft and sec. 1221 of the Code)

 

Present Law

 

 

In general

Capital gain treatment applies to gain on the sale or exchange of a capital asset. The term "capital asset" means property held by the taxpayer (whether or not connected with his trade or business), but does not include property that is part of a hedging transaction which is clearly identified as such before the close of the day on which it was acquired, originated, or entered into (or such other time as the Secretary may by regulations prescribe).996 Gain or loss on property that is part of an identified hedging transaction generally is treated as ordinary, rather than capital.997

A hedging transaction is defined as any transaction entered into by the taxpayer in the normal course of the taxpayer's trade or business primarily to manage risk of price changes or currency fluctuations with respect to ordinary property which is held or to be held by the taxpayer, to manage risk of interest rate or price changes or currency fluctuations with respect to borrowings made or to be made, or ordinary obligations incurred or to be incurred, by the taxpayer, or to manage other risks as prescribed under Treasury regulations.998

Hedge identification requirement

The regulations issued under section 1221 require that, in order to qualify as a hedge, a taxpayer that enters into the hedge must clearly identify the transaction as a hedging transaction before the close of the day on which the taxpayer acquired, originated, or entered into the transaction and must also999 identify the item, items, or aggregate risk being hedged.1000 Identification of an item being hedged generally involves indentifying a transaction that creates risk and the type of risk that the transaction creates.1001 Additional information is required for certain types of hedging transactions.1002 The regulations also specify that the identification of a hedging transaction for financial accounting or regulatory purposes does not satisfy the identification requirement unless the taxpayer's books and records indicate that the identification also is being made for tax purposes. However, the taxpayer may indicate that individual hedging transactions or a class or classes of hedging transactions that are identified for financial accounting or regulatory purposes also are being identified as hedging transactions for tax purposes.1003

Financial accounting hedge identification requirement

Under U.S. Generally Accepted Accounting Principles ("GAAP"), there are rules applicable to accounting for hedging transactions, which have the effect of matching the timing of the income recognition of an instrument used as a hedge with that of the hedged item.1004 These financial accounting rules have a hedge identification requirement similar, though not identical, to the Federal income tax requirement contained in the section 1221 regulations. To qualify for hedge accounting for financial accounting purposes, a formal identification must be made at the inception of a hedge,1005 including documentation of the hedging relationship and the entity's risk management objective and strategy for undertaking the hedge. The documentation must include identification of the hedging instrument, the hedged item or transaction, the nature of the risk being hedged, and information for assessing the hedging instrument's effectiveness.

Commodity hedging

Under the subpart F anti-deferral regime applicable to controlled foreign corporations and their United States shareholders, the excess of gains over losses from transactions in commodities generally is foreign personal holding company income, one category of income of a controlled foreign corporation that is included in the income of United States shareholders on a current basis.1006 This treatment of commodities gains as foreign personal holding company income does not, however, apply to income that arises out of commodity hedging transactions.1007 For these purposes, a commodity hedging transaction is any transaction with respect to a commodity if the transaction is a hedging transaction under section 1221(b)(2) that is entered into by a controlled foreign corporation in the normal course of its trade or business primarily to manage risk of price changes or currency fluctuations with respect to ordinary property or section 1231(b) property that is held or is to be held by the controlled foreign corporation, or to manage such other risks as the Secretary may prescribe.1008

 

Description of Proposal

 

 

Under the proposal, a hedging transaction is treated as meeting the hedge identification requirement under section 1221 if the transaction is identified as a hedging transaction for tax purposes (as required under existing law), or if the transaction is treated as a hedging transaction within the meaning of GAAP for purposes of the taxpayer's audited financial statement. The audited financial statement must be certified as being prepared in accordance with GAAP by an independent auditor and must be used for the purposes of a statement or report to shareholders, partners, or other proprietors, or to beneficiaries, or for credit purposes.1009

A transaction treated as a hedging transaction for purposes of an audited financial statement is treated as a hedging transaction for tax purposes, as long as the transaction also meets the substantive definition of a tax hedging transaction, which is unchanged by the proposal. If a transaction identified as a hedging transaction for purposes of an audited financial statement does not meet the definition of a hedging transaction for tax purposes, the taxpayer is not permitted to use hedge accounting for the transaction in its tax return. The rules under Treasury regulations for improper identification of a hedging transaction are not applicable to a hedge which is identified as a hedging transaction for financial statement purposes, but does not qualify as a hedging transaction for tax purposes, unless the taxpayer improperly treats the transaction as a tax hedging transaction in its tax return for the taxable year which includes such transaction.

The proposal treats a bond, debenture, note, certificate, or other evidence of indebtedness held by an insurance company as ordinary property solely for purposes of the determination of whether a transaction is to manage risk of price changes or currency fluctuations with respect to ordinary property held or to be held by the taxpayer. Thus, such a transaction involving such an instrument can be accorded hedging transaction tax treatment if identified in accordance with section 1221, as amended by this proposal. The proposal does not treat a bond, debenture, note, certificate, or other evidence of indebtedness held by an insurance company as ordinary property for any other purpose, such as for purposes of determining the character of gain, loss, or income.

The proposal broadens the exception from foreign personal holding company income for income arising out of commodity hedging transactions. It does so by providing that a commodity hedging transaction the income from which is excluded from foreign personal holding company income may be used to manage risk of price changes or currency fluctuations with respect to ordinary property or section 1231(b) property that is held or is to be held by the controlled foreign corporation engaging in the transaction (as under present law), or by another controlled foreign corporation that is a related person (within the meaning of section 954(d)(3)).

 

Effective Date

 

 

The proposal applies to transactions entered into after December 31, 2014.

3. Current inclusion in income of market discount (sec. 3411 of the discussion draft and new sec. 1278 of the Code)

 

Present Law

 

 

If a bond declines in value after it is originally issued, the purchaser of the bond will acquire it with market discount. The decline in value may occur because general interest rates have risen, because the creditworthiness of the issuer has declined, or both. A taxpayer who purchases a bond after original issue at a price less than its principal amount (or adjusted issue price in the case of a bond originally issued at a discount) does not, absent an election, include in income any portion of the market discount prior to the disposition of the bond.

Market discount that accrues while the taxpayer holds a bond is treated as ordinary income, rather than capital gain, upon the disposition of the bond.1010 The amount treated as ordinary income does not exceed the amount of gain recognized on the disposition of the bond. Market discount accrues on a ratable basis unless the taxpayer elects to accrue on the basis of a constant interest rate. A de minimis rule treats the amount of market discount as zero if the market discount is less than one quarter of one percent of the stated redemption price times the number of complete remaining years to maturity after the bond is acquired by the taxpayer.1011

Interest expense on indebtedness incurred or continued to purchase or carry a bond with market discount is allowed as a deduction for a taxable year only to the extent the interest expense exceeds the market discount accruing on the bond in that year.1012 The taxpayer may elect to treat any interest expense disallowed in a prior taxable year as interest expense accruing in the current taxable year to the extent of the net interest income with respect to the bond.1013 To the extent any interest expense has been previously disallowed, it is allowed at the time the market discount is recognized.1014

A taxpayer may elect to include market discount in income as it accrues.1015 If an election is made, the amount included in income is generally treated as interest. However, market discount on a State or local bond is not treated as interest and therefore not exempt from taxation. Similarly market discount realized by a foreign person is not treated as interest for purposes of determining the foreign person's U. S. tax liability under sections 871(a), 881, 1441 and 1442. Consequently, market discount not effectively connected with a U. S. trade or business is treated as gain from the sale of personal property and sourced in accordance with the rules of section 865. Thus, foreign persons generally are not subject to U. S. tax on market discount not effectively connected with a U. S. trade or business.

Original issue discount ("OID"), unlike market discount, is includible in income of the holder currently using a constant interest rate.1016 OID is discount arising on the issuance of a bond for less than its principal amount. For example, if a publicly traded bond with a principal amount of $1,000 is issued for $800, the bond has $200 OID. OID is deductible by the issuer of the debt instrument over the term of the instrument, whereas the issuer is not impacted by market discount.

Amounts of OID includible in gross income in excess of $10 for one year on bonds for a term of more than one year must be reported to the bond holder by the issuer or broker from whom the bond was acquired.1017 In addition, brokers are required to report gross proceeds from sale or disposition of bonds, as well as the adjusted basis in covered securities, and furnish copies of these reports or statements to their customers.1018 Also, a person who transfers a bond to a broker is required to provide a statement to the transferee reflecting information necessary for the broker to comply with his information reporting obligations.1019

 

Description of Proposal

 

 

In general

 

Current inclusion of market discount accruals

 

Under the proposal, the holder of a market discount bond acquired after December 31, 2014, includes in gross income currently the sum of the daily portions of the market discount for each day during the taxable year that the taxpayer holds the bond. The amount of the inclusion for any taxable year is computed on the basis of a constant interest rate. The amount included in gross income is generally treated as interest, with the same exceptions that apply under present law where an election to accrue market discount has been made.

The daily portion of market discount on any market discount bond is the amount that would be the daily portion of original issue discount which would be determined for a bond at original issuance if the bond had been issued for a price equal to the adjusted basis of the bond immediately after its acquisition. The daily portion of market discount is adjusted to exclude the daily portion of any OID on the bond so as to prevent a double inclusion of OID.1020

 

Limitation of market discount accruals

 

The amount of market discount includible in gross income by reason of this provision with respect to any bond for any accrual period may not exceed the excess (if any) of (i) the product of the maximum accrual rate which is the greater of (a) the bond's yield to maturity (determined as of the date of the issuance of the original bond) plus five percentage points or (b) the applicable Federal rate for the bond (determined at the time of acquisition using a term equal to the remaining term of the bond) plus ten percentage points, multiplied by the adjusted basis of the bond at the beginning of the accrual period, over (ii) the sum of the amounts of qualified stated interest and original issue discount allocable to the accrual period.

 

Other rules

 

The adjusted basis of the bond is increased by amounts included in gross income of the holder of a bond under this provision.

In the case of a bond held by a partnership with respect to which a transfer of a partnership interest occurs by sale or exchange or by reason of death, the market discount rules apply to the transferee partner as if any bond held by the partnership was acquired at the time of the transfer (and the basis of the bond for purposes of determining market discount shall be determined after any adjustment under section 743). If a partnership distributes a bond to a partner and the partner's basis in the bond is determined by reference to the basis in its partnership interest (sec. 732(a)(2) and (b)), for purposes of determining the amount of market discount, the adjusted basis of the bond immediately after its acquisition by the partner is not less than its fair market value.

The market discount provisions of present law (secs. 1276 (treatment of gain), 1277 (deferral of interest deduction), and 1278(b) (election for inclusion)) do not apply to any bond to which this provision applies.

Under the provision, gain or loss on the sale or exchange of a market discount bond (assuming the bond is a capital asset) is capital gain or capital loss, except that the amount of any loss is treated as an ordinary loss to the extent market discount was included in gross income.

