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Joint Committee Report JCS-10-87: General Explanation of the Tax Reform Act of 1986

MAY 4, 1987

JCS-10-87

DATED MAY 4, 1987
DOCUMENT ATTRIBUTES
Citations: JCS-10-87

 

III. GENERAL EXPLANATION OF THE ACT

 

 

TITLE I--INDIVIDUAL INCOME TAX PROVISIONS

 

 

A. Basic Rate Structure: Rate Reductions; Increase in Standard Deduction and Personal Exemptions; Repeal of Two-Earner Deduction and Income Averaging

 

 

(secs. 101-104, 131, 141, and 151 of the Act and secs. 1, 63, 151, and 221 of the Code)1

 

Prior Law

 

 

Tax rate schedules
Filing status classifications
Separate tax rate schedules are provided for the four filing status classifications applicable to individuals--(1) married individuals filing jointly2 and certain surviving spouses; (2) heads of household; (3) single individuals; and (4) married individuals filing separately.

In general, the term head of household means an unmarried individual (other than a surviving spouse) who pays more than one-half the expenses of maintaining a home for himself or herself and for a child or dependent relative who lives with the taxpayer, or who pays more than one-half the expenses, and of the cost of maintaining their household, of his or her dependent parents. An unmarried surviving spouse may use the rate schedule for married individuals filing jointly in computing tax liability for the two years following the year in which his or her spouse died if the surviving spouse maintains a household that includes a dependent child.

Computation of tax liability
Federal income tax liability is calculated by applying the tax rates from the appropriate schedule to the individual's taxable income, and then subtracting any allowable tax credits. Under prior law, taxable income equaled adjusted gross income (gross income less certain exclusions and deductions) minus personal exemptions, and minus itemized deductions to the extent they exceeded the zero bracket amount (ZBA). For 1986, individuals who did not itemize were allowed a deduction for charitable contributions in addition to the ZBA.

The prior-law rate schedules included the zero (tax rate) bracket amount as the first bracket; the ZBA was provided in lieu of a standard deduction. The prior-law rate structure consisted of up to 15 taxable income brackets and tax rates beginning above the ZBA.

1986 tax-rate schedules
The following rate schedule provisions applied for 1986 and reflected an adjustment for 1985 inflation.

Married individuals; surviving spouses.--There were 14 taxable income brackets above the ZBA of $3,670. The minimum 11-percent rate started at taxable income above $3,670; the maximum 50-percent rate started at taxable income above $175,250.

For married individuals filing separate returns, the ZBA was one-half the ZBA on joint returns, and the taxable income bracket amounts began at one-half the amounts for joint returns.

Heads of household.--There were 14 taxable income brackets above the $2,480 ZBA. The minimum 11-percent tax rate started at taxable income above $2,480; the maximum 50-percent rate started at taxable income above $116,870. The tax rates applicable to a head of household were lower than those applicable to other unmarried individuals on taxable income above $13,920. Thus, a head of household in effect received a portion of the benefits of the lower rates accorded to a married couple filing a joint return.

Single individuals.--There were 15 taxable income brackets above the $2,480 ZBA for single individuals (other than heads of household or surviving spouses). The minimum 11-percent tax rate started at taxable income above $2,480; the maximum 50-percent rate started at taxable income above $88,270.

The bracket dollar amounts described above for 1986 were indexed to reflect an inflation rate of approximately four percent in the preceding fiscal year, i.e., for the 12-month period ending September 30, 1985. For 1987 and later years, prior law would have provided that the dollar figures defining the tax brackets were to be adjusted annually according to annual percentage changes in the consumer price index for the 12-month period ending September 30 of the preceding year.

Standard deduction (zero bracket amount)

Under prior law, the first positive taxable income bracket (i.e., the 11-percent marginal tax rate bracket) began just above the ZBA. The following ZBA amounts applied for 1986 and reflected an adjustment for 1985 inflation.

     Filing status                        ZBA

 

 

 Joint returns and surviving spouses      $3,670

 

 Heads of household                        2,480

 

 Single individuals                        2,480

 

 Married individuals filing separately     1,835

 

 

The ZBA also served under prior law as a floor under the amount of itemized deductions. Itemizers reduced their AGI by their personal exemptions and by the excess of their itemized deductions over the appropriate ZBA, in order to avoid doubling the benefit of the ZBA, and then used the appropriate tax rate schedule or tax table to compute or find their tax liability.

Personal exemption

Exemption amount
For 1986, the personal exemption amount for an individual, the individual's spouse, and each dependent was $1,080. Under prior law, one additional personal exemption was provided for an individual who was age 65 or older, and for an individual taxpayer who was blind.
Rules for dependents
Under prior law, a taxpayer could claim a personal exemption for himself or herself and for each additional dependent--spouse, child, or other individual--whose gross income did not exceed the personal exemption amount. In addition, parents could claim a personal exemption for a dependent child (for whom they provided more than one-half the support) who had income exceeding the personal exemption amount if the dependent child was either under age 19 or a full-time student. The child or other dependent also could claim a full personal exemption on his or her return.

A child eligible to be claimed as a dependent on his or her parents' return could use the ZBA only to offset earned income. Thus, a child with unearned income exceeding the personal exemption amount was required to file a return and pay tax on the excess (reduced by any allowable itemized deductions).

Adjustments for inflation

Under prior law, the dollar amounts defining the tax rate brackets, the ZBA (standard deduction), and the personal exemption amount were adjusted annually for inflation, measured by changes in the Consumer Price Index for all urban consumers (CPI) over the 12-month period ending September 30 of the prior calendar year. If the inflation adjustment was not a multiple of $10, the increase was rounded (up or down) to the nearest multiple of $10.

Two-earner deduction

Under prior law, married individuals filing a joint return were allowed a deduction equal to 10 percent of the lesser of the earned income of the lower-earning spouse or $30,000; the maximum deduction thus was $3,000.

Income averaging

An eligible individual could elect under prior law to have a lower marginal rate apply to the portion of the current year's taxable income that exceeded 140 percent of the average of his or her taxable income for the prior three years.

 

Reasons for Change

 

 

General objectives

The approach of the Act in broadening the base of the individual income tax allows a considerable reduction in marginal tax rates and in the overall income tax burden on individuals.

The provisions in the Act reducing tax rates for individuals, as well as increasing the standard deduction, the personal exemption, and the earned income credit, were fashioned to achieve three important objectives: (1) to eliminate income tax burdens for families with incomes below the poverty line; (2) to provide an equitable distribution of tax reductions among individuals; and (3) to reduce the marriage penalty sufficiently so that there is no need for an additional deduction for two-earner couples. In addition, the increase in the standard deduction, coupled with changes to the itemized deductions, will reduce the number of individuals who must itemize their deductions, and thus will contribute to a simpler tax system.

Relief for low-income families

A fundamental goal of the Congress was to relieve families with the lowest incomes from Federal income tax liability. Consequently, the Act increases the amounts of both the personal exemption and the standard deduction, as well as the earned income credit, so that the income level at which individuals begin to have tax liability (the tax threshold) will be raised sufficiently to remove six million poverty-level taxpayers from Federal income tax liability. This restores to the tax system an essential element of fairness that has been eroded since the last increase in the personal exemption.

The ZBA and personal exemption had been unchanged from the levels set in the Revenue Act of 1978, until inflation adjustments began in 1985. Notwithstanding these adjustments, inflation had reduced the real value of the standard deduction and personal exemption in setting a threshold level below which income was not taxed. Although the rate reductions in 1981 reduced tax liabilities partly in recognition of the burdens of inflation and social security taxes, those reductions did not provide relief for marginally taxable individuals who would not have been subject to tax liability but for past inflation.

The increase in the personal exemption to $1,900 in 1987 ($1,950 and $2,000 in 1988 and 1989) under the Act--the first statutory increase in the exemption since 1978--contributes both to removing the working poor from the tax rolls and extending relief to other low-income individuals. The personal exemption increase also recognizes the significant costs of raising children. The increases in the standard deduction and personal exemption reduce tax burdens for families (below the phase-out ranges) by raising the tax threshold.

Under the Act, all tax thresholds (the beginning point of income tax liability) are higher than the estimated poverty level for 1988 except for single individuals. In Table I-1 below, the columns showing calculations without taking into account the earned income credit reflect the fact that the tax threshold for heads of household (unmarried individuals who support children or certain dependent relatives) is raised proportionately more than the tax thresholds for married individuals filing jointly or single individuals. Married individuals receive a larger proportionate increase in the threshold than single individuals, in order to offset the effect of the repeal of the two-earner deduction. With the addition of the earned income credit to the computation, the tax threshold for those eligible for the credit rises even further.

     Table I-1.--Income Tax Thresholds in 1988 Under Prior Law and

 

                           Under the 1986 Act

 

 

                          Including       Without

 

                           earned         earned

 

                        income credit    income credit   Estimated 

 

 Filing        Family   Prior     1986   Prior     1986    poverty

 

 status          size     law      Act     law      Act      level

 

 

 Single             1   3,760    4,950   3,760    4,950      6,024

 

 Joint              2   6,150    8,900   6,150    8,900      7,709

 

 Head of

 

 household          2   8,110   12,416   4,900    8,300      7,709

 

 Joint              4   9,783   15,116   8,430   12,800     12,104

 

 Head of

 

 household          4   9,190   14,756   7,180   12,200     12,104

 

NOTE.--These calculations are based on the following assumptions: (1) inflation is equal to the figures forecast by the Congressional Budget Office in January 1987; (2) families with dependents are eligible for the earned income credit; (3) all income consists of money wages and salaries; and (4) taxpayers are under age 65.
There are two principal reasons why the tax threshold for single persons (other than heads of household) is not above the poverty line. First, any further increases in the standard deduction for single taxpayers beyond those provided by the Act would cause significant marriage penalties for two single individuals who married. Second, because the income of family members (other than spouses) is not combined in computing tax liability, and because the tax rate structure does not recognize economies of sharing household costs with other individuals, the income of single individuals does not represent a good measure of whether or not the living conditions of these individuals are impoverished.

More than two-thirds of all single individuals with income less than $10,000 are under age 25, according to 1984 census data; these individuals are likely to be receiving significant support from other family members that is not reflected on the tax return. In addition, the census data reflects that the majority of single individuals between ages 25 and 64 live with other individuals; thus, their household costs are shared. Accordingly, within the existing framework of defining the unit of tax liability, the Congress believed that the poverty line is not an accurate guide to the true economic circumstances of the majority of those who file tax returns as single individuals.

Equitable distribution of tax burden

The Congress also believed that it was desirable for the tax reductions provided under the Act to be distributed equitably among taxpayers. Table I-2 below shows the changes made by the Act in the distribution of the tax burden in 1987 and 1988; this table reflects the effect of major provisions affecting individuals, including the rate reductions, increases in the standard deduction and personal exemption, and changes in itemized deductions.

Table I-2 shows the percentage changes in tax liabilities between prior law and the Act for each of nine income classes. In the aggregate, the Act reduces tax liability of individuals by 2.2 percent in 1987 and by 6.1 percent in 1988.

      Table I-2.--Percentage Change in 1987 and 1988 in Income Tax

 

               Liability Under the Tax Reform Act of 1986

 

 

                                Percentage Change in

 

 Income class [thousands        Income Tax Liability

 

 of 1986 dollars]               1987           1988 

 

 

 Less than $10                  -57.2          -65.1

 

 $10 to $20                     -16.7          -22.3

 

 $20 to $30                     -10.8           -9.8

 

 $30 to $40                      -9.4           -7.7

 

 $40 to $50                      -9.8           -9.1

 

 $50 to $75                      -1.0           -1.8

 

 $75 to $100                      4.3           -1.2

 

 $100 to $200                     4.6           -2.2

 

 $200 and above                   9.8           -2.4

 

                                -----          -----

 

      Total                      -2.2           -6.1

 

                                -----          -----

 

NOTE.--These figures do not take account of certain provisions affecting individuals. Thus, the total tax reductions are somewhat different from what is indicated in this table.
Table I-3 shows average income tax liability and tax rate by income class for 1988, the first year in which the changes in the tax rates and standard deduction are fully effective. By virtue of restructuring the tax schedules and broadening the tax base for individuals, and reducing corporate tax preferences, the Act produces substantial reductions in individual income tax liabilities.

     Table I-3.--Average Income Tax Liability and Tax Rates in 1988

 

          Under Prior Law and Under the Tax Reform Act of 1986

 

 

                       Average income tax       Average income tax

 

 Income class                                      rate (percent)

 

 [thousands of       Prior     1986    Diffe-      Prior      1986

 

 1986 dollars]         law      Act   erence         law       Act 

 

 

 

 Less than $10         $60      $21     -$39         1.6       0.5

 

 $10 to $20            895      695     -200         5.7       4.4

 

 $20 to $30          2,238    2,018     -220         8.3       7.5

 

 $30 to $40          3,527    3,254     -273         9.5       8.7

 

 $40 to $50          5,335    4,849     -486        11.1      10.1

 

 $50 to $75          8,538    8,388     -150        13.3      13.1

 

 $75 to $100        14,469   14,293     -176        15.7      15.6

 

 $100 to $200       27,965   27,353     -612        19.3      18.9

 

 $200 and above    138,463  135,101   -3,362        22.8      22.3

 

                   -------  -------   ------       -----      ----

 

 Average tax

 

 liability or

 

 tax rate            3,176    2,982    -194         11.8      11.1

 

                   -------  -------   ------        -----     ----

 

NOTE.--These figures do not take account of certain provisions affecting individuals. Thus, the total tax reductions are somewhat different from what is indicated in this table.
The income tax liability of individual taxpayers will decline an average of $194 in 1988, from an average $3,176 under prior law to an average $2,982 under the Act, as shown in Table I-3.

Simplification of tax returns

The Congress believed that the tax rate schedules in prior law were too lengthy and complicated. The Act provides a two-rate tax structure (15 and 28 percent), beginning in 1988. Under the Act, more than 80 percent of individuals either will be in the 15-percent bracket or will have no Federal income tax liability.

The prior-law tax rate structure is modified by the Act to make the individual income tax fairer and simpler and to reduce disincentives to economic efficiency and growth. Simplicity in the rate structure is achieved by using only two taxable income brackets. The four filing statuses are retained because they are the fewest classifications that can be implemented to provide fairly and equitably for the diverse characteristics of the taxpaying population.

The two-bracket tax structure replaces the prior-law ZBA with a standard deduction. Under the new structure, individuals determine taxable income by subtracting from adjusted gross income either the standard deduction or the total amount of allowable itemized deductions. Unlike the ZBA, the standard deduction enables the taxpayer to know directly how much income is subject to tax and to understand more clearly that taxable income is the base for determining tax liability.

Further, the difference between the standard deduction for an unmarried head of household and that for a married couple is narrowed by the Act in recognition that the costs of maintaining a household for an unmarried individual and a dependent more closely resemble the situation of a married couple than that of a single individual without a dependent.

The increases in the standard deduction and modifications to specific deduction provisions simplify the tax system by substantially reducing the number of itemizers. As a result of these changes, about 11 million itemizers will shift to using the standard deduction, a reduction of approximately 30 percent in the number of itemizers relative to prior law.

Marriage penalty

Under the Act, the adjustments of the standard deduction and the rate schedule make it possible to minimize the marriage penalty while repealing the two-earner deduction. As a result, single individuals who marry will retain more of the share of the standard deductions for two single individuals than under prior law.

Table I-4 presents a comparison of the marriage penalty in 1988 as it would be under prior law and as changed under the 1986 Act.

     Table I-4.--Marriage Tax Penalty in 1988 for Two-Earner Couple

 

               Under Prior Law and Tax Reform Act of 1986

 

 

 Income                           Income of wife

 

 of husband       $10,000   $20,000   $30,000   $50,000   $100,000

 

 

   $10,000

 

 Prior law            $88       $63      -$15     -$404    -$2,337

 

 1986 Act             150       150      -443      -443     -1,548

 

   $20,000

 

 Prior law             63       131       403       613       -885

 

 1986 Act             150       158       466       466       -210

 

   $30,000

 

 Prior law            -15       403       733     1,310        325

 

 1986 Act            -443       466       774       774        529

 

   $50,000

 

 Prior law           -404       613     1,310     2,609      2,243

 

 1986 Act            -443       466       774     1,284      1,389

 

   $100,000

 

 Prior law         -2,337      -885       325     2,243      3,974

 

 1986 Act          -1,548      -210       529     1,389      1,494

 

NOTE.--The marriage bonus or penalty is the difference between the tax liability of a married couple and the sum of the tax liabilities of the two spouses had each been taxed as a single person. Marriage bonuses are negative in the table; marriage penalties are positive. It is assumed that all income is earned, that taxpayers have no dependents, that deductible expenses were 16.7 percent of income under prior law and 14 percent of income under the Act, and that deductible expenses are allocated between spouses in proportion to income. The computations in the table reflect the standard deduction, personal exemption, rate bracket, and prior-law deduction for two-earner married couples.
Elderly and blind taxpayers

The tax burden on elderly or blind taxpayers is eased by the Act apart from the effect of rate reductions. The prior-law income tax credit for certain elderly or disabled individuals is retained.

As discussed above, the Act increases the standard deduction amounts and personal exemptions for all taxpayers. Thus, in 1989, the $2,000 personal exemption amount for each individual under the Act will be almost equal to the two personal exemption amounts allowed under prior law ($2,160 for 1986) for an elderly or blind individual. Also, the higher standard deduction amounts under the Act go into effect one year earlier (in 1987) for elderly or blind individuals than for all other taxpayers (in 1988). These increased amounts are further augmented under the Act by an additional standard deduction amount of $600 for an elderly or blind individual ($1,200, if both) who is married (or who is a surviving spouse), or of $750 for an unmarried elderly or blind individual ($1,500, if both). The higher personal exemptions and standard deduction, plus the additional standard deduction amount, offset the loss of the additional personal exemption under prior law.

 

Explanation of Provisions

 

 

1. Tax rate schedules

The rate structure under the Act consists of two brackets and tax rates--15 and 28 percent--for individuals in each of the four filing status classifications. Reflecting the replacement of the ZBA by the standard deduction, the 15-percent bracket begins at taxable income of zero. (Under the Act, taxable income equals AGI minus personal exemptions and minus either the standard deduction or the total of allowable itemized deductions.) Effective for taxable years beginning on or after January 1, 1988, the rate structure is as follows.

                        Taxable Income Brackets

 

 Tax rate       Married, filing        Head of              Single

 

                 joint returns        household         individual

 

 

 15%              0 to $29,750     0 to $23,900       0 to $17,850

 

 28%             Above $29,750    Above $23,900      Above $17,850

 

 

For married individuals filing separate returns, the 28-percent bracket begins at $14,875, i.e., one-half the taxable income amount for joint returns. The bracket amounts for surviving spouses are the same as those for married individuals filing joint returns.

Beginning in 1989, the taxable income amounts at which the 28-percent rate starts will be adjusted for inflation (as described below). By December 15 of each year, beginning in 1988, the Treasury Department is to prescribe tables reflecting the bracket amounts applicable for the following year as adjusted for inflation.

Rate adjustment
Beginning in 1988, the benefit of the 15-percent bracket is phased out for taxpayers having taxable income exceeding specified levels. The income tax liability of such taxpayers is increased by five percent of their taxable income within specified ranges, until the tax benefit of the 15-percent tax rate has been recaptured.

The rate adjustment occurs between $71,900 and $149,250 of taxable income for married individuals filing jointly and surviving spouses; between $61,650 and $123,790 of taxable income for heads of household; between $43,150 and $89,560 of taxable income for single individuals; and between $35,950 and $113,300 of taxable income for married individuals filing separately. These dollar amounts will be adjusted for inflation beginning in 1989.

The maximum amount of the rate adjustment generally equals 13 percent of the maximum amount of taxable income within the 15-percent bracket applicable to the taxpayer (for a married individual filing separately, in order to preclude an incentive for separate filing, it is the 15-percent bracket applicable for married taxpayers filing jointly). Thus, if the maximum rate adjustment applies, the 28-percent rate in effect applies to all of the taxpayer's taxable income, rather than only to the amount of taxable income above the bracket breakpoint.

Transitional rate structure for 1987
For taxable years beginning in 1987, rate schedules with five brackets are provided, as shown in the table below. Neither the rate adjustment (described above) nor the personal exemption phaseout (described below) applies to taxable years beginning in 1987.

                                 Taxable Income Brackets

 

 Tax rate       Married, filing          Head of          Single

 

                  joint returns         household      individual 

 

 

 11%                   0-$3,000         0-$2,500         0-$1,800

 

 15%               3,000-28,000     2,500-23,000     1,800-16,800

 

 28%              28,000-45,000    23,000-38,000    16,800-27,000

 

 35%              45,000-90,000    38,000-80,000    27,000-54,000

 

 38.5%              Over 90,000      Over 80,000      Over 54,000

 

 

For married individuals filing separate returns, the taxable income bracket a mounts for 1987 begin at one-half the amounts for joint returns. The bracket amounts for surviving spouses are the same as those for married individuals filing joint returns.

2. Standard deduction

Increased deduction
The Act repeals the zero bracket amount (ZBA) and substitutes a standard deduction of the following amounts, effective beginning in 1988.

 Filing status                                 Standard

 

                                              deduction

 

 

 Married individuals filing jointly;

 

   surviving spouses                           $5,000

 

 Heads of household                             4,400

 

 Single individuals                             3,000

 

 Married individuals filing separately          2,500

 

 

Beginning in 1989, these increased standard deduction amounts (designated the "basic standard deduction") will be adjusted for inflation.
Elderly or blind individuals
An additional standard deduction amount of $600 is allowed for an elderly or a blind individual who is married (whether filing jointly or separately) or is a surviving spouse; the additional amount is $1,200 for such an individual who is both elderly and blind. An additional standard deduction amount of $750 is allowed for a head of household who is elderly or blind ($1,500, if both), or for a single individual (i.e., an unmarried individual other than a surviving spouse or head of household) who is elderly or blind ($1,500, if both).3

For elderly or blind taxpayers only, the new basic standard deduction amounts (i.e., $5,000, $4,400, $3,000, or $2,500) and the additional $600 or $750 standard deduction amounts are effective beginning in 1987. For example, for married taxpayers both of whom are 65 or older, the standard deduction in 1987 on a joint return will be $6,200. If only one spouse is 65 or older, or blind, the standard deduction in 1987 on a joint return will be $5,600. Beginning in 1989, the $600 and $750 additional standard deduction amounts will be adjusted for inflation.

Standard deduction for 1987
For all individual taxpayers other than elderly or blind individuals, the standard deduction amounts for taxable years beginning in 1987 are $3,760 for married individuals filing jointly and surviving spouses; $2,540 for heads of household and single individuals; and $1,880 for married individuals filing separately.

As under prior law, the Internal Revenue Service will continue to prepare tax tables reflecting the tax liability of individuals who use the standard deduction. (The IRS also may prepare tax tables for taxpayers who itemize, but these tables may not incorporate the standard deduction into the tables in the way the ZBA was previously incorporated in the tax tables.) In preparing the tables, the IRS may adjust the size of the intervals between taxable income amounts in the tables to reflect meaningful differences in tax liability.

3. Personal exemption

Exemption amount
The Act increases the personal exemption for each individual, the individual's spouse, and each eligible dependent to $1,900 for taxable years beginning during 1987, $1,950 for taxable years beginning during 1988, and $2,000 for taxable years beginning after December 31, 1988. Beginning in 1990, the $2,000 personal exemption amount will be adjusted for inflation. The Act also repeals the additional exemption for an elderly or blind individual, beginning in 1987. (As described above, the Act provides an additional standard deduction amount for an elderly or blind individual, beginning in 1987; also, the generally applicable increased standard deduction amounts apply for elderly or blind individuals beginning in 1987.)
Phaseout
Beginning in 1988, the benefit of the personal exemption is phased out for taxpayers having taxable income exceeding specified levels. The income tax liability of such taxpayers is increased by five percent of taxable income within certain ranges.

This reduction in the personal exemption benefit starts at the taxable income level at which the benefit of the 15-percent rate is totally phased out (see "Rate adjustment," above). For example, in the case of married individuals filing joint returns, in 1988 the personal exemption phaseout begins at taxable income of $149,250.

The benefit of each personal exemption amount is phased out over an income range of $10,920 in 1988 and $11,200 in 1989. The phaseout occurs serially. For example, the phaseout of the benefit of the second personal exemption on a joint return does not begin until the phaseout of the first has been completed. Thus, in the case of married individuals filing jointly who have two children, in 1988 the benefit of the four personal exemptions on the joint return would phase out over an income range of $43,680 (four times $10,920) and would be phased out completely at taxable income of $192,930; in 1989, the benefit of each exemption would phase out over an income range of $44,800 (four times $11,200).

Rules for certain dependents
The Act provides that an individual for whom a personal exemption deduction is allowable on another taxpayer's return is not entitled to any personal exemption amount on his or her own return. For example, if married individuals may claim a personal exemption deduction for their child, the child may not claim any personal exemption on his or her return.

Under prior law, the ZBA could be used by such a dependent taxpayer only to offset earned income. The Act provides that in the case of an individual for whom a personal exemption deduction is allowable on another taxpayer's return, the individual's basic standard deduction is limited to the greater of (a) $500 (to be adjusted for inflation beginning in 1989) or (b) the individual's earned income. The preceding limitation is intended to apply only with respect to the basic standard deduction, and not with respect to the additional standard deduction amount allowable to an elderly or blind individual.4 For example, in 1987 an unmarried elderly individual (other than a surviving spouse) who may be claimed as a dependent on her son's tax return may first utilize the basic standard deduction ($3,000) to offset the greater of (1) earned income or (2) nonearned income up to $500. In addition, the individual could apply the additional standard deduction amount ($750) against any remaining income not offset by the basic standard deduction (pursuant to the rule stated in the preceding sentence), whether earned or nonearned income.

Under the Act, an individual who is eligible to be claimed as a dependent on another's tax return must file a Federal income tax return only if he or she either (1) has total gross income in excess of the standard deduction (including, in the case of an elderly or blind individual, the additional standard deduction amount) or (2) has nonearned income in excess of $500 plus, in the case of an elderly or blind individual, the additional standard deduction amount. For example, an elderly individual who may be claimed as a dependent on her daughter's tax return must file a return for 1987 only if the elderly individual either (1) has total gross income exceeding $3,750 or (2) has nonearned income exceeding $1,250.5

These rules for dependents are effective for taxable years beginning on or after January 1, 1987.

4. Adjustments for inflation

The new rate structure will be adjusted for inflation (i.e., indexed) beginning in 1989, to reflect changes in the Consumer Price Index for all-urban consumers (CPI) between the 12-month period ending on August 31, 1987 and the following 12-month period. Any inflation adjustment will apply to the breakpoint between the 15-percent and 28-percent brackets, and to the income levels above which the rate adjustment and personal exemption phaseouts apply.

Inflation adjustments will begin in 1989 to the increased standard deduction amounts that generally are effective for 1988, and to the additional standard deduction amount for blind or elderly individuals (which goes into effect in 1987). Inflation adjustments will begin in 1990 to the $2,000 personal exemption amount that applies for 1989.

Under the Act, inflation adjustments (except to the earned income credit) will be rounded down to the next lowest multiple of $50.6 For example, an inflation rate adjustment of four percent would raise the starting point of the 28-percent bracket for 1989 returns of married individuals filing jointly from $29,750 to $30,940; this amount then would be rounded down to $30,900 for purposes of constructing the indexed rate schedule applicable to 1989.

In subsequent years, the indexing adjustment will reflect the rate of inflation for the cumulative period after the 12-month period ended August 31, 1987, with respect to the rate brackets and the increased standard deduction amounts; and August 31, 1988, with respect to the $2,000 personal exemption. As a result, while rounding down affects the inflation adjustments made in each year, there is no cumulative effect from rounding on the bracket thresholds and related amounts, since each year's inflation adjustment will be computed to reflect the cumulative rate of inflation from the initial base period. If the CPI currently published by the Department of Labor is revised, then the revision that is most consistent with the CPI for calendar year 1986 is to be used.

5. Two-earner deduction

The prior-law deduction for two-earner married couples is repealed, effective for taxable years beginning on or after January 1, 1987.

6. Income averaging

The prior-law provisions for income averaging are repealed, effective for taxable years beginning on or after January 1, 1987.

 

Effective Dates

 

 

Rate structure

The transitional five-bracket tax rate schedules are effective for taxable years beginning in 1987. The two-bracket tax rate schedules and the rate adjustment are effective for taxable years beginning on or after January 1, 1988.

Standard deduction

For taxable years beginning on or after January 1, 1987, the standard deduction replaces the ZBA. The transitional standard deduction amounts apply for taxable years beginning in 1987. The increased standard deduction amounts generally are effective for taxable years beginning on or after January 1, 1988. For elderly or blind individuals, the increased basic standard deduction amounts and the additional standard deduction amounts are effective for taxable years beginning on or after January 1, 1987.

Personal exemption

The personal exemption amounts of $1,900, $1,950, and $2,000 apply, respectively, for taxable years beginning during 1987, taxable years beginning during 1988, and taxable years beginning after December 31, 1988. The phase-out of the personal exemption amount applies for taxable years beginning on or after January 1, 1988. The rules disallowing any exemption amount on the return of an individual who is eligible to be claimed as a dependent on another taxpayer's return are effective for taxable years beginning on or after January 1, 1987.

Inflation adjustments

The change of the date of the 12-month measuring period for inflation adjustments to August 31 and the provision relating to rounding down inflation adjustments to the nearest $50 are effective for taxable years beginning on or after January 1, 1987.

Two-earner deduction

The repeal of the prior-law deduction for two-earner married couples is effective for taxable years beginning on or after January 1, 1987.

Income averaging

The repeal of the prior-law provisions for income averaging is effective for taxable years beginning on or after January 1, 1987.

 

Revenue Effect

 

 

Tax rates

The changes in the income tax rates are estimated to decrease fiscal year budget receipts by $16,900 million in 1987, $56,812 million in 1988, $53,725 million in 1989, $39,039 million in 1990, and $40,626 million in 1991.7

Standard deduction

The increases in the standard deduction amounts are estimated to decrease fiscal year budget receipts by $1,127 million in 1987, $6,183 million in 1988, $8,276 million in 1989, $8,864 million in 1990, and $9,493 million in 1991.

Personal exemption

The increase in the personal exemption amount, the repeal of the prior-law additional exemption for the elderly and blind, and the disallowance of a personal exemption for an individual who is eligible to be claimed as a dependent on another taxpayer's return are estimated to decrease fiscal year budget receipts by $13,414 million in 1987, $26,298 million in 1988, $26,530 million in 1989, $27,678 million in 1990, and $28,876 million in 1991.

Two-earner deduction

The repeal of the prior-law deduction for two-earner married couples is estimated to increase fiscal year budget receipts by $1,379 million in 1987, $6,016 million in 1988, $6,177 million in 1989, $6,572 million in 1990, and $6,995 million in 1991.

Income averaging

The repeal of the prior-law provisions for income averaging is estimated to increase fiscal year budget receipts by $430 million in 1987, $1,814 million in 1988, $1,928 million in 1989, $2,077 million in 1990, and $2,239 million in 1991.

 

B. Earned Income Credit

 

 

(sec. 111 of the Act and secs. 32 and 3507 of the Code)8

 

Prior Law

 

 

An eligible individual who maintains a home for one or more children is allowed a refundable income tax credit based on the individual's earned income up to a specified dollar amount. The credit is available to married individuals filing a joint return who are entitled to a dependency exemption for a child, a head of household, and a surviving spouse.9

Under prior law, the earned income credit generally equaled 11 percent of the first $5,000 of earned income, for a maximum credit of $550 (Code sec. 32). The amount of the credit was reduced if the individual's adjusted gross income (AGI) or, if greater, earned income, exceeded $6,500; no credit was available for individuals with AGI or earned income of $11,000 or more.

To relieve eligible individuals of the burden of computing the amount of credit to be claimed on their returns, the Internal Revenue Service publishes tables for determining the credit amount. Eligible individuals may receive the benefit of the credit in their paychecks throughout the year by electing to receive advance payments.

 

Reasons for Change

 

 

The earned income credit is intended to provide tax relief to low income working individuals with children and to improve incentives to work. Periodically since enactment of the credit in 1975, the Congress has increased the maximum amount and the phase-out levels of the credit to offset the effects of inflation and social security tax increases.

The Congress concluded that further increases in the maximum amount and phase-out level of the credit were necessary to offset past inflation and increases in the social security tax. In addition, the Congress believed that an automatic adjustment to the credit to reflect future inflation should be provided, just as it is provided for the personal exemption, the standard deduction, and rate brackets, in order to eliminate the reduction in the real value of the credit caused by inflation.

 

Explanation of Provisions

 

 

The Act increases the rate and base of the earned income credit to 14 percent of the first $5,714 of an eligible individual's earned income. As a result, the maximum credit is increased to $800.

The income level at which the credit is completely phased out is raised to $13,500. Starting in taxable years that begin on or after January 1, 1988, the phase-out range is raised to $9,000/$17,000.

Under the Act, the credit is to be adjusted (beginning in 1987) for inflation. The adjustment factor for 1987 equals the increase in the consumer price index (CPI) from August 31, 1984, to August 31, 1988. (Thus, the maximum amount of earned income eligible for the credit beginning in 1987 equals $5,714 as adjusted for inflation between August 31, 1984 and August 31, 1986.) Subsequent annual increases are to adjust for the effects of additional annual changes in the CPI. These adjustments affect the amount of income to which the credit applies and the lower and upper limits of the phaseout range.

These inflation adjustments to the earned income credit are not subject to the $50 rounding-down rule otherwise applicable under the Act to inflation adjustments. Instead, as under the generally applicable inflation adjustment rule of prior law, any inflation adjustment relating to the credit that is not a multiple of $10 will be rounded to the nearest multiple of $10.

The Act also directs the Treasury Department to include in regulations a requirement that employers notify their employees whose wages are not subject to income tax withholding that they may be eligible for a refundable earned income credit. (The regulations are to prescribe the time and manner for such notification.) However, this notice does not have to be given to employees whose wages are exempt from withholding pursuant to Code section 3402(n). This exemption applies, for example, to many high school or college students who are employed for the summer.

 

Effective Date

 

 

The increases in the credit rate and base and the provisions relating to inflation adjustments are effective for taxable years beginning on or after January 1, 1987.

The increase in the beginning phase-out level to $9,000 is effective for taxable years beginning on or after January 1, 1988.

 

Revenue Effect

 

 

This provision is estimated to decrease fiscal year budget receipts by $14 million in 1987, $309 million in 1988, $723 million in 1989, $886 million in 1990, and $1,077 million in 1991, and to increase fiscal year budget outlays by $83 million in 1987, $1,731 million in 1988, $3,149 million in 1989, $3,481 million in 1990, and $3,848 million in 1991. (To the extent that the amount of earned income credit exceeds tax liability and thus is refundable, it is treated as an outlay under budget procedures.)

 

C. Exclusions from Income

 

 

1. Unemployment compensation benefits

(sec. 121 of the Act and sec. 85 of the Code)10

 

Prior Law

 

 

Prior law provided a limited exclusion from income for unemployment compensation benefits paid pursuant to a Federal or State program (Code sec. 85).

If the sum of the individual's unemployment compensation benefits and adjusted gross income (AGI) did not exceed a defined base amount, then no unemployment compensation benefits were included in gross income. The base amount was $18,000 in the case of married individuals filing a joint return; $12,000 in the case of an unmarried individual; and zero in the case of married individuals filing separate returns. If the sum of unemployment compensation benefits and AGI exceeded the base amount, the amount of the benefits included in gross income generally was limited to the lesser of (1) one-half the excess of the sum of such benefits plus AGI over the base amount, or (2) the amount of such benefits received.

 

Reasons for Change

 

 

While all cash wages and similar compensation (such as vacation pay and sick pay) received by an individual generally have been treated as fully includible in gross income under the tax law, unemployment compensation benefits were includible under prior law only if the taxpayer's AGI and benefits exceeded specified levels. The Congress concluded that unemployment compensation benefits, which essentially are wage replacement payments, should be treated for tax purposes in the same manner as wages or other wage-type payments. Thus, repeal of the prior-law partial exclusion contributes to more equal tax treatment of individuals with the same economic income. Also, if wage replacement payments are given more favorable tax treatment than wages, some individuals may be discouraged from returning to work.

 

Explanation of Provision

 

 

Under the Act, all unemployment compensation benefits (whether paid pursuant to a Federal or State law) received after 1986 are includible in gross income.

 

Effective Date

 

 

The provision is effective for amounts received after December 31, 1986.

 

Revenue Effect

 

 

The provision is estimated to increase fiscal year budget receipts by $230 million in 1987, $764 million in 1988, $749 million in 1989, $723 million in 1990, and $701 million in 1991.

2. Prizes and awards

(sec. 122 of the Act and secs. 74, 102, and 274 of the Code)11

 

Prior Law

 

 

Under prior and present law, prizes and awards received by an individual (other than scholarships or fellowship grants to the extent excludable under sec. 117) generally are includible in gross income. Treasury regulations provide that such taxable prizes and awards include amounts received from giveaway shows, door prizes, awards in contests of all types, and awards from an employer to an employee in recognition of some achievement in connection with employment.

However, prior-law section 74(b) provided a special exclusion from income for certain prizes and awards that were received in recognition of charitable, religious, scientific, educational, artistic, literary, or civic achievement ("charitable achievement awards"). This exclusion applied only if the recipient (1) had not specifically applied for the prize or award (for example, by entering a contest), and (2) was not required to render substantial services as a condition of receiving it. Treasury regulations stated that the section 74(b) exclusion did not apply to prizes or awards from an employer to an employee in recognition of some achievement in connection with employment.12

While section 74 determines the includibility in gross income of prizes and awards, the treatment of other items provided by an employer to an employee could be affected by section 61, defining gross income, and prior-law section 102, under which gifts may be excluded from gross income. Section 61 provides in part that "gross income means all income from whatever source derived," including compensation for services whether in the form of cash, fringe benefits, or similar items. However, under prior law, an item transferred from an employer to an employee, other than a prize or award that was includible under section 74, might be excludable from gross income if it qualified as a gift under section 102.

The U.S. Supreme Court, in a 1960 case involving payments made "in a context with business overtones," defined excludable gifts as payments made out of "detached and disinterested generosity" and not in return for past or future services or from motives of anticipated benefit (Comm'r v. Duberstein, 363 U.S. 278 (1960)). Under this standard, the Court said, transfers made in connection with employment could constitute gifts only in the "extraordinary" instance.13

In certain circumstances, if an award to an employee could constitute an excludable gift under prior law, the employer's deduction was subject to limitation under section 274(b). That section expressly defines the term "gift" to mean any amount excludable from gross income under section 102 that is not excludable under another statutory provision.

Section 274(b) generally disallows business deductions for gifts to the extent that the total cost of all gifts of cash, tangible personal property, and other items to the same individual from the taxpayer during the taxable year exceeds $25. Under an exception to the $25 limitation provided by prior law, the ceiling on the deduction was $400 in the case of an excludable gift of an item of tangible personal property awarded to an employee for length of service, safety achievement, or productivity. In addition, the prior-law ceiling on the employer's business gift deduction was $1,600 for an excludable employee award for such purposes when provided under a qualified award plan, if the average cost of all plan awards in the year did not exceed $400.

A further rule that may be relevant with respect to a prize or award arises under section 132(e), which provides that de minimis fringe benefits are excludable from income. A de minimis fringe generally is defined as any property or service the value of which is (taking into account the frequency with which similar fringes are provided by the employer to the employer's employees) so small as to make accounting for it unreasonable or administratively impracticable.

 

Reasons for Change

 

 

Charitable achievement awards

A prize or award generally increases an individual's net wealth in the same manner as any other receipt of an equivalent amount that adds to the individual's economic well-being. For example, the receipt of an award of $10,000 for scientific achievement increases the recipient's net wealth and ability to pay taxes to the same extent as the receipt of $10,000 in wages, dividends, or as a taxable award; nonetheless, such an award was not treated as income under prior law. Also, as in the case of other exclusions or deductions, the tax benefit of the prior-law section 74(b) exclusion depended on the recipient's marginal tax rate, and thus generally was greater in the case of higher-income taxpayers.

In light of these considerations, the Congress concluded that prizes and awards generally should be includible in gross income even if received because of achievement in fields such as the arts and sciences. This repeal of the special prior-law exclusion for certain awards was viewed as consistent with the Act's general objectives of fairness and economic neutrality.

In addition, the Congress was concerned about problems of complexity that had arisen as a result of the special prior-law exclusion under section 74(b). The questions of what constituted a qualifying form of achievement, whether an individual had initiated action to enter a contest or proceeding, and whether the conditions of receiving a prize or award involved rendering "substantial" services, had all caused some difficulty in this regard. Finally, in some circumstances the prior-law exclusion could have served as a possible vehicle for the payment of disguised compensation.

At the same time, the Congress recognized that in some instances the recipient of the type of prize or award described in section 74(b) may wish to assign the award to charity, rather than claiming it for personal consumption or use. Accordingly, the Act retains the prior-law exclusion for charitable achievement awards described in section 74(b) but only if the award is transferred by the payor, pursuant to a designation made by the winner of the prize or award, to a governmental unit or to a tax-exempt charitable, educational, religious, etc. organization contributions to which are deductible under section 170(c)(1) or section 170(c)(2), respectively.

Employee awards

An additional reason for change relates to the prior-law tax treatment of employee awards of tangible personal property given by reason of length of service, safety achievement, or productivity. Except for any item that might be able to qualify as a de minimis fringe benefit as defined by section 132(e), such employee awards were not excludable from the employee's gross income, and the deduction of their cost by the employer was not limited under section 274(b), if they could not qualify as gifts because of either the "detached generosity" standard applicable under section 102 or the rule of section 74(a) that prizes and awards generally are includible in income.

The Congress understood that uncertainty had arisen among some taxpayers concerning the proper tax treatment under prior law of an employee award. Such uncertainty could lead some employers to seek to replace amounts of taxable compensation (such as sales bonuses) with "award" programs of tangible personal property. The business and the employee might contend that such awards are not subject to income or social security taxes, but that the employer could still deduct the costs of the awards up to the section 274(b) limitations. In the case of highly compensated employees, who often might not be significantly inconvenienced by the fact that such awards would be made in the form of property rather than cash, an exclusion for transfers of property with respect to regular job performance (such as for productivity) could serve as a means of providing tax-free compensation. As in the case of other exclusions or deductions, the tax benefit of such an exclusion for transfers to an employee would depend on the recipient's marginal tax rate, and thus generally would be greater for higher-income employees.

Accordingly, the Congress believed that it was desirable to provide express rules with regard to the tax treatment of amounts transferred by or for an employer to or for the benefit of an employee. The Congress concluded that, in general, an award to an employee from his or her employer does not constitute a "gift" comparable to such excludable items as intrafamily holiday gifts, and should be included in the employee's gross income for income tax purposes and in wages for withholding and employment tax purposes.

However, the Congress believed that no serious potential for avoiding taxation on compensation arises from transfers by employers to employees of items of minimal value. Therefore, the Congress wished to clarify that the section 132(e) exclusion for de minimis fringe benefits can apply to employee awards of low value. The Congress also concluded that this exclusion should be viewed as applicable to traditional awards (such as a gold watch) upon retirement after lengthy service for an employer. For example, in the case of an employee who has worked for an employer for 25 years, a retirement gift of a gold watch may qualify for exclusion as a de minimis fringe benefit even though gold watches given throughout the period of employment would not so qualify for exclusion. In that case, the award is not made in recognition of any particular achievement, relates to many years of employment, and does not reflect any expectation of or incentive for the recipient's rendering of future services.

Also, the Congress concluded that, in certain narrowly defined circumstances, it is appropriate to recognize traditional business practices of making awards of tangible personal property for length of service or safety achievement. These traditional practices may involve, for example, awards of items that identify or symbolize the awarding employer or the achievement being recognized, and that do not merely provide an economic benefit to the employee. Such practices were not entirely equivalent, for example, to providing either a bonus in cash or an allowance of a dollar amount toward the purchase of ordinary merchandise. The Congress believed that the double income tax benefit of excludability and deductibility is acceptable for such types of employee achievement awards under rules intended to prevent abuse and limit the scope of the double benefit.

In light of these considerations, the Act restricts the double benefit through dollar limitations, limits the frequency with which length of service awards can be made to the same employee, and limits safety achievement awards to the employer's work force (other than administrators, professionals, etc. whose work ordinarily does not involve significant safety concerns) and to no more than 10 percent of such eligible recipients in one year. In addition, the exclusion applies only if the item of tangible personal property is awarded under conditions and circumstances that do not create a significant likelihood of the payment of disguised compensation.

The Act removes the prior-law uncertainty concerning the tax treatment of some employee awards by making clear that the fair market value of any employee award that does not constitute either a length of service award or a safety achievement award qualifying under the Act or a de minimis fringe benefit described in section 132(e)(1) is includible in gross income for income tax purposes and in wages or compensation for employment tax and withholding purposes. The Congress believed that this general rule of includibility is consistent with the Act's objectives of fairness and economic neutrality.

 

Explanation of Provisions

 

 

Charitable achievement awards

Under the Act, the prior-law limited exclusion under section 74(b) for a prize or award for certain charitable, religious, scientific, educational, artistic, literary, or civic achievement (a "charitable achievement award") is further restricted to apply only if the recipient designates that the award is to be transferred by the payor to a governmental unit or a tax-exempt charitable, educational, religious, etc. organization that is eligible to receive contributions that are deductible under sections 170(c)(1) or 170(c)(2), respectively. If such designation is made and if the charitable achievement award is so transferred to the designated governmental unit or charitable organization by the payor, the award is not included in the winner's gross income, and no charitable deduction is allowed either to the winner or to the payor on account of the transfer to the governmental unit or charitable organization.

For purposes of determining whether a charitable achievement award that is so transferred qualifies as excludable under the Act, the prior-law rules concerning the scope of section 74(b) are retained without change. (Thus, for example, the exclusion is available only if the award winner had not specifically applied for the award, and was not required to render substantial services as a condition of receiving it.) In addition, in order to qualify for the section 74(b) exclusion as modified by the Act, the designation must be made by the taxpayer (the award recipient), and must be carried out by the party making the prize or award, before the taxpayer uses the item that is awarded (e.g., in the case of an award of money, before the taxpayer spends, deposits, invests, or otherwise uses the money)

Disqualifying uses by the taxpayer include such uses of the property with the permission of the taxpayer or by one associated with the taxpayer (e.g., a member of the taxpayer's family). Absent a disqualifying use, however, the taxpayer can make the required designation of the governmental unit or charitable organization (to which the award is to be transferred by the payor) after receipt of the prize or award.