The proposal repeals the special rules for short-term non-governmental obligations held by taxpayers subject to current inclusion, which require the accrual of original issue discount but not market discount.1021 Likewise the proposal repeals the special rules for short-term non-governmental obligations held by taxpayers not subject to current inclusion, which requires gain attributable to original issue discount, but not market discount, to be treated as ordinary income.1022

Brokers who hold a "covered bond" are required to report includible OID and market discount with respect to such bonds to the IRS and the customer. A covered bond is any debt instrument that has OID or market discount that was acquired after 2014 through a broker or transferred from a broker with a statement prescribed by the Code with respect to the transfer. In addition, persons who transfer a covered bond are required to provide the transferee with a statement in sufficient detail to permit the transferee to comply with its obligation to report market discount. Finally, to the extent that there may be duplicative reporting obligations with respect to OID, this provision takes precedence except to the extent provided in guidance from the Secretary.

 

Modernization of certain terms

 

The proposal makes changes to certain terms to conform the terms to definitions set forth in Treasury regulations or to eliminate obsolete material. The definitions of market discount bond, the revised issue price of a market discount bond, redemption price, adjusted issue price, the determination of daily portions, yield to maturity, and accrual period are updated by the proposal.

Example

On January 1, 2014, XYZ Corporation issues a $1,000 ten-year publicly-traded bond with a five-percent coupon, with $50 of interest paid annually on December 31 of each calendar year. The bond is issued for $960, with original issue discount of $40. Bondholders accrue original issue discount based on the bond's yield to maturity at issuance.1023 XYZ Corporation deducts this amount of original issue discount over the life of the bond. The annual yield to maturity at the time the bond is issued is 5.53 percent.1024

On January 1, 2016, Taxpayer buys the bond in the secondary market for $950. In addition to original issue discount, Taxpayer accrues market discount under the proposal based on the calculated annual yield to maturity for the bond based on Taxpayer's adjusted basis of $950, which is 5.80 percent. On December 31, 2016, Taxpayer has income of $55.09 ($950 multiplied by .0580), of which $50 represents stated interest, $3.45 represents accrued original issue discount, and $1.64 represents accrued market discount. The accrued original issue discount and accrued market discount are added to the basis of the bond. For 2016, Taxpayer has total ordinary income of $55.09 and adjusted basis of $955.09.

Taxpayer holds the bond to maturity and receives $1,000 on December 31, 2024. Over the time it holds the bond, Taxpayer accrues $50 total in discount ($1,000-$950), including $33.63 of original issue discount1025 and $16.37 of market discount.

The table below summarizes the annual income inclusions for Taxpayer.

               Table 7. -- Annual Income Inclusions for Taxpayer

 

 ______________________________________________________________________________

 

 

            Adjusted                  Original                   Total

 

            Basis as of   Stated      Issue        Market        Ordinary

 

 Year       January 1     Interest    Discount     Discount      Income

 

 ______________________________________________________________________________

 

 

 2016         $950.00      $50.00       $3.45        $1.64        $55.09

 

 2017         $955.09      $50.00       $3.65        $1.73        $55.38

 

 2018         $960.47      $50.00       $3.85        $1.85        $55.70

 

 2019         $966.17      $50.00       $4.06        $1.97        $56.03

 

 2020         $972.20      $50.00       $4.28        $2.10        $56.38

 

 2021         $978.58      $50.00       $4.52        $2.23        $56.75

 

 2022         $985.33      $50.00       $4.77        $2.37        $57.14

 

 2023         $992.47      $50.00       $5.05        $2.48        $57.53

 

 TOTAL      $1,000.00     $400.00      $33.63       $16.37       $450.00

 

Effective Date

 

 

The proposal applies to debt obligations acquired after December 31, 2014.

4. Treatment of certain exchanges of debt instruments (sec. 3412 of the discussion draft and secs. 1037 and 1274B of the Code)

 

Present Law

 

 

Treatment of issuer

Gross income includes income from the cancellation of debt ("COD").1026 The amount of COD income is generally the difference between the adjusted issue price1027 of the debt being cancelled and the amount used to satisfy the debt.1028 The COD rules generally apply to the exchange of an old debt obligation for a new debt obligation, including a modification of the old debt that is treated as an exchange.1029 In the case of an old obligation that is exchanged for a new obligation, for purposes of determining the amount of COD, the amount used to satisfy the old obligation is the issue price of the new obligation.1030

If the issue price of the new debt obligation exceeds the adjusted issue price of the old debt obligation, the issuer has retirement premium that is immediately deductible if the debt obligation is publicly traded and, if not, the issuer reduces the issue price of the new debt and the premium is amortized over the term of the new debt.1031

Treatment of holder

The holder of an existing debt instrument exchanged for a new debt instrument generally recognizes gain or loss to the extent the adjusted basis of the existing debt differs from the sum of money and fair market value of any property received (including the new debt).1032 The issue price of the new debt obligation generally determines the amount realized by the holder of the old debt.1033 In the case of a corporate reorganization and certain corporate distributions, gain on the exchange of securities is recognized only to the extent of the fair market value of the excess of the principal amount of the securities received over the principal amount of the securities surrendered1034 and loss on the exchange is not recognized.1035

Issue price of new obligation

The issue price of the new obligation is determined under the general rules applicable to a debt instrument issued for property.1036 If the new debt is publicly traded, the issue price is the fair market value of the debt. If the new debt is not publicly traded, but the old debt is publicly traded, the issue price is the fair market value of the old debt. If neither debt is publicly traded, the issue price of the new debt is its stated redemption price at maturity if the debt has adequate stated interest, generally based on the applicable Federal rate ("AFR"). If the new debt does not have adequate stated interest, the issue price is an imputed principal amount using the applicable AFR as the discount rate.

Prior to the Omnibus Budget Reconciliation Act of 1990 ("the 1990 Act"),1037 the Code provided a special rule for the determination of issue price in the case of exchange of debt instruments in a corporate reorganization. The special rule generally provided that in a corporate reorganization the issue price of the new debt instrument would not be less that the adjusted issue price of the old debt instrument. The 1990 Act repealed the special rule.1038

Certain exchange of government obligations

Present law provides that United States obligations may be exchanged without recognition of gain or loss.1039 At one time, this provision allowed an individual to exchange Series E or EE savings bonds for Series H or HH savings bonds without recognition of income. The Treasury Department no longer issues Series H or HH savings bonds.1040

 

Description of Proposal

 

 

Issue price of new obligation

The proposal provides that in the case of an exchange (including by significant modification)1041 of a new debt instrument for an existing debt instrument of the same issuer, the issue price of the new debt instrument is the least of (1) the adjusted issue price of the existing debt instrument, (2) the stated principal amount of the new debt instrument, or (3) the imputed principal amount of the new debt instrument. The discount rate used to determine the imputed principal amount of the new debt instrument is the lesser of the AFR determined with respect to the new debt instrument or the AFR determined with respect to the old debt instrument (or, if greater, the stated interest rate of the old debt instrument). Thus, if the principal amount of the debt does not change and there is adequate stated interest, the exchange does not cause the issuer to recognize COD income.

Treatment of holder

In the case of an exchange of an existing debt obligation solely for a new debt obligation of the same issuer no gain or loss is recognized. If the holder receives money or property other than the new debt instrument ("boot"), the holder recognizes gain to the extent of the lesser of the amount of boot received or the amount of gain that would be recognized if the issue price of the new debt was determined without regard to the new issue price rule of section 1274B.

Conforming amendments are made to the reorganization provisions providing that the measure of recognized gain is determined by reference to the issue price of the securities received and the adjusted issue price of the securities surrendered.

Examples

The following examples illustrate the operation of the proposal.

Example 1. -- If a debt instrument (whether or not publicly traded) with a redemption price and an adjusted issue price of $10,000 is exchanged for a new debt instrument of the issuer with a redemption price of $10,000 (and adequate stated interest) with an extended maturity, the issue price of the new debt is $10,000 regardless of the fair market value of the old debt. Thus, the issuer does not have any COD income. Likewise, the holder has no gain or loss, regardless whether the holder acquired the debt in the secondary market for more or less than $10,000.

Example 2. -- The facts are the same as in example 1, except the debt instrument was originally issued for $9,000 and $500 OID had been accrued. The exchange is treated in the same manner as in example 1, and the OID and market discount (if any) carry over to the new obligation.

Example 3. -- The facts are the same as in example 1, except the principal amount is reduced to $9,000. Under the proposal, the issuer has $1,000 COD income. The holder has no gain or loss.

Example 4. -- X issues a publicly traded debt instrument with an issue price and redemption price of $100,000. Y purchases the debt for $40,000. Immediately after the purchase when fair market value of the debt is still $40,000, Y exchanges the old debt instrument with X for a new debt instrument with a redemption price of $50,000 (and adequate stated interest) and $10,000 cash. X has $40,000 income from the discharge of indebtedness (a $100,000 debt is satisfied with $10,000 cash and a $50,000 debt). Y recognizes no gain or loss, since in the absence of section 1274B, the new debt would have an issue price of $40,000 (its fair market value at issuance), and thus the amount realized by Y equals its basis in the old debt.

Certain exchange of government obligations

The proposal repeals as obsolete the present-law provision allowing the tax-free exchange of certain United States obligations.

 

Effective Date

 

 

The proposal applies to transactions after December 31, 2014.

5. Coordination with rules for inclusion not later than for financial accounting purposes (sec. 3413 of the discussion draft and sec. 451 of the Code)

 

Present Law

 

 

In general

A taxpayer generally is required to include an item in income no later than the time of its actual or constructive receipt, unless the item properly is accounted for in a different period under the taxpayer's method of accounting.1042 If a taxpayer has an unrestricted right to demand the payment of an amount, the taxpayer is in constructive receipt of that amount whether or not the taxpayer makes the demand and actually receives the payment.1043

In general, for a cash basis taxpayer, an amount is included in income when actually or constructively received.1044 For an accrual basis taxpayer, an amount generally is recognized (and included in income) the earlier of when such amount is earned by, due to, or received by the taxpayer, unless an exception permits deferral or exclusion.1045

Interest income

A taxpayer generally must include in gross income the amount of interest received or accrued within the taxable year on indebtedness held by the taxpayer.1046

Original issue discount

The holder of a debt instrument with original issue discount ("OID") generally accrues and includes in gross income, as interest, the OID over the life of the obligation, even though the amount of the interest may not be received until the maturity of the instrument.1047

The amount of OID with respect to a debt instrument is the excess of the stated redemption price at maturity over the issue price of the debt instrument.1048 The stated redemption price at maturity includes all amounts payable at maturity.1049 The amount of OID in a debt instrument is allocated over the life of the instrument through a series of adjustments to the issue price for each accrual period.1050 The adjustment to the issue price is determined by multiplying the adjusted issue price (i.e., the issue price increased by adjustments prior to the accrual period) by the instrument's yield to maturity, and then subtracting the interest payable during the accrual period. Thus, in order to compute the amount of OID and the portion of OID allocable to a period, the stated redemption price at maturity and the time of maturity must be known. Issuers of OID instruments accrue and deduct the amount of OID as interest expense in the same manner as the holder.1051

Debt instruments subject to acceleration

Special rules for determining the amount of OID allocated to a period apply to certain instruments that may be subject to prepayment. First, if a borrower can reduce the yield on a debt by exercising a prepayment option, the OID rules assume that the borrower will prepay the debt. In addition, in the case of (1) any regular interest in a real estate mortgage investment conduit ("REMIC"), (2) qualified mortgages held by a REMIC, or (3) any other debt instrument if payments under the instrument may be accelerated by reason of prepayments of other obligations securing the instrument, the daily portions of the OID on such debt instruments are determined by taking into account an assumption regarding the prepayment of principal for such instruments.1052

The Taxpayer Relief Act of 19971053 extended these rules to any pool of debt instruments the payments on which may be accelerated by reason of prepayments.1054 Thus, if a taxpayer holds a pool of credit card receivables that require interest to be paid only if the borrowers do not pay their accounts by a specified date ("grace-period interest"), the taxpayer is required to accrue interest or OID on such pool based upon a reasonable assumption regarding the timing of the payments of the accounts in the pool. Under these rules, certain amounts (other than grace-period interest) related to credit card transactions, such as late-payment fees,1055 cash-advance fees,1056 and interchange fees,1057 have been determined to create OID or increase the amount of OID on the pool of credit card receivables to which the amounts relate.1058

 

Description of Proposal

 

 

The proposal modifies the proposed rules under section 451.1059 Specifically, the proposal directs taxpayers to apply the revenue recognition rules under section 451 before applying the OID rules under section 1272. Thus, for example, to the extent amounts are included in income for financial statement purposes when received (e.g., late-payment fees, cash-advance fees, interchange fees, etc.), such amounts generally are includable income at such time in accordance with the general recognition principles under section 451.

 

Effective Date

 

 

The proposal is effective for taxable years beginning after December 31, 2014. Application of these rules is a change in the taxpayer's method of accounting for purposes of section 481.

6. Rules regarding certain government debt (sec. 3414 of the discussion draft and secs. 454 and 1272A of the Code)

 

Present Law

 

 

A cash-basis taxpayer holding a non-interest bearing obligation issued at a discount may elect to include in income the increase in the value of the obligation.1060

Discount on certain short-term government obligations, such as Treasury bills, is not considered to accrue until the obligation is paid at maturity or otherwise disposed of.1061 However, in the case of a taxpayer using an accrual method of accounting and certain other taxpayers, discount on short-term obligations is required to be included currently in income.1062

Any increase in the redemption value of a United States savings bond (to the extent not previously included in income) is includible in gross income in the taxable year the bond is redeemed or the taxable year of final maturity, whichever is earlier.1063

 

Description of Proposal

 

 

The proposal moves the rules relating to the tax treatment of United States savings bonds to the portion of the Internal Revenue Code of 1986 relating generally to the treatment of bonds and other debt instruments. The proposal does not change the present-law tax treatment of United States savings bonds.

The proposal repeals the provision of present law relating to the accrual of interest on short-term government obligations as obsolete.

 

Effective Date

 

 

The proposal is generally effective on the date of enactment.

7. Cost basis of specified securities determined without regard to identification (sec. 3421 of the discussion draft and sec. 1012 of the Code)

 

Present Law

 

 

In general

Gain or loss generally is recognized for Federal income tax purposes on realization of that gain or loss (for example, through the sale of property giving rise to the gain or loss). The taxpayer's gain or loss on a disposition of property is the difference between the amount realized and the adjusted basis.1064

To compute adjusted basis, a taxpayer must first determine the property's unadjusted or original basis and then make adjustments prescribed by the Code.1065 The original basis of property is its cost, except as otherwise prescribed by the Code (for example, in the case of property acquired by gift or bequest or in a tax-free exchange). Once determined, the taxpayer's original basis generally is adjusted downward to take account of depreciation or amortization, and generally is adjusted upward to reflect income and gain inclusions or capital outlays with respect to the property.

Basis computation rules

If a taxpayer has acquired stock in a corporation on different dates or at different prices and sells or transfers some of the shares of that stock, and the lot from which the stock is sold or transferred is not adequately identified, the shares deemed sold are the earliest acquired shares (the "first-in-first-out rule") .1066 If a taxpayer makes an adequate identification ("specific identification") of shares of stock that it sells, the shares of stock treated as sold are the shares that have been identified.1067 A taxpayer who owns shares in a regulated investment company ("RIC") generally is permitted to elect, in lieu of the specific identification or first-in-first-out methods, to determine the basis of RIC shares sold under one of two average-cost-basis methods described in Treasury regulations (together, the "average basis method").1068

In the case of the sale, exchange, or other disposition of a specified security (defined below) to which the basis reporting requirement described below applies, the first-in-first-out rule, specific identification, and average basis method conventions are applied on an account by account basis.1069 To facilitate the determination of the cost of RIC stock under the average basis method, RIC stock acquired before January 1, 2012, generally is treated as a separate account from RIC stock acquired on or after that date unless the RIC (or a broker holding the stock as a nominee) elects otherwise with respect to one or more of its stockholders, in which case all the RIC stock with respect to which the election is made is treated as a single account and the basis reporting requirement described below applies to all that stock.1070

The basis of stock acquired after December 31, 2010, in connection with a dividend reinvestment plan ("DRP") is determined under the average basis method for as long as the stock is held as part of that plan.1071

Basis reporting

A broker is required to report to the IRS a customer's adjusted basis in a covered security that the customer has sold and whether any gain or loss from the sale is long-term or short-term.1072

A covered security is, in general, any specified security acquired after an applicable date specified in the basis reporting rules. A specified security is any share of stock of a corporation (including stock of a RIC); any note, bond, debenture, or other evidence of indebtedness; any commodity, or contract or derivative with respect to such commodity, if the Treasury Secretary determines that adjusted basis reporting is appropriate; and any other financial instrument with respect to which the Treasury Secretary determines that adjusted basis reporting is appropriate.

For purposes of satisfying the basis reporting requirements, a broker must determine a customer's adjusted basis in accordance with rules intended to ensure that the broker's reported adjusted basis numbers are the same numbers that customers must use in filing their tax returns.1073

 

Description of Proposal

 

 

The proposal requires that the cost of any specified security sold, exchanged, or otherwise disposed of on or after January 1, 2015, be determined on a first-in first-out basis except to the extent the average basis method is otherwise allowed (as in the case of stock of a RIC).

The proposal includes several conforming amendments, including a rule restricting a broker's basis reporting method to the first-in first-out method in the case of the sale of any stock for which the average basis method is not permitted.

 

Effective Date

 

 

The proposal applies to sales, exchanges, and other dispositions after December 31, 2014.

8. Wash sales by related parties (sec. 3422 of the discussion draft and sec. 1091 of the Code)

 

Present Law

 

 

A taxpayer may not deduct losses from the disposition of stock or securities if substantially identical stock or securities (or an option to acquire such property) are acquired by the taxpayer during the period beginning 30 days before the date of sale and ending 30 days after such date of sale (a "wash sale").1074 Commodity futures are not treated as stock or securities for purposes of this rule. A deduction is allowed if the taxpayer incurred the loss in the ordinary course of business as a dealer in stock or securities.

If a loss is disallowed because of the wash sale rules, the basis of the substantially identical stock or securities is adjusted to include the disallowed loss. The holding period for substantially identical stock or securities acquired in a wash sale includes the holding period of the stock or securities sold.

Similar rules apply to disallow any loss realized on the closing of a short sale of stock or securities if substantially identical stock or securities are sold (or a short sale, option or contract to sell is entered into) during the applicable period before and after the closing of the short sale.

Under IRS guidance, transactions with certain related parties may also constitute wash sales. If a taxpayer sells stock and the taxpayer's spouse or a corporation controlled by the taxpayer buys substantially identical stock, the transaction constitutes a wash sale.1075 If an individual sells stock or securities for a loss and acquires substantially identical stock or securities within an individual retirement account or a Roth IRA within the specified period of time, the loss on the sale of the stock or securities is disallowed under the wash sale rules, and the individual's basis in the IRA or Roth IRA is not increased.1076

 

Description of Proposal

 

 

The proposal expands application of the wash sale rules to acquisition of substantially identical stock or securities by the taxpayer or a related party. In the case of any acquisition of substantially identical stock or securities by a related party (other than the taxpayer's spouse), the basis of the substantially identical stock or securities is not adjusted to include the disallowed loss. If the substantially identical stock or securities is acquired by the taxpayer (or the taxpayer's spouse), the basis of the acquired stock or securities is increased by the amount of the disallowed loss.

For purposes of the wash sale rules, a related party means: (1) the taxpayer's spouse; (2) any dependent of the taxpayer and any other taxpayer with respect to whom the taxpayer is a dependent; (3) any individual, corporation, partnership, trust, or estate that controls, or is controlled by the taxpayer or any individual described in (1) or (2); (4) any individual retirement plan, Archer MSA, or health savings account of the taxpayer or of any individual described in (1) or (2); (5) any account under a qualified tuition program or a Coverdell education savings account if the taxpayer or any individual described in (1) or (2) is the designated beneficiary of such account or has the right to make any decision with respect to the investment of any amount in such account; and (6) any account under a plan described in section 401(a), an annuity plan described in section 403(a), an annuity contract described in section 403(b), or an eligible deferred compensation plan described in section 457(b) and maintained by an employer described in section 457(e)(1)(A), if the taxpayer or any individual described in (1) or (2) with respect to the taxpayer has the right to make any decision with respect to the investment of any amount in such account.

Most relationships are determined as of the time of the acquisition of substantially identical stock or securities. Spousal and dependency relationships are determined for the taxable year that includes such acquisition. Marital status is determined under section 7703, except that a husband and wife who file separate returns for any taxable year and live apart at all times during such taxable year shall not be treated as married individuals for purposes of the wash sale rules.

Regulatory authority is provided to prevent the avoidance of the purposes of the subsection dealing with related parties, including regulations that treat persons as related parties if such persons are formed or availed of to avoid the purposes of such subsection.

 

Effective Date

 

 

The proposal applies to sales and other dispositions after December 31, 2014.

9. Nonrecognition for derivative transactions by a corporation with respect to its stock (sec. 3423 of the discussion draft and sec. 1032 of the Code)

Present Law

A corporation does not recognize gain or loss on the receipt of money or other property in exchange for its own stock.1077 Likewise, a corporation does not recognize gain or loss when it redeems its stock with cash for less or more than it received when the stock was issued.

In addition, a corporation does not recognize gain or loss on any lapse or acquisition of an option, or with respect to a securities futures contract, to buy or sell its stock.1078

 

Description of Proposal

 

 

In general

The proposal provides generally that section 1032 derivative items of a corporation are not taken into account in determining the corporation's liability for income tax. A corporation generally does not recognize gain or loss on the receipt of money or other property in exchange for its stock,1079 except as otherwise provided under the proposal with respect to certain forward contracts giving rise to income in the nature of interest income or under regulatory authority to carry out the purposes of the proposals.