Employee awards

In general
The Act provides an exclusion from gross income (Code sec. 74(c)), subject to certain dollar limitations, for an "employee achievement award" that satisfies the requirements set forth in the Act. The Act defines an employee achievement award (Code sec. 274(j)) as an item of tangible personal property transferred by an employer to an employee for length of service achievement or for safety achievement,14 but only if the item (1) is awarded as part of a meaningful presentation, and (2) is awarded under conditions and circumstances that do not create a significant likelihood of the payment of disguised compensation.15 The exclusion applies only for awards of tangible personal property and is not available for awards of cash, gift certificates, or equivalent items, or for awards of intangible property or real property.

An award for length of service cannot qualify for the exclusion if it is received during the employee's first five years of employment for the employer making the award, or if the employee has received a length of service achievement award (other than an award excludable under sec. 132(e)(1)) from the employer during the year or any of the preceding four years. An award for safety achievement cannot qualify for the exclusion if made to an individual who is not an eligible employee, or if, during the taxable year, employee awards for safety achievement (other than awards excludable under sec. 132(e)(1)) have previously been awarded by the employer to more than 10 percent of the employer's eligible employees. That is, no more than 10 percent of an employer's eligible employees may receive excludable safety achievement awards in any taxable year (even if all the awards are made simultaneously).16 For this purpose, eligible employees are all employees of the taxpayer other than managers, administrators, clerical workers, and other professional employees.

Deduction limitations
Under section 274 as amended by the Act, an employer's deduction for the cost of all employee achievement awards (both safety and length of service) provided to the same employee during the taxable year generally cannot exceed $400. In the case of one or more qualified plan awards awarded to the same employee during the taxable year, however, the employer's deduction limitation for all such qualified plan awards (both safety and length of service) is $1,600. In addition to these separate $400/$1,600 limitations, the $1,600 limitation applies in the aggregate if during the year an employee receives one or more qualified plan awards and also one or more employee achievement awards that are not qualified plan awards; i.e., the $400 and $1,600 limitations cannot be added together to allow deductions exceeding $1,600 in the aggregate for employee achievement awards made to the same employee in a taxable year.17

A qualified plan award is defined as an employee achievement award provided under a qualified award plan, i.e., an established, written plan or program of the taxpayer that does not discriminate in favor of highly compensated employees (within the meaning of sec. 414(q)) as to eligibility or benefits. However, an item cannot be treated as a qualified plan award if the average cost per recipient of all employee achievement awards made under all qualified award plans of the employer during the taxable year exceeds $400. In making this calculation of average cost, qualified plan awards of nominal value are not to be included in the calculation (i.e., are not to be added into the total of award costs under the plan in computing average cost). In the case of a qualified plan award the cost of which exceeds $1,600, the entire cost of the item is to be added into the total of qualified plan award costs in computing average cost, notwithstanding that only $1,600 (or less) of such cost is deductible.

Excludable amount
In the case of an employee achievement award the cost of which is deductible in full by the employer under the dollar limitations of section 274 (as amended by the Act),18 the fair market value of the award is fully excludable from gross income by the employee. For example, assume that an employer makes a length of service achievement award (other than a qualified plan award) to an employee in the form of a crystal bowl, that the employer makes no other length of service awards or safety achievement awards to that employee in the same year, and that the employee has not received a length of service award from the employer during the prior four years. Assume further that the cost of the bowl to the employer is $375, and that the fair market value of the bowl is $415. The full fair market value of $415 is excludable from the employee's gross income for income tax purposes under section 74 as amended by the Act.

However, if any part of the cost of an employee achievement award exceeds the amount allowable as a deduction by an employer because of the dollar limitations of section 274, then the exclusion does not apply to the entire fair market value of the award. In such a case, the employee must include in gross income the greater of (i) an amount equal to the portion of the cost to the employer of the award that is not allowable as a deduction to the employer (but not an amount in excess of the fair market value of the award) or (ii) the amount by which the fair market value of the award exceeds the maximum dollar amount allowable as a deduction to the employer. The remaining portion of the fair market value of the award is not included in the employee's gross income for income tax purposes.

Consider, for example, the case of a safety achievement award to an eligible employee that is not a qualified plan award, and that costs the employer $500; assume that no other employee achievement awards were made to the same employee during the taxable year, and that safety achievement awards were not awarded during the year to more than 10 percent of eligible employees of the employer. The employer's deduction is limited to $400. The amount includible in gross income by the employee is the greater of (1) $100 (the difference between the item's cost and the deduction limitation), or (2) the amount by which the item's fair market value exceeds the deduction limitation. If the fair market value equals, for example, $475, then $100 is includible in the employee's income. If the fair market value equals $600, then $200 is includible in the employee's income.

Except to the extent that the new section 74(c) exclusion or section 132(e)(1) applies, the fair market value of an employee award (whether or not satisfying the definition of an employee achievement award) is includible in the employee's gross income under section 61, and is not excludable under section 74 (as amended by the Act). Also, the Act amends section 102 to provide explicitly that the section 102 exclusion for gifts does not apply to any amount transferred by or for an employer to, or for the benefit of, an employee. The fair market value of an employee award (or any portion thereof) that is not excludable from gross income must be included by the employer on the employee's Form W-2, as was required under prior law.

Any amount of an employee achievement award that is excludable from gross income under the Act also is excludable from wages or compensation for employment tax (e.g., FICA tax) purposes and is excludable from the social security benefit base.

The Act does not modify Code section 132(e)(1), under which de minimis fringe benefits are excluded from gross income. Thus, an employee award is not includible in income if its fair market value, after taking into account the frequency with which similar benefits are provided by the employer to the employer's employees, is so small as to make accounting for it unreasonable or administratively impracticable. For example, the section 132(e)(1) exclusion would apply with respect to a pin or similar item with a value of $15 awarded to an employee on joining a business, on completing six months' employment, or on completing a probationary employment period.

As noted above, for purposes of section 274 (as modified by the Act), an employee award that is excludable under section 132(e)(1) is disregarded in applying the rules regarding how frequently an individual may receive an excludable length of service award, or how many employees of an employer may receive an excludable safety achievement award in the same taxable year. Under appropriate circumstances, however, the fact that an employer makes a practice of giving its employees length of service or safety achievement awards that qualify under section 74 and 274 may affect the question of whether other items given to such employees (particularly if given by reason of length of service or safety achievement) qualify as de minimis fringe benefits under section 132(e)(1).

The question of whether it is unreasonable or administratively impracticable (within the meaning of sec. 132(e)(1)) to account for an item may be affected by the existence of a program whereby the taxpayer regularly accounts for other like items and complies with the statutory reporting requirements. Moreover, in some cases the fact that a particular employee receives items having the maximum fair market value consistent, respectively, with the employee achievement award and the de minimis fringe benefit exclusions may suggest that the employer's practice is not de minimis. This is particularly so when employee awards and other items, purportedly within the scope of section 132(e)(1), are provided to the same individual in the same year.

The Congress intended that the exclusion under section 132(e)(1) for a de minimis fringe benefit is to apply, under appropriate circumstances, to traditional retirement gifts presented to an employee on his or her retirement after completing lengthy service, even if the section 74(c) exclusion for length of service awards does not apply because the employee received such an award within the prior four years. In considering whether an item presented upon retirement so qualifies, the duration of the employee's tenure with the employer generally has relevance. For example, in the case of an employee who has worked for an employer for 25 years, a retirement gift of a gold watch may qualify for exclusion as a de minimis fringe benefit even though gold watches given throughout the period of employment would not so qualify for that exclusion.

 

Effective Date

 

 

The provisions relating to the tax treatment of prizes and awards are effective for prizes and awards granted after December 31, 1986.

 

Revenue Effect

 

 

The provisions relating to the tax treatment of prizes and awards are estimated to decrease fiscal year budget receipts by $21 million in 1987, $59 million in 1988, $63 million in 1989, $66 million in 1990, and $69 million in 1991.

3. Scholarships and fellowships

(sec. 123 of the Act and sec. 117 of the Code)19

 

Prior Law

 

 

In general

Prior law generally provided an unlimited exclusion from gross income for (1) amounts received by a degree candidate as a scholarship at an educational institution (described in sec. 170(b)(1)(A)(ii)), or as a fellowship grant, and (2) incidental amounts received by such individual and spent for travel, research, clerical help, or equipment (sec. 117). The term scholarship meant an amount paid or allowed to, or for the benefit of, a student to aid in pursuing studies; similarly, a fellowship grant was defined as an amount paid or allowed to, or for the benefit of, an individual to aid in pursuing studies or research (Treas. Reg. sec. 1.117-3).

In the case of an individual who was not a candidate for a degree, the prior-law exclusion was available only if the grantor of the scholarship or fellowship was an educational institution or other tax-exempt organization described in section 501(c)(3), a foreign government, certain international organizations, or a Federal, State, or local government agency. The prior-law exclusion for a nondegree candidate in any one year could not exceed $300 times the number of months in the year for which the recipient received scholarship or fellowship grant amounts, and no further exclusion was allowed after the nondegree candidate had claimed exclusions for a total of 36 months (i.e., a maximum lifetime exclusion of $10,800). However, this dollar limitation did not apply to that portion of the scholarship or fellowship received by the nondegree candidate for travel, research, clerical help, or equipment.

Under prior and present law, an educational institution is described in section 170(b)(1)(A)(ii) if it 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. This definition encompasses primary and secondary schools, colleges and universities, and technical schools, mechanical schools, and similar institutions, but does not include noneducational institutions, on-the-job training, correspondence schools, and so forth (Treas. Reg. secs. 1.117-3(b); 1.151-3(c)). Under prior law, the term candidate for a degree was defined as (1) an undergraduate or graduate student at a college or university who was pursuing studies or conducting research to meet the requirements for an academic or professional degree and (2) a student who received a scholarship for study at a secondary school or other educational institution (Treas. Reg. sec. 1.117-3(e)).

Payments for services

Under prior and present law, amounts paid to an individual to enable him or her to pursue studies or research are not excludable from income if they represent compensation for past, present, or future services, or if the studies or research are primarily for the benefit of the grantor or are under the direction or supervision of the grantor (Treas. Reg. sec. 1.117-4(c)). These regulations have been upheld by the U.S. Supreme Court, which described excludable grants as "relatively disinterested, 'no-strings' educational grants, with no requirement of any substantial quid pro quo from the recipients" (Bingler v. Johnson, 394 U.S. 741 (1969)).

In the case of degree candidates, prior law also specifically provided that the exclusion did not apply to any portion of an otherwise qualifying scholarship or fellowship grant that represented payment for teaching, research, or other services in the nature of part-time employment required as a condition of receiving the scholarship or fellowship grant (prior-law sec. 117(b)(1)). However, an exception under prior law provided that such services would not be treated as employment for this purpose if all degree candidates had to perform such services; in that case, the recipient could exclude the portion of the scholarship or fellowship grant representing compensation for such services.

Under another prior-law exception, amounts received by an individual as a grant under a Federal program that would be excludable from gross income as a scholarship or fellowship grant, but for the fact that the recipient must perform future services as a Federal employee, were not includible in gross income if the individual established that the amount was used for qualified tuition and related expenses (prior-law sec. 117(c)).

Tuition reduction plans

Section 117(d) provides that a reduction in tuition provided to an employee of an educational institution is excluded from gross income if (1) the tuition is for education below the graduate level provided by the employer or by another educational institution; (2) the education is provided to a current or retired employee, a spouse or dependent child of either, or to a widow(er) or dependent children of a deceased employee; and (3) certain nondiscrimination requirements are met. P.L. 98-611 provided that, for taxable years beginning after December 31, 1983 and ending on or before December 31, 1985, the section 117(d) exclusion also applied to qualified tuition reduction for graduate-level education provided by an educational institution to a graduate student who was employed by that institution in teaching or research activities (Code sec. 127(c)(8)).

 

Reasons for Change

 

 

By extending the exclusion for scholarships or fellowship grants to cover amounts used by degree candidates for regular living expenses (such as meals and lodging), prior law provided a tax benefit not directly related to educational activities. By contrast, students who are not scholarship recipients must pay for such expenses out of after-tax dollars, just as individuals who are not students must pay for their food and housing costs out of wages or other earnings that are includible in income. The Congress concluded that the exclusion for scholarships should be targeted specifically for the purpose of educational benefits, and should not encompass other items that would otherwise constitute nondeductible personal expenses. The Congress also determined that, in the case of grants to nondegree candidates for travel, research, etc., that would be deductible as ordinary and necessary business expenses, an exclusion for such expenses is not needed, and that an exclusion is not appropriate if the expenses would not be deductible.

In addition, under the Act, the Congress has increased the tax threshold, i.e., the income level at which individuals become subject to tax. Thus, the receipt of a nonexcludable scholarship amount by a student without other significant income will not result in tax liability so long as the individual's total income does not exceed the personal exemption (if available) and either the increased standard deduction under the Act or the taxpayer's itemized deductions. Under the Act, any nonexcludable amount of a scholarship or fellowship grant is treated as earned income, so that such amount can be offset by the recipient's standard deduction even if the recipient can be claimed as a dependent on his or her parents' return.

Under prior law, controversies arose between taxpayers and the Internal Revenue Service over whether a particular stipend made in an educational setting constituted a scholarship or compensation for services. In particular, numerous court cases have involved resident physicians and graduate teaching fellows who have sought--often notwithstanding substantial case authority to the contrary--to exclude from income payments received for caring for hospitalized patients, for teaching undergraduate college students, or for doing research which inures to the benefit of the grantor.20 The limitation on the section 117 exclusion made by the Act, and the repeal of the special rule relating to degree candidates who must perform services as a condition of receiving a degree, should lessen these problems of complexity, uncertainty of tax treatment, and controversy.

The Congress concluded that the section 117 exclusion should not apply to amounts representing payment for teaching, research, or other services by a student, whether or not required as a condition for receiving a scholarship or tuition reduction, and that this result should apply whether the compensation takes the form of cash, which the student can use to pay tuition, or of a tuition reduction, pursuant to which there is no exchange of cash for payment of tuition. Thus, where cash stipends received by a student who performs services would not be excludable under the Act as a scholarship even if the stipend is used to pay tuition, the Congress believed that the exclusion should not become available merely because the compensation takes the form of a tuition reduction otherwise qualifying under section 117(d). The Congress concluded, consistently with the overall objectives of the Act, that principles of fairness require that all compensation should be given the same tax treatment; that is, some individuals (e.g., students who perform teaching services for universities) should not receive more favorable tax treatment of their compensation than all other individuals who earn wages.

The Congress concluded that it was inappropriate under prior law for recipients of certain Federal grants who were required to perform future services as Federal employees to obtain special tax treatment which was not available to recipients of other types of grants who were required to perform services as a condition of receiving the grants. Thus, under the Act, the general exclusion rule and the limitations apply equally to all grant recipients.

 

Explanation of Provisions

 

 

In general
Degree candidates
In the case of a scholarship or fellowship grant received by a degree candidate, an exclusion under section 117 is available only to the extent the individual establishes that, in accordance with the conditions of the grant, the grant was used for (1) tuition and fees required for enrollment or attendance of the student at an educational institution (within the meaning of sec. 170(b)(1)(A)(ii)), and (2) fees, books, supplies, and equipment required for courses of instruction at the educational institution ("course-related expenses").21 This rule applies to all types of scholarship or fellowship grants, whether funded by a governmental agency, college or university, charitable organization, business, or other source, and whether designated as a scholarship or by some other name (e.g., "allowance").

The exclusion available under the Act for degree candidates is not limited to a scholarship or fellowship grant that by its express terms is required to be used for tuition or course-related expenses. Also, there is no requirement that the student be able to trace the dollars paid for tuition or course-related expenses to the same dollars that previously had been deposited in his or her checking account, for example, from a scholarship grant check. Instead, the amount of an otherwise qualified grant awarded to a degree candidate is excludable (after taking into account the amount of any other grant or grants awarded to the individual that also are eligible for exclusion) up to the aggregate amount incurred by the candidate for tuition and course-related expenses during the period to which the grant applies; any excess amount of the grant is includible in income. No amount of a grant is excludable if the terms of the grant earmark or designate its use for purposes other than tuition or course-related expenses (such as for room or board, or "meal allowances") or specify that the grant cannot be used for tuition or course-related expenses, even if the amount of such grant is less than the amount payable by the student for tuition or course-related expenses.

For purposes of the section 117 exclusion as modified by the Act, the term candidate for a degree means (1) a student who receives a scholarship for study at a primary or secondary school, (2) an undergraduate or graduate student at a college or university who is pursuing studies or conducting research to meet the requirements for an academic or professional degree, and (3) a student (whether full-time or part-time) who receives a scholarship for study at an educational institution (described in sec. 170(b)(1)(A)(ii)) that (1) provides an educational program that is acceptable for full credit toward a bachelor's or higher degree, or offers a program of training to prepare students for gainful employment in a recognized occupation, and (2) is authorized under Federal or State law to provide such a program and is accredited by a nationally recognized accreditation agency.

Nondegree candidates
The Act repeals the limited prior-law exclusion under section 117 for grants received by nondegree candidates. Thus, no amount of a scholarship or fellowship grant received by an individual who is not a degree candidate is excludable under section 117, whether or not such amount is used for or is less than the recipient's tuition and course-related expenses. This provision does not affect whether the exclusion under section 127 for certain educational assistance benefits may apply to employer-provided educational assistance to nondegree candidates if the requirements of that section are met (see sec. 1162 of the Act, extending the exclusion under Code sec. 127), or whether unreimbursed educational expenses of some nondegree candidates may be allowable to itemizers as trade or business expenses if the requirements of section 162 are met.

Performance of services

The Act repeals the special rule of prior law under which scholarship or fellowship grants received by degree candidates that represented payment for services nonetheless were deemed excludable from income provided that all candidates for the particular degree were required to perform such services. The Act expressly includes in gross income any portion of amounts received as a scholarship or fellowship grant that represent payment for teaching, research, or other services required as a condition of receiving the grant (Code sec. 117(c)).

To prevent circumvention of the rule set forth in section 117(c), that rule is intended to apply not only to cash amounts received, but also to amounts (representing payment for services) by which the tuition of the person who performs services is reduced, whether or not pursuant to a tuition reduction plan described in Code section 117(d). The Act therefore explicitly provides that neither the section 117(a) exclusion nor the section 117(d) exclusion applies to any portion of the amount received that represents payment for teaching, research, or other services by the student required as a condition of receiving the scholarship or tuition reduction. If an amount representing reasonable compensation (whether paid in cash or as tuition reduction) for services performed by an employee is included in the employee's gross income and wages, then any additional amount of scholarship award or tuition reduction remains eligible for the section 117 exclusion as modified by the Act.

As noted, employees who perform required services for which they include in income reasonable compensation continue to be eligible to exclude amounts of tuition reduction. In addition, section 1162 of the Act extends the availability of the tuition reduction exclusion for certain graduate students an additional two taxable years beyond its previously scheduled expiration for taxable years beginning after December 31, 1985, as part of the extension of Code section 127 under the Act.

The Act also repeals the special rule under prior law that permitted the exclusion of certain Federal grants as scholarships or fellowship grants, even though the recipient was required to perform future services as a Federal employee. Thus, any portion of a Federal scholarship or fellowship grant that represents payment for past, present, or future services required to be performed as a condition of the grant is includible in gross income. As a result, services performed as a Federal employee are not entitled to more favorable tax treatment than services performed for other employers.

Treatment of nonexcludable amounts

Under the Act, a child eligible to be claimed as a dependent on the return of his or her parents may use the standard deduction only to offset the greater of $500 or earned income (see I.A.3., above). Only for purposes of that rule, any amount of a noncompensatory scholarship or fellowship grant that is includible in gross income as a result of the amendments to section 117 made by the Act (including the repeal of any sec. 117 exclusion for nondegree candidates) constitutes earned income.22

Compliance with new rules

Under the Act, the IRS is not required to exercise its authority to require information reporting by grantors of scholarship or fellowship grants to the grant recipients or the IRS, even though some amounts of such grants may be includible in gross income under section 117(a) as amended by the Act. (Of course, any amount of a grant that constitutes payment for services described in sec. 117(c) is subject to income tax withholding, employment taxes, and reporting requirements applicable to other forms of compensation paid by the payor organization.) The Congress anticipated that the IRS will carefully monitor the extent of compliance by grant recipients with the new rules and will provide for appropriate information reporting if necessary to accomplish compliance.

 

Effective Date

 

 

The modifications made by the provision are effective for taxable years beginning on or after January 1, 1987, except that prior law continues to apply to any scholarship or fellowship granted before August 17, 1986.23 Under this rule, in the case of a scholarship or fellowship granted after August 16, 1986 and before January 1, 1987, any amount of such scholarship or fellowship grant that is received prior to January 1, 1987 and that is attributable to expenditures incurred prior to January 1, 1987 is subject to the provisions of section 117 as in effect prior to the amendments made by the Act.

 

Revenue Effect

 

 

The provision is estimated to increase fiscal year budget receipts by $8 million in 1987, $64 million in 1988, $130 million in 1989, $160 million in 1990, and $164 million in 1991.

 

D. Deductions for Personal Expenditures

 

 

1. Disallowance of itemized deduction for State and local sales taxes

(sec. 134 of the Act and sec. 164 of the Code)24

 

Prior Law

 

 

Itemized deduction

Under prior-law section 164, itemizers could deduct four types of State and local taxes even if such taxes had not been incurred either in a trade or business (sec. 162) or in an investment activity (sec. 212)--individual income taxes, real property taxes, personal property taxes, and general sales taxes.

Not all sales taxes imposed by State or local governments were deductible by itemizers under prior law. To be deductible, the sales tax had to be imposed on sales (either of property or of services) at the retail level.25 In addition, to be deductible the sales tax generally had to apply at one rate to a broad range of items. However, deductions were allowed for (1) sales taxes imposed at a lower rate on food, clothing, medical supplies, and motor vehicles, and (2) sales taxes imposed at a higher rate on motor vehicles, but only up to the amount computed using the generally applicable sales tax rate.

As an exception to the general tax principle that a taxpayer has the burden of providing its entitlement to a deduction,26 itemizers were permitted to claim deductions for sales tax amounts derived from IRS-published tables. These tables contained State-by-State estimates of sales tax liability for individuals at different income levels (calculated by including nontaxable receipts as well as adjusted gross income), taking into account the number of individuals in the taxpayer's household.27 Also, taxpayers generally could add to the table amount the actual State and local sales taxes paid on purchases of a boat, airplane, motor vehicle, and certain other large items.

Capitalization rule

Under prior law, section 164(a) provided (in the last sentence of that subsection) that, in addition to the four types of State, local, and foreign taxes (enumerated in that section) for which itemized deductions were allowed, other State, local, and foreign taxes were deductible if paid or accrued in the taxable year in carrying on a trade or business or an investment-type activity described in section 212. However, a specific provision of the Code (for example, sec. 189 or sec. 263) might require capitalization of certain otherwise deductible taxes.

 

Reasons for Change

 

 

Itemized deduction

The Congress concluded that, as part of the approach of the Act in reducing tax rates through base-broadening, it is appropriate to disallow the itemized deduction for State and local sales taxes. In addition, a number of other considerations supported repeal of this deduction.

Prior law did not permit itemized deductions for various types of State and local sales taxes, such as selective sales taxes on telephone and other utility services, admissions, and sales of alcoholic beverages, tobacco, and gasoline. Also, prior law did not allow consumers any deduction to reflect inclusion, in the selling price of a product, of taxes levied at the wholesale or manufacturer's level. Accordingly, the Congress concluded that extending nondeductibility to all State and local sales taxes improves the consistency of Federal tax policy, by not providing an income tax benefit for any type of consumption subject to sales taxes. Further, to the extent that sales taxes are costs of purchasing consumer products or other items representing voluntary purchases, allowing the deduction was unfair because it favored taxpayers with particular consumption patterns, and was inconsistent with the general rule that costs of personal consumption by individuals are nondeductible.

The Congress did not find persuasive evidence for arguments that eliminating the sales tax deduction could provide unwarranted encouragement for States to shift away from these taxes and could be unfair to States that retain them. On the contrary, it is significant how small a portion of general sales taxes paid by individuals actually were claimed as itemized deductions. Data from 1984 show that less than one-quarter of all such sales taxes levied were claimed as itemized deductions; by contrast, well over one-half of State and local income taxes paid by individuals are claimed as itemized deductions. The Congress believed that the fact that the large majority of sales tax payments were not claimed as itemized deductions under prior law alleviates any effect of repealing the deduction on the regional distribution of Federal income tax burdens or on the willingness of State and local governments to use general sales taxes as revenue sources.

For itemizers who did not rely on the IRS-published tables to estimate their deductible sales taxes, the prior-law deduction for sales taxes involved substantial recordkeeping and computational burdens, since the taxpayer had to determine which sales taxes were deductible, keep receipts or invoices showing the exact tax paid on each purchase, and calculate the total of all deductible sales taxes paid. Also, allowing State and local sales taxes to be deducted had created legal controversies between taxpayers and the IRS regarding what was a general, as opposed to a specific, sales tax. Thus, repealing the deduction advanced the goal of simplifying the tax system for individuals.

For itemizers who did rely on the IRS tables, the amount of deductions that could be claimed under prior law without challenge from the IRS could vary significantly in particular instances from the amount of general sales taxes actually paid to State and local governments. The tables did not provide accurate estimates for individuals who had either lower or higher levels of consumption than the average, and did not reflect the fact that an individual might purchase items in several States having different general sales tax rates. Accordingly, use of the tables neither accurately measured the amount of disposable income an individual retained after paying general sales taxes, nor accurately provided an appropriate Federal tax benefit to residents of States that impose general sales taxes.

Capitalization rules

The Congress concluded that the tax treatment of sales and other taxes incurred in a business or investment activity (but not expressly enumerated as deductible under sec. 164) should be consistent with the tax treatment of other costs of capital assets. Thus, for example, the amount of sales tax paid by a business on acquisition of depreciable property for use in the business is treated under the Act as part of the cost of the acquired property for depreciation purposes.

 

Explanation of Provisions

 

 

Itemized deduction

The Act repeals the prior-law itemized deduction for State and local sales taxes under section 164.

Capitalization rule

The Act adds a limitation to the effect of the provision (under prior law, set forth as the last sentence of sec. 164(a)) with respect to deductibility of State and local, or foreign, taxes incurred in a trade or business or in a section 212 activity. This new limitation does not affect deductibility of the six types of taxes listed in the first sentence of section 164(a): (1) State and local, and foreign, real property taxes; (2) State and local personal property taxes; (3) State and local, and foreign, income, war profits, and excess profits taxes; (4) the windfall profit tax (sec. 4986); (5) the environmental tax (sec. 59A); and (6) the generation-skipping transfer tax imposed on income distributions. (The deductibility or capitalization of these enumerated categories of taxes may be modified by provisions in Title VIII of the Act.)

Under the Act, if a State, local, or foreign tax (other than one of the enumerated categories) paid or accrued in carrying on a trade or business or a section 212 activity is paid or accrued by the taxpayer in connection with the acquisition or disposition of property, the tax shall be treated, respectively, as a part of the cost of the acquired property or as a reduction in the amount realized on the disposition. This limitation does not apply to such a tax if not incurred by a taxpayer in connection with the acquisition or disposition of property; e.g., sales taxes on restaurant meals that are paid by the taxpayer as part of a deductible business meal are deductible (subject to the business meal reduction rule described in I.E., below).

 

Effective Date

 

 

The provisions are effective for taxable years beginning after December 31, 1986.

 

Revenue Effect

 

 

The provisions are estimated to increase fiscal year budget receipts by $968 million in 1987, $5,197 million in 1988, $4,708 million in 1989, $4,907 million in 1990, and $5,131 million in 1991.

2. Increased floor for itemized deduction for medical expenses

(sec. 133 of the Act and sec. 213 of the Code)28

 

Prior Law

 

 

In general

Individuals who itemize deductions may deduct amounts paid during the taxable year (if not reimbursed by insurance or otherwise) for medical care of the taxpayer and of the taxpayer's spouse and dependents, to the extent that the total of such expenses exceeds a floor (sec. 213). Under prior law, the floor was five percent of the taxpayer's adjusted gross income.

Medical care expenses eligible for the deduction are amounts paid by the taxpayer for (1) health insurance (including employee contributions to employer health plans); (2) diagnosis, cure, mitigation, treatment, or prevention of disease or for the purpose of affecting any structure or function of the body; (3) transportation primarily for and essential to medical care; and (4) lodging while away from home primarily for and essential to medical care, subject to certain limitations. The cost of medicine or a drug qualifies as a medical care expense only if it is a prescription drug or is insulin.

Capital expenditures

Treasury regulations provide that the total cost of an unreimbursed capital expenditure may be deductible in the year of acquisition as a medical expense if its primary purpose is the medical care of the taxpayer, the taxpayer's spouse, or the taxpayer's dependent (Reg. sec. 1.213-1(e)(1)(iii)). Qualified capital expenditures may include eyeglasses or contact lenses, hearing aids, motorized chairs, crutches, and artificial teeth and limbs. The cost of a movable air conditioner may qualify if purchased for the use of a sick person.

In addition, the regulations provide that the cost of a permanent improvement to property that ordinarily would not have a medical purpose (such as central air conditioning or an elevator) may be deductible as a medical expense if the expenditure is directly related to prescribed medical care, but only for any portion of the cost that exceeds the increased value of the property attributable to the improvement. Related operating and maintenance costs also may be deducted provided that the medical reason for the capital expenditure continues to exist.

Under these rules, the Internal Revenue Service has treated as medical expenses the cost of hand controls and other special equipment installed in a car to permit its use by a physically handicapped individual, including a mechanical device to lift the individual into the car (Rev. Rul. 66-80, 1966-1 C.B. 57). Also, the IRS has ruled that the additional costs of designing an automobile to accommodate wheelchair passengers constitute medical expenses, including the costs of adding ramps for entry and exit, rear doors that open wide, floor locks to hold the wheelchairs in place, and a raised roof giving the required headroom (Rev. Rul. 70-606, 1970-2 C.B. 66). Similarly, specialized equipment used with a telephone by an individual with a hearing disability has been held deductible as a medical expense, since the equipment was acquired primarily to mitigate the taxpayer's condition of deafness (Rev. Rul. 71-48, 1971-1 C.B. 99).

The IRS also has ruled that capital expenditures to accommodate a residence to a handicapped individual may be deductible as medical expenses (Rev. Rul. 70-395, 1970-2 C.B. 65). In that ruling, the taxpayer was handicapped with arthritis and a severe heart condition; as a result, he could not climb stairs or get into or out of a bathtub. On the advice of his doctor, he had bathroom plumbing fixtures, including a shower stall, installed on the first floor of a two-story house he rented. The lessor (an unrelated party) did not assume any of the costs of acquiring or installing the special plumbing fixtures and did not reduce the rent; the entire costs were paid by the taxpayer. The IRS concluded that the primary purpose of the acquisition and installment of the plumbing fixtures was for medical care, and hence that such expenses were deductible as medical expenses.

 

Reasons for Change

 

 

Floor under deduction

The Congress concluded that, as part of the approach of the Act in reducing tax rates through base-broadening, it was appropriate to increase the floor under the itemized deduction for medical expenses. A floor under this deduction has long been imposed in recognition that medical expenses essentially are personal expenses and thus, like food, clothing, and other expenditures of living and other consumption expenditures, generally should not be deductible in measuring taxable income.

In raising the deduction floor to 7.5 percent of the taxpayer's adjusted gross income, the Act retains the benefit of deductibility where an individual incurs extraordinary medical expenses--for example, as a result of major surgery, severe chronic disease, or catastrophic illness--that are not reimbursed through health insurance or Medicare. Thus, the Act continues deductibility if the unreimbursed expenses for a year are so great that they absorb a substantial portion of the taxpayer's income and hence substantially affect the taxpayer's ability to pay taxes. The Congress also believed that the higher floor, by reducing the number of returns claiming the deduction, will alleviate complexity associated with the deduction, including substantiation and audit verification problems and numerous definitional issues.

Capital expenditures

The Congress also concluded that it is desirable to clarify that certain capital expenditures incurred to accommodate a personal residence to the needs of a handicapped taxpayer, such as construction of entrance ramps or widening of doorways to allow use of wheelchairs, qualify as medical expenses eligible for the deduction. The Congress believed that this clarification was consistent with Federal policies that seek to enable handicapped individuals to live independently and productively in their homes and-communities, thereby avoiding unnecessary institutionalization.

 

Explanation of Provision

 

 

Floor under deduction

The Act increases the floor under the itemized medical expense deduction from five to 7.5 percent of the taxpayer's adjusted gross income.

Capital expenditures

The Congress clarified that capital expenditures eligible for the medical expense deduction include certain expenses of removing structural barriers in the taxpayer's personal residence for the purpose of accommodating a physical handicap of the taxpayer (or the taxpayer's spouse or dependent). These costs are expenses paid by the taxpayer during the year, if not compensated for by insurance or otherwise, for (1) constructing entrance or exit ramps to the residence; (2) widening doorways at entrances or exits to the residence; (3) widening or otherwise modifying hallways and interior doorways to accommodate wheelchairs; (4) installing railings, support bars, or other modifications to bathrooms to accommodate handicapped individuals; (5) lowering of or other modifications to kitchen cabinets and equipment to accommodate access by handicapped individuals; and (6) adjustment of electrical outlets and fixtures. (The enumeration of these specific types of expenditures is not intended to preclude the Treasury Department from identifying in regulations or rulings similar expenditures for accommodating personal residences for physically handicapped individuals that would be eligible for deductibility as medical expenses.)

The Congress believed that the six categories of expenditures listed above do not add to the fair market value of a personal residence and hence intended that such expenditures are to count in full as eligible for the medical expense deduction in the year paid by the taxpayer.

 

Effective Date

 

 

The provision (increasing the deduction floor) is effective for taxable years beginning after December 31, 1986.

 

Revenue Effect

 

 

The provision is estimated to increase fiscal year budget receipts by $186 million in 1987, $1,223 million in 1988, $1,141 million in 1989, $1,276 million in 1990, and $1,427 million in 1991.

3. Repeal of deduction for certain adoption expenses

(sec. 135 of the Act and sec. 222 of the Code)29

 

Prior Law

 

 

Prior law (sec. 222) provided an itemized deduction for up to $1,500 of expenses incurred by an individual in the legal adoption of a child with special needs. (This deduction became effective in 1981.) Deductible expenses included reasonable and necessary adoption fees, court costs, and attorney fees.

A child with special needs meant a child with respect to whom adoption assistance payments could be made under section 473 of the Social Security Act. In general, this meant a child who (1) the State had determined cannot or should not be returned to the home of the natural parents, and (2) could not reasonably be expected to be adopted unless adoption assistance was provided, on account of a specific factor or condition (such as ethnic background, age, membership in a minority or sibling group, medical condition, or physical, mental, or emotional handicap).

 

Reasons for Change

 

 

The Congress believed that Federal benefits for families adopting children with special needs more appropriately should be provided through an expenditure program, rather than through an itemized deduction. The deduction provided relatively greater benefits to higher-income taxpayers, who presumably have relatively less need for Federal assistance, and no benefits to nonitemizers or to individuals whose income is so low that they had no tax liability. Also, the Congress believed that the agencies with responsibility and expertise in this area should have direct budgetary control over the assistance provided to families who adopt children with special needs.

 

Explanation of Provision

 

 

The Act repeals the prior-law itemized deduction for certain adoption expenses. Also, section 1711 of the Act amends the adoption assistance program in Title IV-E of the Social Security Act to provide matching funds as an administrative expense for adoption expenses for any child with special needs who has been placed for adoption in accordance with applicable State and local law (see explanation in Part XVII.D.5., below).

 

Effective Date

 

 

The provision repealing the prior-law itemized adoption expense deduction is effective for taxable years beginning on or after January 1, 1987.

 

Revenue Effect

 

 

The provision is estimated to increase fiscal year budget receipts by $1 million in 1987, $5 million in 1988, and $6 million annually in 1989-91.

4. Deductibility of mortgage interest and taxes allocable to tax-free allowances for ministers and military personnel

(sec. 144 of the Act and sec. 265(a) of the Code)30

 

Prior Law

 

 

Code section 265(a) disallows deductions for expenses allocable to tax-exempt income, such as expenses incurred in earning income on tax-exempt investments. In addition, that provision has been applied in certain cases where the use of tax-exempt income is sufficiently related to the generation of a deduction to warrant disallowance of that deduction.

Section 107 provides that gross income does not include (1) the rental value of a home furnished to a minister as part of compensation, or (2) the rental allowance paid to a minister as part of compensation, to the extent the allowance is used to rent or provide a home. In January 1983, the Internal Revenue Service ruled that prior-law section 265 precluded a minister from taking deductions for mortgage interest and real estate taxes on a residence to the extent that such expenditures are allocable to a tax-free housing allowance received by the minister (Rev. Rul. 83-3, 1983-1 C.B. 72). This ruling revoked a 1962 ruling which had taken a contrary position. In its 1983 ruling, the IRS stated that where a taxpayer incurs expenses for purposes for which tax-exempt income was received, permitting a full deduction for such expenses would lead to a double benefit not allowed under section 265 as interpreted by the courts.

The 1983 ruling generally was made applicable beginning July 1, 1983. However, for a minister who owned and occupied a home before January 3, 1983 (or had a contract to purchase a home before that date), the deduction disallowance rule was delayed by the IRS until January 1, 1985, with respect to such home (IRS Ann. 83-100). This transitional rule effective date was extended through 1985 by section 1052 of the Deficit Reduction Act of 1984 (P.L. 98-369) and through 1986 by administrative action of the IRS (Rev. Rul. 85-96, 1985-29 I.R.B. 7).

In July 1985, the IRS announced that it had not "concluded its consideration of the question of whether members of the uniformed services are entitled, under current law, to take deductions on their income tax returns for home mortgage interest and property taxes to the extent they receive tax-free housing allowances from the Federal Government" (IRS Ann. 85-104). The IRS also stated that "any determination on the issue that would adversely affect members of the uniformed services will not be applied to home mortgage interest and property taxes paid before 1987."

For purposes of this rule, the IRS stated, the uniformed services include all branches of the armed forces, the National Oceanic and Atmospheric Administration, and the Public Health Service. Eligible members of such services, the IRS announcement stated, are entitled to receive tax-free housing and subsistence allowances if they do not reside on a Federal base (see Treas. Reg. sec. 1.61-2(b)).

 

Reasons for Change

 

 

The Congress concluded that it was appropriate to continue the long-standing tax treatment with respect to deduction for mortgage interest and real property taxes claimed by ministers and military personnel who receive tax-free housing allowances. In determining the level of regular military compensation, the Federal Government has assumed that such treatment would be continued.

 

Explanation of Provision

 

 

Under the Act, Code section 265 shall not disallow otherwise allowable deductions for interest paid on a mortgage on, or real property taxes paid on, the home of the taxpayer in the case of (1) a minister, on account of a parsonage allowance that is excludable from gross income under section 107, or (2) a member of a military service, on account of a subsistence, quarters, or other military housing allowance under Federal law (Code sec. 265(a)(6)). The term military service means the Army, Navy, Air Force, Marine Corps, Coast Guard, National Oceanic and Atmospheric Administration, and Public Health Service.

 

Effective Date

 

 

The provision applies for taxable years beginning before, on, or after December 31, 1986. The Act does not allow taxpayers to reopen any taxable years closed by the statute of limitations to claim refunds based on the provision.

 

Revenue Effect

 

 

The provision is estimated to reduce fiscal year budget receipts by less than $5 million annually.

 

E. Expenses for Business or Investment

 

 

1. Limitations on deductions for meals, travel, and entertainment

(sec. 142 of the Act and secs. 162, 170, 212, and 274 of the Code)31

 

Prior Law

 

 

Overview

In general, deductions are allowable for ordinary and necessary expenditures paid or incurred in carrying on a trade or business or for the production or collection of income (Code secs. 162, 212). Travel expenses incurred while away from home in the pursuit of a trade or business, including amounts expended for meals and lodging (other than amounts that are lavish or extravagant under the circumstances), generally qualify for the deduction (sec. 162(a)(2)).32

The taxpayer bears the burden of proving both the eligibility of an expenditure as a deduction and also the amount of any such eligible expenditure.33 In addition, certain limitations and special substantiation requirements apply to travel and entertainment deductions (sec. 274). Taxpayers are subject to penalties if any part of an underpayment of tax (e.g., because of improperly claimed deductions) is due to negligence or intentional disregard of rules or regulations (sec. 6653(a)) or due to fraud (sec. 6653(b)).

No deduction is allowed for personal, family, or living expenses (sec. 262). For example, the costs of commuting to and from work are nondeductible personal expenses.34 However, a special deduction is allowed for a limited amount of moving expenses (including certain travel and meal expenses) incurred by a taxpayer in connection with changing job locations or starting a new job, if certain requirements are met (sec. 217).

The Code provides that no deduction is allowed for a payment that is illegal under any Federal law or State law (but only if such State law is generally enforced) that subjects the payor to a criminal penalty or the loss of a license or privilege to engage in a trade or business. For example, if paying more than the face value for a ticket ("scalping") is illegal under an enforced State law, this rule disallows any otherwise available deduction of such payments as business entertainment expenses.

Entertainment activities

In general
In general, expenditures relating to activities generally considered to constitute entertainment, amusement, or recreation are deductible only if the taxpayer establishes that (1) the item was directly related to the active conduct of the taxpayer's business or (2), in the case of an item directly preceding or following a substantial and bona fide business discussion, the item was associated with the active conduct of the taxpayer's business (sec. 274(a)). The "directly related" and "associated with" requirements are intended to require a more proximate relation between the entertainment expense and the taxpayer's business than would be required under the "ordinary and necessary" requirement applicable to all business expenses (including business entertainment expenses).

These special requirements apply (subject, under prior law, to ten statutory exceptions discussed in greater detail below) to entertainment expenses such as expenses incurred at nightclubs, cocktail lounges, theaters, country clubs, golf and athletic clubs, and sporting events, and on hunting, fishing, or vacation trips or yachts, as well as to expenses of food or beverages, lodging not used for business purposes, or the personal use of employer-provided automobiles. If either statutory requirement is met or an exception applies, entertainment expenses of the taxpayer as well as entertainment expenses of the taxpayer's business guests (such as present or potential customers or clients, legal or business advisors, suppliers, etc.) are deductible, assuming all generally applicable requirements for business deductions are satisfied.

"Directly related" requirement
The Treasury regulations under section 274 provide several alternative tests for satisfying the "directly related" requirement. These tests generally are designed to require the taxpayer to show a clear business purpose for the expenditure and a reasonable expectation of business benefits to be derived from the expenditure. For example, under the "active business discussion" test, the taxpayer must have actively engaged in a business meeting during the entertainment period for the purpose of business benefit and must have had more than a general expectation of deriving some income or other business benefit (other than merely goodwill) at some indefinite future time.

The regulations presume that the "active business discussion" test is not met in the entertainment occurred under circumstances where there was little or no possibility of engaging in business. For example, the test is presumed not to have been met if there were substantial distractions, e.g., because the entertainment took place at a nightclub or a cocktail party, or if the taxpayer met with a group at a vacation resort that included nonbusiness-related individuals.

Even if the "active business discussion" test is not met, entertainment expenses are deemed "directly related" to business and hence satisfy the special section 274 limitation if incurred in a "clear business setting" directly in furtherance of the taxpayer's business. For example, the "clear business setting" test is met for expenses of entertainment taking place in a hospitality room at a convention, where business goodwill may be generated through the display of business products, or if civic leaders are entertained at the opening of a new hotel or theatrical production, provided that the clear purpose is to obtain business publicity. However, because of distracting circumstances, entertainment is presumed not to have occurred in a clear business setting in the case of a meeting or discussion taking place at a nightclub, theater, or sporting event, or during a cocktail party.

"Associated with" requirement
The second category of deductible entertainment expenditures under the regulations are expenses associated with the taxpayer's business that are incurred directly preceding or following a substantial and bona fide business discussion. This requirement generally permits the deduction of entertainment costs intended to encourage goodwill, provided that the taxpayer establishes a clear business purpose for the expenditure, assuming all generally applicable requirements for business deductions are satisfied.

The "associated with" requirement has not been viewed as requiring that business actually be transacted or discussed during the entertainment, that the discussion and entertainment take place on the same day, that the discussion last for any specified period, or that more time be devoted to business than to entertainment. Thus, if a taxpayer conducts negotiations with a group of business associates and that evening entertains them and their spouses at a restaurant, theater, concert, or sporting event, the entertainment expenses generally are considered deductible as "associated with" the active conduct of the taxpayer's business, even though the purpose of the entertainment is merely to promote goodwill. Entertainment taking place between business sessions or during evening hours at a convention is treated under the regulations as directly preceding or following a business discussion.

Entertainment facilities

The section 274 rules were amended by the Revenue Act of 1978 to disallow any deduction (or the investment tax credit) for the cost of entertainment facilities, subject to certain specific statutory exceptions. This general disallowance rule applies to property such as "skyboxes" in sports arenas, tennis courts, bowling alleys, yachts, swimming pools, hunting lodges, fishing camps, and vacation resorts.

Dues or fees paid to a social, athletic, or sporting club are deductible provided that more than half the taxpayer's use of the club is in furtherance of the taxpayer's trade or business and the item was directly related to the active conduct of such trade or business (sec. 274(a)(2)). The expenses of box seats and season tickets to theaters and sporting events have not been disallowed as expenses related to entertainment facilities. Instead, such costs were deductible under prior law if they met the requirements applied to entertainment activities and the general requirements for deducting business expenses.

Exceptions for certain entertainment activities

In general
Prior law included ten statutory exceptions to the general section 274 rules that an entertainment, recreation, or amusement activity expenditure must satisfy either the "directly related" or "associated with" requirement, and that entertainment facility costs are not deductible. If an exception applied, the entertainment expenditure was deductible if it constituted an ordinary and necessary business expense and if any applicable section 274(d) substantiation requirements were satisfied.

The prior-law exceptions were for (1) business meals (discussed below), (2) food and beverages furnished to employees on the taxpayer's business premises, (3) entertainment expenses treated by the employer and employee as compensation to the employee (and so reported on the employer's return and on Form W-2 furnished to the employee), (4) expenses paid by the taxpayer under a reimbursement or other expense allowance arrangement in connection with the performance of services, (5) expenses for recreational, social, or similar facilities or activities for the benefit of employees generally, (6) entertainment expenses directly related to bona fide meetings of a taxpayer's employees, stockholders, or directors, (7) entertainment expenses directly related to and necessary to attendance at a business meeting or convention of a tax-exempt trade association, (8) expenditures for entertainment (or a related facility) made available by the taxpayer to the general public, (9) expenses for entertainment sold by the taxpayer to the public, and (10) expenses includible in the income of persons who are not employees.

The regulations under section 274 provide that entertainment expenditures are not deductible to the extent they are lavish or extravagant. Under prior law, the Internal Revenue Service indicated that it would not interpret this provision to disallow deductions merely because entertainment expenses exceed a fixed dollar amount, are incurred at expensive restaurants, hotels, nightclubs, or resorts, or involve first-class accommodations or services (see Rev. Rul. 63-144, 1963-2 C.B. 129).