A section 1032 derivative item of a corporation is an item of income, gain, loss, or deduction to the extent it arises from any rights or obligations under a derivative with respect to the corporation's stock or is attributable to transfer or extinguishment of any such right or obligation. A section 1032 derivative item of a corporation also is an item of income, gain, loss, or deduction that arises under any other contract or position to the extent the item reflects or is determined by reference to changes in the value of the corporation's stock or distributions on the stock. The term does not include any deduction with respect to which section 83 applies (relating to a deduction by an employer in connection with services performed), nor a deduction for any item in the nature of compensation for services rendered. Regulatory authority is provided to treat portions of an instrument separately and to treat section 1032 derivative items as contributions to capital that are includable in gross income of a corporation to the extent that not doing so is inconsistent with the purposes of new section 76 as added by the discussion draft.1080

Income recognition on certain forward contracts with respect to a corporation's stock

The proposal provides for income recognition on certain forward contracts as if the includible amounts were original issue discount. This rule applies if a corporation acquires its stock as part of a plan or series of related transactions pursuant to which the corporation enters into a forward contract with respect to its stock. In this case, the corporation includes in income the excess of the amount to be received under the forward contract over the fair market value of the stock as of the date the corporation entered into the forward contract. The income is included as if the excess were original issue discount on a debt instrument acquired on that date. This rule of inclusion applies only to the extent that the amount of the stock involved in the forward contract does not exceed the amount of stock acquired by the corporation pursuant to the plan or series of related transactions. Under the proposal, a plan is presumed to exist if a corporation enters into a forward contract with respect to its stock with the 60-day period beginning on the date 30 days before the date it acquires its stock.

 

Effective Date

 

 

The proposal applies to transactions entered into after the date of enactment.

10. Termination of private activity bonds (sec. 3431 of the discussion draft and sec. 103 of the Code)

 

Present Law

 

 

In general

Under present law, gross income generally does not include interest paid on State or local bonds.1081 State and local bonds are classified generally as either governmental bonds or private activity bonds. Governmental bonds are bonds which are primarily used to finance governmental functions or that are repaid with governmental funds. Private activity bonds are bonds with respect to which the State or local government serves as a conduit providing financing to nongovernmental persons (e.g., private businesses or individuals). The exclusion from income for State and local bonds only applies to private activity bonds if the bonds are issued for certain permitted purposes ("qualified private activity bonds").

Private activity bonds

Present law provides three main tests for determining whether a State or local bond is in substance a private activity bond, the two-part private business test, the five-percent unrelated or disproportionate use test, and the private loan test.

 

Private business test

 

Private business use and private payments result in State and local bonds being private activity bonds if both parts of the two-part private business test are satisfied --

 

1. More than 10 percent of the bond proceeds is to be used (directly or indirectly) by a private business (the "private business use test"); and

2. More than 10 percent of the debt service on the bonds is secured by an interest in property to be used in a private business use or to be derived from payments in respect of such property (the "private payment test").

 

Private business use generally includes any use by a business entity (including the Federal government), which occurs pursuant to terms not generally available to the general public. For example, if bond-financed property is leased to a private business (other than pursuant to certain short-term leases for which safe harbors are provided under Treasury regulations), bond proceeds used to finance the property are treated as used in a private business use, and rental payments are treated as securing the payment of the bonds. Private business use also can arise when a governmental entity contracts for the operation of a governmental facility by a private business under a management contract that does not satisfy Treasury regulatory safe harbors regarding the types of payments made to the private operator and the length of the contract.

 

Five-percent unrelated or disproportionate business use test

 

A second standard to determine whether a bond is to be treated as a private activity bond is the five percent unrelated or disproportionate business use test. Under this test the private business use and private payment test (described above) are separately applied substituting five percent for 10 percent and generally only taking into account private business use and private payments that are not related or not proportionate to the government use of the bond proceeds. For example, while a bond issue that finances a new State or local government office building may include a cafeteria the issue may become a private activity bond if the size of the cafeteria is excessive (as determined under this rule).

 

Private loan test

 

The third standard for determining whether a State or local bond is a private activity bond is whether an amount exceeding the lesser of (1) five percent of the bond proceeds or (2) $5 million is used (directly or indirectly) to finance loans to private persons. Private loans include both business and other (e.g., personal) uses and payments by private persons; however, in the case of business uses and payments, all private loans also constitute private business uses and payments subject to the private business test. Present law provides that the substance of a transaction governs in determining whether the transaction gives rise to a private loan. In general, any transaction which transfers tax ownership of property to a private person is treated as a private loan.

 

Special limit on certain output facilities

 

A special rule for output facilities treats bonds as private activity bonds if more than $15 million of the proceeds of the bond issue are used to finance an output facility (an output facility includes electric and gas generation, transmission and related facilities but not a facility for the furnishing of water).1082

 

Special volume cap requirement for larger transactions

 

A special volume cap requirement for larger transactions treats bonds as private activity bonds if the nonqualified amount of private business use or private payments exceeds $15 million (even if that amount is within the general 10-percent private business limitation for governmental bonds) unless the issuer obtains a private activity bond volume allocation.1083

Qualified private activity bonds

As stated, interest on private activity bonds is taxable unless the bonds meet the requirements for qualified private activity bonds. Qualified private activity bonds permit States or local governments to act as conduits providing tax-exempt financing for certain private activities. The definition of qualified private activity bonds includes an exempt facility bond, or qualified mortgage, veterans' mortgage, small issue, redevelopment, 501(c)(3), or student loan bond.1084 The definition of exempt facility bond includes bonds issued to finance certain transportation facilities (airports, ports, mass commuting, and high-speed intercity rail facilities); qualified residential rental projects; privately owned and/or operated utility facilities (sewage, water, solid waste disposal, and local district heating and cooling facilities, certain private electric and gas facilities, and hydroelectric dam enhancements); public/private educational facilities; qualified green building and sustainable design projects; and qualified highway or surface freight transfer facilities.1085

In most cases, the aggregate volume of these tax-exempt private activity bonds is restricted by annual aggregate volume limits imposed on bonds issued by issuers within each State. For 2014, the State volume limit is the greater of $100 multiplied by the State population, or $296,825,000.1086

 

Description of Proposal

 

 

The proposal repeals the exception from the exclusion from gross income for interest paid on qualified private activity bonds. Thus, interest on any private activity bond is includible in the gross income of the taxpayer.

 

Effective Date

 

 

The proposal applies to bonds issued after December 31, 2014.

11. Termination of credit for interest on certain home mortgages (sec. 3432 of the discussion draft and sec. 25 of the Code)

 

Present Law

 

 

Qualified governmental units can elect to exchange all or a portion of their qualified mortgage bond authority for authority to issue mortgage credit certificates ("MCCs").1087 MCCs entitle homebuyers to a nonrefundable income tax credit for a specified percentage of interest paid on mortgage loans on their principal residences. The tax credit provided by the MCC may be carried forward for three years. Once issued, an MCC generally remains in effect as long as the residence being financed is the certificate-recipient's principal residence. MCCs generally are subject to the same eligibility and targeted area requirements as qualified mortgage bonds.1088

 

Description of Proposal

 

 

No credit is allowed with respect to any MCC issued after December 31, 2014.

 

Effective Date

 

 

The proposal applies to taxable years ending after December 31, 2014. Credits continue for interest paid on mortgage loans on principal residences for which MCCs have been issued on or before December 31, 2014.

12. Repeal advance refunding bonds (sec. 3433 of the discussion draft and sec. 149(d) of the Code)

 

Present Law

 

 

Section 103 generally provides that gross income does not include interest received on State or local bonds. State and local bonds are classified generally as either governmental bonds or private activity bonds. Governmental bonds are bonds the proceeds of which are primarily used to finance governmental facilities or the debt is repaid with governmental funds. Private activity bonds are bonds in which the State or local government serves as a conduit providing financing to nongovernmental persons (e.g., private businesses or individuals).1089 Bonds issued to finance the activities of charitable organizations described in section 501(c)(3) ("qualified 501(c)(3) bonds") are one type of private activity bond. The exclusion from income for interest on State and local bonds only applies if certain Code requirements are met.

A refunding bond is defined as any bond used to pay principal, interest, or redemption price on a prior bond issue (the refunded bond). The Code contains different rules for current as opposed to advance refunding bonds. A current refunding occurs when the refunded bond is redeemed within 90 days of issuance of the refunding bonds. Conversely, a bond is classified as an advance refunding if it is issued more than 90 days before the redemption of the refunded bond.1090 Proceeds of advance refunding bonds are generally invested in an escrow account and held until a future date when the refunded bond may be redeemed.

Although there is no statutory limitation on the number of times that tax-exempt bonds may be currently refunded, the Code limits advance refundings. Generally, governmental bonds and qualified 501(c)(3) bonds may be advance refunded one time.1091 Private activity bonds, other than qualified 501(c)(3) bonds, may not be advance refunded at all.1092 Furthermore, in the case of an advance refunding bond that results in interest savings (e.g., a high interest rate to low interest rate refunding), the refunded bond must be redeemed on the first call date 90 days after the issuance of the refunding bond that results in debt service savings (the "first call requirement").1093

 

Description of Proposal

 

 

The proposal repeals the exclusion from gross income for interest on any bond issued to advance refund a bond.

 

Effective Date

 

 

The proposal applies to bonds issued after December 31, 2014.

13. Repeal tax credit bond rules (sec. 3434 of the discussion draft and secs. 54A, 54B, 54C, 54D, 54E, 54F and 6431 of the Code)

 

Present Law

 

 

In general

Tax-credit bonds provide tax credits to investors to replace a prescribed portion of the interest cost. The borrowing subsidy generally is measured by reference to the credit rate set by the Treasury Department. Current tax-credit bonds include qualified tax credit bonds, which have certain common general requirements, and include new clean renewable energy bonds, qualified energy conservation bonds, qualified zone academy ("QZABs"), and qualified school construction bonds. The authority to issue two other types of tax-credit bonds, recovery zone economic development bonds and Build America Bonds expired on January 1, 2011.

Qualified tax-credit bonds

 

General rules applicable to qualified tax-credit bonds1094

 

Unlike tax-exempt bonds, qualified tax-credit bonds generally are not interest-bearing obligations. Rather, the taxpayer holding a qualified tax-credit bond on a credit allowance date is entitled to a tax credit. The amount of the credit is determined by multiplying the bond's credit rate by the face amount on the holder's bond. The credit rate for an issue of qualified tax credit bonds is determined by the Secretary and is estimated to be a rate that permits issuance of the qualified tax-credit bonds without discount and interest cost to the qualified issuer.1095 The credit accrues quarterly and is includible in gross income (as if it were an interest payment on the bond), and can be claimed against regular income tax liability and alternative minimum tax liability. Unused credits may be carried forward to succeeding taxable years. In addition, credits may be separated from the ownership of the underlying bond similar to how interest coupons can be stripped for interest-bearing bonds.

Qualified tax-credit bonds are subject to a maximum maturity limitation. The maximum maturity is the term which the Secretary estimates will result in the present value of the obligation to repay the principal on a qualified tax-credit bond being equal to 50 percent of the face amount of such bond. The discount rate used to determine the present value amount is the average annual interest rate of tax-exempt obligations having a term of 10 years or more which are issued during the month the qualified tax-credit bonds are issued.

For qualified tax-credit bonds, 100 percent of the available project proceeds must be used within the three-year period that begins on the date of issuance. Available project proceeds are proceeds from the sale of the bond issue less issuance costs (not to exceed two percent) and any investment earnings on such sale proceeds. To the extent less than 100 percent of the available project proceeds are used to finance qualified projects during the three-year spending period, bonds will continue to qualify as qualified tax-credit bonds if unspent proceeds are used within 90 days from the end of such three-year period to redeem bonds. The three-year spending period may be extended by the Secretary upon the qualified issuer's request demonstrating that the failure to satisfy the three-year requirement is due to reasonable cause and the projects will continue to proceed with due diligence.

Qualified tax-credit bonds also are subject to the arbitrage requirements of section 148 that apply to traditional tax-exempt bonds. Principles under section 148 and the regulations thereunder apply for purposes of determining the yield restriction and arbitrage rebate requirements applicable to qualified tax-credit bonds. However, available project proceeds invested during the three-year spending period are not subject to the arbitrage restrictions (i.e., yield restriction and rebate requirements) . In addition, amounts invested in a reserve fund are not subject to the arbitrage restrictions to the extent: (1) such fund is funded at a rate not more rapid than equal annual installments; (2) such fund is funded in a manner reasonably expected to result in an amount not greater than an amount necessary to repay the issue; and (3) the yield on such fund is not greater than the average annual interest rate of tax-exempt obligations having a term of 10 years or more that are issued during the month the qualified tax-credit bonds are issued.

Issuers of qualified tax-credit bonds are required to report issuance to the IRS in a manner similar to the information returns required for tax-exempt bonds. In addition, issuers of qualified tax-credit bonds are required to certify that applicable State and local law requirements governing conflicts of interest are satisfied with respect to such issue, and if the Secretary prescribes additional conflicts of interest rules governing the appropriate Members of Congress, Federal, State, and local officials, and their spouses, such additional rules are satisfied with respect to such issue.

 

New clean renewable energy bonds

 

New clean renewable energy bonds ("New CREBs") may be issued by qualified issuers to finance qualified renewable energy facilities.1096 Qualified renewable energy facilities are facilities that: (1) qualify for the tax credit under section 45 (other than Indian coal and refined coal production facilities), without regard to the placed-in-service date requirements of that section; and (2) are owned by a public power provider, governmental body, or cooperative electric company.

The term "qualified issuers" includes: (1) public power providers; (2) a governmental body; (3) cooperative electric companies; (4) a not-for-profit electric utility that has received a loan or guarantee under the Rural Electrification Act; and (5) clean renewable energy bond lenders. There was originally a national limitation for New CREBs of $800 million. The national limitation was then increased by an additional $1.6 billion in 2009. As with other tax credit bonds, a taxpayer holding New CREBs on a credit allowance date is entitled to a tax credit. However, the credit rate on New CREBs is set by the Secretary at a rate that is 70 percent of the rate that would permit issuance of such bonds without discount and interest cost to the issuer.1097

 

Qualified energy conservation bonds

 

Qualified energy conservation bonds may be used to finance qualified conservation purposes.

The term "qualified conservation purpose" means:

 

1. Capital expenditures incurred for purposes of reducing energy consumption in publicly owned buildings by at least 20 percent; implementing green community programs;1098 rural development involving the production of electricity from renewable energy resources; or any facility eligible for the production tax credit under section 45 (other than Indian coal and refined coal production facilities);

2. Expenditures with respect to facilities or grants that support research in: (a) development of cellulosic ethanol or other nonfossil fuels; (b) technologies for the capture and sequestration of carbon dioxide produced through the use of fossil fuels; (c) increasing the efficiency of existing technologies for producing nonfossil fuels; (d) automobile battery technologies and other technologies to reduce fossil fuel consumption in transportation; and (e) technologies to reduce energy use in buildings;

3. Mass commuting facilities and related facilities that reduce the consumption of energy, including expenditures to reduce pollution from vehicles used for mass commuting;

4. Demonstration projects designed to promote the commercialization of: (a) green building technology; (b) conversion of agricultural waste for use in the production of fuel or otherwise; (c) advanced battery manufacturing technologies; (d) technologies to reduce peak-use of electricity; and (e) technologies for the capture and sequestration of carbon dioxide emitted from combusting fossil fuels in order to produce electricity; and

5. Public education campaigns to promote energy efficiency (other than movies, concerts, and other events held primarily for entertainment purposes).

 

There was originally a national limitation on qualified energy conservation bonds of $800 million. The national limitation was then increased by an additional $2.4 billion in 2009. As with other qualified tax credit bonds, the taxpayer holding qualified energy conservation bonds on a credit allowance date is entitled to a tax credit. The credit rate on the bonds is set by the Secretary at a rate that is 70 percent of the rate that would permit issuance of such bonds without discount and interest cost to the issuer.1099

 

Qualified zone academy bonds

 

QZABs are defined as any bond issued by a State or local government, provided that (1) at least 95 percent of the proceeds are used for the purpose of renovating, providing equipment to, developing course materials for use at, or training teachers and other school personnel in a "qualified zone academy," and (2) private entities have promised to contribute to the qualified zone academy certain equipment, technical assistance or training, employee services, or other property or services with a value equal to at least 10 percent of the bond proceeds.

A total of $400 million of QZABs has been authorized to be issued annually in calendar years 1998 through 2008. The authorization was increased to $1.4 billion in 2009 and 2010, respectively. The authorization for calendar years 2011, 2012 and 2013 was set at $400 million.

 

Qualified school construction bonds

 

Qualified school construction bonds must meet three requirements: (1) 100 percent of the available project proceeds of the bond issue is used for the construction, rehabilitation, or repair of a public school facility or for the acquisition of land on which such a bond-financed facility is to be constructed; (2) the bond is issued by a State or local government within which such school is located; and (3) the issuer designates such bonds as a qualified school construction bond.

There is a national limitation on qualified school construction bonds of $11 billion for calendar years 2009 and 2010, and zero after 2010. If an amount allocated is unused for a calendar year, it may be carried forward to the following and subsequent calendar years. Under a separate special rule, the Secretary of Interior may allocate $200 million of school construction bond authority for Indian schools.

Direct-pay bonds and expired tax-credit bond provisions

The Code provides that an issuer may elect to issue certain tax credit bonds as "direct-pay bonds." Instead of a credit to the holder, with a "direct-pay bond" the Federal government pays the issuer a percentage of the interest on the bonds. The following tax credit bonds may be issued as direct-pay bonds: new clean renewable energy bonds, qualified energy conservation bonds, and qualified school construction bonds. Qualified zone academy bonds may be issued as direct-pay but such an election is not available regarding any allocation of the national zone academy bond allocation after 2011 or any carryforward of such allocation. The ability to issue Build America Bonds and Recovery Zone bonds, which have direct-pay features, has expired.

 

Description of Proposal

 

 

The proposal prospectively repeals all existing authority for issuing tax-credit bonds and direct-pay bonds.

 

Effective Date

 

 

The proposal is effective for bonds issued after the date of enactment. Current law remains in place for bonds outstanding on the date of enactment.

 

F. Insurance Reforms

 

 

1. Exception to pro rata interest expense disallowance for corporate-owned life insurance restricted to 20-percent owners (sec. 3501 of the discussion draft and sec. 264 of the Code)

 

Present Law

 

 

Inside buildup and death benefits under life insurance contracts generally tax-free

No Federal income tax generally is imposed on a policyholder with respect to the earnings under a life insurance contract1100 ("inside buildup").1101 Further, an exclusion from Federal income tax is provided for amounts received under a life insurance contract paid by reason of the death of the insured.1102

Premium and interest deduction limitations with respect to life insurance contracts

 

Premiums

 

Under present law, no deduction is permitted for premiums paid on any life insurance, annuity or endowment contract, if the taxpayer is directly or indirectly a beneficiary under the contract.1103

 

Interest paid or accrued with respect to the contract1104

 

No deduction is allowed for interest paid or accrued on any debt with respect to a life insurance, annuity or endowment contract covering the life of any individual,1105 with a key person insurance exception.1106 This reflects a broadening of the interest deduction disallowance rule that was enacted in 1996.

 

Pro rata interest deduction limitation

 

A pro rata interest deduction disallowance rule also applies. This rule applies to interest, a deduction for which is not disallowed under the other interest deduction disallowance rules relating to life insurance, for example, interest on third-party debt that is not with respect to a life insurance, endowment or annuity contract. Under this rule, in the case of a taxpayer other than a natural person, no deduction is allowed for the portion of the taxpayer's interest expense that is allocable to unborrowed policy cash surrender values.1107 Interest expense is allocable to unborrowed policy cash values based on the ratio of (1) the taxpayer's average unborrowed policy cash values of life insurance, annuity and endowment contracts, to (2) the sum of the average unborrowed cash values of life insurance, annuity, and endowment contracts, plus the average adjusted bases of other assets.

Under the pro rata interest disallowance rule, an exception is provided for any contract owned by an entity engaged in a trade or business, if the contract covers only one individual who is an employee or is an officer, director, or 20-percent owner of the entity of the trade or business. The exception also applies to a joint-life contract covering a 20-percent owner and his or her spouse.

The pro rata interest deduction limitation was added in 1997.

Excludability of death benefits

In 2006, additional rules for excludability of death benefits under a life insurance contract were added in the case of employer-owned life insurance contracts1108 (generally, those contracts insuring employees that are excepted from the pro rata interest deduction limitation). These rules permit an employer to exclude the death benefit under a contract insuring the life of an employee if the insured was an employee at any time during the 12-month period before his or her death, or if the insured is among the highest paid 35 percent of all employees. Notice and consent requirements must be satisfied.

 

Description of Proposal

 

 

The proposal eliminates the exception under the pro rata interest deduction disallowance rule for employees, officers, and directors. The exception for 20-percent owners is retained, however.

 

Effective Date

 

 

The proposal is effective for contracts issued after December 31, 2014. A material change in the death benefit or other material change in the contract causes the contract to be treated as a new contract for this purpose.