Meals
Under prior law, expenses for food and beverages were deductible, without regard to the "directly related" or "associated with" requirement generally applicable to entertainment expenses, if the meal or drinks took place in an atmosphere conducive to business discussion. There was no requirement under prior law that business actually be discussed before, during, or after the meal.

Travel expenses

Away from home travel
Traveling expenses incurred by the taxpayer while "away from home" in the conduct of a trade or business (e.g., where the taxpayer travels to another city for business reasons and stays there overnight) generally are deductible if the ordinary and necessary standard for business deductions is met (sec. 162(a)(2)). Personal living expenses such as food and lodging incurred during the trip may be deductible under this rule. However, travel deductions for amounts expended for meals and lodging are not allowable if such amounts are "lavish and extravagant under the circumstances" (sec. 162(a)(2)). In addition, deductions for any traveling expenses must be substantiated pursuant to section 274(d).

If, while away from home, a taxpayer engages in both business and personal activities, traveling expenses to and from such destination are deductible only if the trip is related primarily to the taxpayer's trade or business. If the trip is primarily personal in nature, the traveling expenses to and from the destination are not deductible; however, any expenses while at the destination that are properly allocable to the taxpayer's trade or business are deductible. The determination of whether a trip is related primarily to the taxpayer's trade or business or is primarily personal in nature depends on the facts and circumstances in each case. An important factor in determining whether the trip is primarily personal is the amount of time during the period of the trip that is spent on personal activities compared to the amount of time spent on activities directly relating to the taxpayer's trade or business (Treas. Reg. sec. 1.162-2(b)).

Deductions for conventions held on cruise ships are limited to $2,000 per taxpayer per year, and are wholly disallowed unless the cruise ship is registered in the United States and stops only at ports of call in this country (including United States possessions) (sec. 274(b)(2)). Also, special rules apply in the case of travel outside the United States that lasts for more than one week (sec. 274(c)).

Traveling costs as deductible education expenses
Traveling expenses may be deductible as business expenses if the travel (1) maintains or improves existing employment skills or is required by the taxpayer's employer or by applicable rules or regulations, and (2) is directly related to the taxpayer's duties in his or her employment or trade or business. Under prior law, some individuals claimed deductions for travel expenses on the ground that the travel itself served educational purposes.
Traveling costs as deductible charitable contributions
A taxpayer may deduct, as charitable donations, unreimbursed out-of-pocket expenses incurred incident to the rendition of services provided by the taxpayer to a charitable organization (Treas. Reg. sec. 1.170A-1(g)). This rule applies to out-of-pocket transportation expenses, and reasonable expenditures for meals and lodging away from home, if necessarily incurred in performing donated services. (No charitable deduction is allowable for the value of the contributed services.) Under prior law, in some instances taxpayers claimed charitable deductions for travel expenses where the travel involved a significant element of personal pleasure, recreation, or vacation.

General substantiation requirements

As a general rule, deductions for travel, entertainment, and certain gift expenses are subject to stricter substantiation requirements than most other business deductions (sec. 274(d)). These stricter rules were enacted because the Congress recognized that "in many instances deductions are obtained by disguising personal expenses as business expenses."34a

Under the section 274 rules, the taxpayer must substantiate by adequate records, or sufficient evidence corroborating the taxpayer's statement, (1) the amount of the expense or item subject to section 274(d); (2) the time and place of the travel, entertainment, amusement, recreation, or use of the facility or property, or the date and description of the gift; (3) the business purpose of the expense or other item; and (4) the business relationship to the taxpayer of persons entertained, using the facility or property, or receiving the gift. These substantiation rules apply to: (1) traveling expenses (including meals and lodging while away from home); (2) expenditures with respect to entertainment, amusement, or recreation activities or facilities; and (3) business gifts. In addition, the Tax Reform Act of 1984 (P.L. 98-369) made additional property subject to the section 274(d) rules, including automobiles used for local travel: these additional categories of expense became subject to the section 274(d) substantiation requirements on January 1, 1986.

To meet the adequate records standard, documentary evidence (such as a receipt or paid bill) is required for any expenditure of $25 or more (except certain transportation charges). The Congress has emphasized that no deductions for expenditures subject to substantiation under section 274(d) are allowable pursuant to the Cohan approximation rule.34b

 

Reasons for Change

 

 

In general

Since the 1960's the Congress has sought to address various aspects of deductions for meals, entertainment, and travel expenses that the Congress and the public have viewed as unfairly benefiting those taxpayers who are able to take advantage of the tax benefit of deductibility. In his 1961 Tax Message, President Kennedy reported that "too many firms and individuals have devised means of deducting too many personal living expenses as business expenses, thereby charging a large part of their cost to the Federal Government." He stated: "This is a matter of national concern, affecting not only our public revenues, our sense of fairness, and our respect for the tax system, but our moral and business practices as well."

After careful review during consideration of the Act, the Congress concluded that these concerns were not addressed adequately by prior law. In general, prior law required some heightened showing of a business purpose for travel and entertainment costs, as well as stricter substantiation requirements than those applying generally to all business deductions; this approach is retained under the Act. However, the prior-law approach failed to address a basic issue inherent in allowing deductions for many travel and entertainment expenditures--the fact that, even if reported accurately and having some connection with the taxpayer's business, such expenditures also convey substantial personal benefits to the recipients.

The Congress believed that prior law, by not focusing sufficiently on the personal-consumption element of deductible meal and entertainment expenses, unfairly permitted taxpayers who could arrange business settings for personal consumption to receive, in effect, a Federal tax subsidy for such consumption that was not available to other taxpayers. The taxpayers who benefit from deductibility tend to have relatively high incomes, and in some cases the consumption may bear only a loose relationship to business necessity. For example, when executives have dinner at an expensive restaurant following business discussions and then deduct the cost of the meal, the fact that there may be some bona fide business connection does not alter the imbalance between the treatment of those persons, who have effectively transferred a portion of the cost of their meal to the Federal Government, and other individuals, who cannot deduct the cost of their meals.

The significance of this imbalance is heightened by the fact that business travel and entertainment often may be more lavish than comparable activities in a nonbusiness setting. For example, meals at expensive restaurants and the most desirable tickets at sports events and the theatre are purchased to a significant degree by taxpayers who claim business deductions for these expenses. This disparity is highly visible, and has contributed to public perceptions that the tax system under prior law was unfair. Polls indicated that the public identified the full deductibility of normal personal expenses such as meals and entertainment tickets to be one of the most significant elements of disrespect for and dissatisfaction with the tax system.

In light of these considerations, the Act generally reduces to 80 percent the amount of otherwise allowable deductions for business meals, including meals while on a business trip away from home, meals furnished on an employer's premises to its employees, and meal expense at a business luncheon club or a convention, and business entertainment expenses, including sports and theatre tickets and club dues. This reduction rule reflects the fact that all meals and entertainment inherently involve an element of personal living expenses, but still allows an 80-percent deduction where such expenses also have an identifiable business relationship. The Act also tightens the requirements for establishing a bona fide business reason for claiming food and beverage expenses as deductions. The Act includes specified exceptions to the general percentage reduction rule.

In certain respects, more liberal deduction rules were provided under prior law with respect to business meals than other entertainment expenses, both as to the underlying legal requirements for deductibility and as to substantiation requirements. The Congress concluded that more uniform deduction rules should apply; thus, deductions for meals are subject to the same business-connection requirement as applies for deducting other entertainment expenses.

Skybox rentals

Taxpayers generally cannot claim deductions or credits for the cost of entertainment facilities, including private luxury boxes ("skyboxes") at sports arenas. However, under prior law a taxpayer could circumvent this rule by leasing a skybox instead of purchasing it. Accordingly, the Act disallows deductions for all costs of leasing a skybox if the skybox is leased for more than one event during a taxable year; this disallowance rule is phased-in for taxable years beginning in 1987 and 1988.

Excess ticket costs

Under prior law, some taxpayers claimed entertainment expense deductions for ticket purchases in an amount that exceeded the face value of the tickets. For example, a taxpayer may pay an amount in excess of the face price to a "scalper" or ticket agent. The Congress concluded that deductions for ticket costs in excess of the face value amount generally should not be allowed. However, this limitation does not apply to ticket expenses for sports events meeting certain requirements under the Act relating to charitable fundraising.

Luxury water travel

The Congress concluded that prior law could allow excessive deductions for business travel undertaken by luxury water travel (e.g., by cruise ship). Taxpayers who engage in luxury water travel ostensibly for business purposes may have chosen this means of travel for personal enjoyment over other reasonable alternatives that may better serve business purposes by being faster and less expensive. Also, the costs of luxury water travel may include elements of entertainment and meals (not separately charged) that are not present in other transportation. Accordingly, the Act generally places per diem dollar limitations on deductions for luxury water transportation.

Travel as a form of education

The Congress was concerned about deductions claimed under prior law for travel as a form of education. The Congress concluded that any business purpose served by traveling for general educational purposes, in the absence of a specific need such as engaging in research which can only be performed at a particular facility, is at most indirect and insubstantial. By contrast, allowing deductions for travel as a form of education could provide substantial personal benefits by permitting some individuals in particular professions to deduct the cost of a vacation, while most individuals must pay for vacation trips out of after-tax dollars, no matter how educationally stimulating the travel may be. Accordingly, the Act disallows deductions for travel that can be claimed only on the ground that the travel itself is educational, but permits deductions for travel that is a necessary adjunct to engaging in an activity that gives rise to a business deduction relating to education.

Charitable deductions for travel expenses

The Congress also was concerned about charitable deductions claimed by some persons for expenses of travel away from home to visit places that customarily are visited as vacation sites or resorts. Prior to the Act, there had been a proliferation of widely publicized programs advertising that individuals could travel to appealing locations and claim charitable deductions for their travel and living costs, on the ground that the taxpayers were performing services assisting the charities. In many cases, however, the value of the services performed appeared to be minimal compared to the amount deducted, the amount of time spent during the day on activities benefiting the charitable organization was relatively small compared to the amount of time during the day available for recreation and sightseeing activities, or the activities performed were similar to activities that many individuals perform while on vacations paid for out of after-tax dollars.

Accordingly, the Congress concluded that charitable deductions for travel expenses away from home should be denied where the travel involves a significant element of personal pleasure, recreation, or vacation; this same rule applies for travel expenses claimed as medical deductions. However, deductions for such expenses as the out-of-pocket expenditures incurred by a troop leader on a youth group camping trip remain allowable.

Expenses for nonbusiness conventions

The Congress was concerned about deductions claimed under prior law for travel and other costs of attending conventions or other meetings that relate to financial or tax planning of investors, rather than to a trade or business of the taxpayer. For example, individuals claimed deductions for attending seminars about investments in securities or tax shelters. In many cases, these seminars were held in locations (including some that were overseas) that were attractive for vacation purposes, and were structured so as to permit extensive leisure activities on the part of attendees.

Since investment purposes do not relate to the taxpayer's means of earning a livelihood (which usually involves the conduct of a trade or business), the Congress concluded that these abuses, along with the personal consumption issue that arises with respect to any deduction for personal living expenses, justify denial of any deduction for the costs of attending a nonbusiness seminar or similar meeting that does not relate to a trade or business of the taxpayer. However, this disallowance rule does not apply to expenses incurred by a taxpayer in attending a convention, seminar, sales meeting, or similar meeting relating to the trade or business of the taxpayer that are deductible under section 162.

 

Explanation of Provisions

 

 

a. Percentage reduction for meal and entertainment expenses
In general
Under the Act, any amount otherwise allowable as a deduction under chapter 1 of the Code (secs. 1-1399) for any expenses for food or beverages, or for any item with respect to an entertainment, amusement, or recreation activity35 or facility used in connection with such activity, is reduced by 20 percent (new Code sec. 274(n)).36 Thus, if a taxpayer spends $100 for a business meal or an entertainment expense that, but for this rule, would be fully deductible, the amount of the allowable deduction is $80.

This reduction rule applies, for example, to food or beverage costs incurred in the course of travel away from home (whether eating alone or with others), in entertaining business customers at the taxpayer's place of business or a restaurant, or in attending a business convention or reception, business meeting, or business luncheon at a luncheon club. Similarly, the cost of a meal furnished by an employer to employees on the employer's premises is subject to the reduction rule, whether or not the value of the meal is excludable from the employee's gross income under section 119. As another example, meal expenses that are allowable (within certain limitations) as moving expenses deductible under section 217 are subject to the reduction rule. However, as discussed below, the Act provides certain exceptions to the percentage reduction rule.

In determining the amount of any otherwise allowable deduction that is subject to reduction under this rule, expenses for taxes and tips relating to a meal or entertainment activity are included. For example, in the case of a business meal for which the taxpayer pays $50, plus $4 in tax and $10 in tips, the amount of the deduction cannot exceed $51.20 (80 percent of $64). Expenses such as cover charges for admission to a night club, the amount paid for a room which the taxpayer rents for a dinner or cocktail party, or the amount paid for parking at a sports arena in order to attend an entertainment event there, likewise are deductible (if otherwise allowable) only to the extent of 80 percent under the rule. However, an otherwise allowable deduction for the cost of transportation to and from a business meal (e.g., cab fare to a restaurant) is not reduced pursuant to the rule.

The percentage reduction rule is applied only after determining the amount of the otherwise allowable deduction under section 162 (or section 212) and under other provisions of section 274. Meal and entertainment expenses first are limited to the extent (if any) required pursuant to other applicable rules set forth in sections 162, 212, or section 274, and then are reduced by 20 percent.37

For example, if a meal costs $100, but, under section 162(a)(2) or new section 274(k)(1), $40 of that amount is disallowed as lavish and extravagant, then the remaining $60 is reduced by 20 percent, leaving a deduction of $48. Similarly, when a taxpayer buys a ticket to an entertainment event for more than the ticket's face value, the deduction cannot exceed 80 percent of the face value of the ticket.

Following application of the percentage reduction rules as described above, the deductibility of an expense next is subject to the new two-percent floor under the total of unreimbursed employee business expenses and other miscellaneous itemized deductions (see Part I.E.2., below), if applicable to such expense, and then to any deduction limitation that is specifically expressed in dollars.38 For example, assume that a self-employed individual incurs meal expenses that constitute moving expenses under section 217, subject to the dollar limitation (generally, $3,000) on deductibility of moving expenses contained in section 217(b)(3), or that an employee incurs such unreimbursed expenses. The taxpayer must first reduce the amount of such meal expenses by 20 percent; the dollar limitation in section 217(b)(3) then applies to the total of such meal expenses (as so reduced) and other types of allowable moving expenses. As discussed below, moving expenses are not subject to the new two-percent floor under miscellaneous itemized deductions.

The effect of the percentage reduction rule cannot be avoided by reason of the absence of separate charges for, payments for, or allocations as between meal and entertainment expenses subject to the rule, and business expenses that are deductible in full. For example, assume that a hotel charges $200 per night for a room, that it provides dinner and breakfast free of any separately stated charge, and that the amount properly allocable to the meals (or the right to the meals) is $50. Of the taxpayer's $200 payment to the hotel, assuming all other requirements for a business deduction are met, only $190 ($150 for the room, plus 80 percent of the $50 allocable to the meals)39 is deductible. Similarly, if a business provides its employees with a fixed per diem amount to cover lodging and meal expenses incurred in business travel, an allocation on a reasonable basis must be made between the meal expenses and the lodging or other expenses, and the percentage reduction rule applies to the amount so allocated to meal expenses.

Exceptions to percentage reduction rule
The Act provides certain exceptions to the applicability of the percentage reduction rule.

First, the cost of a meal or of an entertainment activity is fully deductible if the full value thereof is treated as compensation to the recipient. Thus, if an employee is the recipient of meals or entertainment provided by his or her employer, the employer's expenses are not subject to the percentage reduction rule if the employer treats such expenses as compensation to the employee on the employer's tax return and as wages for income tax withholding purposes. Similarly, if the recipient is an independent contractor who has rendered services to the taxpayer, the taxpayer's expenses are not subject to the percentage reduction rule if the expenses are includible in the recipient's gross income as compensation (or as a prize or award under sec. 74) and the taxpayer includes such expenses on Form 1099 or other applicable information return issued to the recipient (unless the taxpayer is not required to do so because the aggregate amount paid to the recipient is less than $600).

Second, in the case of an employee who is reimbursed for expenses of a meal or of entertainment incurred in performing services for his or her employer, the percentage reduction rule does not apply to the reimbursed employee; instead, the percentage reduction rule applies to the employer making the reimbursement. This exception may apply, for example, in the case of a salesperson who pays for a lunch with a customer at which a sales contract is discussed and then is reimbursed under a reimbursement or other expense allowance arrangement with his or her employer; in that case, the person making the reimbursement can deduct only 80 percent of the reimbursement.40 Similarly, a nonemployee service provider (such as an accounting firm) that provides the required substantiation (pursuant to sec. 274(d)) and is reimbursed by the service-recipient for meal and entertainment expenses incurred on the latter's behalf is not subject to the percentage reduction rule; instead, the service-recipient can deduct only 80 percent of the reimbursement.

Third, the percentage reduction rule does not apply in the case of certain traditional recreational expenses incurred by an employer primarily for the benefit of its employees (other than certain highly compensated, etc. employees). For example, this exception may apply in the case of an employer's deduction for meal and entertainment costs of a year-end holiday party or a summer picnic for all company employees and their spouses.

Fourth, the percentage reduction rule does not apply to an expense for food or beverages if the full value thereof is excludable from the recipient's gross income under Code section 132(e) as a de minimis fringe benefit. For example, a transfer for business purposes of a packaged food or beverage item (e.g., a holiday turkey or ham, fruitcake, or bottle of wine) is not subject to the percentage reduction rule if the section 132(e) de minimis fringe benefit exclusion applies. Similarly, the percentage-reduction rule does not apply to the cost of an employer-provided meal that is excludable from the employee's gross income as a de minimis fringe benefit under section 132(e)(2), relating to certain eating facilities where revenue derived from the facility normally equals or exceeds the direct operating costs of the facility and where access to the facility is available to employees on a nondiscriminatory basis. This exception does not apply to employer-provided meals that are excludable from the employee's gross income only pursuant to section 119, or to any entertainment expenses (whether or not excludable under sec. 132(e)).

Fifth, the reduction rule does not apply in the case of meal or entertainment expenses, such as samples and promotional activities, that are made available by the taxpayer to the general public. For example, if the owner of a hardware store advertises that tickets to a sports event will be provided to the first 50 people who visit the store on a particular date, or who purchase an item from the store during a sale, then the full amount of the face value of the tickets is deductible by the owner. Similarly, a wine merchant who permits members of the public who are potential customers to sample wine of the type that the merchant is offering for sale may deduct in full the cost of wine used as a sample, along with reasonable costs that are associated with the wine tasting (e.g., food that is provided with the wine to demonstrate the suitability of the wine for particular types of meals.)

Sixth, expenses for attendance at a sports event, to the extent otherwise allowable as a business deduction, are not subject to the percentage reduction rule if the event meets certain requirements related to charitable fundraising. In order for such costs to be subject to the percentage reduction rule under this exception, the event must (1) be organized for the primary purpose of benefiting a tax-exempt charitable organization (described in sec. 501(c)(3)), (2) contribute 100 percent of the net proceeds to the charity, and (3) use volunteers for substantially all work performed in carrying out the event. This rule applies to the cost of a ticket package, i.e., the amount paid both for seating at the event, and for related services such as parking, use of entertainment areas, contestant positions, and meals furnished at and as part of the event.

For example, a golf tournament that donates all of the net proceeds from the event to charity is eligible to qualify under this exception. Such a tournament would not fail to qualify solely because it offered prize money to golfers who participated, or used paid concessionaires or security personnel. However, it is intended that tickets to college or high school football or basketball games or other similar scholastic events will not qualify under the exception. Such games generally do not satisfy the requirement that substantially all work be performed by volunteers, if the institution (or parties acting on its behalf) pays individuals to perform such services as coaching or recruiting.

Seventh, the cost of providing meals or entertainment is fully deductible to the extent that it is sold by the taxpayer in a bona fide transaction for an adequate and full consideration in money or money's worth. For example, a restaurant or dinner theater may deduct the full amount of its ordinary and necessary expenses in providing meals or entertainment to paying customers. Similarly, assume that an employer, not otherwise in the restaurant or catering business, provides meals on the premises to its employees for which the employer can establish that it charges arm's length, fair market value prices. Since in such circumstances the employees are paying adequate and full consideration, the value of the meals does not constitute compensation includible in gross income, even if the section 132(e) exclusion does not apply. For purposes of the above exception to the percentage reduction rule, the employer in these particular circumstances is treated, in effect, like a restaurant, and can deduct in full the cost of providing the meals.

However, a taxpayer cannot avoid the percentage reduction rule, where otherwise applicable, by reason of providing meals on the taxpayer's business premises. By way of illustration, assume that, in the above example, when an employee takes a customer of the employer to lunch on the premises, the employee's or the customer's meals, or both, are provided by the employer free of charge. Under these circumstances, only 80 percent of the cost of providing the free meals is deductible by the employer. If the employee actually paid for the cost of the meals and was not reimbursed by the employer, the percentage reduction rule would apply to the employee.

A restaurant or catering firm may deduct 100 percent (rather than 80 percent) of its costs for food and beverage items, purchased in connection with preparing and providing meals to its paying customers, that are consumed at work by employees of the restaurant or caterer. However, this rule applies only to employees who work in the employer's restaurant or catering business.

Eighth, expenses incurred in calendar year 1987 or calendar year 1988 for food or beverages that are provided as an integral part of a qualified banquet meeting are not subject to the percentage reduction rule if charges for the meal are not separately stated from other meeting expenses.41 In the case of expenses incurred on or after January 1, 1989, the 80-percent reduction rule will apply to qualified banquet meeting meals in the same manner as to other business meals.

For purposes of this two-year exception, the term banquet meeting means a convention, seminar, annual meeting, or similar business program that includes the meal. The exception applies only if more than 50 percent of the participants at the banquet meeting are away from home (within the meaning of sec. 162(a)(2)), i.e., can deduct travel expenses under the "overnight" rule; (2) at least 40 persons attend the banquet meeting; and (3) the meal event is part of the banquet meeting and includes a speaker.42 If a business program or other banquet meeting includes (for example) three meals, but there is a speaker only at one of the meals, only the one meal at which there is a speaker is eligible for the banquet meeting exception to the percentage reduction rule.

b. Additional requirements relating to meals

The Act also makes certain changes in the legal and substantiation requirements applicable to deductions for business meals; these changes apply independently of and prior to the percentage reduction rule (where applicable).

First, under the Act, deductions for meal expenses are subject to the same business-connection requirement as applied to deductions for other entertainment expenses under prior law (and continues to apply under present law).43 Accordingly, an expense for food or beverages is not deductible unless (in addition to generally applicable deduction requirements) the taxpayer (1) establishes that the item was directly related to the active conduct of the taxpayer's trade or business, or, in the case of an item directly preceding or following a substantial and bona fide business discussion (including business meetings at a convention or otherwise), that the item was associated with the active conduct of the taxpayer's trade or business, and (2) substantiates the deduction as required by section 274(d) and Treas. Reg. sec. 1.274-5(b)(4).

Under this requirement, a business meal expense generally is not deductible unless there is a substantial and bona fide business discussion during, directly preceding, or directly following the meal. However, the absence of a business discussion does not preclude satisfying the "directly related" or "associated with" requirement in the case of an individual who is away from home in the pursuit of a trade or business and who has a meal alone or with persons, such as family members, who are not business-connected, and a deduction is claimed only for the meal of such individual, or in the case of a meal expense allowable as a moving expense.

For purposes of deducting food or beverage expenses, the business discussion requirement is deemed not to have been met if neither the taxpayer nor any employee of the taxpayer is present when the food or beverages are provided. Thus, for example, if the taxpayer reserves a table at a business dinner but neither the taxpayer nor an employee of the taxpayer attends the dinner, no deduction is allowed for the taxpayer's expenditures. Similarly, if one party to a contract negotiation buys dinner for other parties involved in the negotiations, but does not attend the dinner, the deduction is denied even if the other parties engage in a business discussion.44

For purposes of this rule, an independent contractor who renders significant services to the taxpayer (other than attending meals on the taxpayer's behalf, or providing services relating to meals) is treated as an employee, if he or she attends the meal in connection with such performance of services. Thus, for example, an attorney who was retained by a taxpayer to represent the taxpayer in a particular legal proceeding is to be treated as an employee of the taxpayer, for purposes of this rule, if the attorney represented the taxpayer at a business meal at which the legal proceeding was discussed.

The requirement for deductibility that the taxpayer must be present at the meal does not apply where an individual traveling away from home on business has a meal alone or with persons, such as family members, who are not business-connected, and a deduction is claimed only for the meal of such individual. Also, the taxpayer-presence requirement is subject to the same exceptions as apply under the Act to the percentage reduction rule.

Second, the Act explicitly provides, apart from the prior-law and present-law statutory rule (sec. 162(a)(2)) disallowing deductions for certain lavish and extravagant travel expenses (including meals), that no deduction is allowed for any food or beverage expense unless the expense is not lavish or extravagant under the circumstances (new sec. 274(k)(1)(A)). This additional provision reflects the intent of the Congress that this standard is to be enforced by the Internal Revenue Service and the courts.

This disallowance rule applies whether or not the expense is incurred while the taxpayer is away from home, and whether the taxpayer incurs the expense alone or with others. Since the percentage reduction is applied only after determining the otherwise allowable deduction under sections 162, 212, and 274, if a taxpayer incurs otherwise deductible business lunch expenses of (for example) $80 for himself and if $30 of that amount is not allowable as lavish or extravagant, the remaining $50 is then reduced by 20 percent, leaving a deduction of $40. This new disallowance rule (but not the sec. 162(a)(2) disallowance rule) is subject to the same exceptions as apply under the Act to the percentage reduction rule (e.g., where the full value of the food or beverages is treated as compensation to the recipient).

The rules of the Act reflect concerns of the Congress about deductions claimed under prior law for meals that did not clearly serve business purposes or were not adequately substantiated. Since the Act provides that deductions for meals are subject to the same business-connection requirement as applies under prior and present law for other entertainment expenses, the substantiation requirements for such entertainment expenses (e.g., in Treas. Reg. sec. 1.274-5(b)(4) with respect to the directly related or associated with requirement for deductibility) also apply to all meal expenses. In addition, the Treasury is instructed to adopt stricter substantiation requirements for business meals, except that the prior-law rule relating to certain expenditures of less than $25 is to be retained.

Under the Act, as under prior law, the Internal Revenue Service and the courts are not to apply the Cohan approximation rule to allow deductibility of any food or beverage expense, other entertainment expense, or other expenditure subject to substantiation pursuant to section 274(d) if the expenditure is not substantiated in accordance with section 274(d) and the regulations thereunder.

c. Deductions for tickets limited to face value

Under the Act, a deduction (if otherwise allowable) for the cost of a ticket for an entertainment activity is limited (prior to application of the percentage reduction rule) to the face value of the ticket. The face value of a ticket includes any amount of Federal, State, or local ticket tax on the ticket. Under this rule, a payment to a "scalper" for a ticket is not deductible (even if not disallowed as an illegal payment) to the extent that the amount paid exceeds the face value of the ticket. Similarly, a payment to a ticket agency or broker for a ticket is not deductible to the extent it exceeds the face value of the ticket.

However, the face value limitation does not apply to an expense that is excepted under the Act from the percentage reduction rule because it relates to a sports event that meets certain requirements related to charitable fundraising (see description above).

d. Disallowance of deductions for certain "skybox" rentals

The Act generally disallows any deductions relating to rental or similar payments for use of a "skybox" if the skybox is used by the taxpayer (or related party) for more than one event during a taxable year. The term "skybox" means any private luxury box or other facility at a sports arena that is separated from other seating, and is available at a higher price (counting all applicable expenses, e.g., rental of the facility, as well as separate charges for food and seating) than the price generally applicable to other seating.

The disallowance rule applies if the taxpayer (or a related party, including one engaged in a reciprocal rental arrangement with the taxpayer) rents a skybox at the same sports arena for more than one event. For purposes of this rule, a single game or other performance counts as one event. Thus, for example, a taxpayer who rents a skybox for two World Series games in the same stadium is treated as renting a skybox for two events. The deductibility of a single-event rental is determined under the rules generally applicable to entertainment activities, including the percentage reduction rule.

In determining whether a taxpayer has rented a skybox for more than one event, all skybox rentals by the taxpayer in the same arena, along with any related rentals, are considered together. For example, rentals of different skyboxes in the same stadium, or rentals by the same taxpayer pursuant to separate rental agreements, constitute related rentals. In addition, rentals by related parties are considered related rentals. For example, this rule applies where members of the same family, corporations or other entities with common ownership, or taxpayers who have made a reciprocal arrangement involving sharing skyboxes, respectively lease skyboxes for different events.

If the disallowance rule applies (i.e., if the taxpayer rents a skybox for more than one event), the amount allowable as a deduction with respect to such events (including the first such rental) cannot exceed the face value of luxury box seat tickets generally held for sale to the public multiplied by the number of seats in the luxury box (subject, however, to further reduction under the percentage reduction rule). In addition, if expenses for food and beverages incurred by the taxpayer are separately stated, such expenses also may be deducted, subject to the rules generally applicable to business meal expenses, including the business-connection requirement the prohibition on deducting lavish and extravagant expenses, the requirement of taxpayer presence, and the percentage reduction rule.

For example, in a stadium where box seats (other than in luxury boxes) are sold for between $8 and $12, a taxpayer who rents a skybox for three events (and meets generally applicable deduction rules) may treat the deductible amount for the three events as equal to $12 multiplied by the number of seats in the luxury box, multiplied by three. This method applies whether or not the luxury box is occupied fully during the event, and without regard to whether amounts paid for the luxury box nominally constitute payments for the seats or rentals for the luxury box.

However, in determining the amount charged for nonluxury box seats, only prices charged for a genuine category of such seats are taken into account. Consider, for example, the case of a sports arena that, in order to increase the deductions allowable with respect to skyboxes, reserved a small group of seats for which it charged $50 even though those seats were not significantly better than the seats that it offered for $12. In such a case, the $50 price would be disregarded as not bona fide. Similarly, the skybox disallowance rule cannot be circumvented by charging inflated amounts for food and beverages provided in the skybox.

Under the Act, the skybox deduction disallowance rule is phased in. Under the phase-in provision, amounts disallowed for taxable years beginning in 1987 and 1988 are, respectively, one-third and two-thirds of the amounts that otherwise would be disallowed under the skybox provision if the provision were fully effective in those years. Assume, for example, that a calendar-year taxpayer rents a stadium skybox with 10 seats for eight events during 1987 at a total cost of $15,000 (with no additional separate charge for tickets), that the face value of a nonluxury box seat (determined as stated above) is $12, that all seats are occupied by business customers of the taxpayer and the taxpayer is present at each event, and that the total cost otherwise would be allowable as a business deduction. Under the Act as in effect following the phase-in, the taxpayer could deduct 80 percent of the face value ticket amounts (i.e., 80 percent of $960). For 1987, only one-third of the nonticket amount ($15,000 less $960) is disallowed, pursuant to the phase-in; i.e., $4,680 is disallowed. Thus, the taxpayer could deduct 80 percent of $9,360 ($14,040 less $4,680), or $7,488, plus 80 percent of the ticket amount, or $768. The total 1987 deduction for ticket and nonticket amounts would be $8,256.

For taxable years beginning after 1989, the Act generally disallows deductions for any costs of rental or other use of a skybox at a sports arena if the taxpayer (or a related party) uses the skybox for more than one event.

e. Travel as a form of education

Under the Act, no deduction is allowed for expenses for travel as a form of education. This rule applies when a travel deduction otherwise would be allowable only on the ground that the travel itself constitutes a form of education. Thus, for example, this provision disallows deductions for transportation or other travel expenses (including meals and lodging) incurred by a teacher of French who travels to and in France in order to maintain general familiarity with the French language and culture.

This disallowance rule does not apply to otherwise allowable deductions claimed with respect to travel that is a necessary adjunct to engaging in an activity that gives rise to a business deduction relating to education. For example, this disallowance rule does not apply where a scholar of French literature travels to Paris in order to do specific library research that cannot be done elsewhere, or to take courses that are offered only at the Sorbonne, in circumstances such that the nontravel research or course costs are deductible.

f. Charitable deductions for travel expenses

The Act places limitations on charitable deductions for the cost of travel away from home, effective for taxable years beginning after December 31, 1986.45 Under this rule (sec. 170(k)), no charitable deduction is allowed for transportation and other travel expenses (including costs for meals and lodging) incurred in performing services away from home for a charitable organization unless there is no significant element of personal pleasure, recreation, or vacation in the travel away from home. The same limitation applies under prior and present law with respect to medical deductions for lodging costs away from home (sec. 213(d)(2)(B)).

This rule applies only with respect to expenses relating to travel by a taxpayer or by a person associated with the taxpayer (e.g., a family member). The rule does not apply to the extent that the taxpayer pays for travel by third parties who are participants in the charitable activity. For example, this disallowance rule does not apply to travel expenditures personally incurred by a troop leader for a tax-exempt youth group who takes children (unrelated to the taxpayer) belonging to the group on a camping trip. Similarly, the disallowance rule does not apply where an officer of a local branch of a national charitable organization travels to another city for the organization's annual meeting and spends the day attending meetings, even if the individual's evening is free for sightseeing or entertainment activities. However, the disallowance rule applies in the case of any reciprocal arrangement (e.g., when two unrelated taxpayers pay each other's travel expenses, or members of a group contribute to a fund that pays for all of their travel expenses).

The disallowance rule applies whether the travel expenses are paid directly by the taxpayer, or indirectly through reimbursement by the charitable organization. For this purpose, any arrangement whereby a taxpayer makes a payment to a charitable organization and the organization pays for his or her travel expenses is treated as a reimbursement.

In determining whether travel away from home involves a significant element of personal pleasure, recreation, or vacation, the fact that a taxpayer enjoys providing services to the charitable organization will not lead to denial of the deduction. For example, a troop leader for a tax-exempt youth group who takes children belonging to the group on a camping trip may qualify for a charitable deduction with respect to his or her own travel expenses if he or she is on duty in a genuine and substantial sense throughout the trip, even if he or she enjoys the trip or enjoys supervising children. By contrast, a taxpayer who only has nominal duties relating to the performance of services for the charity, who for significant portions of the trip is not required to render services, or who performs activities similar to activities that many individuals perform while on vacations paid out of after-tax dollars, is not allowed any charitable deduction for travel costs.

The disallowance rule in the Act has no effect on deductions other than charitable deductions that may be claimed with respect to travel on behalf of a charitable organization. For example, the rule does not affect the eligibility for deduction under section 162 of an employee business expense incurred by an employee of a charitable organization.

g. Expenses for nonbusiness conventions, etc.

Under the Act, no deduction is allowed for expenses related to attending a convention, seminar, or similar meeting unless such expenses qualify under section 162 as ordinary and necessary expenses of carrying on a trade or business of the taxpayer. Thus, the Act disallows deductions for expenses of attending a convention, etc. where the expenses, but for the provision in the Act, would be deductible under section 212 (relating to expenses of producing income) rather than section 162.

The disallowed expenses to which the provision relates typically include such items as travel to the site of such a convention, registration or other fees for attending the convention, and personal living expenses, such as meals, lodging, and local travel, that are incurred while attending the convention or other meeting. This disallowance rule does not apply to expenses incurred by a taxpayer in attending a convention, seminar, sales meeting, or similar meeting relating to the trade or business of the taxpayer that are deductible under section 162.

In adopting this provision, the Congress also was concerned that some taxpayers may be claiming deductions under section 162 for travel and other costs of attending a convention, seminar, or similar meeting ("convention") at which each convention participant is furnished individually with video tapes of lectures, etc. on topics related to the taxpayer's trade or business, to be viewed at the convenience of the participant, and at which no other significant business-related activities occur during the time allotted for the convention. In such situations, the taxpayer does not participate in activities normally conducted at a business-related convention, such as participating in meetings, discussions, workshops, lectures, or exhibits held during the day, and simply views the tapes at his or her own convenience. Because permitting deductions for travel, meal, or entertainment costs associated with such minimal business-related activities would allow taxpayers to treat expenditures that essentially are for vacation, recreation, or other personal purpose as business expenses, the Congress clarified that no deduction is allowable under section 162 for travel or related costs (such as meals, lodging, or local transportation) of attending such a convention.

This clarification does not disallow deductions for the travel and other costs of attending a convention that involves activities otherwise deductible under present law which are related to the taxpayer's trade or business merely because the convention utilizes video-taped or televised materials where the participants must attend a convention session in person to view the video-taped materials, assuming that the generally applicable requirements for deducting expenses of attending a convention are satisfied.46 Under those requirements, traveling expenses to and from the convention destination are deductible only if the trip is related primarily to the taxpayer's trade or business. If the trip is primarily personal in nature, deductions are allowable only for expenses (if any) incurred while at the destination that are properly allocable to the taxpayer's trade or business.

The determination of whether a trip is related primarily to the taxpayer's trade or business, rather than being primarily personal in nature, depends on the facts and circumstances in each case. An important factor in determining whether the trip is primarily personal is the amount of time during the period of the trip that is spent on personal activities compared to the amount of time spent on activities directly relating to the taxpayer's trade or business (Treas. Reg. sec. 1.162-2(b)).

By way of illustration, assume that a four-day convention is held at a resort or vacation location, that the convention sessions (whether or not utilizing video-taped materials) are scheduled solely for two hours each evening, and that the taxpayer does not engage in any nonconvention business activities during the day. In such a case, a taxpayer could not deduct any away-from-home expenses (travel, lodging, or meals) incurred on his or her trip because the travel is not related primarily to the taxpayer's trade or business, but could deduct any expenses properly allocable to the convention sessions, subject to the rule described above relating to furnished video-taped materials.

h. Luxury water travel

The Act places limitations on the amount of any otherwise allowable deduction for costs of travel by ocean liner, cruise ship, or other form of luxury water transportation. This rule applies, for example, in the case of a taxpayer who has business reasons for traveling from New York City to London and who travels by ocean liner.

Under the Act, the deduction allowable in the case of luxury water travel cannot exceed twice the highest amount generally allowable with respect to a day of travel to employees of the executive branch of the Federal Government while away from home but serving in the United States, multiplied by the number of days the taxpayer was engaged in luxury water travel. For example, if during a particular taxable year the highest applicable Federal per diem amount is $126 for travel in the United States, a taxpayer's deduction for a six-day trip cannot exceed $1,512 ($252 per day times six days). The applicable per diem amount generally is the highest travel amount applying for an area in the conterminous United States; however, any limited special exception to this amount (e.g., a higher limit that applied only to high-ranking executive personnel) would be disregarded.

If the portion of the expenses of luxury water travel that are for meals or entertainment are separately stated, the amounts so separately stated are reduced by 20 percent, under the percentage reduction rule, prior to application of this per diem limitation. However, in the absence of separately stated meal or entertainment charges, taxpayers are not required to allocate a portion of the total amount charged for luxury water travel to meals or entertainment unless the amounts to be allocated are clearly identifiable. This special rule, applicable only in the case of luxury water travel, applies in light of the fact that the Act imposes a flat dollar limitation on deductibility of all travel--for transportation, lodging, and meals--incurred in luxury water transportation.

The per diem limitation for luxury water travel does not apply in the case of any expense allocable to a convention, seminar, or other meeting that is held on any cruise ship. Thus, the per diem limitation does not alter the application of the rule (sec. 274(h)(2)) under which deductions for conventions held aboard cruise ships are wholly denied or, in certain special cases, allowed to the extent not in excess of $2,000 per individual. Under the Act, the statutory exceptions to the business meal percentage reduction rule (described above) are also exceptions to the per diem rule with respect to luxury water travel.

 

Effective Date

 

 

The provisions are effective for taxable years beginning after December 31, 1986.

 

Revenue Effect

 

 

The provisions are estimated to increase fiscal year budget receipts by $1,180 million in 1987, $2,068 million in 1988, $2,397 million in 1989 $2,787 million in 1990, and $3,070 million in 1991.

2. Floor on deductibility of miscellaneous itemized deductions; modifications to certain employee business expense deductions

(sec. 132 of the Act and sec. 62 and new sec. 67 of the Code)47

 

Prior Law

 

 

In general

The list of itemized deductions on Schedule A of Form 1040 includes a category labeled miscellaneous deductions, following the listings for medical expenses, charitable donations, interest, taxes, and casualty and theft losses. Under prior law, this category generally included four types of deductions: (1) certain employee business expenses (sec. 162); (2) expenses of producing income (sec. 212); (3) expenses related to filing tax returns (sec. 212); and (4) expenses of adopting children with special needs (sec. 222).

Employee business expenses

An employee business expense is a cost incurred by an employee in the course of performing his or her job. Examples of such costs include an employee's expenditures for subscriptions to professional journals or continuing education courses, union or professional dues, costs of professional uniforms, costs of looking for new employment, and expenses allowable for business use of the employee's home. Ordinary and necessary employee business expenses generally are deductible.

Employee business expenses generally can be claimed only as itemized deductions. However, under prior law four types of employee business expenses were deductible above-the-line in calculating adjusted gross income, and thus were directly available to nonitemizers: (1) certain expenses paid by an employee and reimbursed under an arrangement with the employer; (2) employee travel expenses incurred while away from home; (3) employee transportation expenses incurred while on business; and (4) business expenses of employees who are outside salespersons (sec. 62(2)).48 In addition, the section 217 moving expense deduction was allowable above-the-line to employees or self-employed individuals.

Certain deductions for employee business expenses also are subject to specific limitations or restrictions For example, a taxpayer's business use of his or her home (whether or not the taxpayer is in the business of being an employee) does not give rise "to a deduction for the business portion of expenses related to operating the home (e.g., depreciation and repairs) unless the taxpayer uses a part of the home regularly and exclusively as the principal place of business or as a place of business used by patients, clients, or customers (sec. 280A).49 Educational expenses are deductible only if the education (1) is required by the employer, by law, or by regulations, or (2) maintains or improves skills required to perform the taxpayer's present occupation.50 Costs of looking for new employment are deductible only if they relate to employment in the taxpayer's present occupation. Also, special substantiation requirements must be met in order to deduct certain employee expenses, such as traveling expenses (sec. 274(d)).

Investment expenses

In general, expenses of producing income other than rental or royalty income are treated as itemized deductions if the related activity does not constitute a trade or business. (Trade or business expenses and expenses of producing rental or royalty income are deductible above-the-line.) Among the types of investment expenses that may be eligible, in particular circumstances, for deduction are investment counsel and trust administration fees, subscriptions to investment advisory publications, and attorneys' fees incurred in collecting income.

Other miscellaneous itemized deductions

Tax counsel and assistance fees, as well as appraisal fees paid to determine the amount of a casualty loss or a charitable contribution of property, may be claimed as itemized deductions (sec. 212(3)).

Expenses incurred with respect to a hobby--i.e., an activity that may generate some gross income but that the taxpayer conducts for personal recreational reasons, rather than with the goal of earning a profit--are deductible as itemized deductions to the extent such expenses would be deductible regardless of profit motivation (e.g., certain interest and taxes) or to "the extent of income from the hobby.51 Gambling losses are deductible as itemized deductions to the extent of gambling gains.

 

Reasons for Change

 

 

The Congress concluded that the prior-law treatment of employee business expenses, investment expenses, and other miscellaneous itemized deductions fostered significant complexity, and that some of these expenses have characteristics of voluntary personal expenditures. For taxpayers who anticipated claiming such itemized deductions, prior law effectively required extensive record-keeping with regard to what commonly are small expenditures. Moreover, the fact that small amounts typically were involved presented significant administrative and enforcement problems for the Internal Revenue Service. These problems were exacerbated by the fact that taxpayers frequently made errors of law regarding what types of expenditures were properly allowable under prior law as miscellaneous itemized deductions.52

Since many taxpayers incur some expenses that are allowable as miscellaneous itemized deductions, but these expenses commonly are small in amount, the Congress concluded that the complexity created by prior law was undesirable. At the same time, the Congress concluded that taxpayers with unusually large employee business or investment expenses should be permitted an itemized deduction reflecting that fact. Similarly, in the case of medical expenses and casualty losses, a floor is provided (under prior and present law) to limit those deductions to unusual expenditures that may significantly affect the individual's disposable income.

Accordingly, the Congress concluded that the imposition of a two percent floor on miscellaneous itemized deductions constituted a desirable simplification of the tax law. This floor will relieve taxpayers of the burden of recordkeeping unless they expect to incur expenditures in excess of the floor. Also, the percentage floor will relieve the Internal Revenue Service of the burden of auditing deductions for such expenditures when not significant in aggregate amount.

The use of a deduction floor also takes into account that some miscellaneous expenses are sufficiently personal in nature that they would be incurred apart from any business or investment activities of the taxpayer. For example, membership dues paid to professional associations may serve both business purposes and also have voluntary and personal aspects; similarly, subscriptions to publications may help taxpayers in conducting a profession and also may convey personal and recreational benefits. Taxpayers presumably would rent safe deposit boxes to hold personal belongings such as jewelry even if the cost, to the extent related to investment assets such as stock certificates, were not deductible.

The Congress also concluded that the distinction under prior law between employee business expenses (other than reimbursements) that were allowable above-the-line, and such expenses that were allowable only as itemized deductions, was not supportable in most instances. The reason for allowing these expenses as deductions (i.e., the fact that they may constitute costs of earning income) and the reasons for imposing a percentage floor apply equally to both types of expenses. However, the Congress concluded that it would not be appropriate to apply the new percentage floor to the moving expense deduction (which is subject to separate dollar limitations under sec. 217) or to the new deduction for certain impairment-related work expenses of handicapped individuals (which applies only in limited circumstances).

 

Explanation of Provisions

 

 

Under the Act, all employee business expenses, other than reimbursed expenses described in section 62(a)(2)(A) and the new deduction for certain performing artists, are allowed only as itemized deductions. Thus, under the Act, unreimbursed employee travel expenses incurred away from home, employee transportation expenses incurred while on business, business expenses of employees who are outside salespersons and employee moving expenses no longer are deductible above-the-line in calculating adjusted gross income. Also, the section 217 moving expense deduction is allowable to a self-employed individual only as an itemized deduction.

The Act also provides that, subject to certain exceptions, the total of all the taxpayer's miscellaneous itemized deductions, including employee business expenses that are not deductible above-the-line, are subject under the Act to a floor of two percent of the taxpayer's adjusted gross income. Thus, for example, if an itemizer with AGI of $30,000 incurs miscellaneous itemized deductions totaling $757, the allowable amount of such deductions is $157.