2. Net operating losses of life insurance companies (sec. 3502 of the discussion draft and sec. 805 of the Code)

 

Present Law

 

 

A net operating loss ("NOL") generally means the amount by which a taxpayer's business deductions exceed its gross income. In general, an NOL may be carried back two years and carried over 20 years to offset taxable income in such years. NOLs offset taxable income in the order of the taxable years to which the NOL may be carried.1109

For purposes of computing the alternative minimum tax ("AMT"), a taxpayer's NOL deduction cannot reduce the taxpayer's alternative minimum taxable income ("AMTI") by more than 90 percent of the AMTI.1110

In the case of a life insurance company, present law allows a deduction for the operations loss carryovers and carrybacks to the taxable year, in lieu of the deduction for net operation losses allowed to other corporations.1111 A life insurance company is permitted to treat a loss from operations (as defined under section 810(c)) for any taxable year as an operations loss carryback to each of the three taxable years preceding the loss year and an operations loss carryover to each of the 15 taxable years following the loss year.1112

 

Description of Proposal

 

 

The provision repeals the operations loss deduction for life insurance companies and allows the NOL deduction under section 172. This provides the same treatment for losses of life insurance companies as for losses of property and casualty insurance companies and of other corporations. The provision thus limits the NOL carryback period for life insurance companies to two years and extends the NOL carryover period to 20 years. The NOL deduction is determined by treating the NOL for any taxable year generally as the excess of the life insurance deductions for such taxable year, over the life insurance gross income for such taxable year.

 

Effective Date

 

 

The provision applies to losses arising in taxable years beginning after December 31, 2014.

3. Repeal small life insurance company deduction (sec. 3503 of the discussion draft and sec. 806 of the Code)

 

Present Law

 

 

The small life insurance company deduction for any taxable year is 60 percent of so much of the tentative life insurance company taxable income ("LICTI") for such taxable year as does not exceed $3 million, reduced by 15 percent of the excess of tentative LICTI over $3 million. The maximum deduction that can be claimed by a small company is $1.8 million, and a company with a tentative LICTI of $15 million or more is not entitled to any small company deduction. A small life insurance company for this purpose is one with less than $500 million of assets.

 

Description of Proposal

 

 

The provision repeals the small life insurance company deduction.

 

Effective Date

 

 

The provision applies to taxable years beginning after December 31, 2014.

4. Computation of life insurance tax reserves (sec. 3504 of the discussion draft and sec. 807 of the Code)

 

Present Law

 

 

Reserves

In determining life insurance company taxable income, a life insurance company includes in gross income any net decrease in reserves, and deducts a net increase in reserves.1113 Methods for determining reserves for tax purposes generally are based on reserves prescribed by the National Association of Insurance Commissioners for purposes of financial reporting under State regulatory rules.

In computing the net increase or net decrease in reserves, six items are taken into account. These are (1) life insurance reserves; (2) unearned premiums and unpaid losses included in total reserves; (3) amounts that are discounted at interest to satisfy obligations under insurance and annuity contracts that do not involve life, accident, or health contingencies when the computation is made; (4) dividend accumulations and other amounts held at interest in connection with insurance and annuity contracts; (5) premiums received in advance and liabilities for premium deposit funds; and (6) reasonable special contingency reserves under contracts of group term life insurance or group accident and health insurance that are held for retired lives, premium stabilization, or a combination of both.

Life insurance reserves for any contract are the greater of the net surrender value of the contract or the reserves determined under Federally prescribed rules, but in no event to exceed the statutory reserve with respect to the contract (for regulatory reporting). In computing the Federally prescribed reserve for any type of contract, the taxpayer must use the tax reserve method applicable to the contract, an interest rate for discounting of reserves to take account of the time value of money, and the prevailing commissioners' standard tables for mortality or morbidity.

Interest rate

The assumed interest rate to be used in computing the Federally prescribed reserve is the greater of the applicable Federal interest rate or the prevailing State assumed interest rate. The applicable Federal interest rate is the annual rate determined by the Secretary under the discounting rules for property and casualty reserves for the calendar year in which the contract is issued. The prevailing State assumed interest rate is generally the highest assumed interest rate permitted to be sued in at least 26 States in computing life insurance reserves for insurance or annuity contracts of that type as of the beginning the calendar year in which the contract is issued. In determining the highest assumed rates permitted in at least 26 States, each State is treated as permitting the use of every rate below its highest rate.

A one-time election is permitted (revocable only with the consent of the Secretary) to apply an updated applicable Federal interest rate every five years in calculating life insurance reserves. The election is provided to take account of the fluctuations in market rates of return that companies experience with respect to life insurance contracts of long duration. The use of the updated applicable Federal interest rate under the election does not cause the recalculation of life insurance reserves for any prior year. Under the election no change is made to the interest rate used in determining life insurance reserves if the updated applicable Federal interest rate is less than one-half of one percentage point different from the rate utilized by the company in calculating life insurance reserves during the preceding five years.

 

Description of Proposal

 

 

Under the provision, the interest rate used in determining reserves is the applicable Federal interest rate plus 3.5 percentage points. Any income or loss resulting from a change in reserves as a result of the change in interest rate under the provision is taken into account ratably over an eight-year period.

 

Effective Date

 

 

The provision applies to taxable years beginning after December 31, 2014. For the first taxable year beginning after December 31, 2014, the reserve with respect to any contract at the end of the preceding taxable year is determined as if the provision had applied to such reserve in such preceding taxable year and by using the interest rate applicable to such reserves for calendar year 2015.

5. Adjustment for change in computing reserves (sec. 3505 of the discussion draft and sec. 807 of the Code)

 

Present Law

 

 

Change in method of accounting

In general, a taxpayer may change its method of accounting under section 446 with the consent of the Secretary of the Treasury (or may be required to change its method of accounting by the Secretary). In such instances, a taxpayer generally is required to make an adjustment (a "section 481(a) adjustment") to prevent amounts from being duplicated in, or omitted from, the calculation of the taxpayer's income. Pursuant to IRS procedures, negative section 481(a) adjustments generally are deducted from income in the year of the change whereas positive section 481(a) adjustments generally are required to be included in income ratably over four taxable years.1114

However, section 807(f) explicitly provides that changes in the basis for determining life insurance company reserves are to be taken into account ratably over 10 years.

10-year spread for change in computing life insurance company reserves

For Federal income tax purposes, a life insurance company includes in gross income any net decrease in reserves, and deducts a net increase in reserves.1115 Methods for determining reserves for tax purposes generally are based on reserves prescribed by the National Association of Insurance Commissioners for purposes of financial reporting under State regulatory rules.

Income or loss resulting from a change in the method of computing reserves is taken into account ratably over a 10-year period.1116 The rule for a change in basis in computing reserves applies only if there is a change in basis in computing the Federally prescribed reserve (as distinguished from the net surrender value). Although life insurance tax reserves require the use of a Federally prescribed method, interest rate, and mortality or morbidity table, changes in other assumptions for computing statutory reserves (e.g., when premiums are collected and claims are paid) may cause increases or decreases in a company's life insurance reserves that must be spread over a 10-year period. Changes in the net surrender value of a contract are not subject to the 10-year spread because, apart from its use as a minimum in determining the amount of life insurance tax reserves, the net surrender value is not a reserve but a current liability.

If for any taxable year the taxpayer is not a life insurance company, the balance of any adjustments to reserves is taken into account for the preceding taxable year.

 

Description of Proposal

 

 

Income or loss resulting from a change in method of computing life insurance company reserves is taken into account consistent with IRS procedures, generally ratably over a four-year period, instead of over a 10-year period.

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014.

6. Modification of rules for life insurance company proration (sec. 3506 of the discussion draft and sec. 812 of the Code)

 

Present Law

 

 

Reduction of reserve deduction and dividends received deduction to reflect untaxed income

A life insurance company is subject to proration rules in calculating life insurance company taxable income.

The proration rules reduce the company's deductions, including reserve deductions and dividends received deductions, if the life insurance company has tax-exempt income, deductible dividends received, or other similar untaxed income items, because deductible reserve increases can be viewed as being funded proportionately out of taxable and tax-exempt income.

Under the proration rules, the net increase and net decrease in reserves are computed by reducing the ending balance of the reserve items by the policyholders' share of tax-exempt interest.1117

Similarly, under the proration rules, a life insurance company is allowed a dividends-received deduction for intercorporate dividends from nonaffiliates only in proportion to the company's share of such dividends,1118 but not for the policyholders' share. Fully deductible dividends from affiliates are excluded from the application of this proration formula, if such dividends are not themselves distributions from tax-exempt interest or from dividend income that would not be fully deductible if received directly by the taxpayer. In addition, the proration rule includes in prorated amounts the increase for the taxable year in policy cash values of life insurance policies and annuity and endowment contracts.

Company's share and policyholder's share

The life insurance company proration rules provide that the company's share, for this purpose, means the percentage obtained by dividing the company's share of the net investment income for the taxable year by the net investment income for the taxable year.1119 Net investment income means 95 percent of gross investment income, in the case of assets held in segregated asset accounts under variable contracts, and 90 percent of gross investment income in other cases.1120

Gross investment income includes specified items.1121 The specified items include interest (including tax-exempt interest), dividends, rents, royalties and other related specified items, short term capital gains, and trade or business income. Gross investment income does not include gain (other than short term capital gain to the extent it exceeds net long-term capital loss) that is, or is considered as, from the sale or exchange of a capital asset. Gross investment income also does not include the appreciation in the value of assets that is taken into account in computing the company's tax reserve deduction under section 817.

The company's share of net investment income, for purposes of this calculation, is the net investment income for the taxable year, reduced by the sum of (a) the policy interest for the taxable year and (b) a portion of policyholder dividends.1122 Policy interest is defined to include required interest at the greater of the prevailing State assumed rate or the applicable Federal rate (plus some other interest items). Present law provides that in any case where neither the prevailing State assumed interest rate nor the applicable Federal rate is used, "another appropriate rate" is used for this calculation. No statutory definition of "another appropriate rate" is provided; the law is unclear as to what rate or rates are appropriate for this purpose.1123

In 2007, the IRS issued Rev. Rul. 2007-54,1124 interpreting required interest under section 812(b) to be calculated by multiplying the mean of a contract's beginning-of-year and end-of-year reserves by the greater of the applicable Federal interest rate or the prevailing State assumed interest rate, for purposes of determining separate account reserves for variable contracts. However, Rev. Rul. 2007-54 was suspended by Rev. Rul. 2007-61, in which the IRS and the Treasury Department stated that the issues would more appropriately be addressed by regulation.1125 No regulations have been issued to date.

General account and separate accounts

A variable contract is generally a life insurance (or annuity) contract whose death benefit (or annuity payout) depends explicitly on the investment return and market value of underlying assets.1126 The investment risk is generally that of the policyholder, not the insurer. The assets underlying variable contracts are maintained in separate accounts held by life insurers. These separate accounts are distinct from the insurer's general account in which it maintains assets supporting products other than variable contracts.

Reserves

For Federal income tax purposes, a life insurance company includes in gross income any net decrease in reserves, and deducts a net increase in reserves.1127 Methods for determining reserves for tax purposes generally are based on reserves prescribed by the National Association of Insurance Commissioners for purposes of financial reporting under State regulatory rules.