However, the two-percent floor does not apply to the following miscellaneous itemized deductions, if otherwise allowable: impairment-related work expenses for handicapped employees (new Code sec. 67(d));53 moving expenses (sec. 217); the estate tax in the case of income in respect to a decedent (sec. 691(c)); certain adjustments where a taxpayer restores amounts held under a claim of right (sec. 1341); amortizable bond premium (sec. 171); certain costs of cooperative housing corporations (sec. 216); deductions allowable in connection with personal property used in a short sale; certain terminated annuity payments (new Code sec. 72(b)(3)); and gambling losses to the extent of gambling winnings (sec. 165(d)). In addition, it is intended that the two-percent floor is not applicable to deductions allowable to estates or trusts under sections 642(c), 651, and 661.54

The Act did not modify the above-the-line deduction under section 62(a)(2)(A) for certain reimbursed expenses (allowable under secs. 161-196 of the Code) paid or incurred by the taxpayer, in connection with performing services as an employee, under a reimbursement or other expense allowance arrangement with his or her employer. Thus, the Act did not alter the prior-law rules55 relating to an employee who incurs expenses solely for the benefit of the employer and who is reimbursed for those expenses under an arrangement with the employer (regardless of whether the employer or a third party for whom the employee performs a benefit as an employee of the employer actually provides the reimbursement).56 These rules provide that such an employee need not report on the employee's tax return either the expenses or the reimbursement (to the extent the reimbursement does not exceed the expenses). The Congress intended that this nonreporting rule is to be continued.

If the employee has a reimbursement or other expense allowance arrangement with his or her employer, but under the arrangement the full amount of such expenses is not reimbursed, the unreimbursed portion paid by the employee is allowable only to the extent (if any) otherwise allowable as an itemized deduction (e.g., after taking into account the percentage reduction rule for meals and entertainment expenses, if applicable to the expense), and subject to the two-percent floor provided by the Act.57

Pursuant to Treasury regulations, the two-percent floor is to apply with respect to indirect deductions through pass-through entities (including mutual funds) other than estates, nongrantor trusts, cooperatives, and REITs (sec. 67(c)). The floor also applies with respect to indirect deductions through grantor trusts, partnerships, and S corporations by virtue of grantor trust and pass-through rules.

In the case of an estate or trust, the Act provides that adjusted gross income is to be computed in the same manner as in the case of an individual, except that the deductions for costs that are paid or incurred in connection with the administration of the estate or trust and that would not have been incurred if the property were not held in such trust or estate are treated as allowable in arriving at adjusted gross income and hence are not subject to the floor. The regulations to be prescribed by the Treasury Department relating to application of the floor with respect to indirect deductions through certain pass-through entitles are to include such reporting requirements as may be necessary to effectuate this provision.

Under the Act, an actor or other individual who performs services in the performing arts (a "performing artist") is allowed a new above-the-line deduction for his or her employee business expenses (allowable under sec. 162) during a year if the performing artist for that year (1) had more than one employer (excluding any nominal employer)58 in the performing arts, (2) incurred allowable section 162 expenses as an employee in connection with such services in the performing arts in an amount exceeding 10 percent of the individual's gross income from such services, and (3) did not have adjusted gross income, as determined before deducting such expenses, exceeding $16,000. In general, if the performing artist is married at the close of the taxable year, this deduction is available only if the taxpayer and his or her spouse file a joint return for the year, and only if the combined adjusted gross income of the taxpayer and his or her spouse (as determined before deducting such expenses) shown on the return does not exceed $16,000. (Code sec. 62(b)).

 

Effective Date

 

 

The provisions apply to taxable years beginning after December 31, 1986.

 

Revenue Effect

 

 

The provisions are estimated to increase fiscal year budget receipts by $694 million in 1987, $4,630 million in 1988, $4,716 million in 1989, $5,039 million in 1990, and $5,383 million in 1991.

3. Changes in treatment of hobby losses

(sec. 143(a) of the Act and sec. 183 of the Code)59

 

Prior Law

 

 

Expenses arising from hobbies (i.e., activities not engaged in for profit) are allowed only as itemized deductions. Except for expenses that are deductible without reference to whether they are incurred in an activity designed to produce income (e.g., certain residential mortgage interest and real property taxes), hobby expenses are deductible only to the extent not exceeding the amount of hobby income for the year (Code sec. 183). These rules apply, for example, to activities such as horse breeding, farming, and researching a restaurant or travel guide, if the taxpayer's motivations are recreational rather than profit-oriented.

A facts and circumstances test generally applies to determine whether a particular activity constitutes a hobby. However, statutory rules provided under prior law that if the gross income from an activity exceeded the deductions attributable thereto for two or more out of five consecutive years (seven consecutive years in the case of an activity which consisted in major part of the breeding, training, showing, or racing of horses), then the activity was presumed to be engaged in for profit rather than as a hobby. The presumption that an activity was not a hobby if it was profitable in two out of five consecutive years (or seven consecutive years, for certain horse activities) could be overcome by the Internal Revenue Service under the general facts and circumstances test.

 

Reasons for Change

 

 

The Congress was concerned that the statutory presumption under prior law regarding whether an activity was being engaged in for profit may have unduly benefited some taxpayers who engaged in activities as hobbies, but who could structure their earnings and expenses so as to realize a profit in at least two out of five consecutive years. For example, the prior-law presumption could apply even if the taxpayer realized a substantial net loss over five years that reflected a willingness to incur losses as the cost of personal recreation, rather than unexpected business difficulties. Even though the Internal Revenue Service could overcome the statutory presumption, some abuse nonetheless could arise, in light of the subjective nature of a general facts and circumstances test. However, in the case of horse breeding, training, showing, and racing activities, the Congress concluded that the prior-law rules should continue to apply.

 

Explanation of Provision

 

 

Under the Act, for activities other than those consisting in major part of horse breeding, training, showing, or racing, the statutory presumption of being engaged in for profit applies only if the activity is profitable in three out of five consecutive years. As under prior law, this presumption can be overcome by the Internal Revenue Service under the general facts and circumstances test.

As in the case of other expenses that under prior and present law are deductible as miscellaneous itemized deductions, deductions for hobby expenses--other than costs that are deductible without reference to whether they are incurred in an activity designed to produce income (such as certain taxes)--are subject to the two-percent floor under section 132 of the Act.

 

Effective Date

 

 

The provision is effective for taxable years beginning after December 31, 1986.

 

Revenue Effect

 

 

The provision relating to the statutory presumption is estimated to increase fiscal year budget receipts by a negligible amount.

4. Changes in restrictions on deductions for business use of home

(secs. 143(b) and (c) of the Act and sec. 280A of the Code)60

 

Prior Law

 

 

In general

A taxpayer's business use of his or her home may give rise to a deduction for the business portion of expenses related to operating the home (e.g., depreciation and repairs). However, deductions are allowed only with respect to a part of the home that is used exclusively and regularly either as the principal place of business for a trade or business of the taxpayer or as a place of business used to meet or deal with patients, clients, or customers in the normal course of the taxpayer's trade or business, or if the part of the home used for business purposes constitutes a separate structure not attached to the dwelling unit (Code sec. 280A). In the case of an employee, a further requirement for a deduction is that the business use of the home must be for the convenience of the employer (sec. 280A(c)(1)).

For an employee, any deductions for depreciation or operating expenses of a home allowable under these rules generally must be claimed as itemized deductions. If an employee receives employer reimbursements for home office costs and includes the reimbursements in gross income, the home office expenses generally are reported on Form 2106 and are deductible "above-the-line" as an adjustment to gross income; under prior law, an employee who constituted an "outside" salesperson similarly deducted such amounts above-the-line. Self-employed individuals claim any allowable deductions for home office expenses above-the-line on Schedule C of Form 1040.

Rental use of home

The general business-use requirements described above do not apply in the case of rental use of a part of the home (e.g., when the taxpayer rents a room to a lodger). In a recent Tax Court case interpreting prior law (Feldman v. Comm'r, 84 T.C. 1 (1985), aff'd, 791 F.2d 781 (9th Cir. 1986)), this rental exception was applied, and the general requirements for the deduction held inapplicable, where an employer nominally rented a portion of the employee's home used by the employee in performing services for the employer. The court permitted the taxpayer to deduct home office expenses without requiring regular and exclusive use of the home either as the taxpayer's principal place of business or as a place to meet or deal with patients, clients, or customers, notwithstanding the court's finding that the rental was not an arm's length arrangement and was made for more than the fair rental value of the space that nominally was rented.

Limitations on deduction

Deductions for home office costs that are allowed solely because there is a qualifying business use of the home are limited to the amount of the taxpayer's gross income derived from the business use of the home during the taxable year. Costs in excess of the limitation cannot be carried over and used as deductions in other taxable years. This limitation has no effect on deductions (such as certain home mortgage interest and real property taxes) that are allowable in the absence of business use.

The internal Revenue Service has issued proposed regulations defining gross income derived from the business use of the home as gross income from the business activity in the unit reduced by expenditures required for the activity but not allocable to the use of the unit itself such as expenditures for supplies and compensation paid to other persons.61 However, in Scott v. Comm'r, 84 T.C. 683 (1985), the Tax Court rejected this interpretation of prior law, holding that gross income from the use of the home means gross income from the business activity itself, i.e., not reduced by any outside expenditures required for the activity.

Under the Tax Court's interpretation. deductions for business use of one's home could be used to create or increase a net loss from the activity and thus, in effect, to offset income from unrelated activities. For example, assume that a taxpayer derived gross income of $1,000 from an activity, and incurred expenses of $1,500 that related to the activity but that did not relate to use of the home (e.g., expenses for supplies, secretaries, and messengers). Under the Tax Court's interpretation of prior law, the taxpayer would be permitted to deduct up to $1,000 in home office costs that are not otherwise deductible (e.g., rent or depreciation), despite the fact that there was no net income from the activity.

 

Reasons for Change

 

 

The provision of the Act placing a two-percent floor under miscellaneous itemized deductions (see Part I.E.2., above) partially alleviates concerns of the Congress about the rules governing home office deductions claimed by employees. However, to the extent home office expenses remain deductible by self-employed persons or to some extent by employees, the Congress concluded that the following modifications to the deductibility of such expenses are desirable.

Requirements for deduction

The Congress concluded that taxpayers should not be able to circumvent the limitations on home office deductions by arranging for their employers to rent portions of their homes. The allowance of such arrangements would significantly narrow the applicability of section 280A and could encourage tax avoidance of the sort that section was intended to prevent.

Section 280A was enacted because of concerns that some taxpayers were converting nondeductible personal and living expenses into deductible business expenses simply because they found it convenient to perform some work at home.62 The Congress reorganized that in some instances a legitimate cost resulting from business use of a home could conceivably be disallowed under the restrictions of section 280A: however, any such instances would be difficult to identify and define.

Further, the Congress believed that allowing deductions for use of a taxpayer's residence inherently involves the potential for abuse. In enacting section 280A, the Congress had concluded that absent limitations, taxpayers could claim home office deductions even when no marginal cost of maintaining the home was incurred by the taxpayer as a result of the business use. Thus, the Congress had concluded that home office deductions should be disallowed in the absence of specified circumstances indicating a compelling reason for business use of the home, and in any event should not be permitted to offset taxable income derived from unrelated activities.

Under the interpretation of prior-law section 280A applied by the Tax Court in the Feldman decision, the Congress concluded the statute would fail to achieve its intended purpose. Allowing employees to use lease arrangements with employers as a method of circumventing the restrictions on home office deductions might encourage some taxpayers to arrange sham transactions whereby a portion of salary is paid in the form of rent. Moreover, it is questionable whether lease transactions between an employer and employee are generally negotiated at arm's length. particularly if such a transaction could provide added tax deductions to the employee at no additional cost to the employer. Accordingly, the Congress concluded that no home office deductions should be allowable (except for expenses such as certain home mortgage interest and real property taxes that are deductible absent business use) if the employee rents a portion of his or her home to the employer.

Limitations on deduction

In general
The Scott decision would permit taxpayers to use home office deductions to create or increase a net loss from the business activity, and thus to offset unrelated income. The Congress believed that a home office deduction to which section 280A applies should not be used to reduce taxable income from the activity to less than zero. In adopting the provisions of the Act, the Congress reemphasized that section 280A was enacted because of concerns about allowing deductions for items which have a substantial personal component relating to the home, which most taxpayers cannot deduct, and which frequently do not reflect the incurring of significantly increased costs as a result of the business activity, and that the provision should be interpreted to carry out its objectives.
Carryover
The Congress concluded that the application of section 280A under prior law might be unduly harsh in one respect. Deductions that are disallowed because they exceed the statutory limitation (i.e., the amount of income from the business activity) cannot be carried forward to subsequent taxable years and claimed to the extent of subsequent income from the home office activity. However, since the purpose of this limitation is to deny the use of home office deductions to offset unrelated income, the Congress concluded that deduction carryforwards should be allowed, subject to the general limitation that the home office deductions in any year cannot create or increase a net loss from the business activity.

 

Explanation of Provisions

 

 

Requirements for deduction

The Act provides that no home office deduction is allowable by reason of business use where an employee leases a portion of his or her home to the employer.63 For this purpose, an individual who is an independent contractor is treated as an employee, and the party for whom such individual is performing services is treated as an employer. In the case of a lease that is subject to this rule, no home office deductions are allowed except to the extent that they would be allowable in the absence of any business use (e.g., certain home mortgage interest expense and real property taxes).

Limitations on deduction

In general
The Act limits the amount of a home office deduction (other than expenses that are deductible without regard to business use. such as certain home mortgage interest expense and real property taxes) to the taxpayer's gross income from the activity, reduced by all other deductible expenses attributable to the activity but not allocable to the use of the unit itself. Thus, home office deductions are not allowed to the extent that they create or increase a net loss from the business activity to which they relate.
Carryover
The Act provides a carryforward for those home office deductions that are disallowed solely due to the income limitation on the amount of an otherwise allowable home office deduction. Deductions that meet the general requirements of section 280A but that are disallowed solely because of the income limitation may be carried forward to subsequent taxable years, subject to the continuing application of the income limitation to prevent the use of such deductions to create or increase a net loss in any year from the business activity.

 

Effective Date

 

 

The provision is effective for taxable years beginning after December 31, 1986.

 

Revenue Effect

 

 

The provision is estimated to increase fiscal year budget receipts by a negligible amount.

 

F. Repeal of Political Contributions Tax Credit

 

 

(sec. 112 of the Act and sec. 24 of the Code)64

 

Prior Law

 

 

Individual taxpayers could claim a nonrefundable income tax credit equal to one-half the amount of their contributions during the year to political candidates and certain political campaign organizations (Code sec. 24). The maximum allowable credit was $50 for an individual and $100 for a married couple filing a joint return.

 

Reasons for Change

 

 

The Congress concluded that, as part of the approach of the Act to reduce tax rates through base-broadening, it was appropriate to repeal the political contributions tax credit. The Congress also understood that data compiled by the Internal Revenue Service suggest that a significant percentage of persons claiming the credit have sufficiently high incomes to make contributions in after-tax dollars, without the benefit of the credit. Also, the credit provided no incentive for individuals with no income tax liability for the year. The small credit amount allowable per return under the dollar limitations made verification costly in relation to the tax liability at issue.

 

Explanation of Provision

 

 

The Act repeals the credit for political contributions.

 

Effective Date

 

 

The provision is effective for taxable years beginning after December 31, 1986.

 

Revenue Effect

 

 

The provision is estimated to increase fiscal year budget receipts by $327 million in 1988, $341 million in 1989, $354 million in 1990, and $368 million in 1991.

 

TITLE II--CAPITAL COST PROVISIONS

 

 

A. Depreciation; Regular Investment Tax Credit; and Finance Leases

 

 

(secs. 201, 202, 203, 204, 211, 212, and 213 of the Act and secs. 38, 46, 57, 168, 178, 179, 280F, 312(k), 467, 1245, 1250, and new sec. 49 of the Code)1

 

Prior Law

 

 

Accelerated depreciation
Overview
The Economic Recovery Tax Act of 1981 ("ERTA") enacted the Accelerated Cost Recovery System ("ACRS") for tangible depreciable property placed in service after 1980. Under ACRS, the cost or other basis of eligible property (without reduction for salvage value) was recovered using an accelerated method of depreciation over a predetermined recovery period. Before ACRS was enacted, an asset's cost (less salvage value) was recovered over its estimated useful life. The pre-ACRS rules remain in effect for property placed in service by a taxpayer before 1981, and for property not eligible for ACRS.

Under ACRS, the allowable recovery deduction in each taxable year was determined by applying a statutory percentage to the property's original cost (adjusted, as described below, for investment tax credit allowed).

Personal property
The statutory percentages for personal property were based on the 150-percent declining balance method for the early recovery years, switching to the straight-line method at a time to maximize the recovery allowance. Alternatively, taxpayers could elect to use the straight-line method over the applicable ACRS recovery period (or over a longer recovery period) with respect to one or more classes of ACRS property placed in service during a taxable year (sec. 168(b)(3)(A)). Under a "half-year" convention, the statutory tables and straight-line alternatives provided a half-year recovery allowance for the first recovery year, whether the property was placed in service early or late in the year. No recovery allowance was allowed in the taxable year in which a taxpayer disposed of an asset.

The cost of eligible personal property was recovered over a three-year, five-year, 10-year, or 15-year recovery period, depending on the recovery class of the property.

The classification of personal property under ACRS generally was based on the Asset Depreciation Range ("ADR") system of the law in effect before 1981. Under the ADR system, a present class life ("midpoint") was provided for all assets used in the same activity, other than certain assets with common characteristics (e.g., automobiles). Property with an ADR midpoint life of four years or less (such as automobiles, light general purpose trucks, certain special tools, and over-the-road tractor units), racehorses more than two years old when placed in service, other horses more than 12 years old when placed in service, and property used in connection with research and experimentation were included in the three-year class. The 10-year class included long-lived public utility property with an ADR midpoint life from 18.5 to 25 years, certain burners and boilers, and railroad tank cars. Longer-lived public utility property having an ADR midpoint life over 25 years was in the 15-year class. Personal property not included in any other class was assigned to the five-year class.

Taxpayers were required to reduce the basis of assets by 50 percent of the amount of regular or energy investment tax credits allowed with respect to personal property (and the reduced basis was used to compute recovery deductions). With respect to the regular investment tax credit, a taxpayer could elect a 2-percentage point reduction in the credit in lieu of the half-basis adjustment.

Real property
The statutory percentages for real property were based on the 175-percent declining balance method (200-percent for low-income housing described in prior law section 1250(a)(1)(B)(i)-(iv)), switching to the straight-line method at a time to maximize the deduction. For the year of acquisition and disposition of real property, the recovery allowances were based on the number of months during those years that the property was in service. Under a "mid-month" convention, real property (other than low-income housing) placed in service or disposed of by a taxpayer at any time during a month was treated as having been placed in service or disposed of in the middle of the month.

For real property placed in service after May 8, 1985, the cost was recovered over a 19-year recovery period (15 years for low-income housing), although longer recovery periods could be elected.

Generally, low-income housing included projects eligible for various Federal, State, and local housing programs and projects where 85 percent of the tenants are eligible for, but do not necessarily receive, subsidies under Section 8 of the Housing Act of 1937.

Component cost recovery was not permitted under ACRS. Thus, the same recovery period and method had to be used for a building as a whole, including all structural components. A substantial improvement (generally, one that is made over a two-year period at a cost that is at least 25 percent of a building's unadjusted basis) was treated as a separate building, the cost of which was separately recovered when the improvement was placed in service.

If the 15-percent or 20-percent investment tax credit for rehabilitation expenditures was allowed, the basis of real property was reduced by the amount of credit earned (and the reduced basis was used to compute recovery deductions). The basis of real property was reduced by 50 percent of the 25-percent credit allowed for the rehabilitation of a certified historic structure. In addition, if a credit for rehabilitation expenditures was allowed, the straight-line method of cost recovery had to be used with respect to the rehabilitation expenditures.

Recapture
With certain limited exceptions, gain from the disposition of depreciable property was "recaptured" as ordinary income to the extent of previously allowed ACRS deductions (sec. 1245). For residential real property that was held for more than one year, gain was treated as ordinary income only to the extent the depreciation deductions allowed under the prescribed accelerated method exceeded the deductions that would have been allowed under the straight-line method (prior law sec. 1250(b)(1)). In addition, recapture for qualified low-income housing was phased out after such property had been held for a prescribed number of months, at the rate of one percentage point per month (prior law sec. 1250(a)(1)(B)). For nonresidential real property held for more than one year, there was no recapture if the taxpayer elected to recover the property's cost using the straight-line method over the applicable ACRS recovery periods (prior law sec. 1245(a)(5)(C)). If accelerated depreciation was claimed with respect to nonresidential real property, the full amount of the depreciation deductions previously taken (to the extent of gain) was recaptured.
Application of different depreciation methods for certain purposes
In general, ACRS recovery allowances were reduced for property that is (1) used predominantly outside the United States ("foreign-use property"), (2) leased to a tax-exempt entity, including a foreign person--unless more than 50 percent of the gross income derived from the property was subject to U.S. tax--("tax-exempt use property"), or (3) financed with industrial development bonds the interest on which is exempt from taxation.

Different depreciation methods were also used for purposes of computing earnings and profits of a domestic corporation and applying the minimum tax provisions.

Foreign-use property

The rationale for reducing ACRS deductions for foreign-use property is that the investment incentive is intended to encourage capital investment in the United States and should not be available to property used predominantly outside the United States.

The recovery period for foreign-use personal property was equal to the asset's ADR midpoint life (12 years for property without a midpoint life), and the 200-percent declining balance method could be used. The recovery period for foreign-use real property was 35 years, and the 150-percent declining balance method could be used. A taxpayer could elect to use the straight-line method over the applicable recovery period or certain longer periods.

Communications satellites, as defined in section 48(a)(2)(B), were excluded from the definition of foreign-use property. Other spacecraft (and interests therein) were not specifically excluded from the definition of foreign-use property.

Tax-exempt use property

The policy underlying the restriction on tax-exempt use property is to provide tax-reducing incentives only to those who are subject to income tax, and to deny them to tax-exempt entities, including foreign entities.

Depreciation deductions for tax-exempt use property were computed using the straight-line method and disregarding salvage value. The cost of tax-exempt use personal property was generally recovered over the longer of the asset's ADR midpoint life (12 years if the property had no ADR midpoint life) or 125 percent of the lease term. The recovery period for qualified technological property subject to these rules was five years. The recovery period for tax-exempt use real property was the longer of 40 years or 125 percent of the lease term. A taxpayer could elect to recover the cost of tax-exempt use property over an optional extended recovery period. The rules for tax-exempt use property overrode the rules relating to foreign-use property.

Property financed with industrial development bonds

Except in the case of property placed in service in connection with projects for residential rental property, the cost of property that was financed with tax-exempt industrial development bonds was recovered using the straight-line method over either the applicable ACRS recovery period or an optional extended recovery period.

Computation of earnings and profits

If an accelerated depreciation method were used for purposes of computing earnings and profits, the acceleration of depreciation deductions would reduce a corporation's earnings and profits, and thereby facilitate the distribution of tax-free dividends. For this reason, domestic corporations were required to compute earnings and profits using the straight-line method over recovery periods that were longer than the standard ACRS recovery periods.

The extended recovery periods used to compute earnings and profits were: (1) five years for three-year property, (2) 12 years for five-year property, (3) 25 years for 10-year property, (4) 35 years for 15-year public utility property, and (5) 40 years for 19-year real property and low-income housing.

Minimum taxes

The minimum tax provisions are designed to prevent taxpayers with substantial economic income from avoiding tax liability by using certain exclusions, deductions, and credits (referred to as "items of tax preference"). In applicable cases, the excess of ACRS deductions over depreciation deductions that would have been allowed had the taxpayer used the straight-line method over a prescribed recovery period were treated as items of tax preference. For purposes of this rule, the prescribed recovery periods were: (1) five years for three-year property, (2) eight years for five-year property, (3) 15 years for 10-year property, (4) 22 years for 15-year public utility property, (5) 15 years for low-income housing, and (6) 19 years for real property other than low-income housing. These rules applied to personal property subject to a lease and 19-year real property and low-income housing (prior law sec. 57(a)(12)). Further, personal property subject to a lease was not taken into account for corporations other than personal holding companies (as defined in sec. 542).

Luxury automobiles and mixed-use property

ACRS deductions were subject to fixed limitations for automobiles and reduced for certain property (including automobiles) used for both personal and business purposes (prior law sec. 280F). For luxury automobiles, depreciation deductions were limited to $3,200 for the first year in the recovery period, and $4,800 for each succeeding year. For mixed-use property used 50 percent or more for personal purposes, capital costs--to the extent of business use--were recovered using the straight-line method of depreciation over the same recovery periods that were used for purposes of computing the earnings and profits of a domestic corporation. ACRS was available for mixed-use property used more than 50 percent for business purposes, but only with respect to the portion of the property's basis attributable to business use.

Mass asset vintage accounts
In general, taxpayers computed depreciation deductions, as well as gain or loss on disposition, on an asset-by-asset basis. A taxpayer could elect to establish mass asset vintage accounts for assets in the same recovery class and placed in service in the same taxable year. Under proposed Treasury regulations, the definition of mass assets eligible for this treatment was limited to assets (1) each of which is minor in value relative to the total value of such assets, (2) that are numerous in quantity, (3) that are usually accounted for only on a total dollar or quantity basis, and (4) with respect to which separate identification is impractical (Prop. Treas. reg. sec. 1.168-2(h)(2)).
Lessee-leasehold improvements
In general, if a lessee made improvements to property, the lessee was entitled to recover the cost of the improvement over the shorter of the ACRS recovery period applicable to the property or the portion of the term of the lease remaining on the date the property was acquired. If the remaining lease term was shorter than the recovery period, the cost was amortized over the remaining term of the lease. For purposes of these rules, under prior law section 178, if the remaining term of a lease was less than 60 percent of the improvement's ACRS recovery period, the term of a lease was treated as including any period for which the lease could be renewed pursuant to an option exercisable by the lessee, unless the lessee established that it was more probable that the lease would not be renewed. In any case, a renewal period had to be taken into account if there was a reasonable certainty the lease would be renewed. Section 178 also provided rules relating to the amortization of lease acquisition costs.
Public utility property
In general

In general, a regulatory commission allows a public utility to charge customers rates that are sufficient to recover the utility's cost of service. A public utility's cost of service includes its annual operating expense and the capital expense allocable to a year. The capital expense that can be passed through to customers consists of an annual depreciation charge for equipment and also a rate of return on the capital invested in the equipment and other property (which capital is referred to as the "rate base").

ACRS distinguished between long-lived public utility equipment and other equipment. Further, as described below, public utilities were required to use a "normalization" method of accounting for ACRS deductions.

Definition of public utility property.--In general, public utility property was defined as property used predominantly in the trade or business of furnishing or selling:

 

(1) electrical energy, water, or sewage disposal services,

(2) gas or steam through a local distribution system,

(3) telephone services,

(4) other communication services if furnished or sold by the Communications Satellite Corporation for purposes authorized by the Communications Satellite Act of 1962 (47 U.C.C. sec. 701), or

(5) transportation of gas or steam by pipeline.

 

if the rates are established or approved by certain regulatory bodies.

Normalization accounting

A public utility could use ACRS only if a "normalization" method of accounting was used for purposes of establishing the utility's cost of service and reflecting operating results in its regulated books of account. Normalization required that (1) a utility's tax expense for rate-making purposes be computed as if the depreciation deduction were computed in the same manner as the rate-making allowance for depreciation (which is generally based on the straight-line method over relatively long useful lives), (2) the deferred taxes (i.e., the difference between the actual tax expense computed using ACRS and that computed for rate-making purposes) be reflected in a reserve (and thus be available for capital investment), and (3) the regulatory commission not exclude from the rate base an amount that is greater than the amount of the reserve for the period used in determining the tax expense as part of the utility's cost of service (see Treas. reg. sec. 1.167(1)-1, which interprets a similar provision of pre-ACRS law).

Normalization prevented the immediate lowering of rates charged to customers as a result of the cost savings from ACRS. Rather, current tax reductions were flowed through to customers over the period of tax deferral.

Expensing of up to $5,000 of personal property
A taxpayer (other than a trust or estate) could elect to deduct the cost of up to $5,000 of qualifying personal property in the year the property was placed in service, in lieu of recovering the cost under ACRS (prior law sec. 179). In general, qualifying property had to be acquired by purchase for use in a trade or business, and eligible for the investment tax credit (although no investment credit was allowed for the portion of the cost expensed under this rule). The $5,000 limit was scheduled to increase to $7,500 for taxable years beginning in 1988 and 1989, and to $10,000 for years beginning after 1989.

If expensed property was converted to nonbusiness use within two years of the time the property was placed in service, the difference between the amount expensed and the ACRS deductions that would have been allowed for the period of business use was recaptured as ordinary income.

Anti-churning rules
Under rules enacted as part of ACRS, taxpayers were prevented from bringing property placed in service before January 1, 1981 under ACRS by certain post effective date transactions (referred to as "churning transactions"). In general, churning transactions include those in which either the owner or user of property before January 1, 1981 (or a related party) is the owner or user immediately after the transaction. Taxpayers subject to the anti-churning rules compute depreciation under the law in effect before 1981.

Regular investment tax credit

General rule
A credit against income tax liability was allowed for up to 10 percent of a taxpayer's investment in certain tangible depreciable property (generally, not including buildings or their structural components) (secs. 38 and 46). The amount of the regular investment credit was based on the ACRS recovery class to which the property was assigned. The 10-percent credit was allowed for eligible property in the five-year, 10-year, or 15-year public utility property class. Three-year ACRS property was eligible for a six-percent regular credit (even if the taxpayer elected to use a longer recovery period). The maximum amount of a taxpayer's investment in used property that was eligible for the regular investment credit was $125,000 per year; the limitation on used property was scheduled to increase to $150,000 for taxable years beginning after 1987.

Generally, the investment credit was claimed for the taxable year in which qualifying property was placed in service. In cases where property was constructed over a period of two or more years, an election was provided under which the credit could be claimed on the basis of qualified progress expenditures ("QPEs") made during the period of construction before the property was completed and placed in service. Investment credits claimed on QPEs were subject to recapture if the property failed to qualify for the investment credit when placed in service.

The amount of income tax liability that could be reduced by investment tax credits in any year was limited to $25,000 plus 85 percent of the liability in excess of $25,000 (sec. 38(c)). Unused credits for a taxable year could be carried back to each of the three preceding taxable years and then carried forward to each of the 15 following taxable years (sec. 39).

Public utility property
Public utility property was eligible for the regular investment credit only if the tax benefits of the credit were normalized in setting rates charged by the utility to customers and in reflecting operating results in regulated books of account (sec. 46(f)). The investment credit was denied for public utility property if the regulatory commission's treatment of the credit resulted in benefits being flowed through to customers more rapidly than under either (1) the ratable flow-through method or (2) the rate base reduction method.

Under the ratable flow-through method (sec. 46(f)(2)), utilities passed through to customers a pro rata portion of the credit during each year of the useful life of the asset. The regulatory commission could not require that the utility reduce its rate base by the amount of the credit. Therefore, even though the credit itself was flowed through to customers over the life of the asset, the utility's shareholders were allowed to earn a return on that amount of the cost of the equipment which had, in effect, been supplied by the Federal government through the regular investment credit.

Under the rate base reduction method (sec. 46(f)(1)), the utility's rate base was reduced by the amount of the credit, so the shareholders were prevented from earning a return on that part of the cost of the equipment which was paid for by the credit. Under this method, the regulatory commission could not require that the utility flow through to customers any part of the credit itself, or allow the utility to charge customers for the depreciation expense on the entire cost of the equipment, including the part paid for by the investment credit.

Finance leases

Overview
The law contains rules to determine who owns an item of property for tax purposes when the property is subject to an agreement that the parties characterize as a lease. Such rules are important because the owner of the property is entitled to claim tax benefits including cost recovery deductions and investment tax credits with respect to the property. These rules attempt to distinguish between true leases, in which the lessor owns the property for tax purposes, and conditional sales or financing arrangements, in which the user of the property owns the property for tax purposes. These rules generally are not written in the Internal Revenue Code. Instead they evolved over the years through a series of court cases and revenue rulings and revenue procedures issued by the Internal Revenue Service. Essentially, the law is that the economic substance of a transaction, not its form, determines who is the owner of property for tax purposes. Thus, if a transaction is, in substance, simply a financing arrangement, it is treated that way for tax purposes, regardless of how the parties choose to characterize it. Under these rules, lease transactions cannot be used solely for the purpose of transferring tax benefits; they have to have nontax economic substance.
Finance lease provisions
The Tax Equity and Fiscal Responsibility Act of 1982 provided rules (finance lease rules) that liberalized the leasing rules with respect to certain property. Under the finance leasing rules, the fact that (1) the lessee had an option to purchase the property at a fixed price of 10 percent or more of its original cost to the lessor, or (2) the property could be used only by the lessee (referred to as "limited use property"), could not be taken into account in determining whether the agreement was a lease.

A qualified agreement under the finance lease rules had to be a lease determined without taking into account the fact that it contained a 10-percent fixed price purchase option or that the property was limited use property. Thus, the transaction had to have economic substance independent of tax benefits. The lessor had to reasonably expect to derive a profit independent of tax benefits. In addition, the transaction, without taking into account the fact the agreement contains a fixed price purchase option or that the property is limited use property, could not otherwise be considered a financing arrangement or conditional sale.

The finance lease rules were to have been generally effective for agreements entered into after December 31, 1983, with three temporary restrictions intended to limit the tax benefits of finance leasing in 1984 and 1985. First, no more than 40 percent of property placed in service by a lessee during any calendar year beginning before 1986 was to qualify for finance lease treatment. Second, a lessor could not have used finance lease rules to reduce its tax liability for any taxable year by more than 50 percent. This 50-percent lessor cap was to apply to property placed in service on or before September 30, 1985. Third, the investment tax credit for property subject to a finance lease and placed in service on or before September 30, 1985, was only allowable ratably over 5 years, rather than entirely in the year the property was placed in service.

Notwithstanding these general rules, finance leasing was to be available for up to $150,000 per calendar year of a lessee's farm property for agreements entered into after July 1, 1982, and before 1984. Furthermore, the 40-percent lessee cap, 50-percent lessor cap, and 5-year spread of the investment credit did not apply to this amount of farm property.

The Tax Reform Act of 1984, however, postponed the effective date of the finance lease rules to generally apply to agreements entered into after December 31, 1987, and extended the three restrictions. Thus, the 40-percent lessee cap was extended to property placed in service by a lessee during any calendar year beginning before 1990; the 50-percent lessor cap was extended through September 30, 1989; and the 5-year spread of the investment credit for property subject to a finance lease was extended to property placed in service on or before September 30, 1989.

The Tax Reform Act of 1984 provided transitional rules which exempted property from the 4-year postponement if, before March 7, 1984, (1) a binding contract to acquire or construct the property was entered into by or for the lessee, (2) the property was acquired by the lessee, or (3) construction of the property was begun by or for the lessee. In addition, the Act exempted from the 4-year postponement property that is placed in service before 1988 and is (1) a qualified lessee's automotive manufacturing property (limited to an aggregate of $150 million of cost basis per lessee) or (2) property that was part of a coal-fired cogeneration facility for which certification and construction permit applications were filed on specified dates. The special rules relating to the availability of finance leasing for up to $150,000 per calendar year of a lessee's farm property were extended to cover agreements entered into before 1988.

 

Reasons for Change

 

 

ACRS provides a small number of depreciation classes and relatively short recovery periods. The Congress chose to maintain this structure, while adopting improvements. For example, the Congress believed ACRS could be made more neutral by increasing the recovery period for certain long-lived equipment, and by extending the recovery period of real property. Another modification approved by the Congress provides equal recovery periods for the long-lived assets of regulated and nonregulated utilities. Under prior law, nonregulated utilities received more favorable depreciation treatment, which may have resulted in an unfair competitive advantage where they provided essentially the same services as regulated utilities.

The Congress concluded that some further acceleration in the rate of recovery of depreciation deductions should be provided to compensate partly for the repeal of the investment tax credit. The Act increases the rate of acceleration from 150-percent declining balance to 200-percent declining balance for property in the 3-year, 5-year, 7-year, and 10-year classes. Together with the large tax rate reductions, investment incentives will remain high and the nation's savings can be utilized more efficiently. An efficient capital cost recovery system is essential to maintaining U.S. economic growth. As the world economies become increasingly competitive, it is most important that investment in our capital stock be determined by market forces rather than by tax considerations.

Under prior law, the tax benefits of the combination of the investment tax credit and accelerated depreciation were more generous for some equipment than if the full cost of the investment were deducted immediately--a result more generous than exempting all earnings on the investment from taxation. At the same time, assets not qualifying for the investment credit and accelerated depreciation bore much higher effective tax rates. The output attainable from our capital resources was reduced because too much investment occurred in tax-favored sectors and too little investment occurred in sectors that were more productive but which were tax-disadvantaged. The nation's output can be increased simply by a reallocation of investment, without requiring additional saving.

The Congress concluded that the surest way of encouraging the efficient allocation of all resources and the greatest possible economic growth was by reducing statutory tax rates. A large reduction in the top corporate tax rate was achieved by repealing the investment tax credit without reducing the corporate tax revenues collected. One distorting tax provision was replaced by lower tax rates that provide benefits to all investment. A neutral tax system allows the economy to most quickly adapt to changing economic needs.

 

Explanation of Provisions

 

 

1. Depreciation
Overview
The Act modifies ACRS for property placed in service after December 31, 1986, except for property covered by transition rules. The cost of property placed in service after July 31, 1986, and before January 1, 1987, which is not transition-rule property, may, at the election of the taxpayer on an asset-by-asset basis, be covered under the modified rules.

The Act provides more accelerated depreciation for the revised three-year, five-year and 10-year classes, reclassifies certain assets according to their present class life (or "ADR midpoints"), and creates a seven-year class, a 20-year class, a 27.5-year class, and a 31.5-year class. The Act prescribes depreciation methods for each ACRS class (in lieu of providing statutory tables). Eligible personal property and certain real property are assigned among the three-year class, five-year class, seven-year class, 10-year class, 15-year class, or 20-year class.

The depreciation method applicable to property included in the three-year, five-year, seven-year, and 10-year classes is the double declining balance method, switching to the straight-line method at a time to maximize the depreciation allowance. For property in the 15-year and 20-year class, the applicable depreciation method is the 150-percent declining balance method, switching to the straight-line method at a time to maximize the depreciation allowance. The cost of section 1250 real property generally is recovered over 27.5 years for residential rental property and 31.5 years for nonresidential property, using the straight-line method.

Under the Act, if a lessee makes improvements to leased property, the cost of the leasehold improvement is recovered under the same rules that apply to an owner of property.

General rules
The Act reclassifies certain assets based on midpoint lives under the ADR system, as in effect on January 1, 1986 (Rev. Proc. 83-35, 1983-1 C.B. 745). Certain ADR classifications are made on the basis of regulated accounts (e.g., ADR class 49.14, regarding electric utility transmission and distribution plants). Under the Act, if an asset is described in a particular ADR class, it is assigned to an ACRS class without regard to whether the taxpayer who owns the asset is subject to regulation (e.g., for property described in ADR class 49.14, without regard to whether the taxpayer is a public utility or an unregulated company). As under prior law, the salvage value of property is treated as zero; thus, the entire cost or other basis of eligible property is recovered under the Act.

Eligible property

Property eligible for modified ACRS generally includes tangible depreciable property (both real and personal), whether new or used, placed in service after December 31, 1986. Eligible property does not include (1) property that the taxpayer properly elects to depreciate under the unit-of-production method or any other method not expressed in terms of years (other than the "retirement replacement betterment" method or similar method), (2) any property used by a public utility (within the meaning of section 167(1)(3)(A)) if the taxpayer does not use a normalization method of accounting, (3) any motion picture film or video tape, (4) any sound recording described in section 280(c)(2), or (5) any property subject to ACRS as in effect before enactment of the Act or pre-ACRS depreciation rules (by application of an effective date or transitional rule or the anti-churning rule). As under present law, intangible property may be amortizable under section 167.

The legislative history clarifies that under present law cargo containers have an ADR midpoint of six years and this present class life shall be used in applying the provisions of the Act.2

As under prior law, property that the taxpayer properly elects to depreciate under the unit-of-production method or any other method not expressed in terms of years (other than the retirement-replacement-betterment method or similar method), will be so depreciated. For example, depreciation is allowable with respect to landfills on a unit basis (without regard to whether the space for dumping waste was excavated by the taxpayer), to the extent capital costs are properly allocable to the space to be filled with waste rather than to the underlying land.

Normalization requirements for public utility property

The Act continues the rule that public utility property is eligible for ACRS only if the tax benefits of ACRS are 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 ACRS deductions, the Act 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 1987).

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 Act had been in effect for all prior periods. The average rate assumption method is the method which 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.

The Congress did not intend that the provisions apply retroactively to any excess deferred tax reserve generated from previous reductions in corporate tax rates; such excess deferred tax reserves will continue to be treated under prior law.

Classification of assets and recovery periods

For purposes of assigning assets to ACRS classes (and applying the alternative depreciation system, described below), the Act prescribes ADR midpoint lives for the following assets: (1) Semiconductor manufacturing equipment (described in ADR class 36.0), 5 years; (2) computer-based telephone central office switching equipment and related equipment (described in ADR class 48.12) the functions of which are those of a computer or peripheral equipment (as defined in section 168(i)(2)(B)) in their capacity as telephone central office equipment, 9.5 years; (3) Railroad track, 10 years; (4) Single-purpose agricultural and horticultural structures within the meaning of sec. 48(p) (described in ADR class 01.3), 15 years; (5) Telephone distribution plant (e.g., telephone fiber optic cable) (described in ADR class 48.14) and comparable equipment, 24 years (comparable equipment means equipment used by non-telephone companies for two-way exchange of voice and data communications (equivalent of telephone communications)--comparable equipment does not include cable television equipment used primarily for one-way communication); (6) Municipal waste-water treatment plant, 24 years; and (7) Municipal sewers, 50 years.

Personal property
Three-year class.--The Act retains the three-year class for property with an ADR midpoint of four years or less, but excludes automobiles, light general purpose trucks, and property used in connection with research and experimentation. Property used in connection with research and experimentation is included in the five-year class described below.

Five-year class.--The Act modifies the five-year class to include property with ADR midpoint lives of more than four but less than ten years, and adding automobiles, light trucks, qualified technological equipment, computer-based telephone central office switching equipment, research and experimentation property, and geothermal, ocean thermal, solar, and wind energy properties, and biomass properties described in section 48(1) that are used in connection with qualifying small power production facilities.

Telephone central office switching equipment and related equipment (described in ADR class 48.12) is computer-based only if its functions are those of a computer or peripheral equipment (as defined in section 168(i)(2)(B)) in its capacity as telephone central office switching equipment. The identical qualities of this computer-based equipment and computers are the basis for placing the computer-based equipment in the five-year class along with computers (rather than excluding such property because of its 18-year ADR midpoint life). Telephone central office switching equipment does not include private branch exchange (PBX) equipment.

Seven-year class.--The Act creates a new class for assets with ADR midpoints of at least 10 years but less than 16 years, and adding single-purpose agricultural or horticultural structures and property with no ADR midpoint that is not classified elsewhere.

Ten-year class.--The Act modifies the ten-year class to include only property with ADR midpoints of at least 16 years but less than 20 years.

15-year class.--Under the Act, the 15-year class includes property with ADR midpoints of at least 20 years and less than 25 years, and adding municipal wastewater treatment plants, and telephone distribution plant and comparable equipment used for the two-way exchange of voice and data communications.

20-year class.--The Act creates a 20-year class for property with ADR midpoints of 25 years and more, other than section 1250 real property with an ADR midpoint of 27.5 years and more, and adding municipal sewers.

Depreciation methods.--The cost of property in the three-year, five-year, seven-year, or ten-year class is recovered using the 200-percent declining balance method, switching to the straight-line method at a time to maximize the deduction.

The cost of property included in the 15-year or 20-year class is recovered using the 150-percent declining balance method, switching to the straight-line method at a time to maximize the deduction.

Real property
The Act provides different recovery periods for residential rental property and nonresidential real property.

Residential rental property.--Residential rental property is defined as a building or structure (including manufactured homes that are residential rental property, elevators, and escalators) with respect to which 80 percent or more of the gross rental income is rental income from dwelling units. The term "dwelling unit" is defined as a house or apartment used to provide living accommodations, but does not include a unit in a hotel, motel, inn, or other establishment more than one-half of the units in which are used on a transient basis. If any portion of a building or structure is occupied by the taxpayer, the gross rental income from such property shall include the rental value of the portion so occupied.

The cost of residential rental property is recovered using the straight-line method of depreciation, and a recovery period of 27.5 years.

Nonresidential real property.--Nonresidential real property is defined as section 1250 class property that either has no ADR midpoint or has an ADR midpoint of 27.5 years or more, and that is not residential rental property (including elevators and escalators).

The cost of nonresidential real property is recovered using the straight-line method of depreciation and a recovery period of 31.5 years.

Optional depreciation method
The Act repeals the provision that permitted taxpayers to elect use of the straight-line method over an optional recovery period. The election to use the straight-line method over the applicable ACRS recovery period is retained. Further, a taxpayer is permitted to elect use of an alternative depreciation system based on ADR midpoints (described below) for property that is otherwise eligible for ACRS.3
Changes in classification
The Secretary, through an office established in the Treasury Department is authorized to monitor and analyze actual experience with all tangible depreciable assets, to prescribe a new class life for any property or class of property (other than real property) when appropriate, and to prescribe a class life for any property that does not have a class life. If the Secretary prescribes a new class life for property, such life will be used in determining the classification of the property. The prescription of a new class life for property will not change the ACRS class structure, but will affect the ACRS class in which the property falls. Any classification or reclassification would be prospective.

Any class life prescribed under the Secretary's authority must reflect the anticipated useful life, and the anticipated decline in value over time, of an asset to the industry or other group. Useful life means the economic life span of property over all users combined and not, as under prior law, the typical period over which a taxpayer holds the property. Evidence indicative of the useful life of property, which the Secretary is expected to take into account in prescribing a class life, includes the depreciation practices followed by taxpayers for book purposes with respect to the property, and useful lives experienced by taxpayers, according to their reports. It further includes independent evidence of minimal useful life-the terms for which new property is leased, used under a service contract, or financed--and independent evidence of the decline in value of an asset over time, such as is afforded by resale price data. If resale price data is used to prescribe class lives, such resale price data should be adjusted downward to remove the effects of historical inflation. This adjustment provides a larger measure of depreciation than in the absence of such an adjustment. Class lives using this data would be determined such that the present value of straight-line depreciation deductions over the class life, discounted at an appropriate real rate of interest, is equal to the present value of what the estimated decline in value of the asset would be in the absence of inflation.

Initial studies are expected to concentrate on property that now has no ADR midpoint. Additionally, clothing held for rental and scientific instruments (especially those used in connection with a computer) should be studied to determine whether a change in class life is appropriate.