For purposes of determining the amount of the tax reserves for variable contracts, however, a special rule eliminates gains and losses. Under this rule,1128 in determining reserves for variable contracts, realized and unrealized gains are subtracted, and realized and unrealized losses are added, whether or not the assets have been disposed of. The basis of assets in the separate account is increased to reflect appreciation, and reduced to reflect depreciation in value, that are taken into account in computing reserves for such contracts.

Dividends received deduction

A corporate taxpayer may partially or fully deduct dividends received.1129 The percentage of the allowable dividends received deduction depends on the percentage of the stock of the distributing corporation that the recipient corporation owns.

 

Limitation on dividends received deduction under section 246(c)(4)

 

The dividends received deduction is not allowed with respect to stock either (1) held for 45 days or less during a 91-day period beginning 45 days before the ex-dividend date, or (2) to the extent the taxpayer is under an obligation to make related payments with respect to positions in substantially similar or related property.1130 The taxpayer's holding period is reduced for periods during which its risk of loss is reduced.1131

 

Description of Proposal

 

 

The proposal modifies the life insurance company proration rule for reducing dividends received deductions and reserve deductions with respect to untaxed income.

Under the proposal, the company's share of untaxed income, for purposes of reducing deductions, is determined on an account by account basis. That is, a company determines its company's share separately for the general account and for each separate account.

The company's share is the excess of the mean assets of such account over the mean reserves with respect to such account divided by the mean assets of such account for such taxable year. The policyholder's share is the excess of 100 percent over the company share.

Mean assets for any taxable year are 50 percent of the sum of the fair market value of the assets of an account as of the beginning of the taxable year and the fair market value of the assets as of the close of the taxable year. Mean reserves are 50 percent of the sum of the reserves with respect to such account determined under section 807 as of the beginning of the year and the reserves with respect to such account determined under section 807 as of the close of the taxable year.

For purposes of determining mean assets or mean reserves, dividends described in section 246(c) (relating to the holding period limitation on the dividends received deduction), fees, and expenses, are not taken into account.

 

Effective Date

 

 

The provision applies to taxable years beginning after December 31, 2014.

7. Repeal treatment of distributions to shareholders from pre-1984 policyholders surplus account (sec. 3507 of the discussion draft and sec. 815 of the Code)

 

Present and Prior Law

 

 

Under the law in effect from 1959 through 1983, a life insurance company was subject to a three-phase taxable income computation under Federal tax law. Under the three-phase system, a company was taxed on the lesser of its gain from operations or its taxable investment income (Phase I) and, if its gain from operations exceeded its taxable investment income, 50 percent of such excess (Phase II). Federal income tax on the other 50 percent of the gain from operations was deferred, and was accounted for as part of a policyholder's surplus account and, subject to certain limitations, taxed only when distributed to stockholders or upon corporate dissolution (Phase III). To determine whether amounts had been distributed, a company maintained a shareholders surplus account, which generally included the company's previously taxed income that would be available for distribution to shareholders. Distributions to shareholders were treated as being first out of the shareholders surplus account, then out of the policyholders surplus account, and finally out of other accounts.

The Deficit Reduction Act of 19841132 included provisions that, for 1984 and later years, eliminated further deferral of tax on amounts (described above) that previously would have been deferred under the three-phase system. Although for taxable years after 1983, life insurance companies may not enlarge their policyholders surplus account, the companies are not taxed on previously deferred amounts unless the amounts are treated as distributed to shareholders or subtracted from the policyholders surplus account (sec. 815).

Any direct or indirect distribution to shareholders from an existing policyholders surplus account of a stock life insurance company is subject to tax at the corporate rate in the taxable year of the distribution. Present law (like prior law) provides that any distribution to shareholders is treated as made (1) first out of the shareholders surplus account, to the extent thereof, (2) then out of the policyholders surplus account, to the extent thereof, and (3) finally, out of other accounts.

For taxable years beginning after December 31, 2004, and before January 1, 2007, the application of the rules imposing income tax on distributions to shareholders from the policyholders surplus account of a life insurance company were suspended. Distributions in those years were treated as first made out of the policyholders surplus account, to the extent thereof, and then out of the shareholders surplus account, and lastly out of other accounts.

 

Description of Proposal

 

 

The provision repeals section 815, the rules imposing income tax on distributions to shareholders from the policyholders surplus account of a stock life insurance company.

In the case of any stock life insurance company with an existing policyholders surplus account (as defined in section 815 before its repeal), tax is imposed on the balance of the account as of December 31, 2014. A life insurance company is required to pay tax on the balance of the account ratably over the first eight taxable years beginning after December 31, 2014. Specifically, the tax imposed on a life insurance company is the tax on the sum of life insurance company taxable income for the taxable year (but not less than zero) plus 1/8 of the balance of the existing policyholders surplus account as of December 31, 2014. Thus, life insurance company losses are not allowed to offset the amount of the policyholders surplus account balance subject to tax.

 

Effective Date

 

 

The provision applies to taxable years beginning after December 31, 2014.

8. Modification of proration rules for property and casualty insurance companies (sec. 3508 of the discussion draft and sec. 832 of the Code)

 

Present Law

 

 

The taxable income of a property and casualty insurance company is determined as the sum of its gross income from underwriting income and investment income (as well as gains and other income items), reduced by allowable deductions.

A proration rule applies to property and casualty insurance companies. In calculating the deductible amount of its reserve for losses incurred, a property and casualty insurance company must reduce the amount of losses incurred by 15 percent of (1) the insurer's tax-exempt interest, (2) the deductible portion of dividends received (with special rules for dividends from affiliates), and (3) the increase for the taxable year in the cash value of life insurance, endowment or annuity contracts the company owns.1133 This proration rule reflects the fact that reserves are generally funded in part from tax-exempt interest, from deductible dividends, and from other untaxed amounts.

 

Description of Proposal

 

 

The proposal modifies the percentage applicable under the proration rule for property and casualty insurers. The deduction for losses incurred is reduced by the ratio (expressed as a percentage) of the average adjusted basis of tax-exempt assets to the average adjusted basis of all assets of the company. This percentage replaces the 15-percent reduction under present law.

Adjustments to basis are made in accordance with section 1016. For purposes of the proposal, tax-exempt assets are assets of the type which give rise to income subject to proration (i.e., tax-exempt interest, deductible dividends received, or the increase for the taxable year in the cash value of life insurance, endowment, or annuity contracts).

 

Effective Date

 

 

The proposal applies to taxable years beginning after December 31, 2014. A transition rule provides that for the first taxable year beginning after December 31, 2014, adjustments are taken into account ratably for that taxable year and the seven succeeding taxable years.

9. Treatment of Blue Cross and Blue Shield organizations (sec. 3509 of the discussion draft and sec. 833 of the Code)

 

Present Law

 

 

A property and casualty insurance company is subject to tax on its taxable income, generally defined as its gross income less allowable deductions.1134 For this purpose, gross income includes underwriting income and investment income, as well as other items. Underwriting income is the premiums earned on insurance contracts during the year, less losses incurred and expenses incurred. The amount of losses incurred is determined by taking into account the discounted unpaid losses. Premiums earned during the year is determined taking into account a 20-percent reduction in the otherwise allowable deduction, intended to represent the allocable portion of expenses incurred in generating the unearned premiums.1135

Present law provides that an organization described in sections 501(c)(3) or (4) of the Code is exempt from tax only if no substantial part of its activities consists of providing commercial-type insurance.1136 When this rule was enacted in 1986,1137 special rules were provided under section 833 for Blue Cross and Blue Shield organizations providing health insurance that (1) were in existence on August 16, 1986; (2) were determined at any time to be tax-exempt under a determination that had not been revoked; and (3) were tax-exempt for the last taxable year beginning before January 1, 1987 (when the present-law rule became effective), provided that no material change occurred in the structure or operations of the organizations after August 16, 1986, and before the close of 1986 or any subsequent taxable year. Any other organization is eligible for section 833 treatment if it meets six requirements set forth in section 833(c).1138

Section 833 provides a deduction with respect to health business of such organizations. The deduction is equal to 25 percent of the sum of (1) claims incurred, and liabilities incurred under cost-plus contracts, for the taxable year, and (2) expenses incurred in connection with administration, adjustment, or settlement of claims or in connection with administration of cost-plus contracts during the taxable year, to the extent this sum exceeds the adjusted surplus at the beginning of the taxable year. Only health-related items are taken into account.

Section 833 provides an exception for such an organization from the application of the 20-percent reduction in the deduction for increases in unearned premiums that applies generally to property and casualty companies.

Section 833 provides that such an organization is taxable as a stock property and casualty insurer under the Federal income tax rules applicable to property and casualty insurers.

The rules of section 833 are limited to those organizations meeting a medical loss ratio standard of 85 percent for the taxable year. Thus, an organization that does not meet the 85-percent standard is not allowed the 25-percent deduction and the exception from the 20-percent reduction in the unearned premium reserve deduction under section 833.

For this purpose, an organization's medical loss ratio is determined as the percentage of total premium revenue expended on reimbursement for clinical services that are provided to enrollees under the organization's policies during the taxable year, as reported under section 2718 of the PHSA.1139

 

Description of Proposal

 

 

The provision repeals section 833 in two stages. In stage one, the special deduction for 25 percent of claims and expenses incurred during the taxable year less the adjusted surplus at the beginning of the year, and the exception from the application of the 20-percent reduction in the deduction for increases in unearned premium reserves, are repealed. The limitation based on medical loss ratio is also repealed.

In stage two, section 833 is repealed in its entirety. Thus, an organization described therein is no longer treated automatically as a stock property and casualty insurance company.

 

Effective Date

 

 

The first stage of repeal applies to taxable years beginning after December 31, 2014.

Repeal of section 833 in its entirety applies to taxable years beginning after December 31, 2016.

10. Modification of discounting rules for property and casualty insurance companies (sec. 3510 of the discussion draft and sec. 846 of the Code)

 

Present Law

 

 

A property and casualty insurance company generally is subject to tax on its taxable income (sec. 831(a)). The taxable income of a property and casualty insurance company is determined as the sum of its underwriting income and investment income (as well as gains and other income items), reduced by allowable deductions (sec. 832). Among the items that are deductible in calculating underwriting income are additions to reserves for losses incurred and expenses incurred.

To take account of the time value of money, discounting of unpaid losses is required. All property and casualty loss reserves (unpaid losses and unpaid loss adjustment expenses) for each line of business (as shown on the annual statement) are required to be discounted for Federal income tax purposes.

The discounted reserves are calculated using a prescribed interest rate which is based on the applicable Federal mid-term rate ("mid-term AFR"). The discount rate is the average of the mid-term AFRs effective at the beginning of each month over the 60-month period preceding the calendar year for which the determination is made.