Certain other assets specifically assigned a recovery period (including horses in the three-year class, qualified technological equipment, computer-based central office switching equipment, research and experimentation property, certain renewable energy and biomass properties, semiconductor manufacturing equipment, railroad track, single-purpose agricultural or horticultural structures, telephone distribution plant and comparable equipment, municipal wastewater treatment plants, and municipal sewers) may not be assigned a longer class life by the Treasury Department if placed in service before January 1, 1992. Additionally, automobiles and light trucks may not be reclassified by the Treasury Department during this five-year period. Such property placed in service after December 31, 1991, and before July 1, 1992, may be prescribed a different class life if the Secretary has notified the Committee on Ways and Means of the House of Representatives and the Committee on Finance of the Senate of the proposed change at least 6 months before the date on which such change is to take effect.

Averaging conventions
The following averaging conventions apply to depreciation computations made under both ACRS (as modified by the Act) and the new alternative depreciation system (described below). The recovery period begins on the date property is placed in service under the applicable convention.

Half-year convention

In general, a half-year convention applies under which all property placed in service or disposed of during a taxable year is treated as placed in service or disposed of at the midpoint of such year. As a result, a half-year of depreciation is allowed for the first year property is placed in service, regardless of when the property is placed in service during the year, and a half-year of depreciation is allowed for the year in which property is disposed of or is otherwise retired from service. No depreciation is allowed in the case of property acquired and disposed of in the same year. In the case of a taxable year less than 12 months, property is treated as being in service for half the number of months in such taxable year.

To illustrate the application of the half-year convention, assume that a taxpayer places in service a $100 asset that is assigned to the five-year class. ACRS deductions, beginning with the first taxable year and ending with the sixth year, are $20, $32, $19.20, $11.52, $11.52, and $5.76. If the asset were disposed of in year two, the ACRS deduction for that year would be $16.

Mid-month convention

In the case of both residential rental property and nonresidential real property, a mid-month convention applies. Under the mid-month convention, the depreciation allowance for the first year property is placed in service is based on the number of months the property was in service, and property placed in service at any time during a month is treated as having been placed in service in the middle of the month. Further, property disposed of by a taxpayer at any time during a month is treated as having been disposed of in the middle of the month.

Special rule where substantial property placed in service during last three months of year

A mid-quarter convention is applied to all property if more than 40 percent of all depreciable property placed in service by a taxpayer during a taxable year is placed in service during the last three months of the taxable year. The mid-quarter convention treats all property placed in service during any quarter of a taxable year as placed in service on the midpoint of such quarter.

Where property is placed in service by a partnership, the 40-percent test generally will be applied at the partnership level, except in the case of partnerships that are formed or availed of to avoid the mid-quarter convention.

Where the taxpayer is a member of an affiliated group (within the meaning of sec. 1504),4 all such members are treated as one taxpayer for purposes of the 40-percent determination. The required determination is made by reference to the parent corporation's taxable year. Further, it was intended that transfers of property between members of the same affiliated group filing a consolidated return be disregarded for purposes of the 40-percent determination.

For example, using the mid-quarter convention, a $100 asset in the five-year class eligible for the 200-percent declining balance method that is placed in service during the first quarter of a taxable year would receive deductions beginning in taxable year 1 and ending in taxable year 6 of $35, $26, $15.60, $11.01, $11.01, and $1.38.

For taxable years straddling January 1, 1987, in which property is placed in service subject both to prior-law ACRS and to the Act, the 40-percent determination is made with respect to all such property. The mid-quarter convention, however, applies only to property subject to the Act.

Alternative depreciation system
In general

In general, an alternative depreciation system is provided for property that (1) is used predominantly outside the United States ("foreign-use" property), (2) is leased to or otherwise used by a tax-exempt entity, including a foreign person unless more than 50 percent of the gross income derived from the property by such person is subject to U.S. tax ("tax-exempt use" property), (3) is financed directly or indirectly by an obligation the interest on which is exempt from taxation under section 103(a), to the extent of such financing ("tax-exempt bond financed" property), (4) is imported from a foreign country with respect to which an Executive Order is in effect because the country maintains trade restrictions or engages in other discriminatory acts, or (5) with respect to which an election to decelerate depreciation deductions is made. In these cases, depreciation allowances are computed under the alternative depreciation system, which provides for straight-line recovery (without regard to salvage value) and use of the applicable averaging conventions described above.

The recovery period under the alternative system generally is equal to the property's ADR midpoint life (12 years for personal property with no ADR midpoint life, and 40 years for real property--including real property that is section 1245 property with no ADR midpoint). In the case of property for which an ADR midpoint is prescribed by the Act, the prescribed midpoint is used as the recovery period under the alternative depreciation system. In addition, qualified technological equipment (as defined under the rules for tax-exempt use property), automobiles, and light purpose trucks are treated as having a recovery period of five years.

The alternative depreciation system is used for purposes of computing the earnings and profits of a corporation, as well as for purposes of computing the portion of depreciation allowances treated as an item of tax preference under the alternative minimum tax applicable to corporations and individuals. The Act also modifies the treatment of depreciation deductions for luxury automobiles and mixed-use property.

Foreign-use property

As under prior law, foreign-use property generally is defined as property that is used outside the United States more than half of a taxable year. In addition to retaining the exceptions to this general rule that were applicable under prior law, the Act provides a new exception for any satellite or other space craft (or any interest therein) held by a U.S. person if such property is launched from within the United States.

Tax-exempt use property

The Act retains the rules for tax-exempt use property, including the rules that (1) increase the recovery period used for purposes of computing depreciation to a period not less than 125 percent of the lease term, if this period would be longer than the depreciation period otherwise applicable to the property, and (2) treat qualified technological equipment with a lease term that exceeds five years as having a recovery period of five years.

For purposes of determining whether property is tax-exempt use property, in the case of a corporation the stock of which is publicly traded on an established securities market, the test of whether 50 percent or more (in value) of the stock of such corporation is held by tax-exempt entities is made by reference to tax-exempt entities that hold 5 percent or more (in value) of the stock in such corporation.

Tax-exempt bond financed property

The Act modifies the definition of tax-exempt bond financed property to include any property to the extent financed "directly or indirectly" by an obligation the interest on which is exempt from tax under section 103(a). Only the portion of the cost of property that is attributable to tax-exempt financing is recovered using this method. If only a part of a facility is financed with tax-exempt bonds, the tax-exempt bond financed portion will be allocated to the portion of the property that is first placed in service. An exception is provided to recover the cost of low-income housing financed with tax-exempt bonds over 27.5 years.

Minimum tax

For purposes of the depreciation preference under the minimum tax, the cost of property other than section 1250 real property (unless it is real property with an ADR midpoint of less than 27.5 years) is recovered using the 150-percent declining balance method, switching to the straight-line method. The cost of section 1250 real property and other property for which the straight-line method is either required or elected to be used for regular tax purposes is recovered using the straight-line method for minimum tax purposes.

Luxury automobiles and mixed-used property

The Act conforms the fixed limitations applicable to automobiles so that the price range of affected cars is unchanged. The new limitations are: $2,560 for the first recovery year, $4,100 for the second recovery year; $2,450 for the third recovery year; and $1,475 for each succeeding taxable year in the recovery period. In addition, the Act clarifies that the fixed limitations apply to all deductions claimed for depreciation of automobiles, not just ACRS deductions.

For mixed-use property that is used 50 percent or more for personal purposes, depreciation deductions are computed under the alternative depreciation system.

Certain imported property

The Act authorizes the President to provide by Executive Order for the application of the alternative depreciation system to certain property that is imported from a country maintaining trade restrictions or engaging in discriminatory acts. For purposes of this provision, the term imported property means any property that is completed outside the United States, or less than 50 percent of the basis of which is attributable to value added within the United States. In applying this test, the term "United States" is treated as including the commonwealth of Puerto Rico and the possessions of the United States.

The Act authorizes reduced depreciation for property that is imported from a foreign country that (1) maintains non-tariff trade restrictions that substantially burden U.S. commerce in a manner inconsistent with provisions of trade agreements, including variable import fees, or (2) engages in discriminatory or other acts or policies unjustifiably restricting U.S. commerce (including tolerance of international cartels). If the President determines that a country is engaging in the proscribed actions noted above, he or she may provide for the application of alternative depreciation to any article or class of articles manufactured or produced in such foreign country for such period as may be provided by Executive Order.

In general, the terms of the provision relating to certain imported property are substantially identical to those of section 48(a)(7) relating to the investment tax credit.

Election to use alternative depreciation system

A taxpayer may irrevocably elect to apply the alternative system to any class of property for any taxable year. If the election is made, the alternative system applies to all property in the ACRS class placed in service during the taxable year. For residential rental property and nonresidential real property, this election may be made on a property-by-property basis. The election to use the alternative system is in addition to the irrevocable election to recover costs using the straight-line method over the ACRS recovery period (described above).

General asset accounts
The Act continues the Secretary's regulatory authority to permit a taxpayer to maintain one or more mass asset accounts for any property in the same ACRS class and placed in service in the same year. As under prior law, unless otherwise provided in regulations, the full amount of the proceeds realized on disposition of property from a mass asset account are to be treated as ordinary income (without reduction for the basis of the asset). As a corollary, no reduction is to be made in the depreciable basis remaining in the account. The limitations on the ability to establish mass asset accounts under prior law, as proposed in Treasury regulations, resulted, in part, from a concern about the mechanics of recapturing investment tax credits on dispositions of property from an account. To facilitate the application of the recapture rules without requiring that individual assets be identified, the proposed regulations provide mortality dispersion tables that cannot be applied easily to diverse assets. In view of the repeal of the investment tax credit, the primary reason for restricting a taxpayer's ability to establish vintage accounts is set aside. Accordingly, the Act contemplates that the definition of assets eligible for inclusion in mass asset accounts will be expanded to include diverse assets.
Lessee leasehold improvements
The cost of leasehold improvements made by a lessee is to be recovered under the rules applicable to other taxpayers, without regard to the lease term. On termination of the lease, the lessee who does not retain the improvements is to compute gain or loss by reference to the adjusted basis of the improvement at that time.

In light of the treatment of a lessee's capital costs, the only future relevance of section 178 will be in determining the amortization period for lease acquisition costs. Accordingly, Act makes conforming changes to section 178. Under revised section 178, the term of a lease is determined by including all renewal options as well as any other period for which the parties reasonably expect the lease to be renewed.

Treatment of certain transferees
A special rule applies after the transfer of any property in a non-recognition transaction described in section 332, 351, 361, 371(a), 374(a), 721, or 731 (other than the case of a termination of a partnership under 708(b)(1)(B)). In any such case, the transferee is treated as the transferee for purposes of computing the depreciation deduction with respect to so much of the basis in the hands of the transferee as does not exceed the adjusted basis in the hands of the transferor. Thus, the transferee of property in one of the transactions described above "steps into the shoes" of the transferor to the extent the property's basis is not increased as the result of the transaction.5 The Congress intended the special rule to apply to any transaction between members of the same affiliated group during any taxable year for which a consolidated return is made by such group. To the extent the transferee's basis exceeds the property's basis in the hands of the transferor (e.g., because the transferor recognized gain in the transaction), the transferee depreciates the excess under the general ACRS rules.
Additions or improvements to property
The Act preserves the prohibition against use of the component method of depreciation. The recovery period for any addition or improvement to real or personal property begins on the later of (1) the date on which the addition or improvement is placed in service, or (2) the date on which the property with respect to which such addition or improvement is made is placed in service. Any ACRS deduction for an addition or improvement to a property is to be computed in the same manner as the deduction for the underlying property would be if such property were placed in service at the same time as such addition or improvement. Thus, for example, the cost of a post-effective date improvement to a building that constitutes nonresidential real property is recovered over 31.5 years using the straight-line method (i.e., the same recovery period and method that would apply to the building if it were placed in service after the effective date, unless a transitional rule applies to such improvement).
Expensing in lieu of cost recovery
The Act continues the provision under which a taxpayer (other than a trust or estate) can elect to treat the cost of qualifying property as an expense that is not chargeable to capital account, with four modifications. The costs for which the election is made are allowed as a deduction for the taxable year in which the qualifying property is placed in service.

Under the first modification, the dollar limitation on the amount that can be expensed is $10,000 a year ($5,000 in the case of a married individual filing a separate return).

The second modification limits the amount eligible to be expensed for any taxable year in which the aggregate cost of qualifying property placed in service during such taxable year exceeds $200,000. For every dollar of investment in excess of $200,000, the $10,000 ceiling is reduced by $1.

The third modification limits the amount eligible to be expensed to the taxable income derived from an active trade or business. For purposes of this rule, taxable income from the conduct of an active trade or business is computed without regard to the cost of the expensed property.

Costs that are disallowed as a result of the limitation based on taxable income are carried forward to the succeeding taxable year (and added to the amount eligible to be expensed under this provision for that year).

Under the fourth modification, if property is converted to nonbusiness use at any time before the end of the recovery period, the difference between the amount expensed and the ACRS deductions that would have been allowed for the period of business use is recaptured as ordinary income.

Disposition of assets and recapture
As under prior law, if a taxpayer uses ACRS to recover the costs of tangible property (other than residential rental property and nonresidential real property), all gain on the disposition of such property is recaptured as ordinary income to the extent of previously allowed depreciation deductions. For purposes of this rule, any deduction allowed under section 179 (relating to the expensing of up to $10,000 of the cost of qualifying property), 190 (relating to the expensing of the costs of removing certain architectural and transportation barriers), or 193 (relating to tertiary injectant expenses) is treated as a depreciation deduction.

There is no recapture of previously allowed depreciation deductions in the case of residential rental property and nonresidential real property.

2. Regular investment tax credit

The Act repeals the regular investment tax credit.

3. Finance leases

The Act repeals the finance lease rules.

 

Effective Dates

 

 

In general

The provisions that modify ACRS apply to all property placed in service after December 31, 1986. The provision that repeals the regular investment tax credit is effective for property placed in service after December 31, 1985. Repeal of the finance lease rules is effective for property placed in service after December 31, 1986. The Act also provides an election to apply the modified ACRS to certain property that is placed in service after July 31, 1986; such an election would disqualify property under the investment tax credit transitional rules. All elections made under section 168 of the Code, as amended, are irrevocable and must be made on the first tax return for the taxable year in which the property is placed in service.

Transitional rules

The Act provides certain exceptions to the general effective dates, in the case of property constructed, reconstructed, or acquired pursuant to a written contract that was binding as of March 1, 1986, (December 31, 1985, for purposes of the investment tax credit) or in other transitional situations discussed below. Expect in the case of qualified solid waste disposal facilities and certain satellites (described below), the application of the transitional rules is conditioned on property being placed in service by a prescribed date in the future. In addition, special rules are provided for investment credits claimed on transitional property, for tax-exempt bond financed property, and for the finance lease rules.

Taxpayers may have difficulty in identifying under their accounting systems whether a particular item placed in service on or after January 1, 1987, (1986, for the investment tax credit) was acquired pursuant to a contract that was binding before March 2, 1986, (January 1, 1986, for the investment tax credit) or meets the rule for self-constructed property. The problem arises where a taxpayer regularly enters into contracts for (or manufactures itself) large stocks of identical or similar items of property to be placed in service as needed. The taxpayer's accounting system may not identify the date on which the contract for an item's acquisition was entered into (or the date on which manufacture commenced). In such a situation, a taxpayer is to assume that the first items placed in service after December 31, 1986, (1985, for the investment tax credit) were those they had under a binding contract on that date. A similar rule is to apply to self-constructed property.

Except as otherwise provided, for purposes of the depreciation transitional rules, the rules described below do not apply to any property unless the property has an ADR midpoint of seven years or more and is placed in service before the applicable date, determined according to the following: (1) for property with an ADR midpoint less than 20 years (other than computer-based telephone central office switching equipment), January 1, 1989, and (2) for property with an ADR midpoint of 20 years or more, residential rental property, and nonresidential real property, January 1, 1991.

For purposes of the investment tax credit transitional rules, the applicable placed-in-service dates are: (1) for property with an ADR midpoint less than five years, July 1, 1986, (2) for property with an ADR midpoint of at least five but less than seven years and including computer-based telephone central office switching equipment, January 1, 1987, (3) for property with an ADR midpoint of at least seven but less than 20 years (other than computer-based telephone central office switching equipment), January 1, 1989, and (4) for property with an ADR midpoint of 20 years or more, January 1, 1991.

For purposes of a placed-in-service requirement, if any transitional rule substitutes an applicable date for a project, then the substitute date is used. Further, all property included in a taxpayer-specific transitional rule under section 204(a) of the Act is treated as having an ADR midpoint of 20 years; thus, all such property qualifies for the placed-in-service window that closes on December 31, 1990. Similarly, property that is incorporated into an equipped building or plant facility need not independently satisfy the placed in-service requirements. Instead, such property would qualify for transition relief as part of the equipped building or plant facility--as long as the equipped building or plant facility is placed in service by the applicable date prescribed for the building or facility.

For purposes of the general effective dates, if at least 80 percent of a target corporation's stock is acquired on or before December 31, 1986, (December 31, 1985, for purposes of the investment tax credit) and the acquiring corporation makes a section 338 election to treat the stock purchase as an asset purchase after the relevant date, then the deemed new target corporation is treated as having purchased the assets before the general effective date.

As under prior law, property that is leased to a tax-exempt entity and was not "tax-exempt use property" within the meaning of Section 168(j) of the Code (as in effect immediately prior to the enactment of the Act) because of the application of a transitional rule contained in Section 31(g) of the Tax Reform Act of 1984 will not become "tax-exempt use property" within the meaning of Section 168(h) (as amended by the Act) merely by reason of a transfer of the property subject to the lease so long as the lessee does not change, but only to the extent the transfer would have received similar protection under the 1984 Act.

Anti-churning rules

The Act expands the scope of the prior law anti-churning rules to prevent taxpayers from bringing certain property placed in service after December 31, 1980, under the modified ACRS. The expanded anti-churning rules apply to all ACRS property, other than residential rental property and nonresidential real property, where the result would be to qualify such property for more generous depreciation than would be available under prior law. In determining whether property would qualify for more generous depreciation, the Congress intended that taxpayers compare ACRS deductions for the first taxable year (whether a short year or a full year), assuming a half-year convention. The Act retains the anti-churning rules applicable to property that was originally placed in service before January 1, 1981.6

Regarding the applicable depreciation regime if the anti-churning rules apply, for property that was originally placed in service before January 1, 1981, the Congress intended the pre-1981 depreciation rules to apply. For property originally placed in service after December 31, 1980, the Congress intended ACRS--before amendment by the Act--to apply. Further, the anti-churning rules are intended to apply to property placed in service after July 31, 1986, but before January 1, 1987, with respect to which an election is made to apply the modified ACRS.

Binding contracts

The amendments made by the Act do not apply to property that is constructed, reconstructed, or acquired by a taxpayer pursuant to a written contract that was binding as of March 1, 1986 (December 31, 1985, for investment tax credits), and at all times thereafter. If a taxpayer transfers his rights in any such property under construction or such contract to another taxpayer, the Act does not apply to the property in the hands of the transferee, as long as the property was not placed in service by the transferor before the transfer by the transferor. For purposes of this rule, if by reason of sales or exchanges of interests in a partnership, there is a deemed termination and reconstitution of a partnership under section 708(b)(1)(B), the partnership is to be treated as having transferred its rights in the property under construction or the contract to the new partnership.

The general binding contract rule applies only to contracts in which the construction, reconstruction, erection, or acquisition of property is itself the subject matter of the contract.

A contract is binding only if it is enforceable under State law against the taxpayer, and does not limit damages to a specified amount (e.g., by use of a liquidated damages provisions). A contractual provision that limits damages to an amount equal to at least five percent of the total contract price is not treated as limiting damages.

For purposes of the general binding contract rule, a contract under which the taxpayer is granted an option to acquire property is not to be treated as a binding contract to acquire the underlying property. In contrast, a contract under which the taxpayer grants an irrevocable put (i.e., an option to sell) to another taxpayer is treated as a binding contract, as the grantor of such an option does not have the ability to unilaterally rescind the commitment. In general, a contract is binding even if subject to a condition, as long as the condition is not within the control of either party or a predecessor (except in the limited circumstances described below). A contract that was binding as of March 1, 1986 (or December 31, 1985, in the case of the investment tax credit) will not be considered binding at all times thereafter if it is substantially modified after that date.

A binding contract to acquire a component part of a larger property will not be treated as a binding contract to acquire the larger property under the general rule for binding contracts. For example, if a written binding contract to acquire an aircraft engine was entered into before March 2, 1986, there would be a binding contract to acquire only the engine, not the entire aircraft.

Design changes to a binding contract to construct a project that are made for reasons of technical or economic efficiencies of operation and that cause an insignificant increase in the original price will not constitute substantial modifications of the contract so as to affect the status of the project under the binding contract rule. In addition, a supplementary contract that stands on its own and is not protected by the binding contract rule, for example, to build an addition to a project protected by the binding contract rule, will not adversely affect the status of the portion of the project subject to a separate binding contract.

The general binding contract rule does not apply to supply agreements with manufacturers, where such contracts fail to specify the amount or design specifications of property to be purchased; such contracts are not to be treated as binding contracts until purchase orders are actually placed. A purchase order for a specific number of properties, based on the pricing provisions of the supply agreement, will be treated as a binding contract.

Self-constructed property

The Act is inapplicable to property that is constructed or reconstructed by the taxpayer, if (1) the lesser of $1 million or five percent of the cost of the property was incurred or committed, (i.e., required to be incurred pursuant to a written binding contract in effect) as of March 1, 1986 (December 31, 1985, for purposes of the investment tax credit) and (2) the construction or reconstruction began by that date. For purposes of this rule, a taxpayer who serves as the engineer and general contractor of a project is to be treated as constructing the property. For purposes of this rule, the construction of property is considered to begin when physical work of a significant nature starts. Construction of a facility or equipment is not considered as begun if work has started on minor parts or components. Physical work does not include preliminary activities such as planning or designing, securing financing, exploring, researching, or developing.

For purposes of the rule for self-constructed property, in the context of a building, the term "property" includes only the building shell, its structural components, and the normal and customary components that are purchased from others and installed without significant modification (e.g., light fixtures) (see the discussion below, relating to equipped buildings, for the treatment of machinery and equipment to be used in the completed building).

 

Example.--Prior to January 1, 1986, an aircraft manufacturer entered into binding contracts with third parties for the construction of aircraft subassemblies to be included by the manufacturer in the construction of the completed aircraft. The cost to the aircraft manufacturer of these subassemblies is approximately $300,000, which together with the costs of other components of the aircraft which the manufacturer had incurred or was required to incur pursuant to a written binding contract on December 31, 1985, exceeds 5 percent of the cost of the aircraft. These subassemblies were designed for this model of aircraft, were specifically ordered for the aircraft and are essential to its operation, and include wing trailing edges, ailerons and tabs, and rudders and tabs. The subcontractors commenced physical construction of these subcomponents prior to January 1, 1986. Prior to the date the aircraft is placed in service, the manufacturer will transfer it to its wholly-owned subsidiary that is included in the same consolidated tax return as the manufacturer.

 

The aircraft qualifies for the investment tax credit under the transitional rule for self-constructed property. Construction of the aircraft would be considered to have begun by the aircraft manufacturer when the subcontractors commenced physical construction of the subassemblies on behalf of the manufacturer pursuant to the binding written contract.7

Equipped buildings

Where construction of an equipped building began on or before March 1, 1986 (December 31, 1985, for purposes of the investment tax credit), pursuant to a written specific plan, and more than one-half the cost of the equipped building (including any machinery and equipment for it) was incurred or committed before March 2, 1986 (January 1, 1986, for the investment tax credit) the entire equipped building project and incidental appurtenances are excepted from the Act's application.8 This rule is not limited to manufacturing facilities. Where the costs incurred or committed before March 2, 1986 (January 1, 1986, for the investment tax credit) do not equal more than half the cost of the equipped building, each item of machinery and equipment and the building is treated separately for purposes of determining whether the item qualifies for transitional relief.

Under the equipped building rule, the Act will not apply to equipment and machinery to be used in the completed building, and also incidental machinery, equipment, and structures adjacent to the building (referred to here as appurtenances) which are necessary to the planned use of the building, where the following conditions are met:

 

(1) The construction (or reconstruction or erection) or acquisition of the building, machinery, and equipment was pursuant to a specific written plan of a taxpayer in existence on March 1, 1986 (December 31, 1985, for the investment tax credit); and

(2) More than 50 percent of the adjusted basis of the building and the equipment and machinery to be used in it (as contemplated by the written plan) was attributable to property the cost of which was incurred or committed by March 1, 1986 (December 31, 1985, for the investment tax credit), and construction commenced on or before March 1, 1986 (December 31, 1985, for the investment tax credit).

 

The written plan for an equipped building may be modified to a minor extent after March 1, 1986 (December 31, 1985, for the investment tax credit) and the property involved may still come under this rule; however, there cannot be substantial modification in the plan if the equipped building rule is to apply. The plan referred to must be a definite and specific plan of the taxpayer that is available in written form as evidence of the taxpayer's intentions.

The equipped building rule can be illustrated by an example where the taxpayer has a plan providing for the construction of a $100,000 building with $80,000 of machinery and equipment to be placed in the building and used for a specified manufacturing process. In addition, there may be other structures or equipment, here called appurtenances, which are incidental to the operations carried on in the building, that are not themselves located in the building. Assume that the incidental appurtenances have further costs of $30,000. These appurtenances might include, for example, an adjacent railroad siding, a dynamo or water tower used in connection with the manufacturing process, or other incidental structures or machinery and equipment necessary to the planned use of the building. Of course, appurtenances, as used here, do not include a plant needed to supply materials to be processed or used in the building under construction. In this case, if construction of the building is under a binding contract and property but no equipment had been ordered, and the appurtenances had not been constructed or placed under binding order, the equipped building rule would apply. This is true because the building cost represents more than 50 percent of the total $180,000. As a result, the machinery and equipment, even though not under binding contract, is eligible for the rule. In this connection, it should be noted that the additional cost of appurtenances, $30,000, is not taken into account for purposes of determining whether the 50-percent test is met. Nevertheless, the Act would not apply to these appurtenances since the 50-percent test is met as to the equipped building.

Plant facilities

The Act also provides a plant facility rule that is comparable to the equipped building rule (described above), for cases where the facility is not housed in a building. For purposes of this rule, the term "plant facility" means a facility that does not include any building (or of which buildings constitute an insignificant portion), and that is a self-contained single operating unit or processing operation--located on a single site--identifiable as a single unitary project as of March 1, 1986.

If pursuant to a written specific plan of a taxpayer in existence as of March 1, 1986 (December 31, 1985, for the investment tax credit), the taxpayer constructed, reconstructed, or erected a plant facility, the construction, reconstruction, or erection commenced as of March 1, 1986 (December 31, 1985, for the investment tax credit), and the 50-percent test is met, then the conference agreement will not apply to property that makes up the facility. For this purpose, construction, etc., of a plant facility is not considered to have begun until it has commenced at the site of the plant facility. (This latter rule does not apply if the facility is not to be located on land and, therefore, where the initial work on the facility must begin elsewhere.) In this case, as in the case of the commencement of construction of a building, construction begins only when actual work at the site commences; for example, when work begins on the excavation for footings, etc., or pouring the pads for the facility, or the driving of foundation pilings into the ground. Preliminary work, such as clearing a site, test drilling to determine soil condition, or excavation to change the contour of the land (as distinguished from excavation for footings), does not constitute the beginning of construction, reconstruction or erection.

The application of the plant facility rule is clarified where the original construction of a power plant is pursuant to a written specific plan of a taxpayer in existence as of March 1, 1986 (December 31, 1985, in the case of the investment tax credit), and both the original construction and more than one-half of the total cost of the property to be used at the power plant has been incurred or committed by such date. The plant facility rule will apply to the power plant even though the type of fuel to be utilized at the plant may have changed subsequent to the original plan and other changes may be made to accommodate the change in the fuel source, as long as more than one-half of the total cost of the plant, including all conversion costs, were incurred or committed by March 1, 1986. The plant facility rule also will apply to the plant in the hands of a transferee, upon its transfer prior to the time that construction is completed and before it is placed in service.

Special rules for sale-leasebacks within three months

Property is treated as meeting the requirements of a transitional or general effective date rule if (1) the property is placed in service by a taxpayer who acquired the property from a person in whose hands the property would qualify under a transitional or general effective date rule, (2) the property is leased back by the taxpayer to such person, and (3) the leaseback occurs within three months after such property was originally placed in service, but no later than the applicable date. The special rule for sale-leasebacks is intended to apply to any property that qualifies for transitional relief under the Act or that was originally placed in service by the lessee under the sale-leaseback before the general effective date. This rule would apply where a taxpayer acquires property from a manufacturer, places the property in service by leasing it to the ultimate user, and subsequently engages in a sale-leaseback within three months after the property was originally placed in service under the initial lease.

In the case of a facility that would otherwise qualify for transitional relief as an equipped building (described above), if a portion of such equipped building is sold and leased back in accordance with the requirements of the special rule for sale-leasebacks, both the leased and retained portions will continue to qualify for transitional relief as an equipped building.

Special rules for tax-exempt bond financed property

The provision restricting ACRS deductions for property financed with tax-exempt bonds applies to property placed in service after December 31, 1986, to the extent such property is financed (directly or indirectly) by the proceeds of bonds issued after March 1, 1986. The revised restrictions on ACRS deductions do not apply to facilities placed in service after December 31, 1986, if--

 

(1) the original use of the facilities commences with the taxpayer and the construction (including reconstruction or rehabilitation) commenced before March 2, 1986, and was completed after that date;

(2) a binding contract to incur significant expenditures for the construction (including reconstruction or rehabilitation) of the property financed with the bonds was entered into before March 2, 1986, was binding at all times thereafter, and some or all of the expenditures were incurred after March 1, 1986; or

(3) the facility was acquired after March 1, 1986, pursuant to a binding contract entered into before March 2, 1986, and that is binding at all times after March 1, 1986.

 

For purposes of this restriction, the determination of whether a binding contract to incur significant expenditures existed before March 2, 1986, is made in the same manner as under the rules governing the redefinition of industrial development bonds.

The restrictions on ACRS deductions for bond-financed property do not apply to property placed in service after December 31, 1986, to the extent that the property is financed with tax-exempt bonds issued before March 2, 1986. ACRS deductions for such property may be determined, however, under the rules generally provided by the Act. For purposes of this exception, a refunding issue issued after March 1, 1986, generally is treated as a new issue and the taxpayer must use the alternative depreciation method provided by the Act for costs that are unrecovered on the date of the refunding issue.

In cases where a change of recovery method is required because of a refunding issue, only the remaining unrecovered cost of the property is required to be recovered using the alternative depreciation system provided by the Act. Therefore, no retroactive adjustments to ACRS deductions previously claimed are required when a pre-March 2, 1986, bond issue is refunded where no significant expenditures are made with respect to the facility after December 31, 1986.

Contract with persons other than a person who will construct or supply the property

The Act provides transitional relief for certain situations where written binding contracts require the construction or acquisition of property, but the contract is not between the person who will own the property and the person who will construct or supply the property. This rule applies to written service or supply contracts and agreements to lease entered into before March 2, 1986 (January 1, 1986, in the case of the investment tax credit). An example of a case to which this rule would apply would be lease agreements under which a grantor trust is obligated to provide property under a finance lease (to the extent continued under the bill). This rule applies to cable television franchise agreements embodied in whole or in part in municipal ordinances or similar enactments before March 2, 1986 (January 1, 1986, for the investment tax credit).

This transitional rule is applicable only where the specifications and amount of the property are readily ascertainable from the terms of the contract, or from related documents. A supply or service contract or agreement to lease must satisfy the requirements of a binding contract (discussed above). A change in the method or amount of compensation for services under the contract, without more, will not be considered a substantial modification of the contract if, taken as a whole, the change does not affect the scope or function of the project. This rule does not provide transitional relief to property in addition to that covered under a contract described above, which additional property is included in the same project but does not otherwise qualify for transitional relief.

As a further example, where a taxpayer before January 1, 1986 entered into a written binding contract to construct a wastewater treatment facility and to provide wastewater treatment services, the subsequent amendment of the contract to (1) extend the date for completion of construction by a short period (e.g., three months), (2) provide for a letter of credit or other financial protection against defaults of the service provider, (3) add a pledge of net revenue and a sewer use rate covenant by the service recipient, (4) cause the service recipient's options to purchase the facility to comply with "service contract" definitional requirements of the Internal Revenue-Code, (5) merely clarify rights and remedies in the event of performance defaults, and (6) treat the obligations of the taxpayer to accept and treat wastewater as separate obligations (and treat similarly the obligation of the service recipient to pay for such services) would not in the aggregate constitute a "substantial modification," if the taxpayer's obligations to provide wastewater treatment services and to construct or acquire the facility are not affected thereby.

Development agreements relating to large-scale multi-use urban projects

The Act does not apply to property that is included in a "qualified urban renovation project." The term qualified urban renovation project includes certain projects that satisfy the following requirements as of March 1, 1986 (December 31, 1985, for the investment tax credit): the project is described in the Act and (1) was publicly announced by a political subdivision, for the renovation of an urban area in its jurisdiction, (2) was either the subject of an agreement for development or a lease between such political subdivision and the primary developer of the project, or was undertaken pursuant to the political subdivision's grant of development rights to a primary developer-purchaser; or (3) was identified as a single unitary project in the internal financing plans of the primary developer, and (4) is not substantially modified at any time after March 1, 1986 (December 31, 1985, for the investment tax credit).

Federal Energy Regulatory Commission application or action

The requirements of the general binding contract rule will be treated as satisfied with respect to a project if, on or before March 1, 1986 (for purposes of depreciation and the investment tax credit), the Federal Energy Regulatory Commission ("FERC") licensed the project or certified the project as a "qualifying facility" for purposes of the Public Utility Regulatory Policies Act of 1978 ("PURPA"). A project that a developer has simply put FERC on notice as a qualifying facility is not certified as a qualifying facility.

This rule will not apply if a FERC license or certification is substantially amended after March 1, 1986. On the other hand, minor modifications will not affect the application of this rule (e.g., technical changes in the description of a project, extension of the deadline for placing property in operation, changes in equipment or in the configuration of equipment).

FERC does not distinguish between an application to amend an existing certificate and one to have a project recertified and responds in both cases by "recertifying" the project. The Congress intends that substance should control over form, and property will remain transitional property if no substantial change occurs. Similarly, a mere change in status from a "qualifying small power production facility" to a "qualifying cogeneration facility," under PURPA, without more, would not affect application of the transitional rule. The following paragraph provides guidance about how the "substance over form" rule applies in typical cases.

The requirements of the transitional rule for FERC Certification will not be violated under the following circumstances: (1) after FERC certification, the introduction of efficiencies results in a reduction of the project cost and an increase in net electricity output, and the FERC certificate is amended to reflect the higher electricity output, (2) a project was originally certified as three separate facilities, but the taxpayer determines that it is more efficient to have a single powerhouse, and the FERC certification is amended to have the facilities combined under a single certificate.

The Act also provides transitional relief for hydroelectric projects of less than 80 megawatts if an application for a permit, exemption, or license was filed with FERC before March 2, 1986 (for purposes of depreciation and the investment tax credit).

Qualified solid waste disposal facilities

The Act does not apply to a qualified solid waste disposal facility if, before March 2, 1986 (for purposes of depreciation and the investment tax credit) (1) there is a written binding contract between a service recipient and a service provider, providing for the operation of such facility and the payment for services to be provided by the facility, or (2) a service recipient, governmental unit, or any entity related to such an entity made a financial commitment of at least $200,000 to the financing or construction of the facility.

For purposes of this rule, a qualified solid waste disposal facility is a facility (including any portion of the facility used for power generation or resource recovery) that provides solid waste disposal services for residents of part or all of one or more governmental units, if substantially all of the solid waste processed at such facility is collected from the general public. This rule does not apply to replacement property. For example, assume a taxpayer/service provider enters into a long-term service contract before January 1, 1986, and a facility is initially placed in service after that date. Assume that the taxpayer finds it necessary to replace the facility 20 years later, pursuant to its obligation to provide continuing services under the pre-1987 service contract. The special rule will apply only to the first facility necessary to fulfill the taxpayer's obligations under the service contract.

For purposes of this provision, a contract is to be considered as binding notwithstanding the fact that the obligations of the parties are conditioned on factors such as the receipt of permits, satisfactory construction or performance of the facility, or the availability of acceptable financing. A change in the method or amount of compensation for services under the contract will not be considered a substantial modification of the contract if, taken as a whole, the change does not materially affect the scope or function of the project.

A service recipient or governmental unit or a related party is to be treated as having made a financial commitment of at least $200,000 for the financing or construction of a facility if one or more entities have issued bonds or other obligations aggregating more than 10 percent of the anticipated capital cost of such facility, the proceeds of which are identified as being for such facility or for a group of facilities that include the facility, and if the proceeds of such bonds or other obligations to be applied to the development or financing of such facility are at least $200,000 in the aggregate. Alternatively, the test would be satisfied if one or more entities have expended in the aggregate at least $200,000 of their funds, or utilized or committed at least $200,000 of their assets, toward the development or financing of such facility (e.g., for the cost of feasibility studies and consultant fees). If a governmental entity acquires a site for a facility by purchase, option to purchase,9 purchase contract, condemnation, or entering into an exchange of land, it shall be considered to have made a financial commitment equal to the fair market value of such site for purposes of this rule. For purposes of this provision, entities are related if they are described in section 168(h)(4)(A)(i).

Other exceptions

The Act also provides other special transitional rules of limited application.

Property treated under prior tax Acts
The Act does not apply to (1) those mass commuting vehicles exempted from the application of the tax-exempt leasing rules under DEFRA, (2) a qualified lessee's automotive manufacturing property that was exempted from deferral of the finance lease rules10 (3) a qualified lessee's farm property that was exempted from deferral of the finance lease rules, or (4) property described in section 216(b)(3) of TEFRA. Property that qualifies under one of these provisions is also intended to be excepted from the 35-percent reduction of the investment credit and the full-basis adjustment (described below).11
Master plans
Under the special rule for master plans for integrated projects, (1) in the case of multi-step plans described in sec. 204(a)(5)(E) of the Act, the rule will include executive approval of a plan or executive authorization of expenditures under the plan before March 2, 1986, and (2) in the case of single-step plans described in sec. 204(a)(5)(E) of the Act, the rule will include project-specific designs for which expenditures were authorized, incurred or committed before March 2, 1986.

A master plan for a project will be considered to exist on March 1, 1986 if the general nature and scope of the project was described in a written document or documents in existence on March 1, 1986, or was otherwise clearly identifiable on that date. Each of the projects described in this rule had a master plan in existence on March 1, 1986, and the existence of such a plan is not intended to be a separate requirement for transitional relief for property comprising these projects.

Satellites
The Act provides transitional relief (including exceptions to the placed-in-service requirements) for certain satellites. Solely for purposes of the special rule for satellites, a binding contract for the construction or acquisition of two satellites by a joint venture shall be sufficient if such contract was in existence on July 2, 1986, and is for the construction or acquisition of the same satellites that were the subject of a contract to acquire or construct in effect on January 28, 1986, to which one of the joint venturers (or one of its affiliates) was a party.

The satellite transition rule was drafted with the understanding that in many instances launch agreements were executed years in advance of launch and that substitution of satellites in such agreements was, and is, a common practice within the industry. The Congress intended to recognize the possibility of alternative launch agreements. For example, NASA launch manifests revisions, made pursuant to an Executive Order of the President, were announced on October 3, 1986, and necessitated such alternative launch agreements. Under the satellite transition rule, it is not necessary that the agreement in existence on January 28, 1986, be the same agreement under which launch actually occurs.

Commercial passenger airliners
The Act extends the placed-in-service window for one year (through 1989) for commercial passenger airliners described in ADR class 45.0.

Special rules applicable to the regular investment credit

Full basis adjustment
A taxpayer is required to reduce the basis of property that qualifies for transition relief ("transition property") by the full amount of investment credits earned with respect to the transition property (after application of the phased-in 35-percent reduction, described below).12 The full-basis adjustment requirement also applies to credits claimed on qualified progress expenditures made after December 31, 1985. Further, the full-basis adjustment requirement applies to all depreciable property, regardless of whether such property is eligible for ACRS. The lower basis will be used to compute depreciation deductions, as well as gain or loss on disposition of property.13
Reduction of ITC carryforwards and credits claimed under transitional rules
These rules apply only to the portion of an investment credit attributable to the regular percentage (other than the portion thereof attributable to qualified timber property). Thus, for example, 100 percent of ITC carryovers may continue to be allowed for funding of an investment tax credit employee stock ownership plan.

Under the Act, the investment tax credit allowable for carryovers and transition property is reduced by 35 percent.14 The reduction in the investment tax credit is phased in with the corporate rate reduction to provide an approximately equal deduction equivalent value of the credit. The 35-percent reduction is fully effective for taxable years beginning on or after July 1, 1987. Taxpayers having a taxable year that straddles July 1, 1987, will be subject to a partial reduction that reflects the reduction for the portion of their year after that date. For example, for a taxpayer using the calendar year as a taxable year, the reduction for 1987 is 17.5 percent. For taxable years that straddle July 1, 1987, the Congress intended that the amount added to carryforwards (under new section 49(c)(4)(B)(ii)) bear the same ratio to the carryforwards from the taxable year (before inclusion of the additional amount) as the reduction of the credit under new section 49(c)(3) bears to the sum of the current year credit for the taxable year and the carryforwards to the taxable year, less the reduction of the credit under new section 49(c)(3). Further, new section 49(c)(3) should be taken into account in applying new section 49(c)(4)(A) (providing that the amount of the reduction shall not be allowed as a credit for any taxable year).

Thus, a taxpayer utilizing the investment tax credit in any year receives approximately the same deduction equivalent value of the investment tax credit. Combined with the full basis adjustment, these provisions ensure that taxpayers placing property in service in the same taxable year are treated similarly.

 

Example.--Assume a taxpayer places transition property in service on January 1, 1987, generating a $100 regular investment tax credit. In the first instance, the credit is reduced by 17.5 percent to $82.50. Because of the application of the 75% limitation on general business tax credits, assume further that only $60 of the credit is used in 1987. Thus, $22.50 is carried forward to 1988. Further, an additional amount equal to $4.77 (determined as described above) is carried forward to 1988. The entire $27.27 ($22.50 + $4.77) is then reduced by 35 percent.

 

The amount by which the credit is reduced will not be allowed as a credit for any other taxable year. For purposes of determining the extent to which an investment credit determined under section 46 is used in a taxable year, the regular investment credit is assumed to be used first. This rule is inapplicable to credits that a taxpayer elects to carryback 15 years under the special rules described below.

As described above, a full basis adjustment is required with respect to the reduced amount of the investment tax credit arising in the year property is placed in service. Thus, for transition property placed in service after 1987 and eligible for a 6.5 percent investment tax credit, the basis reduction would be with respect to the 6.5 percent credit, not the unreduced 10-percent credit.

The phased-in 35-percent reduction is to be applied to the investment tax credit before application of the general 75-percent limitation. Further, the amount of investment tax credit carryovers subject to reduction shall first be adjusted to reflect credits that were recaptured.

Section 48(d) election
A taxpayer in whose hands property qualifies for transitional relief can make an election under section 48(d) to pass the credit claimed to a lessee. In applying section 48(d)(5), which coordinates the section 48(d) election with the section 48(q) basis adjustment, Congress intended the income inclusion to equal 100 percent of the credit allowed to the lessee.15a
Estimated tax payments
The repeal of the regular investment tax credit for property placed in service after December 31, 1985, presents an issue about the manner in which estimated tax payments should be calculated for payment due dates occurring before the date of enactment of this Act. In general, for example, a corporation calculates estimated tax by determining its expected regular tax liability, less any allowable tax credits. Any underpayment of estimated corporate tax generally results in the imposition of penalties.

The Act provides a general provision that waives estimated tax penalties for underpayments that are attributable to changes in the law that increase tax liabilities from the beginning of 1986 (sec. 1543 of the Act).15b Individual taxpayers have until April 15, 1987, and corporations until March 15, 1987 (the final filing dates for calendar years returns) to pay 1986 income tax liabilities without incurring additions to tax due to underpayments.

Elective 15-year carryback for certain taxpayers
Certain companies can elect a 15-year carryback of 50 percent of investment tax credit carryforwards in existence as of the beginning of a taxpayer's first taxable year beginning after December 31, 1985. The amount carried back is treated as a payment against the tax imposed by chapter 1 of the Internal Revenue Code, made on the last day prescribed by law (without regard to extensions) for filing a return of tax under chapter 1 of the Code for the first taxable year beginning on or after January 1, 1987. The amount carried back would reduce tax liability for the first taxable year beginning after December 31, 1986; to the extent the amount carried back exceeds the tax liability for such year, any excess could be claimed as a refund under generally applicable rules. Carryforwards taken into account under the carryback rule are not taken into account under section 38 for any other taxable year. Generally, taxpayers eligible to elect the 15-year carryback are domestic corporations whose raw steel production in the United States during 1983 exceeded 1.5 million tons. A similar election is available to qualified farmers, except a $750 limitation applies.

The amount claimed as a payment against the tax for the first taxable year beginning on or after January 1, 1987 cannot exceed the taxpayer's net tax liability. The net tax liability is the amount of tax liability for all taxable years during the carryback period (not including minimum tax liability), reduced by the sum of credits allowable (other than the credit under section 34 relating to certain fuel taxes). The carryback period is the period that (1) begins with the taxpayer's 15th taxable year preceding the first taxable year from which there is a credit included in the taxpayer's existing carryforward (in no event can such period begin before the first taxable year ending after December 31, 1961), and (2) ends with the corporation's last taxable year beginning before January 1, 1986.

Normalization requirement for public utility property
If the tax benefits of previously allowed investment tax credits on public utility property are not normalized, then certain investment tax credits will be recaptured. In general, the amount recaptured is the greater of (1) all investment tax credits for open taxable years of the taxpayer or (2) unamortized credits of the taxpayer or credits not previously restored to rate base (whether or not for open years), whichever is applicable. If such credits have not been utilized and are being carried forward, the carryforward amount is reduced in lieu of recapture. These rules apply to violations of the relevant normalization requirements occurring in taxable years ending after December 31, 1985. Similar principles apply to the failure to normalize the tax benefits of previously allowed employee stock ownership plan credits.
General treatment of QPEs
Neither the repeal of the regular investment credit nor the phased-in 35-percent reduction of credits affects QPEs claimed with respect to the portion of the basis of any progress expenditure property attributable to progress expenditures for periods before January 1, 1986. The fact that the property on which QPEs are claimed is placed in service after 1985 is immaterial. Carryovers of credits attributable to QPEs are subject to the general rules providing for a reduction in carryforwards. If a taxpayer elected to take a reduced rate of credit on a QPE basis in lieu of the 50-percent basis adjustment of prior law, the portion of basis attributable to such QPEs, claimed for periods before 1986, will not be reduced and such election will not apply to any other portion of such basis. After December 31, 1985, QPEs cannot be claimed unless it is reasonable to expect that the property will be placed in service before the applicable date. The determination of whether it is reasonable to expect that the placement-in-service requirement will be met is to be made on a year-by-year basis, beginning with the first taxable year that includes January 1, 1986. For any taxable year in which reasonable expectations change, no QPEs will be allowed, and previously claimed post-1985 QPEs will be recaptured. Further, if the property is not placed in service on or before the last applicable date, post-1985 QPEs will be recaptured in the taxable year that includes such date.
Special rules for television and motion picture films
Special transitional rules apply to television and motion picture films for purposes of the investment credit (but not depreciation). For purposes of the general binding contract rule, (1) construction is treated as including production, (2) in accordance with industry practice, written contemporaneous evidence of a binding contract is treated as a written binding contract, and (3) in the case of any television film, a license agreement or agreement for production services between a television network and a producer (including written evidence of such an agreement as provided in (2) above) is treated as a binding contract to produce property. For these purposes, license agreement options are binding contracts as to the optionor (non-exercising party) but not as to the optionee (exercising party).16 In addition, a special rule is provided for certain films produced pursuant to a permanent financing arrangement described by the bill. For purposes of the placed-in-service requirement, films and sound recordings are treated as having ADR midpoints of 12 years.

Finance leases

The finance lease rules continue to apply to any transaction permitted by reason of section 12(c)(2) of DEFRA or section 209(d)(1)(B) of TEFRA.

 

Revenue Effect

 

 

The provisions are estimated to increase fiscal year budget receipts by $18,879 million in 1987, $21,413 in 1988, $30,501 million in 1989, $37,692 million in 1990, and $46,802 million in 1991.

 

B. Limitation on General Business Credit

 

 

Prior Law

 

 

The general business tax credit earned by a taxpayer could be used to reduce up to $25,000 of tax liability, plus 85 percent of tax liability in excess of $25,000.

 

Explanation of Provision

 

 

The Act reduces the 85-percent limitation on the general business credit to 75 percent.

 

Effective Date

 

 

The provision is effective for taxable years that begin after December 31, 1985.

 

Revenue Effect

 

 

The effect of this provision is included in the estimate for the corporate minimum tax.

 

C. Research and Development

 

 

1. Tax credit for increasing research expenditures; university basic research credit

(sec. 231 of the Act and sec. 30 of the Code)17

 

Prior Law

 

 

Expensing deduction

Under prior and present law, a taxpayer may elect to deduct currently the amount of research or experimental expenditures incurred in connection with its trade or business (sec. 174), notwithstanding the general rule that business expenditures to develop or create an asset that has a useful life extending beyond the taxable year must be capitalized. (Alternatively, the taxpayer may elect to treat these expenditures as deferred expenses and deduct them over a period of not less than 60 months on a straight-line basis.) This provision was enacted in the 1954 Code in order to eliminate the need to distinguish research from business expenses for deduction purposes, and to encourage taxpayers to carry on research and experimentation activities.18

The Code does not specifically define "research or experimental expenditures" eligible for the section 174 deduction election, except to exclude certain costs. Treasury regulations (sec. 1.174-2(a)) define "research or experimental expenditures" to mean "research and development costs in the experimental or laboratory sense." The regulations provide that this includes generally "all such costs incident to the development of an experimental or pilot model, a plant process, a product, a formula, an invention, or similar property, and the improvement of already existing property of the type mentioned." Other research or development costs-i.e., research or development costs not "in the experimental or laboratory sense"-do not qualify under section 174.

The section 174 election does not apply to expenditures for the acquisition or improvement of depreciable property, or land, to be used in connection with research.19 Thus, for example, the total cost of a research building or of equipment used for research cannot be deducted currently under section 174 in the year of acquisition. However, the amount of depreciation (cost recovery) allowance for a year with respect to depreciable property used for research may be deducted in that year under sections 167 and 168.

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

Incremental tax credit

Under a provision enacted in the Economic Recovery Tax Act of 1981, a taxpayer could claim a nonrefundable 25-percent income tax credit for certain research expenditures paid or incurred in carrying on an existing trade or business.20 The credit applied only to the extent that the taxpayer's qualified research expenditures for the taxable year exceeded the average amount of the taxpayer's yearly qualified research expenditures in the specified base period (generally, the preceding three taxable years). Under prior law, the credit was not available for expenses paid or incurred after December 31, 1985.

Research expenditures eligible for the incremental credit under prior law consisted of (1) in-house expenditures by the taxpayer for research wages and supplies used in research, plus certain amounts paid for research use of laboratory equipment, computers, or other personal property; (2) 65 percent of amounts paid by the taxpayer for contract research conducted on the taxpayer's behalf; and (3) in the case of a corporate taxpayer, 65 percent of the taxpayer's expenditures (including grants or contributions) pursuant to a written research agreement for basic research to be performed by universities or certain scientific research organizations.

The prior-law credit provision adopted the definition of research used for purposes of the section 174 expensing provision, but subject to three exclusions: (1) expenditures for research which is conducted outside the United States; (2) research in the social sciences or humanities; and (3) research to the extent that it is funded by any grant, contract, or otherwise by another person (or any governmental entity).

Under prior and present law, the credit is available for incremental qualified research expenditures for the taxable year whether or not the taxpayer has elected under section 174 to deduct currently research expenditures. The amount of any section 174 deduction to which the taxpayer is entitled is not reduced by the amount of any credit allowed for qualified research expenditures.

Under prior law, the incremental research credit was not subject to the general limitation on use of business credits (85 percent of tax liability over $25,000).

 

Reasons for Change

 

 

Three-year extension; reduction in rate of credit

When the incremental research credit was enacted in 1981, the Congress expressed serious concern about the then substantial relative decline in total U.S. expenditures for research and experimentation. The purpose of enacting the credit was to encourage business firms to perform the research necessary to increase the innovative qualities and efficiency of the U.S. economy. An expiration date for the credit was deemed desirable in order to enable the Congress to evaluate the operation of the credit, and to determine whether it should be extended and, if so, what modifications would be necessary to make the credit more effective.

The Congress concluded that an additional three-year extension of the credit is desirable in order to obtain more complete and comprehensive information to evaluate whether the credit should be further extended or modified. In the context of the base broadening and rate reduction provisions of the Act, and the continued allowance of full expensing of research expenditures, the credit rate is reduced to 20 percent.

Eligibility of certain computer-use costs

Under prior law, expenditures for renting research equipment were eligible for the credit, but depreciation allowances for purchased research equipment were not. The Congress believed that such inconsistent treatment should not be continued, and that the taxpayer's investment decision to purchase or lease should not be skewed by availability of the credit. The Act makes such rental costs, etc. ineligible for the credit, except for certain payments by the taxpayer to another person for the use of computer time in research. Continued eligibility for the latter payments is intended to benefit small businesses that cannot afford to purchase or lease their own computers for research purposes, and hence is intended to apply where the taxpayer is not the principal user of the computer.

Research definition for credit purposes

After reviewing available information and testimony on the actual use of the credit to date, the Congress concluded that the statutory credit provision should set forth an express definition of qualified research expenses for purposes of the credit. The Congress believed that the definition has been applied too broadly in practice, and some taxpayers have claimed the credit for virtually any expenses relating to product development. According to early data on the credit reported by the Treasury Department, research by these taxpayers often does not involve any of the attributes of technological innovation.

Accordingly, the Act targets the credit to research undertaken for the purpose of discovering information that is technological in nature and when applied is intended to be useful in developing a new or improved business component for sale or use in carrying on the taxpayer's trade or business. In addition, research is eligible for the extended credit only when substantially all the activities undertaken in developing or improving the business component constitute elements of a process of experimentation relating to functional aspects of the business component. The Act provides exclusions from the credit for certain research or nonresearch activities, and limits allowance of the credit for the costs of developing certain internal-use computer software to such software meeting a high threshold of innovation.

University basic research

The Congress believed it is desirable to provide increased tax incentives for corporate cash expenditures for university basic research where such expenditures do not merely represent a switching of donations from general university giving and where certain other maintenance-of-effort levels are exceeded. By contrast to other types of research or product development, where expected commercial returns attract private investment, basic research typically does not produce sufficiently immediate commercial applications to make investment in such research self-supporting. Because basic research typically involves greater risks of not achieving a commercially viable result, larger-term projects, and larger capital costs than ordinary product development, the Federal Government traditionally has played a lead role in funding basic research, principally through grants to universities and other nonprofit scientific research organizations. In addition, the research credit as modified by the Act provides increased tax incentives for corporate funding of university basic research to the extent that such expenditures reflect a significant commitment by the taxpayer to basic research.

Credit use limitation

The Congress concluded that the general limitation on use of business credits (under the Act, 75 percent of tax liability over $25,000) should apply to the research credit.

 

Explanation of Provisions

 

 

Three-year extension; reduction in rate of incremental credit

The Act extends the incremental research tax credit for three additional years, i.e., for qualified research expenditures paid or incurred through December 31, 1988, at a credit rate of 20 percent.

Eligibility of certain computer-use costs

The Act generally repeals the prior-law provision treating amounts paid by the taxpayer to another person for the right to use personal property in qualified research as generally eligible for the credit. However, the Act provides that, under regulations to be prescribed by the Treasury Department, amounts paid or incurred by the taxpayer to another person for the right to use computer time in the conduct of qualified research are eligible for the incremental credit. This provision is intended to benefit smaller businesses that cannot afford to purchase or lease their own computers for research purposes, and hence is intended to apply where the taxpayer is not the principal user of the computer. Consistent with the prior-law limitations on credit-eligibility of research equipment rental costs, such computer-use payments are not eligible for the credit to the extent that the taxpayer (or a person with which the taxpayer must aggregate expenditures in computing the credit) receives or accrues any amount from any other person for computer use.

In computing the incremental research credit for a taxable year beginning after December 31, 1985 (when rental costs will not be eligible for the credit), a taxpayer may exclude from the base-period amount with respect to such year any rental costs, etc. (other than for computer-use costs of a type remaining eligible for the credit in post-1985 years) that were allowable as qualified research expenses under section 30(b)(2)(A)(iii) (as then in effect) in a base-period year.21

Definition of research for credit purposes

In general
The Act targets the credit to research undertaken for the purpose of discovering information that is technological in nature and the application of which is intended to be useful in developing a new or improved business component for sale or use in carrying on the taxpayer's trade or business. In addition, research is eligible for the extended credit only where substantially all the activities undertaken in developing or improving the business component constitute elements of a process of experimentation relating to functional aspects of the business component. The Act provides exclusions from the credit for certain research or nonresearch activities. The costs of developing certain internal-use software are eligible for the credit only if specified requirements are met.

No inference is intended from the provisions of the Act defining research eligible for the credit as to the scope of the term "research or experimental" for purposes of the section 174 expensing deduction.

Research
As under prior law, the Act limits research expenditures eligible for the incremental credit to "research or experimental expenditures" eligible for expensing under section 174. Thus, for example, the credit is not available for (1) expenditures other than "research and development costs in the experimental or laboratory sense," (2) expenditures "such as those for the ordinary testing or inspection of materials or products for quality control or those for efficiency surveys, management studies, consumer surveys, advertising, or promotions," (3) costs of acquiring another person's patent, model, production, or process, or (4) research expenditures incurred in connection with literary, historical, or similar projects (Treas. Reg. sec. 1.174-2(a)).22 The term research includes basic research.

Under the Act, research satisfying the section 174 expensing definition is eligible for the credit only if the research is undertaken for the purpose of discovering information (a) that is technological in nature, and also (b) the application of which is intended to be useful in the development of a new or improved business component of the taxpayer. In addition, such research is eligible for the credit only if substantially all of the activities of the research constitute elements of a process of experimentation for a functional purpose. The Act also expressly sets forth exclusions from eligibility for the credit for certain research activities that might otherwise qualify and for certain nonresearch activities.

Technological nature
The determination of whether the research is undertaken for the purpose of discovering information that is technological in nature depends on whether the process of experimentation utilized in the research fundamentally relies on principles of the physical or biological sciences, engineering, or computer science23--in which case the information is deemed technological in nature--or on other principles, such as those of economics--in which case the information is not to be treated as technological in nature. For example, information relating to financial services or similar products (such as new types of variable annuities or legal forms) or advertising does not qualify as technological in nature.
Process of experimentation
The term process of experimentation means a process involving the evaluation of more than one alternative designed to achieve a result where the means of achieving that result is uncertain at the start. This may involve developing one or more hypotheses, testing and analyzing those hypotheses (through, for example, modeling or simulation), and refining or discarding the hypotheses as part of a sequential design process to develop the overall component.

Thus, for example, costs of developing a new or improved business component are not eligible for the credit if the method of reaching the desired objective (the new or improved product characteristic) is readily discernible and applicable as of the beginning of the research activities, so that true experimentation in the scientific or laboratory sense would not have to be undertaken to develop, test, and choose among viable alternatives. On the other hand, costs of experiments undertaken by chemists or physicians in developing and testing a new drug are eligible for the credit because the researchers are engaged in scientific experimentation. Similarly, engineers who design a new computer system, or who design improved or new integrated circuits for use in computer or other electronic products, are engaged in qualified research because the design of those items is uncertain at the outset and can only be determined through a process of experimentation relating to specific design hypotheses and decisions as described above.

Functional purposes
Under the Act, research is treated as conducted for a functional purpose only if it relates to a new or improved function, performance, or reliability or quality. Activities to assure achievement of the intended function, performance, etc. of the business component undertaken after the beginning of commercial production of the component are not eligible for the credit. The Act also provides that research relating to style, taste, cosmetic, or seasonal design factors shall in no event be treated as conducted for a functional purpose and hence is not eligible for the credit.
Application of tests
The term business component means a product, process, computer software, technique, formula, or invention that is to be held for sale, lease, or license, or is to be used by the taxpayer in a trade or business of a taxpayer. If the requirements described above for credit eligibility are not met with respect to a product, etc. but are met with respect to one or more elements thereof, the term business component means the most significant set of elements of such product, etc. with respect to which all requirements are met.

Thus, the requirements for credit eligibility are applied first at the level of the entire product, etc. to be offered for sale, etc. by the taxpayer. If all aspects of such requirements are not met at that level, the test applies at the most significant subset of elements of the product, etc. This shrinking back of the product is to continue until either a subset of elements of the product that satisfies the requirements is reached, or the most basic element of the product is reached and such element fails to satisfy the test. Treasury regulations may prescribe rules for applying these rules where a research activity relates to more than one business component.

A plant process, machinery, or technique for commercial production of a business component is treated as a different component than the product being produced. Thus, research relating to the development of a new or improved production process is not eligible for the credit unless the definition of qualified research is met separately with respect to such production process research, without taking into account research relating to the development of the product.

Internal-use computer software
Under a specific rule in the Act, research with respect to computer software that is developed by (or for the benefit of) the taxpayer primarily for the taxpayer's own internal use is eligible for the credit only if the software is used in (1) qualified research (other than the development of the internal-use software itself) undertaken by the taxpayer, or (2) a production process that meets the requirements for the credit (e.g., where the taxpayer is developing both robotics and software for the robotics to be used in a manufacturing process, and the taxpayer's research costs of developing the robotics are eligible for the credit). Any other research activities with respect to internal-use software are ineligible for the credit except to the extent provided in Treasury regulations. Accordingly, the costs of developing computer software are not eligible for the credit where the software is used internally, for example, in general and administrative functions (such as payroll, bookkeeping, or personnel management) or in providing noncomputer services (such as accounting, consulting, or banking services), except to the extent permitted by Treasury regulations.

The Congress intended and expected that these regulations will make the costs of new or improved internal-use software eligible for the credit only if the taxpayer can establish, in addition to satisfying the general requirements for credit eligibility, (1) that the software is innovative (as where the software results in a reduction in cost, or improvement in speed, that is substantial and economically significant); (2) that the software development involves significant economic risk (as where the taxpayer commits substantial resources to the development and also there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period); and (3) that the software is not commercially available for use by the taxpayer (as where the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the first two requirements just stated). The Congress intended that these regulations are to apply as of the effective date of the new specific statutory rule relating to internal-use software; i.e., internal-use computer software costs that qualify under the three-part test set forth in this paragraph are eligible for the research credit even if incurred prior to issuance of such final regulations.

The specific rule in the Act relating to internal-use computer software is not intended to apply to the development costs of a new or improved package of software and hardware developed together by the taxpayer as a single product, of which the software is an integral part, that is used directly by the taxpayer in providing technological services in its trade or business to customers. For example, the specific rule would not apply where a taxpayer develops together a new or improved high technology medical or industrial instrument containing software that processes and displays data received by the instrument, or where a telecommunications company develops a package of new or improved switching equipment plus software to operate the switches. In these cases, eligibility for the incremental research tax credit is to be determined by examining the combined hardware-software product as a single product, and thus the specific rule applicable to internal-use computer software would not apply to the combined hardware-software product.

In the case of computer software costs incurred in taxable years before the effective date for the new specific statutory rule, the eligibility of such costs for the research credit is to be determined in the same manner as the eligibility of hardware product costs. The Congress expected and was assured by the Treasury Department that guidance to this effect would be promulgated on an expedited basis.

Excluded activities
The Act specifies that expenditures incurred in certain research, research-related, or nonresearch activities are excluded from eligibility for the credit, without reference to the requirements described above relating to technological information, process of experimentation, and functional purposes.

Post-production research activities.--The Act provides that any research with respect to a business component conducted after the beginning of commercial production of the component does not constitute qualified research eligible for the credit. Thus, no expenditures relating to a business component are eligible for the credit after the component has been developed to the point where it either meets the basic functional and economic requirements of the taxpayer for such component or is ready for commercial sale or use.24 For example, the credit is not available for such expenditures as the costs of preproduction planning for a finished business component, tooling-up for production, trial production runs, trouble-shooting involving detecting faults in production equipment or processes, accumulation of data relating to production processes, and the cost of debugging product flaws.

By way of further illustration, the credit is not available for costs of additional clinical testing of a pharmaceutical product after the product is made commercially available to the general public. However, the clinical testing in the United States of a product prior to production for sale in this country, or clinical testing seeking to establish new functional uses, characteristics, indications, combinations, dosages, or delivery forms as improvements to an existing product, is eligible for the credit. Thus, research (e.g., body chemistry research) undertaken on a product approved for one specified indication to determine its effectiveness and safety for other potential indications is eligible for the credit. Similarly, testing a drug currently used to treat hypertension for a new anti-cancer application, and testing an antibiotic in combination with a steroid to determine its therapeutic value as a potential new anti-inflammatory drug, are eligible for the credit.

Adaptation.--The Act provides that research related to the adaptation of an existing business component to a particular customer's requirement or need is not eligible for the credit. Thus, for example, the costs of modifying an existing computer software item for a particular customer are not eligible for the credit. However, the mere fact that a business component is intended for a specific customer does not disqualify otherwise qualified research costs of the item (assuming that the research is not funded by the customer).

Surveys, studies, certain other costs.--The Act provides that the credit is not available for the costs of efficiency surveys; activities (including studies) related to management functions or techniques; market research, market testing, or market development (including advertising or promotions); routine data collections; or routine or ordinary testing or inspection of materials or business components for quality control. Management functions and techniques include such items as preparation of financial data and analysis, development of employee training programs and management organization plans, and management-based changes in production processes (such as rearranging work stations on an assembly line).

Duplication.--The Act provides that the credit does not apply to research related to the reproduction of an existing business component (in whole or in part) of another person from a physical examination of the component itself or from plans, blueprints, detailed specifications, or publicly available information with respect to such component. While such "reverse engineering" activities thus are not eligible for the credit, the exclusion for duplication does not apply merely because the taxpayer examines a competitor's product in developing its own component through a process of otherwise qualified experimentation requiring the testing of viable alternatives and based on the knowledge gained from such tests.

Additional exclusions.--As under prior law, the Act excludes from eligibility for the credit expenditures for research (1) that is conducted outside the United States; (2) in the social sciences (including economics, business management, and behavioral sciences), arts, or humanities; or (3) to the extent funded by any person (or governmental entity) other than the taxpayer, whether by grant, contract, or otherwise.

Effect on section 174 definition
No inference is intended from the rules in the Act defining research for purposes of the incremental credit as to the scope of the term "research or experimental" for purposes of the section 174 expensing deduction.

University basic research credit

In general
Under prior law, research expenditures entering into the computation of the incremental research credit included 65 percent of a corporation's expenditures (including grants or contributions) pursuant to a written research agreement for basic research to be performed by universities or certain scientific research organizations. Under the Act, a 20-percent tax credit applies to the excess of (1) 100 percent of corporate cash payments for university basic research over (2) the sum of (a) the greater of two fixed 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.25
Qualifying payments
For purposes of the credit, qualifying basic research payments are cash payments paid during the taxable year pursuant to a written agreement between the taxpayer corporation26 and a university or certain other qualified organizations for basic research to be performed by the qualified organization (or by universities receiving funds through certain initial recipient qualified organizations). Such corporate payments for university basic research are deemed to satisfy the trade or business test for the research credit, whether or not the basic research is in the same field as an existing trade or business of the corporation.

Under the Act, qualifying basic research payments include both grants or contributions for basic research by the corporate taxpayer that constitute charitable contributions under section 170, and also contract payments for basic research to be performed by the qualified organization on behalf of the corporation. Such payments are not eligible for a credit unless and until actually paid by the corporation to a qualified organization. Thus, an accrual-basis corporation may not treat amounts incurred, but not actually paid during the taxable year, for university basic research as eligible for the credit in that year.

Under the Act, only cash payments may qualify as a basic research payment. No amount (basis or value) on account of contributions or transfers of property is eligible for either the incremental credit or the basic research credit, whether or not such property constitutes scientific equipment eligible for an augmented charitable deduction under section 170(e)(4).

As under prior law, the term basic research is defined in the Act as any original investigation for the advancement of scientific knowledge not having a specific commercial objective. However, expenditures for basic research in the social sciences (including economics, business management, and behavioral sciences), arts, or humanities and basic research conducted outside the United States are excluded from eligibility for the credit.

Qualified organizations
To be eligible for a credit, the corporate payments must be for basic research to be conducted by a qualified organization. For this purpose, the term qualified organization generally includes colleges or universities, tax-exempt scientific research organizations, and certain tax-exempt conduit or grant organizations, as specified in the Act.

The first category of qualified organizations consists of educational institutions that both are described in Code section 170(b)(1)(A)(ii) and constitute institutions of higher education within the meaning of section 3304(f).27 The second category consists of tax-exempt organizations that (1) are organized and operated primarily to conduct scientific research, (2) are described in section 501(c)(3) (relating to exclusively charitable, educational, scientific, etc., organizations), and (3) are not private foundations. Also, certain tax-exempt grant funds that qualified under prior law continue to qualify under the Act.

In addition, the Act treats as a qualified organization any tax-exempt organization that is organized and operated primarily to promote scientific research by colleges or universities pursuant to written research agreements, that expends on a current basis substantially all its funds (or substantially all the basic research payments received by it) through grants to or contracts with colleges and universities for basic research, and that is either (a) described in section 501(c)(3) and is not a private foundation or (b) described in section 501(c)(6) (trade associations).

Computation rules for revised basic research credit
Under the Act, the university basic research credit applies to the excess of (1) 100 percent of corporate cash payments for university basic research over (2) the sum of the minimum basic research amount plus the maintenance-of-effort amount.

The minimum basic research amount is the greater of two fixed floors--

 

(a) the average of all credit-eligible basic research expenditures under Code section 30(e)(1) (as in effect during the base period) for the three taxable years immediately preceding the taxpayer's first taxable year beginning after December 31, 1983; or

(b) one percent of the average of the sum of all in-house research expenses, contract research expenses, and credit-eligible basic research expenditures under Code section 30(e)(1) (as in effect during the base period) for each of the three taxable years immediately preceding the taxpayer's first taxable year beginning after December 31, 1983.

 

In the case of a corporation that was not in existence for at least one full taxable year during this fixed base period, the Act provides that the minimum basic research amount for the base period shall not be less than 50 percent of the basic research payments for the current taxable year. If the corporation was in existence for one full taxable year or two full taxable years during such base period, the fixed floor is to be computed with respect to such year or years.

The maintenance-of-effort amount means, with respect to the taxpayer's current taxable year, the excess of the average of the nondesignated university donations paid by the taxpayer during the three taxable years immediately preceding the taxpayer's first taxable year beginning after December 31, 1983, as adjusted under the Act to reflect inflation, over the amount of nondesignated university donations paid by the taxpayer in the current taxable year. The term nondesignated university donation means all amounts paid by the taxpayer to all colleges or universities for which a charitable deduction was allowable (under sec. 170) and that were not taken into account in computing the research credit.

Any amount of credit-eligible basic research payments to which the revised university basic research credit applies does not enter into the computation of the incremental credit. Any remaining amount of credit-eligible basic research payments--i.e., the amount to which the revised credit does not apply because it does not exceed the qualified organization base period amount--is treated as contract research expenses, for purposes of section 41(a)(1), in computing the taxpayer's incremental credit (and in subsequent years enters into the base period amounts for purposes of computing the incremental credit).

Credit limitations

The Act makes the research credit subject to the general business credit limitation (Code sec. 38), as amended by the Act (i.e., 75 percent of tax liability over $25,000).

 

Effective Date

 

 

The extension of the credit is effective for taxable years ending after December 31, 1985. Under the Act, the credit will not apply to amounts paid or incurred after December 31, 1988.28

The modifications to the credit made by the Act are effective for taxable years beginning after December 31, 1985, except that the modifications relating to the university basic research credit are effective for taxable years beginning after December 31, 1986. In computing the research credit for taxable years beginning after December 31, 1985, base-period expenditures for taxable years beginning before January 1, 1986 are to be determined under the prior-law credit definition of qualified research that was applicable in such base-period years and are not to be redetermined under the definition of qualified research in the Act.29

 

Revenue Effect

 

 

The provision is estimated to decrease fiscal year budget receipts by $1,429 million in 1987, $1,183 million in 1988, $833 million in 1989, $429 million in 1990, and $259 million in 1991.

2. Augmented charitable deduction for certain donations of scientific equipment

(sec. 231(f) of the Act and sec. 170(e)(4) of the Code)30

 

Prior Law

 

 

Under prior and present law, the amount of charitable deduction otherwise allowable for donated property generally must be reduced by the amount of any ordinary gain that the taxpayer would have realized had the property been sold for its fair market value at the date of the contribution (Code sec. 170(e)). Under a special rule, corporations are allowed an augmented charitable deduction for certain donations of newly manufactured scientific equipment to a college or university for research use in the physical or biological sciences (sec. 170(e)(4)).

 

Reasons for Change

 

 

The Congress believed that the prior-law provision concerning certain charitable donations of newly manufactured scientific equipment to universities for research use should be extended to include such donations to tax-exempt scientific research organizations.

 

Explanation of Provision

 

 

Under the Act, the category of eligible donees under section 170(e)(4) is expanded to include organizations described in Code section 41(e)(6)(B), i.e., tax-exempt organizations that (1) are organized and operated primarily to conduct scientific research, (2) are described in section 501(c)(3) (relating to exclusively charitable, educational, scientific, etc., organizations), and (3) are not private foundations.

 

Effective Date

 

 

The provision is effective for taxable years beginning after December 31, 1985.

 

Revenue Effect

 

 

The revenue effect of this provision is included with the revenue effect for item 1 above.

3. Tax credit for orphan drug clinical testing

(sec. 232 of the Act and sec. 28 of the Code)31

 

Prior Law

 

 

A 50-percent, nonrefundable tax credit is allowed for a taxpayer's qualified clinical testing expenses paid or incurred in the testing of certain drugs (generally referred to as "orphan drugs") for rare diseases or conditions (Code sec. 28). Prior law defined a rare disease or condition is one that occurs so infrequently in the United States that there is no reasonable expectation that businesses could recoup the costs of developing a drug for it from U.S. sales of the drug. These rare diseases and conditions include Huntington's disease, myoclonus, ALS (Lou Gehrig's disease), Tourette's syndrome, and Duchenne's dystrophy (a form of muscular dystrophy).

Under prior law, the orphan drug credit would not have been available for amounts paid or incurred after December 31, 1987.

 

Reasons for Change

 

 

The Congress decided to extend the orphan drug credit for three additional years, to be consistent with the longer authorization period for research grants for development of vaccines or drugs to treat rare diseases.

 

Explanation of Provision

 

 

The Act extends the orphan drug credit for three additional years (i.e., through December 31, 1990).32

 

Effective Date

 

 

The provision is effective on the date of enactment (October 22, 1986).

 

Revenue Effect

 

 

The provision is estimated to decrease fiscal year budget receipts by $7 million in 1988, $15 million in 1989, $15 million in 1990, and $8 million in 1991.

 

D. Rapid Amortization Provisions

 

 

1. Trademark and trade name expenditures

(sec. 241 of the Act and sec 177 of the Code)33

 

Prior Law

 

 

Prior law permitted taxpayers to elect to amortize over a period of at least 60 months expenditures for the acquisition, protection, expansion, registration, or defense of a trademark or trade name, other than an expenditure which was part of the consideration for an existing trademark or trade name.

 

Reason for Change

 

 

The special amortization provision for trademark and trade name expenditures was enacted in 1956, in part because of a perception that certain large companies whose in-house legal staff handled trademark and trade name matters were able in some cases to deduct compensation with respect to these matters, because of difficulties of identification, while smaller companies that retained outside counsel were required to capitalize such expenses.34 However, in reconsidering this provision, Congress did not believe that the possibility that some taxpayers may fail accurately to compute nondeductible expenses was a justification for permitting rapid amortization. Furthermore, to the extent such mischaracterization occurs, a five-year amortization provision only partially alleviates any unfairness. There is no basis for a presumption that a trademark or trade name will decline in value, or that investment in trademarks and trade names produces special social benefits that market forces might inadequately reflect. Congress believed that a tax incentive for trademark or trade name expenditures is therefore inappropriate.

 

Explanation of Provision

 

 

The Act repeals the election. Trademark and trade name expenditures must be capitalized and recovered on a disposition of the asset. No amortization or depreciation is allowed with respect to such expenditures.

 

Effective Date

 

 

The provision is generally effective for expenditures paid or incurred after December 31, 1986.

However, prior law applies to expenditures incurred: (1) pursuant to a written contract that was binding as of March 1, 1986; or (2) with respect to development, protection, expansion, registration or defense of trademarks or trade names commenced as of March 1, 1986, if the lesser of $1 million or 5 percent of cost has been incurred or committed by that date, provided in each case the trademark or trade name is placed in service before January 1, 1988.

 

Revenue Effect

 

 

This provision is estimated to increase fiscal year budget receipts by $4 million in 1987, $13 million in 1988, $25 million in 1989, $41 million in 1990, and $58 million in 1991.

2. Qualified railroad grading and tunnel bores

(sec. 242 of the Act and sec. 185 of the Code)35

 

Prior Law

 

 

Under prior law, domestic railroad common carriers could elect to amortize the cost of qualified railroad grading and tunnel bores over a 50 year period. "Qualified railroad grading and tunnel bores" included all land improvements (including tunneling) necessary to provide, construct, reconstruct, alter, protect, improve, replace, or restore a roadbed of right-of-way for railroad track.

 

Reason for Change

 

 

The special amortization provision for railroad grading and tunnel bore expenditures were enacted in 1969 to encourage investment in light of uncertainties about the useful life of such property. The scope of the provision was extended in 1976, to cover expenditures for pre-1969 property. However, Congress believed that continuation of the benefit is inconsistent with tax reform.

 

Explanation of Provision

 

 

The election is repealed. No amortization or depreciation deduction for railroad grading and tunnel bores will be allowed.

In addition, special ACRS treatment is provided for a particular railroad disaster and involuntary conversion treatment of insurance proceeds in that case is specified.

The repeal of the election generally applies to expenses paid or incurred on or after January 1, 1987. However, prior law continues to apply to expenditures incurred: (1) pursuant to a written contract that was binding as of March 1, 1986; or (2) with respect to construction, reconstruction, alteration, improvement, replacement or restoration commenced as of March 1, 1986, if the lesser of $1 million or 5 percent of cost has been incurred or committed by that date, provided in each case the improvements are placed in service before January 1, 1988.

 

Revenue Effect

 

 

This provision is estimated to decrease fiscal year budget receipts by less than $5 million in each of the years 1987 through 1991.

3. Bus operating authorities; freight forwarders

(sec. 243 of the Act and section 266 of the Economic Recovery Tax Act of 1981)36

 

Prior Law

 

 

Prior to enactment of the Bus Regulatory Reform Act of 1982, intercity bus operators were required to obtain an operating authority from the Interstate Commerce Commission (ICC) before providing service on a particular route. Because the ICC issued only a limited number of bus operating authorities, persons wishing to enter a route often purchased an existing bus company with the desired operating authority, paying substantial amounts for these operating authorities. Thus, the value of bus operating rights constituted a substantial part of a bus operator's assets and a source of loan collateral.

The 1982 statute greatly eased entry into the intercity bus industry. Because of this, the value of bus operating authorities diminished significantly, to the point where they are now essentially worthless.

A deduction is allowed for any loss incurred in a trade or business during the taxable year, if the loss is not compensated for by insurance or otherwise (Code sec 165(a)). In general, the amount of the deduction equals the adjusted basis of the property giving rise to the loss (sec. 165(b)). Treasury regulations provide that, to be deductible, a loss must be evidenced by a closed and completed transaction (i.e., must be "realized"), and must be fixed by an identifiable event (Treas. Reg. sec. 1.165-1(b)).

As a general rule, no deduction is allowed for a decline in value of property absent a sale, abandonment, or other disposition. Thus, for a loss to be allowed as a deduction, generally the business must be discontinued or the property must be abandoned (Treas. Reg. sec. 1.165-2)). Further, if the property is a capital asset and is sold or exchanged at a loss, the deduction of the resulting capital loss is subject to limitations (secs. 1212, 1211, and 165(f)).

The courts have denied a loss deduction where the value of an operating permit or license decreased as the result of legislation expanding the number of licenses or permits that could be issued. In the view of several courts,37 the diminution in the value of a license or permit would not constitute an event giving rise to a deductible loss if the license or permit continues to have value as a right to carry on a business.

 

Reasons for Change

 

 

The owners of bus operating authorities face a situation similar to that faced by owners of trucking company operating authorities after enactment of the Motor Carrier Act of 1980. That statute deregulated the trucking industry; as a result, motor carrier operating authorities lost significant value. In the Economic Recovery Tax Act of 1981, the Congress enacted a provision allowing trucking companies an ordinary deduction ratably over five years for loss in value of motor carrier operating authorities (sec. 166 of the 1981 Act).

 

Explanation of Provision

 

 

The Act allows an ordinary deduction ratably over a 60-month period for taxpayers who held one or more bus operating authorities on November 19, 1982 (the date of enactment of the Bus Regulatory Reform Act of 1982). The amount of the deduction is the aggregate adjusted bases of all bus operating authorities that were held by the taxpayer on November 19, 1982, or acquired after that date under a contract that was binding on that date.

The Act provides a similar rule for surface freight forwarders that were deregulated pursuant to the Surface Freight Forwarder deregulation Act of 1986.

The 60-month period for bus operating authorities begins on November 1, 1982, or, at the taxpayer's election, the first month of the taxpayer's first taxable year beginning after that date. The Act requires that adjustments be made to the bases of authorities to reflect amounts allowable as deductions under the Act.

Under regulations to be prescribed by the Treasury, a taxpayer (whether corporate or noncorporate) holding an eligible bus operating authority would be able to elect to allocate to the authority a portion of the cost to the taxpayer of stock in an acquired corporation (unless an election under section 338 is in effect). The election would be available if the bus operating authority was held (directly or indirectly) by the taxpayer at the time its stock was acquired. In such a case, a portion of the stock basis would be allocated to the authority only if the corporate or noncorporate taxpayer would have been able to make such an allocation had the authority been distributed in a liquidation to which prior-law section 334(b)(2) applied. The election would be available only if the stock was acquired on or before November 19, 1982 (or pursuant to a binding contract in effect on such date).

 

Effective Date

 

 

The provision for bus operating authorities is effective retroactively for taxable years ending after November 18, 1982. The Act extends the period of limitations for filing claims for refund or credit of any overpayment of tax resulting from this provision, if such claim is presented on or before the date that is one year after the date of enactment of the Act. In such a case, a claim for refund or credit may be made or allowed if filed on or before the date that is eighteen months after such date.

 

Revenue Effect

 

 

The provision is estimated to reduce fiscal year budget receipts by $20 million in 1987.

4. Removal of architectural and transportation barriers to the handicapped and elderly

(sec. 244 of the Act and sec. 190 of the Code)38

 

Prior Law

 

 

Prior law allowed electing taxpayers to deduct currently up to $35,000 of qualifying capital expenditures for the removal of architectural and transportation barriers to the handicapped and elderly. This rule applied to expenses paid or incurred in order to make more accessible to and usable by the handicapped and elderly any facility or public transportation vehicle owned or leased by the taxpayer for use in a trade or business. The election was not available in taxable years beginning after December 31, 1985.

 

Reasons for Change

 

 

Congress believed it desirable to continue to encourage the removal of architectural and transportation barriers to the handicapped and elderly, inasmuch as the social benefits of such expenditures may not be fully taken into account in private calculations of benefits and costs.

 

Explanation of Provision

 

 

The Act reinstates on a permanent basis, effective for expenses incurred in taxable years beginning after 1985, the provision that allows the expensing of up to $35,000 of costs incurred in the removal of architectural and transportation barriers to the handicapped and elderly.

 

Effective Date

 

 

The provision, effective on October 22, 1986 (date of enactment of the Act) applies to expenses incurred in taxable years beginning after 1985.

 

Revenue Effect

 

 

The provision is estimated to decrease fiscal year budget receipts by $26 million in 1987, $18 million in 1988, $19 million in 1989, $20 million in 1990, and $21 million in 1991.

 

E. Real Estate Provisions

 

 

1. Tax credit for rehabilitation expenditures

(sec. 251 of the Act and secs. 46(b), 48(g), and 48(q) of the Code)39

 

Prior Law

 

 

A three-tier investment tax credit was provided for qualified rehabilitation expenditures. The credit was 15 percent for nonresidential buildings at least 30 years old, 20 percent for nonresidential buildings at least 40 years old, and 25 percent for certified historic structures (including residential buildings). A certified historic structure was defined as a building (and its structural components) that is listed in the National Register of Historic Places, or is located in a registered historic district and certified by the Secretary of the Interior as being of historic significance to the district.

The rehabilitation credit was available only if the taxpayer elected to use the straight-line method of cost recovery with respect to the rehabilitation expenditures. If the 15- or 20-percent investment credit was allowed for qualified rehabilitation expenditures, the basis of the property was reduced by the amount of credit earned (and the reduced basis was used to compute cost recovery deductions) (sec. 48(q)(1) and (3)). The basis was reduced by 50 percent of the 25-percent credit allowed for the rehabilitation of certified historic structures.

Qualified rehabilitation expenditures were eligible for the credit only if incurred in connection with a substantial rehabilitation that satisfied an external-walls requirement. The test of substantial rehabilitation generally was met if the qualified expenditures during a 24-month measuring period exceeded the greater of the adjusted basis of the building as of the first day of the 24-month period, or $5,000. (In phased rehabilitations, the 24-month measuring period was extended to 60 months.)

The external-walls requirement provided generally that at least 75 percent of the existing external walls of the building had to be retained in place as external walls in the rehabilitation process. An alternative test provided that the external-walls requirement was met if (1) at least 75 percent of the external walls were retained in place as either internal or external walls, (2) at least 50 percent of such walls were retained in place as external walls, and (3) at least 75 percent of the building's internal structural framework was retained in place.

In the case of rehabilitations of certified historic structures, certain additional rules applied. In particular, the Secretary of the Interior had to certify that the rehabilitation was consistent with the historic character of the building or the historic district in which the building was located. In fulfilling this statutory mandate, the Secretary of the Interior's Standards for Rehabilitation were applied. See 36 CFR Part 67.7 (March 12, 1984).

Qualified rehabilitation expenditures generally included any amounts properly chargeable to capital account of a building in connection with a rehabilitation, but did not include the following:

 

(1) the cost of acquiring a building or an interest in a building (such as a leasehold interest);

(2) the cost of facilities related to a building (such as a parking lot); and

(3) the cost of enlarging an existing building.

 

Lessees were entitled to the credit for qualified expenditures incurred by the lessee if, on the date the rehabilitation was completed, the remaining lease term (without regard to renewal periods) was at least as long as the applicable recovery period (generally 19 years; 15 years in the case of low-income housing). Under regulations prescribed by the Secretary of the Treasury, the substantial rehabilitation test for a lessee was generally applied by comparing the lessee's qualified rehabilitation expenditures to the lessor's adjusted basis in the building (i.e., the lessee stepped into the shoes of the lessor).

The rehabilitation credit was subject to recapture if the rehabilitated building was disposed of or otherwise ceased to be qualified investment credit property with respect to the taxpayer during the five years following the date the property was placed in service. If the Department of the Interior decertified a rehabilitation of a certified historic structure during the recapture period, the property ceased to be qualified investment credit property.

 

Reasons for Change

 

 

In 1981, the Congress restructured and increased the tax credit for rehabilitation expenditures. The Congress was concerned that the tax incentives provided to investments in new structures (e.g., accelerated cost recovery) would have the undesirable effect of reducing the relative attractiveness of the prior-law incentives to rehabilitate and modernize older structures, and might lead investors to neglect older structures and relocate their businesses.

The Congress concluded that the incentives granted to rehabilitations in 1981 remain justified. Such incentives are needed because the social and aesthetic values of rehabilitating and preserving older structures are not necessarily taken into account in investors' profit projections. A tax incentive is needed because market forces might otherwise channel investments away from such projects because of the extra costs of undertaking rehabilitations of older or historic buildings.

The Congress also sought to focus the credit particularly on historic and certain older buildings, to insure that the credits accomplish their intended objectives of preserving such historic and older buildings. In addition, the Congress was concerned that the existing credit percentages would be too high in the context of the lower overall rates provided in the Act. For example, the 25-percent credit under prior law offset tax on 50 cents of income for every $1 of rehabilitation expenditures made by an individual taxpayer in the top 50-percent bracket. A credit of 14 percent would accomplish the same offset to income with a top bracket of 28 percent. Similarly reduced credits would reproduce the same offsets to income as the current 15-percent and 20-percent rehabilitation credits.

 

Explanation of Provision

 

 

Two-tier credit

The Act replaces the existing three-tier rehabilitation credit with a two-tier credit for qualified rehabilitation expenditures. The credit percentage is 20 percent for rehabilitations of certified historic structures and 10 percent for rehabilitations of buildings (other than certified historic structures) originally placed in service before 1936.

Retention of certain rules

As under prior law, the 10-percent credit for the rehabilitation of buildings that are not certified historic structures is limited to non-residential buildings, but the 20-percent credit for rehabilitation of historic buildings is available for both residential and nonresidential buildings.

The prior law provisions that determine whether rehabilitation expenditures qualify for the credit were generally retained. In general, no changes were made regarding the substantial rehabilitation test, the specific types of expenditures that do not qualify for the credit, the provisions applicable to certified historic structures and tax-exempt use property, or the recapture rules.

No expenditure will be eligible for credit unless the taxpayer recovers the costs of the rehabilitation using the straight-line method of depreciation. Further, expenditures incurred by a lessee will not qualify for the credit unless the remaining lease term, on the date the rehabilitation is completed, is at least as long as the recovery period under ACRS (generally 27.5 years for residential real property or 31.5 years for nonresidential real property).

External-walls requirement

The external-walls requirement was significantly modified. The provision that requires 75 percent of the existing external walls to be retained in place as external walls was deleted and replaced by the alternative test provided by prior law that requires the retention in place of (1) at least 75 percent of the existing external walls (including at least 50 percent as external walls) as well as (2) at least 75 percent of the building's internal structural framework. Thus, unlike the situation that could occur under prior law, a building that is completely gutted cannot qualify for the rehabilitation credit under the Act. In general, a building's internal structural framework includes all load-bearing internal walls and any other internal structural supports, including the columns, girders, beams, trusses, spandrels, and all other members that are essential to the stability of the building.

Because the Secretary of the Interior's Standards for Rehabilitation insure that certified historic structures are properly rehabilitated, the external-walls requirement for such buildings was deleted to provide the Secretary of the Interior with appropriate flexibility. Rehabilitations eligible for the 20-percent credit must continue to be true rehabilitations, however, and not substantially new construction. Therefore, the Secretary of the Interior is expected to continue generally to deny certification to rehabilitations if less than 75 percent of the external walls are retained in place.

Basis reduction

The Act deletes the limited exception that required a basis reduction for only 50 percent of the credit in the case of certified historic structures. Thus, a full basis adjustment is required for both the ten-percent and 20-percent rehabilitation credits.

 

Effective Date

 

 

The modifications to the rehabilitation credit are generally applicable to property placed in service after December 31, 1986.

A general transitional rule provides that the modifications to the rehabilitation credit (other than certain reductions in the credit percentage--see below) will not apply to property placed in service before January 1, 1994, if the property is placed in service (as rehabilitation property) as part of either a rehabilitation completed pursuant to a written contract that was binding (under applicable state law) on March 1, 1986. This rule also applies to a rehabilitation with respect to property (including any leasehold interest) that was acquired before March 2, 1986, or was acquired on or after such date pursuant to a written contract that was binding on March 1, 1986, if (1) parts 1 (if necessary) and 2 of the Historic Preservation Certification Application were filed with the Department of the Interior (or its designee) before March 2, 1986, or (2) the lesser of $1,000,000 or five percent of the cost of the rehabilitation (including only qualified rehabilitation expenditures) is incurred before March 2, 1986, or is required to be incurred pursuant to a written contract that was binding on March 1, 1986.40

If a taxpayer transfers his rights in property under rehabilitation or under a binding contract to another taxpayer, the modifications do not apply to the property in the hands of the transferee, as long as the property was not placed in service before the transfer by the transferor. For purposes of this rule, if by reason of sales or exchanges of interests in a partnership, there is a deemed termination and reconstitution of a partnership under section 708(b)(1(B), the partnership is to be treated as having transferred its rights in the property under rehabilitation or the binding contract to the new partnership.

If property that qualifies under a transitional rules is placed in service after December 31, 1986, the applicable credit percentages are reduced from 15 to ten, and 20 to 13, respectively. The credit percentage is not reduced for property that qualifies for the 25-percent credit.41

Property that qualifies for transitional relief from the amendments relating to the rehabilitation tax credit is also excepted from the depreciation changes made by section 201 of the Act.

 

Revenue Effect

 

 

This provision is estimated to increase fiscal year budget receipts by $43 million in 1987, $165 million in 1988, $581 million in 1989, $1,371 million in 1990, and $1,779 million in 1991.

2. Tax credit for low-income rental housing

(sec. 252 of the Act and sec. 42 of the Code)1

 

Prior Law

 

 

No low-income rental housing tax credit was provided under prior law, but other tax incentives for low-income housing were available. These tax incentives consisted principally of special accelerated depreciation, five-year amortization of rehabilitation expenses, expensing of construction period interest and taxes, and tax-exempt bond financing for multifamily residential rental property.