To determine the period over which the reserves are discounted, a prescribed loss payment pattern applies. The prescribed length of time is either the accident year and the following three calendar years, or the accident year and the following 10 calendar years, depending on the line of business. In the case of certain "long-tail" lines of business, the 10-year period is extended, but not by more than five additional years. Thus, present law limits the maximum duration of any loss payment pattern to the accident year and the following 15 years. The Treasury Department is directed to determine a loss payment pattern for each line of business by reference to the historical loss payment pattern for that line of business using aggregate experience reported on the annual statements of insurance companies, and is required to make this determination every five years, starting with 1987.

Under the discounting rules, an election is provided permitting a taxpayer to use its own (rather than an industry-wide) historical loss payment pattern with respect to all lines of business, provided that applicable requirements are met.

The Treasury Department publishes discount factors for each line of business to be applied by taxpayers for discounting reserves.1140 The discount factors are published annually, based on (1) the interest rate applicable to the calendar year, and (2) the loss payment pattern for each line of business as determined every five years.

 

Description of Proposal

 

 

The provision modifies the reserve discounting rules applicable to property and casualty insurance companies. In general, the provision modifies the prescribed interest rate, extends the periods applicable under the loss payment pattern, and repeals the election to use a taxpayer's historical loss payment pattern.

Interest rate

The provision provides that the interest rate is an annual rate for any calendar year to be determined by the Treasury Department based on the corporate bond yield curve (rather than the mid-term AFR as under present law). For this purpose, the corporate bond yield curve means, with respect to any month, a yield curve that reflects the average, for the preceding 24-month period, of monthly yields on investment grade corporate bonds with varying maturities and that are in the top 3 quality levels available.1141 Because the corporate bond yield curve provides for 24-month averaging, the present-law rule providing for 60-month averaging to determine the interest rate is repealed under the provision. It is expected that the Treasury Department will determine a 24-month average for the 24 months preceding the first month of the calendar year for which the determination is made.

 

Loss payment patterns

 

 

The provision extends the periods applicable for determining loss payment patterns. Under the provision, the maximum duration of the loss payment pattern is determined by the amount of losses remaining unpaid using aggregate industry experience for each line of business, rather than by a set number of years as under present law.

Like present law, the provision provides that the Treasury Department determines a loss payment pattern for each line of business by reference to the historical loss payment pattern for that line of business using aggregate experience reported on the annual statements of insurance companies, and is required to make this determination every five years. Under the provision, the first determination is to be made for calendar year 2013.

Under the provision, the present-law three-year and 10-year periods following the accident year are extended for the lines of business to which each period applies. For lines of business to which the three-year period applies, the amount of losses that would have been treated as paid in the third year after the accident year is treated as paid in that year and each subsequent year in an amount equal to the amount treated as paid in the second year (or, if less, the remaining amount). Similarly, for lines of business to which the 10-year period applies, the amount of losses that would have been treated as paid in the 10th year following the accident year is treated as paid in that year and each subsequent year in an amount equal to the amount treated as paid in the ninth year (or if less, the remaining amount).

The provision repeals the present-law rule providing that in the case of certain "long-tail" lines of business, the 10-year period is extended, but not by more than 5 additional years. The provision does not change the lines of business to which the three-year, and 10-year, periods, respectively, apply.

The provision retains the present-law rule providing that, for lines of business to which the 10-year period applies, if the amount of losses treated as paid in the ninth year is zero or negative, then the rule extending the payment period is applied by using the average of losses treated as paid in the seventh, eighth and ninth years. The provision adds a similar rule for lines of business to which the three-year period applies, providing that if the amount of losses treated as paid in the third year is zero or negative, then the rule extending the payment period is applied by using the average of losses treated as paid in the first and second years. The provision retains the present-law rule that, except as otherwise provided in regulations, any determination by the Treasury Department with respect to unpaid losses relating to the international and reinsurance lines of business is made using a pattern based on the combined losses for the auto liability, other liability, medical malpractice, workers' compensation and multiple peril lines of business.

Election to use own historical loss payment pattern

The provision repeals the present-law election permitting a taxpayer to use its own (rather than an industry-wide) historical loss payment pattern with respect to all lines of business.

 

Effective Date

 

 

The provision is effective generally for taxable years beginning after December 31, 2014. Under a transitional rule for the first taxable year beginning in 2015, the amount of unpaid losses and expenses unpaid (under section 832(b)(5)(B) and (6)) and the unpaid losses (under sections 805(c)(2) and 805(a)(1)) at the end of the preceding taxable year are determined as if the provision had applied to these items in such preceding taxable year, using the interest rate and loss payment patterns for accident years ending with calendar year 2015. Any adjustment is spread over eight taxable years, i.e., is included in the taxpayer's gross income ratably in the first taxable year beginning in 2015 and the seven succeeding taxable years. For taxable years subsequent to the first taxable year beginning in 2015, the provision applies to such unpaid losses and expenses unpaid (i.e., unpaid losses and expenses unpaid at the end of the taxable year preceding the first taxable year beginning in 2015) by using the interest rate and loss payment patterns applicable to accident years ending with calendar year 2015.

11. Repeal of special estimated tax payments (sec. 3511 of the discussion draft and sec. 847 of the Code)

 

Present Law

 

 

Allowance of additional deduction and establishment of special loss discount account

Present law allows an insurance company required to discount its reserves an additional deduction that is not to exceed the excess of (1) the amount of the undiscounted unpaid losses over (2) the amount of the related discounted unpaid losses, to the extent the amount was not deducted in a preceding taxable year. This provision imposes the requirement that a special loss discount account be established and maintained, and that special estimated tax payments be made. Unused amounts of special estimated tax payments are treated as a section 6655 estimated tax payment for the 16th year after the year for which the special estimated tax payment was made.1142

The total payments by a taxpayer, including section 6655 estimated tax payments and other tax payments, together with special estimated tax payments made under this provision, are generally the same as the total tax payments that the taxpayer would make if the taxpayer did not elect to have this provision apply, except to the extent amounts can be refunded under the provision in the 16th year.

Calculation of special estimated tax payments based on tax benefit attributable to deduction

More specifically, present law imposes a requirement that the taxpayer make special estimated tax payments in an amount equal to the tax benefit attributable to the additional deduction allowed under the provision. If amounts are included in gross income due to a reduction in the taxpayer's special loss discount account or due to the liquidation or termination of the taxpayer's insurance business, and an additional tax is due for any year as a result of the inclusion, then an amount of the special estimated tax payments equal to such additional tax is applied against such additional tax. If there is an adjustment reducing the amount of additional tax against which the special estimated tax payment was applied, then in lieu of any credit or refund for the reduction, a special estimated tax payment is treated as made in an amount equal to the amount that would otherwise be allowable as a credit or refund.

The amount of the tax benefit attributable to the deduction is to be determined (under Treasury regulations (which have not been promulgated)) by taking into account tax benefits that would arise from the carryback of any net operating loss for the year as well as current year benefits. In addition, tax benefits for the current and carryback years are to take into account the benefit of filing a consolidated return with another insurance company without regard to the consolidation limitations imposed by section 1503(c).

The taxpayer's estimated tax payments under section 6655 are to be determined without regard to the additional deduction allowed under this provision and the special estimated tax payments. Legislative history1143 indicates that it is intended that the taxpayer may apply the amount of an overpayment of his section 6655 estimated tax payments for the taxable year against the amount of the special estimated tax payment required under this provision. The special estimated tax payments under this provision are not treated as estimated tax payments for purposes of section 6655 (e.g., for purposes of calculating penalties or interest on underpayments of estimated tax) when such special estimated tax payments are made.

Refundable amount

To the extent that a special estimated tax payment is not used to offset additional tax due for any of the first 15 taxable years beginning after the year for which the payment was made, such special estimated tax payment is treated as an estimated tax payment made under section 6655 for the 16th year after the year for which the special estimated tax payment was made. If the amount of such deemed section 6655 payment, together with the taxpayer's other payments credited against tax liability for such 16th year, exceeds the tax liability for such year, then the excess (up to the amount of the deemed section 6655 payment) may be refunded to the taxpayer to the same extent provided under present law with respect to overpayments of tax.

Regulatory authority

In addition to the regulatory authority to adjust the amount of special estimated tax payments in the event of a change in the corporate tax rate, authority is provided to the Treasury Department to prescribe regulations necessary or appropriate to carry out the purposes of the provision.

Such regulations include those providing for the separate application of the provision with respect to each accident year. Separate application of the provision with respect to each accident year (i.e., applying a vintaging methodology) may be appropriate under regulations to determine the amount of tax liability for any taxable year against which special estimated tax payments are applied, and to determine the amount (if any) of special estimated tax payments remaining after the 15th year which may be available to be refunded to the taxpayer.

Regulatory authority is also provided to make such adjustments in the application of the provision as may be necessary to take into account the corporate alternative minimum tax. Under this regulatory authority, rules similar to those applicable in the case of a change in the corporate tax rate are intended to apply to determine the amount of special estimated tax payments that may be applied against tax calculated at the corporate alternative minimum tax rate. The special estimated tax payments are not treated as payments of regular tax for purposes of determining the taxpayer's alternative minimum tax liability.

Regulations have not been promulgated under section 847.

 

Explanation of Provision

 

 

The provision repeals section 847, effective for taxable years beginning after December 31, 2013. Thus, the election to apply the provision, the additional deduction, special loss discount account, special estimated tax payment, and refundable amount rules of present law are eliminated under the proposal.

The entire balance of an existing account is included in income of the taxpayer for the first taxable year beginning after 2012, and the entire amount of existing special estimated tax payments are applied against the amount of additional tax attributable to this inclusion. Any special estimated tax payments in excess of this amount are treated as estimated tax payments under section 6655.

 

Effective Date

 

 

The provision applies to taxable years beginning after December 31, 2014.

12. Capitalization of certain policy acquisition expenses (sec. 3512 of the discussion draft and sec. 848 of the Code)

 

Present Law

 

 

In the case of an insurance company, specified policy acquisition expenses for any taxable year are required to be capitalized, and are amortized generally over the 120-month period beginning with the first month in the second half of the taxable year.1144

Specified policy acquisition expenses are determined as that portion of the insurance company's general deductions for the taxable year that does not exceed a specific percentage of the net premiums for the taxable year on each of three categories of insurance contracts. For annuity contracts, the percentage is 1.75; for group life insurance contracts, the percentage is 2.05; and for all other specified insurance contracts, the percentage is 7.7.

With certain exceptions, a specified insurance contract is any life insurance, annuity, or noncancellable accident and health insurance contract or combination thereof. A group life insurance contract is any life insurance contract that covers a group of individuals defined by reference to employment relationship, membership in an organization, or similar factor, the premiums for which are determined on a group basis, and the proceeds of which are payable to (or for the benefit of) persons other than the employer of the insured, an organization to which the insured belongs, or other similar person.

 

Description of Proposal

 

 

The three categories of insurance contracts are replaced with two categories: (1) group contracts and (2) all other specified insurance contracts. The percentage of net premiums that may be treated as specified policy acquisition expenses is 5 percent for group insurance contracts and 12 percent for all other specified insurance contracts.

A group insurance contract is any specified i