 

Reasons for Change

 

 

Congress was concerned that the tax preferences for low-income rental housing available under prior law were not effective in providing affordable housing for low-income individuals. Congress believed a more efficient mechanism for encouraging the production of low-income rental housing could be provided through the low-income rental housing tax credit.

The primary tax preferences provided for low-income housing under prior law were tax-exempt bond financing, accelerated cost recovery deductions, five-year amortization of rehabilitation expenditures, and special deductions for construction period interest and taxes. These preferences operated in an uncoordinated manner, resulted in subsidies unrelated to the number of low-income individuals served, and failed to guarantee that affordable housing would be provided to the most needy low-income individuals.

A major shortcoming of the prior-law tax subsidies was that, beyond a minimum threshold requirement of low-income housing units that were required to be served, the degree of subsidy was not directly linked to the number of units serving low-income persons. As a result, there was no incentive to provide low-income units beyond the minimum required. Under the tax credit, however, the amount of the low-income housing tax credit which an owner may receive is directly related to the number of rental units made available to low-income individuals. By providing tax credits which are based on the number of units serving low-income persons, an incentive exists to provide a greater number of housing units for more low-income individuals.

Another weakness of the Federal tax subsidies available under prior law was that they were not targeted to persons of truly low-income. For example, a study by the General Accounting Office2 (GAO) of tax-exempt bond financed residential rental projects found that above-average income renters could qualify under prior law as "low" or "moderate" income for two reasons. First, persons with incomes as high as 80 percent of area median income were eligible to occupy units reserved for low- and moderate-income tenants. This income ceiling was relatively high, particularly when compared with the median income of renters. Second, the Treasury Department did not require household incomes to be adjusted for family size until after 1985. Congress believed that the low-income housing tax credit (as well as tax-exempt bond financing for low-income housing, discussed in Title XIII) should be provided only for households with incomes not exceeding 50 percent or 60 percent of area median income. Congress further believed that these income limits should be adjusted for family size. These provisions better target affordable housing to those persons most in need of assistance.

Another shortcoming of the tax subsidies under prior law was that none limited the rents that could be charged to low-income individuals. The same GAO study found, for example, that while 96 percent of individuals with incomes over 80 percent of area median income (the prior-law ceiling on "low" or "moderate" income) paid rents of less than 30 percent of their income, only 37 percent of individuals with incomes below 80 percent of area median paid rents of less than 30 percent of their income. The low-income housing tax credit limits the rent that may be charged to a low-income tenant, and therefore ensures that the subsidized housing is affordable to low-income individuals. In return for providing housing at reduced rents, owners of rental housing receive a tax credit designed to compensate them for the rent reduction.

Congress believed that the low-income housing tax credit (and tax-exempt bonds, as retargeted) will more effectively serve both low-income individuals and owners willing to provide affordable low-income housing than the multiple, uncoordinated tax preferences for low-income housing under prior law.

 

Explanation of Provisions

 

 

Overview

The Act provides a tax credit that may be claimed by owners of residential rental property used for low-income housing. The credit is claimed annually, generally for a period of ten years. New construction and rehabilitation expenditures for low-income housing projects placed in service in 1987 are eligible for a maximum nine percent credit, paid annually for ten years. The acquisition cost of existing projects and the cost of newly constructed projects receiving other Federal subsidies placed in service in 1987 are eligible for a maximum four percent credit, also paid annually for ten years. For buildings placed in service after 1987, these credit percentages will be adjusted to maintain a present value of 70 percent and 30 percent for the two types of credits.

The credit amount is based on the qualified basis (defined below) of the housing units serving the low-income tenants. Low-income tenants for purposes of the low-income housing tax credit are defined as tenants having incomes equal to or less than either 50 percent or 60 percent of area median income, adjusted for family size. The qualifying income for a particular property depends on the minimum percentage of units that the owner elects to provide for low-income tenants. Rents that may be charged families in units on which a credit is claimed may not exceed 30 percent of the applicable income qualifying as "low", also adjusted for family size.

To qualify for the credit, residential rental property must comply continuously with all requirements of the credit throughout a 15 year compliance period. A credit allocation from the appropriate State or local credit authority must be received by the owner of property eligible for the low-income housing tax credit, unless the property is substantially financed with the proceeds of tax-exempt bonds subject to the new private activity bond volume limitation. These provisions are further explained in the following sections.

Credit amount and credit period

The Act provides two separate credit amounts: (1) a 70-percent present value credit for qualified new construction and rehabilitation expenditures (in excess of specified minimum amounts per unit) that are not federally subsidized and (2) a 30-percent present value credit for other qualifying expenditures. Expenditures qualifying for the 30-percent present value credit consist of the cost of acquisition of an existing building (including certain rehabilitation expenditures which are incurred in connection with acquisition and which do not exceed prescribed minimum amounts), and federally subsidized new construction or rehabilitation expenditures.

A taxpayer's credit amount in any taxable year is computed by applying the appropriate credit percentage to the appropriate qualified basis amount in such year, as defined below.3 Except as described below, both credits are claimed annually over a 10-year period.

The credit period is the 10-year period beginning with the taxable year in which the building is placed in service or, at the election of the taxpayer, the succeeding taxable year. The credit may not be claimed for a taxable year in which the building is not in compliance with all requirements of the credit.

Credit percentage
For buildings placed in service in 1987, the credit percentages are 9 percent annually over 10 years for the 70-percent present value credit, and 4 percent annually over 10 years for the 30-percent present value credit.

For buildings placed in service after 1987, these credit percentages are to be adjusted monthly by the Treasury Department to reflect the present values of 70 percent and 30 percent at the time the building is placed in service. Treasury's monthly adjustments of the credit percentages are to be determined on a discounted after-tax basis, based on the average of the annual applicable Federal rates (AFR) for mid-term and long-term obligations for the month the building is placed in service. The after-tax interest rate is to be computed as the product of (1) the average AFR and (2) .72 (one minus the maximum individual Federal income tax rate). The discounting formula assumes each credit is received on the last day of each year and that the present value is computed as of the last day of the first year. For example, if 72 percent of the average AFR for a given month were 5.85 percent, the 70-percent and 30-percent present value credit percentages for buildings placed in service in that month would be 8.92 percent and 3.82 percent. (For the 70-percent present value credit, this is derived as .0892 = (.70)(.0585)/ [1.0585 - 1/(1.0585)9].) In a project consisting of two or more buildings placed in service in different months, a separate credit percentage may apply to each building.4

For buildings originally placed in service after 1987, Congress intended that the taxpayer, with the consent of the housing credit agency, may irrevocably elect to use the credit percentage determined using the above method for the month in which the taxpayer receives a binding commitment for a credit allocation from the credit agency or, in the case of a tax-exempt bond financed project for which no allocation is required, the month in which the tax-exempt bonds are issued.5

The credit percentage for rehabilitation expenditures (in excess of a prescribed minimum amount) is determined when rehabilitation is completed and the rehabilitated property is placed in service, but no later than the end of the 24-month period for which such expenditures may be aggregated.6 These rehabilitation expenditures are treated as a separate new building for purposes of the credit.

The credit percentage for rehabilitation expenditures that are incurred in connection with the acquisition of an existing building (and which do not exceed prescribed minimum amounts) is the same percentage as is used for the acquired building, i.e., the percentage determined when the acquired building is placed in service.

Qualified basis
In general

The qualified basis amounts with respect to which the credit amount is computed are determined as the proportion of eligible basis in a qualified low-income building attributable to the low-income rental units. This proportion is the lesser of (1) the proportion of low-income units to all residential rental units or (2) the proportion of floor space of the low-income units to the floor space of all residential rental units. Generally, in these calculations, low-income units are those units presently occupied by qualifying tenants, whereas residential rental units are all housing units, whether or not presently occupied.

The qualified basis for each building is determined on the last day of each taxable year, beginning in the taxable year in which the building is placed in service or, if the taxpayer elects, the following taxable year.

Special rules for determining qualified basis

The Treasury Department may provide regulations for projects consisting of two or more buildings. Unless prescribed in regulations, the qualified basis of a project consisting of two or more buildings is determined separately for each building. Common facilities in such a project must be allocated in an appropriate manner to all buildings (whether existing or to be constructed) in the project.

The first year the credit is claimed, the allowable credit amount is determined using an averaging convention to reflect the number of months units comprising the qualified basis were occupied by low-income individuals during the year. For example, if half of the low-income units included in qualified basis were first occupied in October and the remaining half were occupied in December, a calendar year taxpayer would adjust the allowable first-year credit to reflect that these units were occupied on average only one-sixth of the year. To the extent there is such a reduction of the credit amount in the first year, an additional credit in the amount of such reduction is available in the eleventh taxable year. (This first-year adjustment does not affect the amount of qualified basis with respect to which the credit is claimed in subsequent years of the 10-year credit period.)

Additions to qualified basis

The qualified basis of a building may be increased subsequent to the initial determination only by reason of an increase in the number of low-income units or in the floor space of the low-income units (as opposed to by reason of increases in the eligible basis). Credits claimed on such additional qualified basis are determined using a credit percentage equal to two-thirds of the applicable credit percentage allowable for the initial qualified basis. As described below under the description of the State credit ceiling, an allocation of credit authority must be received for credits claimed on additions to qualified basis, in the same manner as for credits claimed on the initial qualified basis. Unlike credits claimed on the initial qualified basis, credits claimed on additions to qualified basis are allowable annually for the portion of the required 15-year compliance period remaining after eligibility for such credits arises, regardless of the year such additional qualified basis is determined. The additional qualified basis is determined by reference to the original adjusted basis (before deductions for depreciation) of the property.

The credit amount on the additional qualified basis is adjusted in the first year such additions are made using an averaging convention to reflect the number of months units comprising the additional qualified basis were occupied by low-income individuals during the year. Any reduction of the credit amount in the first year may not be claimed in a later year. (This first-year adjustment does not affect the amount of additional qualified basis with respect to which the credit is claimed in subsequent years of the compliance period.)

Eligible basis
Eligible basis consists of (1) the cost of new construction, (2) the cost of rehabilitation, or (3) the cost of acquisition of existing buildings acquired by purchase (including the cost of rehabilitation, if any, to such buildings incurred before the close of the first taxable year of the credit period which do not exceed a prescribed minimum amount). Only the adjusted basis of the depreciable property may be included in eligible basis.7 The cost of land is not included in adjusted basis.

Generally, the eligible basis of a building is determined at the time the building is placed in service. For this purpose, rehabilitation expenditures (in excess of $2,000 per unit) are treated as placed in service at the close of the period for which rehabilitation expenditures are aggregated, not to exceed 24 months. In the case of rehabilitation expenditures incurred in connection with the acquisition of an existing building (and which do not exceed a prescribed minimum amount), the capital expenditures incurred through the end of the first year of the credit period may be included in eligible basis.

For purposes of the low-income housing credit, the term residential rental property generally has the same meaning as residential rental property within Code section 142(d).8 Thus, residential rental property includes residential rental units, facilities for use by the tenants, and other facilities reasonably required by the project. Eligible basis may include the cost of such facilities and amenities (e.g., stoves, refrigerators, air conditioning units, etc.) only if the included amenities are comparable to the cost of the amenities in the low-income units. Additionally, the allocable cost of tenant facilities, such as swimming pools, other recreational facilities, and parking areas, may be included provided there is no separate fee for the use of these facilities and they are made available on a comparable basis to all tenants in the project. (See generally, Treas. Reg. sec. 1.103-8(b)(4)(iii).)

Except as described below, costs of the residential rental units in a building which are not low-income units may be included in eligible basis only if such units are not above the average quality standard of the low-income units. Similarly, rehabilitation expenditures may not be included in eligible basis if such expenditures improve any unit in the building beyond comparability with the low-income units. Units are of comparable quality if the construction or acquisition costs are comparable and if such units are provided in a similar proportion for both the low-income and other tenants. Congress intended that, at the election of the taxpayer, the cost of a unit which would otherwise be excluded from eligible basis may be included in eligible basis if (1) the excess cost of such unit over the average cost of the low-income units does not exceed 15 percent of the average cost of the low-income units and (2) the excess cost is excluded from eligible basis.9

Residential rental property may qualify for the credit even though a portion of the building in which the residential rental units are located is used for a commercial use. No portion of the cost of such nonresidential rental property included in a project may be included in eligible basis. Congress intended that the costs of such a mixed-use facility be allocated according to any reasonable method that properly reflects the proportionate benefit to be derived, directly or indirectly, by the nonresidential rental property and the residential rental units. (See, e.g., Prop. Treas. Reg. sec. 1.103-8(b)(4)(v).)

Certain rehabilitation expenditures

The qualified basis attributable to rehabilitation expenditures, unless incurred in connection with the acquisition of an existing building, must equal at least $2,000 per low-income unit.10 The $2,000 minimum is computed as an average based on all qualifying expenditures in the building, rather than on a unit-by-unit determination. Qualified basis is determined in the same fractional manner as for new construction or acquisition costs even if all rehabilitation expenditures are made only to low-income units. Rehabilitation expenditures may be included in eligible basis without a transfer of property. Rehabilitation expenditures may be aggregated only for such expenditures incurred during any 24-month period. Where rehabilitation is limited to a group of units, Treasury may provide regulations treating a group of units as a separate new building.

Where rehabilitation expenditures are paid or incurred by a person (or persons) and the taxpayer acquires the property attributable to such expenditures (or an interest therein) before such property is placed in service, the taxpayer will be treated as having paid or incurred the expenditures (see Treas. Reg. sec. 1.167(k)1(b)(1) and (2)). The portion of the basis of the property not attributable to rehabilitation expenditures may not be included in the eligible basis relating to the rehabilitated property, but may be includible in the eligible basis relating to acquisition costs, as described below.

Acquisition of existing buildings

The cost of acquisition of an existing building may be included in eligible basis and any rehabilitation expenditures to such a building incurred before the close of the first year of the credit period may at the election of the taxpayer also be included in eligible basis, without a minimum rehabilitation requirement. These costs may be included in eligible basis, however, only if the building or a substantial improvement (a capital expenditure of 25 percent or more of the adjusted basis of the building to which five-year rapid amortization was elected or to which ACRS applied (as in effect before the enactment of this Act)) to the building has not been previously placed in service within 10 years and if the building (or rehabilitated property within the building) is not subject to the 15-year compliance period.

A building that is transferred in a transfer where the basis of the property in the hands of the new owner is determined in whole or part by the adjusted basis of the previous owner (for example, by a gift of property) is considered not to have been newly placed in service for purposes of the 10-year requirement.11 Further, Congress intended that a building which has been acquired by a governmental unit or certain qualified 501(c)(3) or 501(c)(4) organizations would not be treated as placed in service by that governmental unit or organization for purposes of the 10-year requirement if the acquisition occurs more than 10 years from the date the building or a substantial improvement to the building has last been placed in service.12 Congress also intended that a building acquired by foreclosure by taxpayers other than a governmental unit or 501(c)(3) organization would not be treated as newly placed in service by that taxpayer for purposes of the 10-year requirement if the foreclosure occurs more than 10 years from the date the building or a substantial improvement to the building has last been placed in service and the property is resold within a short period.13 Any other transfer will begin a new 10-year period.

The Treasury Department may waive the 10-year requirement for any building substantially assisted, financed or operated under the HUD section 8, section 221(d)(3), or section 236 programs, or under the Farmers' Home Administration section 515 program when an assignment of the mortgage secured by property in the project to HUD or the Farmers Home Administration otherwise would occur or when a claim against a Federal mortgage insurance fund would occur.

Federal grants and other subsidies

Eligible basis may not include in any taxable year the amount of any Federal grant, regardless of whether such grant is included in gross income. A Federal grant includes any grant funded in whole or in part by the Federal government, to the extent funded with Federal funds. Examples of grants which may not be included in eligible basis include grants funded by Community Development Block Grants, Urban Development Action Grants, Rental Rehabilitation Grants, and Housing Development Grants.

If any portion of the eligible basis attributable to new construction or to rehabilitation expenditures is financed with Federal subsidies, the qualified basis is eligible only for the 30-percent present value credit, unless such Federal subsidies are excluded from eligible basis. A Federal subsidy is defined as any obligation the interest on which is exempt from tax under section 103 or a direct or indirect Federal loan, if the interest rate on such loan is less than the applicable Federal rate. A Federal loan under the Farmers' Home Administration section 515 program is an example of such a Federal subsidy, as is a reduced interest rate loan attributable in part to Federal grant funds lent to a building owner.

The determination of whether rehabilitation expenditures are federally subsidized is made without regard to the source of financing for the construction or acquisition of the building to which the rehabilitation expenditures are made. For example, a Federal loan or tax-exempt bond financing that is continued or assumed upon purchase of existing housing is disregarded for purposes of the credit on rehabilitation expenditures. Congress intended that tax-exempt financing or a below market loan to provide construction financing for any building will not be treated as a Federal subsidy if such loan is repaid and any underlying obligation (e.g., tax-exempt bond) is redeemed before the building is placed in service.14

Minimum set-aside requirement for low-income individuals

In general
A residential rental project providing low-income housing qualifies for the credit only if (1) 20 percent or more of the aggregate residential rental units in the project are occupied by individuals with incomes of 50 percent or less of area median income, as adjusted for family size, or (2) 40 percent or more of the aggregate residential rental units in the project are occupied by individuals with incomes of 60 percent or less of area median income, as adjusted for family size.15 (This requirement is referred to as the "minimum set-aside" requirement.)

A special set-aside may be elected for projects that satisfy a stricter requirement and that significantly restrict the rents on the low-income units relative to the other residential units in the building (the "deep-rent skewing" set-aside). Projects qualify for this rule only if, as part of the general set-aside requirement, 15 percent or more of all low-income units are occupied by individuals having incomes of 40 percent (rather than 50 percent or 60 percent) or less of area median income, and the average rent charged to tenants in the residential rental units which are not low-income units is at least 300 percent of the average rent charged to low-income tenants for comparable units. Under this special rule, a low-income tenant will continue to qualify as such, as long as the tenant's income does not exceed 170 percent of the qualifying income. Additionally, if a project to which this special set-aside requirement applies ceases to comply with the requirement because of increases in existing tenants' incomes, no penalties are imposed if each available low-income unit is rented to tenants having incomes of 40 percent or less of area median income, until the project is again in compliance.16

All units comprising the minimum set-aside in a project must be suitable for occupancy and used on a nontransient basis, and are subject to the limitation on gross rent charged to residents of set-aside units. (See the discussion of the gross rent limitation, below.)

The owner of each project must irrevocably elect the minimum set-aside requirement (including the deep-rent skewing set-aside described above) at the time the project is placed in service. In the case of a project consisting of a single building, the set-aside requirement must be met within 12 months of the date the building (or rehabilitated property) is placed in service, and complied with continuously thereafter for a period ending 15 years after the first day of the first taxable year in which the credit is claimed.

Special rules apply to projects consisting of multiple buildings placed in service on different dates. Unless prescribed by regulations, the initial building, within 12 months of being placed in service, must meet the set-aside requirement determined only by reference to those units in the initial building. When a second or subsequent building is placed in service, the project must meet the set-aside requirement with respect to the units in all buildings placed-in-service up to that time within 12 months of the date the second or subsequent building is placed in service.17 The project must comply with this expanded requirement continuously thereafter for a period ending 15 years after the later of (1) the first day of the taxable year in which the expanded requirement is met or (2) if a credit is claimed with respect to the building, the first day of the taxable year in which the credit period begins with such building.18 Subsequent buildings are subject to separate 15-year compliance periods. After the 15-year period has expired on an initial building, but while other buildings in the same project are still subject to the compliance period, the project must continue to meet the set-aside requirement determined by reference to all buildings in the project or, at the taxpayer's election, all buildings subject to the compliance period.

Continuous compliance required
The determination of whether a tenant qualifies for purposes of the low-income set-aside is made on a continuing basis, both with regard to the tenant's income and the qualifying area income, rather than only on the date the tenant initially occupies the unit. An increase in a tenant's income may result, therefore, in a unit ceasing to qualify as occupied by a low-income person. However, a qualified low-income tenant is treated as continuing to be such notwithstanding de minimis increases in his or her income. Under this rule, a tenant qualifying when initially occupying a rental unit will be treated as continuing to have such an income provided his or her income does not increase to a level more than 40 percent in excess of the maximum qualifying income, adjusted for family size. If the tenant's income increases to a level more than 40 percent above the otherwise applicable ceiling (or if the tenant's family size decreases so that a lower maximum family income applies to the tenant) that tenant is no longer counted in determining whether the project satisfies the set-aside requirement.19 No penalty is assessed in such an event, however, provided that each residential rental unit that becomes vacant (of comparable or smaller size to the units no longer satisfying the applicable income requirement) is rented to tenants satisfying the qualifying income until the project is again in compliance. (For a discussion of the rules for complying with the set-aside requirements, see the discussion of the compliance period and penalty for noncompliance, below.)

Vacant units, formerly occupied by low-income individuals, may continue to be treated as occupied by a qualified low-income individual for purposes of the set-aside requirement (as well as for determining qualified basis) provided reasonable attempts are made to rent the unit and no other units of comparable or smaller size in the project are rented to nonqualifying individuals (see the section "Compliance period and penalty for noncompliance," below).

In no case is a unit considered to be occupied by low-income individuals if all of the occupants of such unit are students (as determined under sec. 151(c)(4)), no one of whom is entitled to file a joint income tax return.

Adjustments for family size
As stated above, the Act requires that adjustments for family size be made in determining the incomes used to qualify tenants as having low income. In general, these adjustments are the same as the adjustments presently made under section 8 of the United States Housing Act of 1937. Thus, for a project which qualifies by setting aside 20 percent of the units for tenants having incomes of 50 percent or less of area median income, a family of four generally will be treated as meeting this standard if the family has an income of 50 percent or less of the area median income; a family of three having an income of 45 percent or less generally will qualify; a family of two having an income of 40 percent or less generally will qualify; and, a single individual having an income of 35 percent or less generally will qualify.

Congress was aware that, in certain cases, the use of section 8 guidelines may result in qualifying incomes below the amounts reflected by these percentages because of dollar ceilings that are applied under the section 8 program. Income limits may be adjusted by the Treasury Department for areas with unusually low family income or high housing costs relative to family income in a manner consistent with determinations of very low income families and area median gross income under section 8 to reflect the 50-percent and 60-percent income levels.

Gross rent limitation
The gross rent paid by families in units included in qualified basis may not exceed 30 percent of the applicable qualifying income, adjusted for family size. Gross rent includes the cost of any utilities, other than telephone. If any utilities are paid directly by the tenant, the maximum rent that may be paid by the tenant is to be reduced by a utility allowance prescribed by the Treasury Department, after taking into consideration the procedures for making such adjustments under section 8 of the United States Housing Act of 1937.

The gross rent limitation applies only to payments made directly by the tenant. Any rental assistance payments made on behalf of the tenant, such as through section 8 of the United States Housing Act of 1937 or any comparable Federal rental assistance, are not included in gross rent. Congress further intended that any comparable State or local government rental assistance not be included in gross rent.20

Low-income unit

A low-income unit includes any unit in a qualified low-income building if the individuals occupying such unit meet the income limitation elected for the project for purposes of the minimum set-aside requirement and if the unit meets the gross rent requirement, as well as meeting all other requirements applicable to units satisfying the minimum set-aside requirement.

Qualified low-income housing projects and qualified low-income buildings

A qualified low-income building is a building subject to the 15-year compliance period and which is part of a qualified low-income housing project.

A qualified low-income housing project is a project that meets the minimum set-aside requirement and other requirements with respect to the set-aside units at all times that buildings comprising the project are subject to the 15-year compliance period. A qualified low-income housing project includes a qualified low-income building containing residential rental units and other property that is functionally related and subordinate to the function of providing residential rental units. A project may include multiple buildings having similarly constructed housing units, provided the buildings are located on the same tract of land, are owned by the same person for Federal income tax purposes, and are financed pursuant to a common plan of financing.

Residential rental units must be for use by the general public and all of the units in a project must be used on a nontransient basis. Residential rental units are not for use by the general public, for example, if the units are provided only for members of a social organization or provided by an employer for its employees. Generally, a unit is considered to be used on a nontransient basis if the initial lease term is six months or greater. Additionally, no hospital, nursing home, sanitarium, life-care facility, retirement home providing significant services other than housing, dormitory, or trailer park may be a qualified low-income project. Factory-made housing which is permanently fixed to real property may be a qualified low-income building (see Treas. Reg. sec. 6a.103A-2(d)(4)(i) on factory-made housing).

Unlike the requirements for units in projects financed with tax-exempt bonds, certain single room occupancy housing used on a nontransient basis may qualify for the credit, even though such housing may provide eating, cooking, and sanitation facilities on a shared basis. An example of housing that may qualify for the credit is a residential hotel used on a nontransient basis that is available to all members of the public.

Compliance period and penalty for noncompliance

Qualified residential rental projects must remain as rental property and must satisfy the minimum set-aside requirement, described above, throughout a prescribed compliance period. Low-income units comprising the qualified basis on which additional credits are based are required to comply continuously with all requirements in the same manner as units satisfying the minimum set-aside requirement. Units in addition to those meeting the minimum set-aside requirement on which a credit is allowable also must continuously comply with this requirement.

The Act defines the compliance period for any building as 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 minimum set-aside requirement must be met, in all cases, within 1 year of the date the building (or rehabilitated property) is placed in service.

Within 90 days of the end of the first taxable year for which the credit is claimed and annually for each taxable year thereafter during the compliance period, the taxpayer must certify to the Secretary that the project has continuously complied throughout the year with the set-aside requirement and report the dollar amount of the qualified basis of the building and the maximum applicable percentage and qualified basis permitted to be taken into account by the housing credit agency. Additionally, the certification must include the date (including the taxable year) in which the building was placed in service and any other information required by Treasury.21

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.

Generally, any change in ownership by a taxpayer of a building subject to the compliance period is also a recapture event. An exception is provided if the seller posts a bond with the Treasury Department (in an amount prescribed by Treasury) and provided it can reasonably be expected that such building will continue to be operated as a qualified low-income building for the remainder of the compliance period. For partnerships consisting of more than 35 individual taxpayers, at the partnership's election, no change in ownership will be deemed to occur provided within a 12-month period at least 50 percent (in value) of the original ownership is unchanged.22

In the year of a recapture event, no credit is allowable for the taxpayer subject to recapture. Additionally, the accelerated portion of credits paid in earlier years is recaptured with interest, from the date the recaptured amount was claimed, at the overpayment rate established under section 6621. The accelerated portion of the credit in any year is the amount of credits determined for the year, less the amount which would have been determined for the year if all credits had been allowed ratably over the 15-year compliance period (with no further discounting). Because credits on the initial qualified basis of a building are claimed ratably over a 10-year credit period rather than the 15-year compliance period, the amount of credit recaptured for noncompliance during the first 11 years is one-third of the credit determined for the year, plus interest. In the absence of additions to qualified basis and previous recapture events, the credits are recaptured in the following amounts (in addition to interest): one-third for violations after year 1 and before expiration of year 11; four-fifteenths for violations after year 11 but before expiration of year 12; three-fifteenths for violations after year 12 but before expiration of year 13; two-fifteenths for violations after year 13 but before expiration of year 14; and one-fifteenth for violations after year 14 but before expiration of year 15.

Because credits claimed on additions to qualified basis are paid ratably over the remainder of the compliance period (the credit percentage is two-thirds of the otherwise applicable percentage), there is no accelerated portion of credits attributable to additions to qualified basis and, therefore, no recapture of these amounts.

The penalty for a decrease in the qualified basis of a building, while still remaining part of a qualified low-income project, is recapture of the credits with respect to the accelerated amount claimed for all previous years on the amount of the reduction in qualified basis.

Owners and operators of low-income housing projects on which a credit has been claimed must correct any noncompliance with the set-aside requirement or with a reduction in qualified basis within a reasonable period after the noncompliance is discovered or reasonably should have been discovered. If any noncompliance is corrected within a reasonable period, there is no recapture. Congress did not intend, however, that tenants be evicted to return a project to compliance. Rather, Congress intended that each residential rental unit of comparable or smaller size that becomes vacant while a project is not in compliance must be rented to a tenant having a qualifying income before any units in the project are rented to tenants not so qualifying until the project again is in compliance. In general, therefore, the event that gives rise to the penalty for noncompliance (i.e., recapture or a reduction in the allowable credit) will be rental of a unit to other than a low-income tenant (on other than a temporary basis) during any period when the project does not comply with the set-aside requirement or with the qualified basis amounts on which the credit is computed (or would not qualify as a result of that rental).

An example of how the recapture provisions operate follows:

 

Example.-- Assume credits are claimed for a project based on a qualified basis of 30 percent of the basis of the project being allocable to units occupied by individuals with incomes of 50 percent or less of area median income and, at a later date, a qualified basis of only 25 percent of the basis of the project is allocable to units occupied by individuals with incomes of 50 percent or less of median income due to vacancies filled by tenants with nonqualifying incomes. Because the minimum set-aside requirement is not violated, recapture occurs only on the accelerated portion of the credit amounts allocable to the 5-percent basis of the project no longer eligible for the credit.

If the maximum credit for which a project is eligible increases and subsequently decreases, a last-in, first-out rule is applied in determining which credits are recaptured. For example, consider a building that initially claimed a credit based on a qualified basis of 25 percent of the basis of the building allocable to units occupied by individuals with incomes of 50 percent or less of area median income, and in year 3 began receiving a credit based on an additional 10 percent of the basis of the building (i.e., a total of 35 percent). The credit amount on the additions to qualified basis is computed by reference to two-thirds of the credit percentage. If in year 5 only 30 percent of the basis of the building qualifies, there is no recapture of previous years' credits because there is no accelerated portion of the credit amounts attributable to the 5 percent of the additions to qualified basis claimed since year 3.

 

Congress intended that there be no recapture for de minimis changes in the qualified basis by reason of changes in the floor space fraction.23 A reduction in qualified basis by reason of a casualty loss is not a recapture event provided such property is restored by reconstruction or replacement within a reasonable period.

State low-income housing credit authority limitation

Generally, any building eligible for the credit must receive an allocation of credit authority from the State or local credit agency in whose jurisdiction the qualifying low-income housing project is located. (An exception is provided for buildings financed with the proceeds of tax-exempt bonds that received an allocation pursuant to the new private activity bond volume limitation.) The aggregate amount of such credits allocated within the State is limited by the State annual low-income credit authority limitation. In all cases, credit allocations are counted against a State's annual credit authority limitation for the calendar year in which the credits are allocated. Congress intended that credits may be allocated only during the calendar year in which the building or rehabilitated property is placed in service, except in the case of (1) credits claimed on additions to qualified basis and (2) credits allocated in a later year pursuant to an earlier binding commitment made no later than the year in which the building is placed in service.24 Under this latter exception, for example, a building placed in service in 1987 may receive a binding commitment in 1987 to receive a credit allocation of a specified amount in 1989. In 1989 this amount is subtracted from the State credit authority limitation. The credit period and compliance period with respect to the building begin in the taxable year in which the building is placed in service or, by an irrevocable election of the taxpayer, the succeeding taxable year.

An election by the taxpayer to defer the start of the credit period for one year does not affect when the allocation must occur. (See also, the discussion below for credits claimed on additions to qualified basis). The credit amount allocated to a building applies for the year the allocation is made and for all future years of the compliance period.

Allowable credit authority
General rules.--The annual credit authority limitation for each State is equal to $1.25 for every individual who is a resident of the State (as determined by the most recent estimate of the State's population released by the Bureau of the Census before the beginning of the year to which the limitation applies). For purposes of the credit authority limitation, the District of Columbia and U.S. possessions (e.g., Puerto Rico, the Virgin Islands, Guam, and American Samoa) are treated as States.

Special set-aside for qualified nonprofit organizations.--A portion of each State's credit authority limitation is set aside for exclusive use by qualified nonprofit organizations. This set-aside is equal to $0.125 per resident of the State. This set-aside amount may not be changed by State action, either legislative or gubernatorial. In addition to the special set-aside, qualified nonprofit organization projects may be allocated any additional amount of a State's remaining credit authority.

To qualify for allocations from this set-aside, an organization must be a section 501(c)(3) or 501(c)(4) organization, one of the exempt purposes of which includes the fostering of low-income housing, and the qualifying project with respect to which the credits are allocated must be one in which such organization materially participates (within the meaning of the passive loss rule). Among the operations in which the organization must be involved in on a regular, continuous, and substantial basis, in addition to the continuing operation of the project, is the development of the project.

Credits subject to the credit authority limitation
Generally, credits subject to the State credit authority limitation include any credits attributable to expenditures not financed with tax-exempt bonds subject to the new private activity bond volume limitation.

In the case of a building financed with the proceeds of tax-exempt bonds subject to the bond volume limitation (Code sec. 146), if 70 percent or more of the aggregate basis of the building and land on which the building is located is financed with such proceeds, no portion of the credits attributable to such building is subject to the credit authority limitation.

If less than 70 percent of the aggregate basis of the building and land on which the building is located is financed with tax-exempt bonds subject to the bond volume limitation, only credits attributable to those bond-financed expenditures are not subject to the credit authority limitation.

Allocation of credit authority limitation among the State and other qualified governmental units therein
In general.--Each State's credit authority limitation is allocated among the various governmental units within the State pursuant to three alternative procedures.

Under the first procedure, each State's credit authority limitation is allocated in its entirety to the State housing agency until either the governor or the legislature makes a different allocation. If more than one such agency exists, they are treated as one agency. In the absence of a qualified State agency, no allocation may occur until provided by either the governor or the legislature.

Under the second procedure, the governor of each State is provided authority to allocate the State's credit authority limitation among all of the governmental units and other issuing authorities. This authority and any allocation rules established by the governor terminate as of the effective date of any overriding State legislation.

Under the third procedure, the State legislature may enact a law providing for a different allocation than that provided under the first or second procedures. Under this authority, the State legislature may allocate all or any portion of the State limitation to any governmental unit or other issuing authority in the State.

Congress intended that any allocation procedure established by the governor or State legislature give balanced consideration to the low-income housing needs of the entire State.

Congress desired to clarify that gubernatorial proclamations issued before the date of enactment of the Act (October 22, 1986) or State legislation enacted before that date is recognized for purposes of allocating the credit authority limitations, provided that the proclamation or legislation refers to the low-income housing tax credit authority limitation.

Congress further intended that a State be permitted to allocate available credit authority to a local issuer until a specified date during each year (e.g., November 1) at which time the authority, if unused, may revert to the State for reallocation. Similarly, a State statute may provide discretionary authority to a public official (e.g., the governor) to allocate the State's credit authority limitation. Because the credit authority limitation is an annual amount, however, any authority that has not been used for credits issued before the end of the calendar year expires.

Special rule for constitutional home rule subdivisions.--The Act provides a special allocation rule for certain political subdivisions with home rule powers under a State constitution (Illinois). The home rule subdivisions to which the special allocation rule applies are those home rule subdivisions that are granted home rule powers by the beginning of the calendar year in which the credits are issued pursuant to a State constitution that was adopted in 1970 and became effective on July 1, 1971. In that State, a full portion of the State credit authority limitation is allocated to each home rule subdivision based upon the ratio that the population of that home rule subdivision bears to the population of the entire State. As is true of the other credit authority limitation determinations, this allocation is made using the most recent population estimate from the Bureau of the Census released before the beginning of the calendar year to which the credits relate. The amount so allocated to home rule subdivisions may not be altered by the power to provide a different allocation otherwise granted by the Act to the governor or the State legislature. However, a home rule subdivision may agree to a different allocation.

The portion of a State's credit authority limitation not allocated to constitutional home rule subdivisions then is allocated under essentially the same three procedures described in the previous section. Thus, under the first procedure, the remaining State credit authority limitation is allocated to the State housing agency. Under the second and third procedures described above, the governor or the State legislature may allocate the State limitation other than that allocated to home rule subdivisions to any governmental units (including home rule subdivisions).

For purposes of the rules on State action establishing allocation rules for the credit authority limitation, a mayor of a constitutional home rule subdivision is treated as a governor, and a city council is treated as a State legislature.

Constitutional home rule subdivisions are treated as States for purposes of the credit authority limitation set-aside for qualified nonprofit organizations. Pursuant to their general authority to alter credit allocation, described above, these subdivisions may agree with the State in which they are located to exchange authority to allocate credits for qualified nonprofit organizations for authority to allocate credits for other projects.

Allocation of set-aside amount for qualified nonprofit organizations.--As described above, a portion of each State's credit authority limitation is set aside exclusively for projects of qualified non-profit organizations. Although the overall amount of credit authority set aside for these credits may not be reduced by any State action, a State may enact a statute determining which credit authorities in the State may allocate these credits and may allocate the entire set-aside amount to those authorities. Similarly, before any legislation, a governor may determine which authorities may allocate credits under the set-aside. The amount of the remaining credit authority limitation allocated to all other authorities must, of course, be adjusted to take into account any reallocation of the set-aside amount.

Determination of credit amount allocation
A building must receive low-income credit authority from the credit agency in whose jurisdiction the qualifying low-income building is located. The credit agency's remaining authority is reduced by the credit percentage multiplied by the amount of qualified basis granted by the credit agency for the building. The credit agency may grant a smaller credit percentage and a smaller qualified basis amount at the time the allocation is made than the maximum percentage and amount that would otherwise be allowed. Congress intended that the credit agencies reduce the maximum available credit percentage when the financing and rental assistance for a project from all sources is sufficient to provide the continuing operation of the qualifying low-income building without the maximum credit.

A credit agency's credit authority is reduced by the maximum amount of credit granted, whether or not the property ultimately is eligible for this maximum amount, and without regard to the averaging convention used in the first year of the credit period.

If a building is granted more credits than would be claimed in the first year of the credit period, without regard to the averaging convention, such amounts are not restored to the credit agency's authority. Such amounts may, however, be used in a later year by the owner of the building to the extent the credit determined with respect to the building is increased as a result of additions to qualified basis (but not beyond the amount allocated by the agency, and without regard to the reduced percentage applicable to such additions). (See also, the discussion on additions to qualified basis, above.)

 

Example 1.--Assume in calendar year 1987 a newly constructed building is placed in service and that the building's qualified basis, before consideration of the credit authority limitation, is determined to be $100,000 in that year. The credit agency may allocate any amount of qualified basis to the building, but the taxpayer may treat as his qualified basis only the lesser of (1) the qualified basis of the building, before consideration of the credit authority limitation, or (2) the qualified basis allocated to the building by the credit agency. If the credit agency allocated $100,000 of qualified basis and the maximum 9 percent credit percentage to the building, the agency's remaining 1987 credit authority would be reduced by $9,000.

Example 2.--Assume $120,000 in qualified basis and a credit percentage of 9 percent were initially authorized by a credit agency in 1987 for a qualified low-income building and that in 1987, the first year of the credit period, the building's qualified basis was $100,000. The credit agency's remaining 1987 credit authority is reduced by $10,800. If in year two of the credit period the qualified basis of the building increases by up to $20,000 due to an increase in the number of low-income units, additional credits may be claimed with respect to this addition to qualified basis without requiring additional credit authority from the credit agency. The credit percentage applicable to the additional qualified basis is two-thirds of the credit percentage applicable to the initial qualified basis. Credits on the additions to qualified basis may be claimed over the remainder of the compliance period.

 

If the qualified basis of a building is greater than the qualified basis allocated to it by the credit agency, credits may not be claimed on the excess portion unless additional low-income housing credits are allocated to the building by the credit agency. The credit authority of the credit agency is reduced for the calendar year of any such additional allocations.

Generally, no carryover authority for unused credit authority is permitted. A limited exception is provided for buildings placed in service in 1990, if expenditures of 10 percent or more of total project costs are incurred before January 1, 1989. Credit authority for such property may be carried over from the 1989 credit allocation for the credit agency. Congress intended that, for allocations made after 1987, if a building cannot be placed in service in the year for which the allocation was made for reasons beyond the control of the taxpayer, then upon approval by the Treasury Department, the credit allocation will be valid if the building is placed in service in the succeeding year.25

Credit agencies are permitted to enter into binding commitments to allocate future credit authority for years before the sunset date to buildings not yet placed in service by binding contracts or other means.

Should a credit agency issue more credits than its credit authority limitation provides, credits will be denied to those buildings last allocated credits until the credit authority limitation is not exceeded.

Credit administration
Credit agencies allocating credits may not condition allocation of credits to the source of financing for the qualifying low-income building. The Act authorizes the Treasury Department to prescribe regulations that may require credit recipients to pay a reasonable fee to cover administrative expenses of the credit agency. The fact that credits must be allocated on a building-by-building basis does not preclude a credit agency from charging a single fee for processing credits for a single project with multiple buildings or for multiple projects of a common taxpayer.

Agencies allocating credits must file reports with the Treasury Department containing (1) the maximum applicable percentage and qualified basis of each building, (2) the fees, if any, charged to credit recipients, (3) the aggregate amount of credits issued, and (4) other information required by Treasury. The time and manner of filing such reports and other information required are to be specified by the Treasury Department.

Transferability

A new owner of a building during its 15-year compliance period is eligible to continue to receive the credit as if the new owner were the original owner, using the same qualified basis and credit percentages as used by the original owner. Rehabilitation expenditures on such property may qualify for a credit in the same manner as rehabilitation expenditures on other qualifying property. The accelerated portion of credits claimed in previous years will be recaptured upon a transfer, subject to the election of the original owner to post a bond. All dispositions of ownership interests in buildings are treated as transfers for purposes of recapture, except for a special rule for certain partnerships. (There is no election for the new owner to assume the recapture liability for prior year credits.)

At-risk limitation

Property with respect to which a low-income housing tax credit is claimed is subject to an at-risk limitation similar to the investment tax credit at-risk rules in the case of nonqualified nonrecourse financing. An exception is provided for lenders related to the buyer of the low-income housing property. Another exception provides that the general investment tax credit at-risk rule, limiting the amount of nonrecourse financing to 80 percent of the credit base of the property, does not apply in the case of the low-income housing tax credit.26

A further exception is provided for financing (including seller financing) not in excess of 60 percent of the basis of the property that is lent by 501(c)(3) and 501(c)(4) organizations whose exempt purpose includes fostering low-income housing. Further, if the rate of interest for any financing qualifying for this exception is below the applicable Federal rate at the time the financing is incurred, less 1 percentage point, then the qualified basis to which such financing relates shall be reduced to reflect the present value of the payments of principal and interest, using as the discount rate such applicable Federal rate. The credit is recaptured if the financing provided by such organizations is not repaid with interest by the end of the 15-year credit compliance period.

Coordination with other provisions

The credit is subject to the rules of the general business credit, including the maximum amount of income tax liability that may be reduced by a general business tax credit in any year. Unused credits for any taxable year may be carried back to each of the 3 preceding taxable years and then carried forward to each of the 15 following taxable years. Congress intended that no credits be carried back to taxable years ending prior to January 1, 1987.27

For purposes of the rules in the Act limiting passive loss deductions, the credit (but not losses) is treated as arising from rental real estate activities in which the taxpayer actively participates. Credits may be used to offset tax on up to $25,000 of nonpassive income, subject to a phaseout between $200,000 and $250,000 of adjusted gross income (disregarding passive losses).

The basis of property for purposes of depreciation is not reduced by the amount of low-income credits claimed.

 

Effective Date

 

 

The credit is effective for buildings placed in service after December 31, 1986, and before January 1, 1991, other than (1) property to which the depreciation rules of prior-law apply or (2) property with respect to which any investor is eligible for passive losses under the special transitional exception contained in section 502 of the Act. Congress further intended that no property to which the provision of prior law allowing five-year amortization of rehabilitation expenditures applies may be included in eligible basis.28 As stated above, all buildings eligible for the credit must be placed in service before January 1, 1991.29 A building placed in service in 1990 is eligible for the credit, however, only if expenditures of 10 percent or more of the reasonably expected cost of the building are incurred before January 1, 1989. Under a special rule, described above, credit authority for such property placed in service in 1990 may be carried over from the 1989 volume allocation for any credit agency.

 

Revenue Effect

 

 

The low-income rental housing tax credit is estimated to reduce fiscal year budget receipts by $67 million in 1987, $324 million in 1988, $705 million in 1989, $1,011 million in 1990, and $1,139 million in 1991.

 

F. Merchant Marine Capital Construction Fund

 

 

(sec. 261 of the Act and new sec. 7518 of the Code)30

 

Prior Law

 

 

The Merchant Marine Act of 1936

The Merchant Marine Act of 1936, as amended, provides federal income tax incentives for U.S. taxpayers who own or lease vessels operated in the foreign or domestic commerce of the United States or in U.S. fisheries; these provisions were not contained in the Internal Revenue Code of 1954.

In general, qualified taxpayers were entitled to deduct from income certain amounts deposited in a capital construction fund pursuant to an agreement with the Secretary of Transportation or, in the case of U.S. fisheries, the Secretary of Commerce. Earnings from the investment or reinvestment of amounts in a capital construction fund were excluded from income.

The tax treatment of a withdrawal from a capital construction fund depended on whether it was "qualified." A nonqualified withdrawal of previously deducted or excluded monies by a taxpayer from a fund generated income to the taxpayer. A qualified withdrawal did not generate income to the taxpayer. A qualified withdrawal was a withdrawal for the acquisition, construction, or reconstruction of a qualified vessel, or for the payment of principal on indebtedness incurred in connection with the acquisition, construction, or reconstruction of such a vessel. A qualified vessel was defined as a vessel (including barges and containers) constructed or reconstructed in the United States, documented under U.S. laws, and which is to be operated in the U.S., foreign, Great Lakes, or noncontiguous domestic trade, or in U.S. fisheries.

A nonqualified withdrawal of previously deducted or excluded monies from a fund generated income to the taxpayer. In addition, interest on the tax liability attributable to a nonqualified withdrawal was payable from the date of deposit.

Capital cost recovery

Because provision was made for the deduction (or exclusion) of certain amounts deposited in a capital construction fund and their tax-free withdrawal in the case of a qualified withdrawal, the amount of funds withdrawn reduced the tax basis of the qualified vessel. This provision was designed to prevent double deductions, which would occur if a taxpayer was permitted to take depreciation deductions for amounts the taxpayer had already deducted from--or never included in--income.

Investment tax credit

In general, the amount of investment tax credit for eligible property was determined with reference to the basis. A taxpayer could compute the investment tax credit for a qualified vessel (i.e., one that was financed in whole or in part by qualified withdrawals from a capital construction fund) by including at least one-half of qualified withdrawals in basis.

 

Reasons for Change

 

 

The Congress concluded that the provision of tax benefits for U.S. shipping through the Capital Construction Fund mechanism is appropriate. Aid to U.S. shipping industries is necessary to assure an adequate supply of ships in the event of war. The Congress has adhered to a policy of providing tax incentives to the domestic shipping industry for many years, and there was a concern that the elimination of such incentives, coupled with reduced appropriations for maritime construction, could injure the industry.

The incentive under prior law may not have functioned properly as an incentive for U.S. shipbuilding. Consequently, the Congress determined that additional requirements should be imposed to insure that capital construction funds are used for the intended purpose. The Congress was also concerned about the ability of taxpayers to avoid taxation on nonqualified withdrawals by making such withdrawals in years for which there are net operating losses (or other tax attributes that reduce the tax attributable to the withdrawal).

The Congress became aware during its tax reform hearings that Treasury's proposal to terminate the Capital Construction Fund (CCF) could have a serious adverse impact on the financial reporting requirements of CCF holders. The Congress did not intend that the modifications to the CCF program be viewed as requiring any change in the financial statement presentation of income taxes by CCF holders. These taxpayers should be allowed to provide future financial statements necessary for ship financing on a basis consistent with that anticipated at the time these taxpayers entered into CCF agreements with the Federal government.

 

Explanation of Provision

 

 

In general

The Act coordinates the application of the Internal Revenue Code of 1986 with the capital construction fund program of the Merchant Marine Act of 1936, as amended. In addition, new requirements are imposed, relating to (1) the tax treatment of nonqualified withdrawals, (2) certain reports to be made by the Secretaries of Transportation and Commerce to the Secretary of the Treasury, and (3) a time limit on the amount of time monies can remain in a fund without being withdrawn for a qualified purpose.

For purposes of the definition of the term "qualified withdrawals," under new section 7518(e) (sec. 607(f) of the Merchant Marine Act, 1936), the phrase "acquisition, construction, or reconstruction of a qualified vessel" is to be interpreted as including acquisition through either purchase or lease of an agreement vessel for a period of five years or more. This interpretation parallels the structure of: (1) the scope of eligibility to establish a capital construction fund under section 607(a) of the Merchant Marine Act, 1936 (which permits deposits into a CCF fund by either an owner/lessor or the lessee of an eligible vessel, or both, subject to certain limitations), and (2) the scope of qualified withdrawals for vessel acquisition through either purchase (in the form of a down payment toward the purchase price) or payment of long-term indebtedness on an agreement vessel. This interpretation is also consistent with current industry acquisition practices reflecting a long-term trend toward vessel acquisition through lease rather than purchase.

Inclusion in Internal Revenue Code

The tax provisions relating to capital construction funds are recodified as part of the Internal Revenue Code of 1986. For purposes of the Internal Revenue Code of 1986, defined terms shall have the meaning given such terms in the Merchant Marine Act of 1936, as amended, as in effect, on the date of enactment of the Act.

Tax treatment of nonqualified withdrawals

The maximum rate of tax (34 percent for corporations and 28 percent for individuals) is to be imposed on nonqualified withdrawals made after December 31, 1986; This penalty is in addition to interest payable from the date the amount withdrawn was reported.

If a taxpayer makes a nonqualified withdrawal out of a capital construction fund, the income tax payable by the taxpayer for the year of withdrawal is generally to be increased by such amount as is necessary to assure that the tax liability with respect to the nonqualified withdrawal is determined by reference to the top marginal tax rates applicable to ordinary income and capital gains. Special rules are provided to limit the application of this provision in cases where the taxpayer derived no tax benefit from depositing the funds.

Departmental reports to Treasury

The Secretary of Transportation and the Secretary of Commerce are required to make annual reports to the Secretary of the Treasury regarding the establishment, maintenance, and termination of capital construction funds. These reports will also include determinations of whether a fund-holder has failed to fulfill a substantial obligation under a capital construction fund agreement. Under joint regulations, and after notice and opportunity for hearing, if the Secretary determines that a substantial obligation is not being fulfilled, he or she may treat the entire fund--or any portion thereof--as a nonqualified withdrawal.

25-year limit on deposits

The Act imposes a 25-year limit on the amount of time monies can remain in a fund without being withdrawn for a qualified purpose. This rule applies to all deposits, including those made before the general effective date. The 25-year period begins to run on the later of the date of deposit or January 1, 1987.

Monies that are not withdrawn after a 25-year period are treated as nonqualified withdrawals, according to the following schedule: for the 26th year, the fund-holder would be treated as having withdrawn 20 percent; for the 27th year, 40 percent; for the 28th year, 60 percent; for the 29th year, 80 percent, and for the 30th year, 100 percent. For purposes of this rule, if a taxpayer commits an amount to the construction or acquisition of identified vessels pursuant to a binding contract entered into before the close of a taxable year, the amount so committed is not treated as remaining in the fund.

 

Effective Date

 

 

The provision is effective for taxable years beginning after December 31, 1986.

 

Revenue Effect

 

 

The provision is estimated to increase fiscal year budget receipts by $3 million in 1987, $5 million in 1988, $4 million in 1989, $4 million in 1990, and $4 million in 1991.

 

TITLE III--CAPITAL GAINS AND LOSSES

 

 

A. Individual Capital Gains and Losses

 

 

(secs. 301 and 302 of the Act and secs. 1(j) and 1202 of the Code)1

 

Prior Law

 

 

Individual and other noncorporate taxpayers could deduct from gross income 60 percent of the amount of any net capital gain for the taxable year, i.e., 60 percent of the excess of net long-term capital gain over net short-term capital loss. As a result, the highest tax rate applicable to a noncorporate taxpayer's net capital gain was 20 percent (the 50 percent maximum individual tax rate times the 40 percent of net capital gain included in adjusted gross income).

Capital losses of individuals were deductible in full against capital gains. In addition, a maximum of $3,000 of capital losses was deductible against ordinary income. However, only 50 percent of net long-term capital losses in excess of net short-term capital gains could be deducted from ordinary income. Excess losses could be carried forward to future years.

 

Reasons for Change

 

 

The Congress believed that as a result of the Act's reduction of individual tax rates on such forms of capital income as business profits, interest, dividends, and short-term capital gains, the need to provide a reduced rate for net capital gain is eliminated. This will result in a tremendous amount of simplification for many taxpayers since their tax will no longer depend upon the characterization of income as ordinary or capital gain. In addition, this will eliminate any requirement that capital assets be held by the taxpayer for any extended period of time in order to obtain favorable treatment. This will result in greater willingness to invest in assets that are freely traded (e.g., stocks) and make investment decisions more neutral.

The Congress believed that the top rate on individual capital gains should not exceed the maximum rates set forth in the Act, and therefore the Act provides that the maximum tax rate on capital gains will not exceed the top individual rate that the Act provides in the event that the top individual rate is increased by a subsequent public law (unless that law specifically increases the capital gains tax).

 

Explanation of Provision

 

 

The Act repeals the net capital gain deduction for individuals.2

The Act also provides that the tax imposed by section 1 on an individual, estate, or trust cannot exceed the sum of (1) a tax computed at the rates under section 1 on the greater of (a) the taxpayer's taxable income reduced by the amount of net capital gain or (b) the amount of the taxpayer's taxable income which is taxed at a rate below 28 percent; (2) a tax of 28 percent on the amount of the taxpayer's taxable income in excess of the amount determined under (1) above; and (3) any additional tax resulting from the gradual phaseout of the benefits of the 15 percent bracket and the personal exemptions. If for any taxable year beginning after 1987, the highest individual rates (under the tax rate schedules set forth in subsections (a), (b), (c), (d) or (e) of section 1) do not exceed 28 percent, then this limitation will have no application.

The maximum rate on long-term capital gain in 1987 is 28 percent.

Capital losses are allowed in full against capital gain as under prior law. Capital losses are also allowed against up to $3,000 of ordinary income and the excess of net long-term capital loss over net short-term capital gain is allowed in full for this purpose. As under prior law, capital losses may be carried forward.

The prior statutory structure for capital gains is retained in the Code to facilitate reinstatement of a long-term capital gains rate differential if there is a future tax rate increase.

 

Effective Date

 

 

This provision applies to taxable years beginning after December 31, 1986, regardless of whether the sale or other transaction giving rise to the gain occurred in a prior year. Thus, if long-term capital gain is properly taken into income under the taxpayer's method of accounting in taxable years beginning after December 31, 1986, it is subject to the repeal of the net capital gain deduction. For example, the repeal of the net capital gain deduction applies to long-term capital gains recognized on the installment method in taxable years beginning after December 31, 1986, without regard to when the sale was made. Gains recognized in taxable years beginning after December 31, 1986, with respect to installment sales made before January 1, 1987, are thus subject to the new provisions.

In the case of a pass-through entity that is not itself liable for tax, the provision applies to gain properly taken into account by the partner or other taxable beneficial owner in such person's taxable years beginning after December 31, 1986. For example, in the case of a calendar year individual partner in a partnership that has a fiscal year ending January 31, 1987, the repeal of the net capital gain deduction would apply to such partner's share of gain resulting from a cash sale by the partnership during the partnership's fiscal year ending January 31, 1987, regardless of whether the sale occurred prior to, or on or after, January 1, 1987. Similarly, the new provision would apply to such partner's share of any gain properly taken into account by the partnership on the installment method during the partnership's fiscal year ending January 31, 1987, regardless of whether the installment sale occurred in an earlier partnership fiscal year.

Long-term capital loss properly taken into account in taxable years beginning after December 31, 1986 is likewise subject to the new provisions. For example, in the case of a calendar year individual taxpayer with no capital gain properly taken into account in 1987, a long-term capital loss carryover from an earlier taxable year is allowed in full as an offset to 1987 ordinary income, up to the $3,000 limit.

 

Revenue Effect

 

 

The revenue effect of this provision is included with the revenue effect for individual rate changes (title I, Part A).

 

B. Corporate Capital Gains

 

 

(sec. 3

 

Prior Law

 

 

An alternative tax rate of 28 percent applied to a corporation net capital gain (the excess of net long-term capital gain over net short-term capital loss) if the tax computed using that rate was lower than the corporation's regular tax (sec. 1201). Corporate capital losses were deductible only against capital gain. Capital losses generally could be carried back 3 years and forward 5 years.

 

Reasons for Change

 

 

Under prior law, large corporations obtained preferential treatment of capital gains income (28 percent alternative rate compared to 46 percent regular rate). The Congress was of the view that corporate capital gain should not be taxed at preferential rates, in light of the overall reduction in rates. Thus, the Act taxes corporate capital gains at the regular corporate tax rates.

 

Explanation of Provision

 

 

The Act makes the alternative tax inapplicable to taxable year for which the new corporate tax rates are fully effective (i.e., taxable years beginning on or after July 1, 1987). Thus, corporate net capital gain for such years is taxed at regular corporate rates (i.e. generally a maximum 34 percent under the Act). In the event that the maximum rate under Code section 11 is increased by a subsequent public law, the Act provides that a 34% alternative rate will be applicable unless such law changes that rate.

For taxable years which include periods prior to the time the new rates are fully effective, the alternative tax rate on gain properly taken into account under the taxpayer's method of accounting after December 31, 1986 is 34 percent. The Act provides that for any taxable year beginning on or after January 1, 1987, and before July 1, 1987, the alternate rate applicable to the net capital gain will be 34 percent. For taxable years beginning in 1986 and ending in 1987, a 28 percent rate will apply to the lesser of: (1) the net capital gain for the taxable year or (2) the net capital gain that is included in income under the taxpayer's method of accounting before January 1, 1987; any remaining net capital gain will be taxed at 34 percent.

The Act does not change the capital loss provisions.

The Act also contains two special rules (applicable to all taxpayers, whether or not corporations) in conjunction with the repeal of the special capital gains rates. First, the Act provides that income from coal and domestic iron ore royalties (under sec. 631(c)) will be eligible for percentage depletion for any taxable year in which the maximum rate of tax on net capital gain is not less than the maximum rate on ordinary income. Second, the Act provides that any election to treat the cutting of timber as a disposition under section 631(a) made for a taxable year beginning before January 1, 1987, may be revoked on a one-time basis by the taxpayer without the permission of the Secretary of the Treasury. Any revocation of an election made in accordance with this provision will not be considered in determining whether a future election under section 631(a) by the taxpayer is allowed. If a taxpayer revokes an election without consent in accordance with this provision, and thereafter makes an election under section 631(a), any future revocations will require the permission of the Secretary of the Treasury.

 

Effective Date

 

 

The provision applies to taxable years beginning after December 31, 1986, regardless of whether the sale or other transaction giving rise to the gain occurred in a prior year. Thus, so long as gain is properly taken into income under the taxpayer's method of accounting in a taxable year beginning after December 31, 1986, it is subject to the provision. A transitional rule described above also applies the provision to taxable years beginning in 1980 and ending in 1987, in the case of gain properly taken into account under the taxpayer's method of accounting on or after January 1, 1987.4

The provision applies to long-term capital gains recognized on the installment method in periods subject to the new alternative tax rates, without regard to when the sale was made. Installment sale gains properly taken into account under the installment method after December 31, 1986 are thus subject to the new provisions without regard to whether the sale was made prior to that date or in a prior taxable year.

In the case of a pass-through entity that is not itself liable for tax, the provisions apply to gain properly taken into account by the partner or other taxable beneficial owner after December 31, 1986. For example, a calendar year corporate partner in a partnership that has a fiscal year ending January 31, 1987 would be subject to the new provision, and would have a 34 percent alternative tax rate, with respect to such partner's share of long-term capital gain resulting from a cash sale by the partnership during the partnership's fiscal year ending January 31, 1987, regardless of whether the sale occurred prior to, or on or after, January 1, 1987. Similarly, the new provision would apply to such partner's share of any long-term capital gain properly taken into account by the partnership on the installment method during the partnership's fiscal year ending January 31, 1987, regardless of whether the installment sale occurred in an earlier partnership fiscal year.

 

Revenue Effect

 

 

The revenue effect of this provision is included with the revenue effect for the corporate rate changes (Title VI, Part A).

 

C. Incentive Stock Options

 

 

(sec. 321 of the Act and sec. 422A of the Code)5

 

Prior Law

 

 

Under present and prior law, an employee is not taxed on the grant or exercise of an incentive stock option, and the employee is generally taxed at capital gains rates when the stock received on the exercise of the option is sold. No deduction is taken by the employer when the option is granted or exercised.

Under prior law, in order to qualify as an incentive stock option, among other requirements, the options must have been exercisable in the order granted, and the employer could not grant the employee such options to acquire stock with a value of more than $100,000 (increased by certain carryover amounts) in any one year.

 

Reasons for Change

 

 

The Congress wished to eliminate certain restrictions on incentive stock options so that it will be easier for employers, particularly small and relatively new companies, to use the options as a means of attracting and motivating talented employees.

The rule requiring options to be exercisable only in the order granted can make incentive stock options unavailable to companies which have experienced a decline in stock prices.

The Congress believed that limiting the amount of incentive stock options an employer may grant to an employee in a year unnecessarily restricts the ability of smaller companies to offer a comprehensive compensation package which it may need to offer talented employees if it is to compete with larger, more established corporations for such employees.

 

Explanation of Provision

 

 

The Act repeals the requirement that incentive stock options must be exercisable in the order granted.

The Act also changes the $100,000 limit to provide that under the terms of the plan the aggregate fair market value (determined at the time the option is granted) of the stock with respect to which incentive stock options are exercisable for the first time by any individual during any calendar year may not exceed $100,000.

 

Effective Date

 

 

The provision applies to options granted after December 31, 1986.

 

Revenue Effect

 

 

The provision is estimated to reduce fiscal year budget receipts for 1987 through 1991 by less than $5 million annually.

 

D. Tax Straddles

 

 

(sec. 331 of the Act and sec. 1092 of the Code)6

 

Prior Law

 

 

In general, if a taxpayer realizes a loss on the disposition of one or more positions in a straddle, the amount of the loss that can be deducted is limited to the excess of the loss over the unrecognized gain (if any) in offsetting positions (sec. 1092). An exception to the loss deferral rule applies to a straddle consisting of stock that is offset by a qualified covered call. For purposes of this exception, a call option is not treated as qualified if gain from the disposition of the underlying stock is included in gross income in a taxable year subsequent to the year in which the option is closed, and the stock is not held for more than 30 days following the date on which the option is closed. This rule is intended to prevent taxpayers from using covered call options to defer tax on income from unrelated transactions (by realizing a loss on the option in one year, and deferring realizing any gain on the related stock until the next year).

 

Reasons for Change

 

 

Under prior law, the exception to the loss deferral rule for qualified covered call options applies even where the straddle is used to defer tax on income from unrelated transactions. Such deferral may occur where gain from closing the option is included in gross income in a taxable year subsequent to the year in which the stock is disposed of at a loss. The Act amends the definition of a qualified covered call to exclude a covered call option in these circumstances.

 

Explanation of Provision

 

 

Under the Act, the qualified covered call exception to the loss deferral rule is denied to a taxpayer who fails to hold a covered call option for 30 days after the related stock is disposed of at a loss, where gain on the option is included in the subsequent year.

 

Effective Date

 

 

The provision applies to positions established after December 31, 1986.

 

Revenue Effect

 

 

This provision is estimated to increase fiscal year budget receipts by less than $5 million in each of fiscal years 1987 through 1991.

 

TITLE IV--AGRICULTURE, NATURAL RESOURCES, AND ENERGY

 

 

A. Agriculture Provisions

 

 

1. Special expensing provisions: soil and water conservation; clearing land

(secs. 401 and 402 of the Act and secs. 175 and 182 of the Code)1

 

Prior Law

 

 

Expenditures for soil and water conservation

Under prior (and present) law, a taxpayer may elect to deduct certain expenditures for the purpose of soil or water conservation that would otherwise be added to the taxpayer's basis in the land on which the conservation activities occur (Code section 175). This deduction is limited in any one year to 25 percent of the gross income derived by the taxpayer from farming. Any excess amount is carried forward to succeeding taxable years.

Under prior law, expenditures deductible under section 175 included amounts paid for grading, terracing, and contour furrowing, the construction of drainage ditches, irrigation ditches, dams and ponds, and the planting of wind breaks. Also, assessments levied by a soil or water conservation drainage district were deductible under this provision to the extent those expenditures would have constituted deductible expenditures if paid directly by the taxpayer. The cost of acquiring or constructing depreciable machinery and facilities, however, were not eligible for expensing under this provision. In the case of depreciable items such as irrigation pumps, concrete dams, or concrete ditches, the taxpayer was allowed to recover costs only through cost recovery allowances, and only if the taxpayer owned the asset.

Expenditures for clearing land

Under prior law, a taxpayer engaged in the business of farming could elect to deduct currently amounts paid or incurred during the taxable year to clear land for use in farming (section 182). For any taxable year, this deduction could not exceed the lesser of $5,000 or 25 percent of the taxable income derived from farming.

 

Reasons for Change

 

 

Congress was concerned that certain Federal income tax provisions might be affecting prudent farming decisions. In particular, Congress was concerned that these provisions were contribution an increase in acreage under production, which in turn encouraged the overproduction of agricultural commodities. Congress believed that to the extent possible, the tax code should be neutral with respect to these business decisions. To eliminate tax biases, therefore, Congress determined that certain of the special farming expensing provisions should be repealed or restricted.

 

Explanation of Provisions

 

 

Soil and water conservation expenditures

The Act limits the soil and water conservation expenditures that may be deducted currently to amounts incurred that, in addition to satisfying the requirements of prior law, are consistent with a conservation plan approved by the Soil Conservation Service (SCS) of the Department of Agriculture. If there is no SCS conservation plan for the area in which property to be improved is located, amounts incurred for improvements that are consistent with a plan of a State conservation agency are deemed to satisfy the Federal standards. Finally, the Act provides that expenditures for general earth moving, draining, and/or filling of wetlands, and for preparing land for installation and/or operation of a center pivot irrigation system may not be deducted under this provision.

Expenditures for clearing land

The Act repeals the provision of prior law that allowed expenditures for clearing land in preparation for farming to be deducted in the year paid or incurred. However, expenditures for routine brush clearing and other ordinary maintenance activities relating to property used in farming continue to be deductible currently, to the extent they constitute ordinary and necessary business expenses under sec. 162.

 

Effective Date

 

 

The amendment to the provision relating to soil and water conservation expenditures is effective for expenditures after December 31, 1986. The repeal of the provision relating to land clearing expenses is effective for expenditures after December 31, 1985.

 

Revenue Effect

 

 

These provisions are estimated to increase fiscal year budget receipts by $50 million in 1987, $37 million in 1988, $34 million in 1989, $33 million in 1990, and $32 million in 1991.

2. Dispositions of converted wetlands and highly erodible croplands

(sec. 403 of the Act and new sec. 1257 of the Code)2

 

Prior Law

 

 

Under prior law, gain realized on the sale or other disposition of a capital asset was subject to tax at preferential rates. The term capital asset (under both prior and present law) does not include property used in a taxpayer's trade or business that is of a character subject to depreciation (sec. 1221(2)). However, gain from the sale of such property ("section 1231 assets") may be taxed on the same basis as gain from the sale of a capital asset if gains on all sales of section 1231 assets during a taxable year exceed losses on such sales.

If losses from the sale or exchange of section 1231 assets during a taxable year exceed the gains from such sales or exchanges, the net losses are treated as ordinary losses. Ordinary losses are deductible in full for tax purposes, while deductions for capital losses are subject to limitations.

 

Reasons for Change

 

 

Congress was concerned about the environmental impact of the conversion of the nation's wetlands and erodible lands to farming uses, and wished to discourage such conversions.

 

Explanation of Provision

 

 

Under the Act, any gain realized on the disposition of "converted wetland" or "highly erodible cropland" is treated as ordinary income, and any loss realized on the disposition of such property is treated as a long-term capital loss.3 For this purpose, the term "converted wetland" means land that is converted wetland within the meaning of section 1201(4) of the Food Security Act of 1985 (16 U.S.C. 3801(4)), provided such land is held by the person who originally converted the wetland, a person who uses the land for farming at any time following the conversion, or by a person whose adjusted basis in the property is determined by reference to the basis of a person in whose hands the property was converted wetland.4 In general, the Food Security Act defines converted wetland as land that has been drained or filled for the purpose of making the production of agricultural commodities possible, if the production would not have been possible but for such action.

The term "highly erodible cropland" means any highly erodible cropland as defined in section 1201(6) of the Food Security Act of 1985 (16 U.S.C. 3801(6)) that is used by the taxpayer at any time for farming purposes other than the grazing of animals. In general, highly erodible cropland is defined as land that (1) is classified by the Department of Agriculture as class IV, VI, VII, or VIII land under its land capability classification system, or (2) that would have an excessive average annual rate of erosion in relation to the soil loss tolerance level, as determined by the Secretary of the Agriculture.

 

Effective Date

 

 

The provision is effective for dispositions of converted wetland and highly erodible cropland first used for farming after March 1, 1986.

 

Revenue Effect

 

 

The provision is estimated to increase fiscal year budget receipts by a negligible amount.

3. Prepayments of farming expenses

(sec. 404 of the Act sec. 464 of the Code)5

 

Prior Law

 

 

In general

Under prior (and present) law, a taxpayer generally is allowed a deduction in the taxable year which is the proper taxable year under the method of accounting used in computing taxable income (sec. 461). The two most common methods of accounting are the cash receipts and disbursements method and the accrual method. If the taxpayer's method of accounting does not clearly reflect income, however, the computation of taxable income must be made under the method which, in the opinion of the Internal Revenue Service, clearly reflects income (sec. 446(b)). Furthermore the income tax regulations provide that if an expenditure results in the creation of an asset having a useful life which extends substantially beyond the close of the taxable year, such an expenditure may not be deductible, or may be deductible only in part, for taxable year in which paid by a taxpayer using the cash receipts and disbursements method of accounting, or in which incurred by a taxpayer using the accrual method of accounting (see Treas. Reg. Sec. 1.461-1(a)(1) and (2).)

Prior law was unclear as to the proper timing of a deduction for prepaid expenses other than interest. No specific statutory provision expressly permitted expenses to be deducted in full when paid by a taxpayer using the cash receipts and disbursements method of accounting. Such deductions were prohibited, however, to the extent that they resulted in a material distortion of income.

Generally, the courts examined all the facts and circumstances in a particular case to determine whether allowing a full deduction for the prepayment would result in a material distortion of income In determining whether an expenditure resulted in the creation of an asset having a useful life extending substantially beyond the end of the taxable year, the court in Zaninovich v. Commissioner, 616 F.2d 429 (9th Cir. 1980), adopted a "one-year" rule. Under this rule, prepayments generally could be deducted if they did not provide benefits extending beyond one year. Thus, under this decision, it might be possible for a calendar-year, cash-basis taxpayer making a lease payment attributable to the following year to claim a deduction in the year of the payment.

Certain cash method tax shelters may not deduct expenses before the time when economic performance occurs (e.g., when the goods are delivered or services performed). An exception is provided where economic performance occurs within 90 days of the end of the taxable year (sec. 461(i)(2)).

Special rules applicable to farming syndicates

Under prior law, certain limitations were imposed on deductions in the case of farming syndicates. A farming syndicate could deduct amounts paid for feed, seed, fertilizer, or other similar farm supplies only in the year in which such items were actually used or consumed or, if later, in the year such amounts were otherwise allowable as a deduction. A farming syndicate was defined generally as a partnership or any other enterprise (other than a corporation which was not an S corporation) engaged in farming if (i) interests in the partnership or enterprise were offered for sale in any offering required to be registered with any Federal or State agency or (ii) if more than 35 percent of the losses during any period were allocable to limited partners or limited entrepreneurs (i.e., persons who did not actively participate in the management of the enterprise).

 

Reasons for Change

 

 

Many farming tax shelters had been established to defer taxation of nonfarming income by prepaying farming expenses allocable to the following and subsequent years. Such tax shelters distorted the measurement of taxable incomes of their investors and affected farming operations that were not established for tax reasons. Congress believed that, in order to avoid these distortions, limits should be placed on the deductibility of prepaid expenses of certain farming tax shelters that did not fall within the definition of a farming syndicate.

Congress understood, however, that because of the seasonal nature of farming, numerous everyday business expenses are prepaid. Accordingly, the Act applies the limitations only to the extent that more than 50 percent of the farming expenses (exclusive of prepaid supplies) for the year are prepaid. In addition, in order to assure that farmers with continuous year-round or full-time farming activities are not subject to the limitations, the Act provides exceptions where a farmer has more than 50 percent prepaid expenses because of unusual or extraordinary circumstances. Congress believed that these rules will limit the application of the new restrictions to cases where the abuse is serious. In addition, Congress believed that the new rules will not impose any significant additional accounting burden on farmers.

 

Explanation of Provision

 

 

Under the Act, in the case of farmers eligible to use the cash method of accounting, the deductibility of prepayments for feed, seed, fertilizer, or other farm supplies may be limited in the same manner as prepayments made by a farming syndicate were limited under prior law.5a In addition, certain costs incurred in producing poultry may be subject to capitalization and amortization under special rules. The limitations apply only to the extent prepayments for supplies (or poultry expenses) exceed 50 percent of the taxpayer's total deductible farming expenses. This excess amount may not be deducted any earlier than the taxable year of actual use or consumption of the supplies to which it relates.

For purposes of the 50-percent test, deductible farm expenses include the operating expenses of the farm, such as ordinary and necessary expenses within the meaning of section 162, interest and taxes paid, depreciation allowances on farm equipment, and other similar expenses.6 However, payments for feed, seed, fertilizer, or other supplies are deductible farm expenses only to the extent they are not prepayments, i.e., the supplies are consumed in the year of payment.

The Act provides two exceptions to the provision.7 First, the provision does not apply to an eligible farmer--a "farm-related taxpayer"--who fails to satisfy the 50-percent test due to a change in business operations directly attributable to extraordinary circumstances, including government crop diversion programs and circumstances described in Code section 464(d) (supplies on hand at the end of the taxable year due to fire, storm, or other casualty, disease, or drought). Second, the provision does not apply to farm-related taxpayers whose prepaid supplies do not exceed the 50-percent threshold applied by aggregating prepayments and expenses (other than prepayments) for the three preceding taxable years.

A farm-related taxpayer includes (1) any person whose principal residence is on a farm, (2) any person with a principal occupation of farming, and (3) any family member of persons described in (1) or (2). The exceptions apply only to farming activities attributable to the farm on which the residence is located, or to farms included in the "principal occupation" of farming activities.

Congress did not intend that farmers will be required generally to take year-end inventories of prepaid items as a result of this provisions of the Act.

In adopting these limitations, Congress did not intend to modify or supersede the general rule that prepaid expenses are not deductible if that deduction would result in a material distortion of income.

 

Effective Date

 

 

The provision applies to amounts paid or incurred after March 1, 1986, in taxable years beginning after that date.

 

Revenue Effect

 

 

This provision is estimated to increase fiscal year budget receipts by $14 million in 1987, $30 million in 1988, $10 million in 1989, $11 million in 1990, and $14 million in 1991.

4. Discharge of indebtedness income for certain farmers

(sec. 405 of the Act and secs. 108 and 1017 of the Code)8

 

Prior Law

 

 

Under prior and present law, gross income is defined to include income from discharge of indebtedness (sec. 61). If a solvent taxpayer received income from discharge of trade or business indebtedness, prior law provided the taxpayer an election to exclude that income if the taxpayer's basis in depreciable property was reduced (secs. 108 and 1017). If the amount of the discharge of indebtedness income exceeded a solvent taxpayer's available basis, the taxpayer recognized income in an amount of the excess.

Under prior (and present) law, if an insolvent taxpayer receives income from discharge of indebtedness, the income is excluded (to the extent it does not exceed the amount of the taxpayer's insolvency).9 The taxpayer's tax attributes must be reduced by the amount of the excluded income. Reduction is required in the following attributes (in the following order): net operating losses and carryovers, general business credit carryovers, capital loss carryovers, basis of property,10 and foreign tax credit carryovers. An insolvent taxpayer may elect to reduce basis in depreciable property before reducing net operating losses or other attributes.

If the amount of the insolvent taxpayer's discharge of indebtedness income (not in excess of the amount of its insolvency) exceeds its available tax attributes, the excess is disregarded, i.e., is not includible in income.

 

Reasons for Change

 

 

Congress was aware of enacted and pending legislation intended to alleviate the credit crisis in the farming sector, and of potential tax problems that might undermine the effectiveness of this legislation. For example, programs providing Federal guarantees on limited amounts of farm indebtedness in exchange for a lender's agreement to reduce the total amount of a farmer's indebtedness when that farmer had a high debt-to-equity ratio (but was not insolvent) were under consideration. Congress was concerned that such farmers would recognize large amounts of discharge of indebtedness income as a result of these loan write-downs--forcing them to forfeit their farmland rather than participate in programs designed to enable them to continue in farming.

 

Explanation of Provision

 

 

Under the Act, certain solvent taxpayers realizing income from the discharge of certain farming-related indebtedness may reduce tax attributes, including basis in property, under rules similar to those applicable to insolvent taxpayers. The discharged indebtedness must have been incurred directly in connection with the operation of a farming business by a taxpayer who satisfies a gross receipts test.11 The gross receipts test is satisfied if the taxpayer's aggregate gross receipts from farming for the three years preceding the year of the discharge are 50 percent or more of his aggregate gross receipts from all sources for the same period.12

If a taxpayer elects to exclude income under this provision, the excluded amount must be applied to reduce tax attributes of the taxpayer in the following order: (1) net operating losses, (2) general business credits, (3) capital loss carryovers, (4) foreign tax credit carryovers, (5) basis in property other than land used or held for use in the trade or business of farming, and (6) basis in land used or held for use in the trade or business of farming.

The amount of the exclusion under this provision may not exceed the aggregate amount of the tax attributes of the taxpayer specified above. Accordingly, income must be recognized to the extent the amount of the discharged indebtedness exceeds his available attributes.13

 

Effective Date

 

 

The provision applies to discharge of indebtedness income realized after the April 9, 1986, in taxable years ending after that date.

 

Revenue Effect

 

 

This provision is estimated to decrease fiscal year budget receipts by $9 million in 1987, $10 million in 1988, $8 million in 1989, $7 million in 1990, and $5 million in 1991.

 

B. Oil, Gas, Geothermal, and Hard Mineral Properties

 

 

1. Intangible drilling costs and mining exploration and development costs

(sec. 411 of the Act and secs. 263, 291, 616, and 617 of the Code)14

 

Prior Law

 

 

Intangible drilling and development costs
General rules
Under prior and present law, intangible drilling and development costs ("IDCs") may either be deducted in the year paid or incurred ("expensed") or else may be capitalized and recovered through depletion or depreciation deductions (as appropriate), a the election of the operator. In general, IDCs include expenditure by the operator incident to and necessary for the drilling and that preparation of wells for the production of oil or gas (or geothermal energy), which are neither for the purchase of tangible property nor part of the acquisition price of an interest in the property IDCs include amounts paid for labor, fuel, repairs, hauling, supplies, etc., to clear and drain the well site, construct an access road and do such survey and geological work as is necessary to preparation for actual drilling. Other IDCs are paid or incurred by the property operator for the labor, etc., necessary to construct derricks, tanks pipelines, and other physical structures necessary to drill the well and prepare them for production. Finally, IDCs may be paid or accrued to drill, shoot, fracture, and clean the wells. IDCs also include amounts paid or accrued by the property operator for drilling or development work done by contractors under any form of contract.15

Only persons holding an operating interest in a property are entitled to deduct IDCs. This includes an operating or working interest in any tract or parcel of oil, gas, or geothermal property, either as a fee owner, or under a lease or any other form of contract granting working or operating rights. In general, the operating interest in an oil or gas property must bear the cost of developing and operating the property. The term operating interest does not include royalty interests or similar interests such as production payment rights or net profits interests.

If IDCs are capitalized, a separate election may be made to deduct currently IDCs paid or incurred with respect to nonproductive wells ("dry holes"), in the taxable year in which the dry hole is completed. Thus, a taxpayer has the option of capitalizing IDCs for productive wells while expensing those relating to dry holes.

Treatment of foreign IDCs
Domestic and foreign IDCs generally were subject to the same tax rules under prior law.
Twenty-percent reduction for integrated producers
In the case of a corporation which is an "integrated oil company",16 the allowable deduction with respect to IDCs that the taxpayer has elected to expense was reduced by 20 percent. The disallowed amount was required to be amortized over a 36-month period, starting with the month in which the costs were paid or incurred. Amounts paid or incurred with respect to non-productive wells (dry hole costs) remain fully deductible when the non-productive well is completed, under prior and present law.

Mining exploration and development costs

General rules
Under prior and present law, taxpayers may elect to expense exploration costs associated with hard mineral deposits (sec. 617). Taxpayers also may expense development costs associated with the preparation of a mine for production (sec. 616).

Mining exploration costs are expenditures for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore or other depletable mineral, which are paid or incurred by the taxpayer prior to the development of the mine or deposit. When the mine reaches the producing stage, adjusted exploration expenditures (but not development costs) either: (1) are included in income (i.e., recaptured) and recovered through cost depletion; or (2) at the election of the taxpayer, reduce depletion deductions with respect to the property. Adjusted exploration expenditures with respect to a property are expensed exploration costs attributable to the property, reduced by the excess of (a) percentage depletion which would have been allowed but for the deduction for expensed exploration costs,17 over (b) cost depletion for the corresponding period. Exploration costs also are subject to recapture if the property is disposed of by a taxpayer after expensing these amounts (secs. 617(d)).

Development costs include expenses incurred for the development of a property after the existence of ores or other minerals in commercially marketable quantities has been determined. These costs typically include costs for construction of shafts and tunnels and, in some cases, costs for drilling and testing to obtain additional information for mining operations.

Treatment of foreign exploration costs
Foreign exploration costs could not be expensed under prior law to the extent that such expensing would cause the cumulative foreign and domestic exploration costs which had been expensed by the taxpayer, in the taxable year and in previous taxable years, to exceed $400,000. Exploration costs which had been expensed by persons transferring mineral properties to the taxpayer were also taken into account for this purpose.
Twenty-percent reduction for corporations
For corporations, 20 percent of exploration and development costs that the taxpayer had otherwise elected to expense were required to be capitalized and recovered using the schedule for 5-year accelerated cost recovery system ("ACRS") property (sec. 291). For deposits located in the United States, such expenses also qualified for the investment tax credit.

 

Reasons for Change

 

 

Domestic production of oil, gas, and other minerals is currently depressed and subject to serious international competition. Congress believed that the tax incentives provided for IDCs and mining expenses are appropriate only with respect to domestic exploration. Accordingly, the Act requires that IDCs and mining exploration and development costs incurred outside the United States be recovered using 10-year amortization, which is the normative recovery period for excess IDCs and mining exploration and development costs under the minimum tax, or (at the taxpayer's election) as part of the cost depletion basis.

The Act increases the reduction in expensible IDCs of integrated oil companies from 20 to 30 percent, and requires nonexpensed amounts to be recovered over a 5 year period. A similar change is made in the treatment of corporate mining expenses. These changes are consistent with the general philosophy of the Act in reducing corporate tax preferences, and provide consistency in the treatment of oil- and mining-related expenses. Congress believed that increasing the section 291 reduction, rather than (e.g.) denying expensing for specified types of IDCs or mining costs, would reduce the tax preference for these industries without unduly limiting the incentive for any particular production.

 

Explanation of Provision

 

 

Domestic costs

Under the Act, 30 percent of domestic IDCs of integrated producers are to be amortized ratably over a 60-month period, beginning in the month the costs are paid or incurred (sec. 291). The remaining 70 percent of integrated producer IDCs, together with all domestic IDCs of other taxpayers, are eligible for expensing as under prior law. This provision does not affect the option to deduct dry hole costs in the year the dry hole is completed.

In addition, 30 percent of domestic mining development and exploration costs of corporations are to be amortized ratably over a 60 month period (under sec. 291). The remaining 70 percent, together with similar costs of noncorporate taxpayers, are eligible for expensing as under prior law.

Foreign costs

Under the Act, IDCs and mining exploration and development costs incurred with respect to properties located outside the United States are recovered (1) over a 10-year straight-line amortization schedule, beginning in the year the costs are paid or incurred, or (2) at the taxpayer's election, by adding these costs to the basis for cost depletion.18 No change is intended in the treatment of property subject to an allowance for depreciation (see Treas. Reg. secs. 1.612-4(b), 1.612-5(b), 1.616-1(b)(2) and 1.617-1(b)(2)).

For purposes of this provision, the United States includes the 50 states, the District of Columbia, and those continental shelf areas which are adjacent to United States territorial waters and over which the United States has exclusive rights with respect to the exploration and exploitation of natural resources (sec. 638(1)).

The section 291 reductions, discussed above, do not apply to costs covered by this provision. The provision does not affect the option to deduct dry well costs in the year the dry well is completed.

 

Effective Date

 

 

These provisions are effective for costs paid or incurred after December 31, 1986. A transitional rule is provided with respect to certain IDCs incurred in connection with North Sea oil, pursuant to a license interest acquired on or before December 31, 1985.

 

Revenue Effect

 

 

The provisions with respect to intangible drilling costs (including foreign and domestic costs) are estimated to increase fiscal year budget receipts by $70 million in 1987, $113 million in 1988, $119 million in 1989, $114 million in 1990, and $54 million in 1991.

The provisions with respect to mining exploration and development costs (including foreign and domestic costs) are estimated to increase fiscal year budget receipts by $23 million in 1987, $34 million in 1988, $28 million in 1989, $24 million in 1990, and $21 million in 1991.

2. Modification of percentage depletion rules

 

a. Denial of percentage depletion for lease bonuses and advance royalties

 

(sec. 412(a) of the Act and secs. 613 and 613A of the Code)19

 

Prior Law

 

 

Depletable costs incurred with respect to an oil, gas, or geothermal property are recovered using cost or percentage depletion, whichever results in the higher deduction for the year in question. Under the cost depletion method, the taxpayer deducts that portion of the adjusted basis of the property which is equal to the ratio of units produced and sold from that property during the taxable year to the number of units as of the taxable year. Under percentage depletion, 15 percent of the taxpayer's gross income from an oil- or gas-producing property is allowed as a deduction in each taxable year. The amount deducted using percentage depletion may not exceed 50 percent of the net income from that property in that year (the "net-income limitation"). Additionally, the deduction for all oil and gas properties may not exceed 65 percent of the taxpayer's overall taxable income.20

The Tax Reduction Act of 1975 repealed the percentage depletion allowance for oil and gas production, except with respect to limited quantities produced by independent producers and royalty owners. Effective January 1, 1984, the percentage depletion rate for oil and gas produced by independent producers and royalty owners declined to a permanent level of 15 percent, and the quantity of oil and gas eligible for percentage depletion was limited to 1,000 barrels per day.

Following the 1975 depletion amendments, disagreement arose whether lease bonuses, advance royalties, and other amounts paid in advance of actual production from an oil or gas property continued to be entitled to percentage depletion. In January, 1984, the Supreme Court held that a bonus or advance royalty paid to a lessor in a year in which no oil or gas is produced was subject to percentage depletion, notwithstanding the 1,000 barrel per day limitation contained in the 1975 legislation (Commissioner v. Engle, 464 U.S. 206 (1984)). The Court left open the possibility that the Treasury Department could promulgate regulations giving effect to the 1,000 barrel per day limitation in such cases.

In June, 1984, the IRS announced the manner for determining percentage depletion by recipients of bonuses and advance royalties. According to this announcement, a bonus or advance royalty was to be taken into account for depletion purposes in the same year that the payment was includible in income (i.e., generally the year received). Bonus or advance royalty payments were to be converted to barrel-equivalents based on the average price of oil or gas produced from the property during the taxable year (if no oil or gas was produced or sold from the property, based on representative market or field prices), with percentage depletion being allowed only for the equivalent of 1,000 barrels per day of oil production. No percentage depletion allowance was provided for in any year other than the year in which the bonus or advance royalty was includible in income (I.R. Ann. 84-59, IRB 1984-23, June 4, 1984).

 

Reasons for Change

 

 

In retaining percentage depletion for oil and gas properties, Congress wished to provide an incentive only with respect to actual production. Accordingly, Congress decided to specify that no percentage depletion is available for lease bonuses, advance royalties, or other payments that are not directly related to the actual production from a property. This provision reverses the holding in Commissioner v. Engle, supra, which required that some form of percentage depletion be allowed for such payments.

 

Explanation of Provision

 

 

The Act provides that percentage depletion is not allowed for lease bonuses, advance royalties, or any other amount payable without regard to actual production from the property. This rule applies to oil, gas, and geothermal properties.

 

Effective Date

 

 

The provision applies to amounts received or accrued after August 16, 1986.

 

Revenue Effect

 

 

The provision is estimated to increase fiscal year budget receipts by $20 million in 1987, $49 million in 1988, $45 million in 1989, $45 million in 1990, and $45 million in 1991.

 

b. Excess percentage depletion for coal and iron ore

 

(sec. 412(b) of the Act and sec. 291 of the Code)21

 

Prior Law

 

 

Prior and present law allow percentage depletion for hard minerals at rates ranging from 5 to 22 percent of gross income from the property. The percentage depletion rate for coal is 10 percent; the rate for iron ore is 15 percent for domestic deposits and 14 percent for deposits located outside the United States. The amount deducted for any mineral may not exceed 50 percent of the net income from the property in any taxable year. Percentage depletion is computed without regard to the taxpayer's basis in the property.

Under prior law, for corporations only, the excess of percentage depletion for coal (including lignite) and iron ore over the adjusted basis of the property was reduced by 15 percent (sec. 291).

 

Reasons for Change

 

 

Excess percentage depletion for coal and iron ore was reduced by 15 percent under TEFRA, as part of a general cutback in corporate tax preferences. This reduction remained at 15 percent after 1984, when other section 291 cutbacks were increased to 20 percent. Congress decided to increase this reduction from 15 to 20 percent as part of the general policy of the Act in reducing corporate tax preferences.

 

Explanation of Provision

 

 

The Act increases the reduction in excess coal and iron ore percentage depletion for corporations (under section 291) from 15 to 20 percent.

 

Effective Date

 

 

The provision applies to taxable years beginning after December 31, 1986.

 

Revenue Effect

 

 

This provision is estimated to increase fiscal year budget receipts by $11 million in 1987, $16 million in 1988, $15 million in 1989, $16 million in 1990, and $17 million in 1991.

3. Gain from disposition of interests in oil, gas, geothermal, or other mineral properties

(sec. 413 of the Act and secs, 617 and 1254 of the Code)22

 

Prior Law

 

 

Under prior and present law, recapture rules characterize as ordinary income a portion of gain upon the disposition of assets when certain deductions previously have been allowed with respect to those assets. Under prior law, these recapture rules included the recapture of mining exploration (but not development) costs and intangible drilling costs, in excess of the amounts which would have been deductible as cost depletion if these items had been capitalized (secs. 617(d) and 1254).

 

Reasons for Change

 

 

Congress believed that if an amount has been allowed as an expense, and if upon the disposition of the asset with respect to which the deduction was allowed it is determined that the amount allowed exceeded the actual decline in value of the asset, capital gains treatment generally should be denied. This principle is applied to depreciation of personal property, and also should apply to depletable property.

 

Explanation of Provision

 

 

Under the Act, the prior law rules of section 1254 are expanded to apply not only to intangible drilling costs (IDCs) but also to depletion, to the extent the depletion deduction has reduced the adjusted basis of the property. Thus, upon the disposition of an oil, gas, or geothermal property, the amount of gain, if any, that is treated as ordinary income will include not only excess IDCs, but rather all IDCs and depletion (to the extent depletion has reduced adjusted basis) with respect to the property.23

The Act also provides the same rules for mining-related costs. Under these rules, all expensed mining exploration and development costs (to the extent not included in income upon reaching the producing stage), as well as depletion to the extent it has reduced adjusted basis, will be subject to recapture upon disposition of mining property.

 

Effective Date

 

 

The provision applies to property placed in service by the taxpayer after December 31, 1986, except if acquired pursuant to a written contract binding on September 25, 1985, and at all times there-after.24

 

Revenue Effect

 

 

The revenue effect of this provision is included in the estimates relating to intangible drilling costs and mining exploration and development costs (Part B.1., above).

 

C. Energy-Related Tax Credits and Other Incentives

 

 

1. Business energy tax credits

(sec. 421 of the Act and sec. 46(b) of the Code)25

 

a. Extension of credits
Prior Law

 

 

The business energy investment tax credits were enacted in addition to the regular investment tax credit to provide an additional tax credit designated as an incentive to purchase specified property or equipment that would reduce current demand for scarce petroleum resources. Credits for certain energy property expired after 1982. Energy credits were available through 1985 for the following energy property at the following rates: solar--15 percent; geothermal--15 percent; wind--15 percent; ocean thermal--15 percent; biomass--10 percent; and small scale hydroelectric--11 percent.

 

Reasons for Change

 

 

Business energy investment tax credits were enacted in the Energy Tax Act of 1978 and the Crude Oil Windfall Profit Tax Act of 1980 in order to stimulate the development and business application of a broad variety of property which utilized or produced energy sources which were perceived to be alternatives to petroleum, natural gas, and their products. Generally, the methods and sources of producing or utilizing alternative forms of energy were well known but, because of price and other advantages of systems using fossil fuel, they were not experiencing widespread application. The energy tax credits were intended to increase demand for alternate energy sources, thus stimulating technological advances in the production of equipment to produce such fuels and in the design and operating efficiency of the property using a renewable energy source.

Even though the regular and energy investment tax credits generally are repealed as part of the process of broadening the income tax base and increasing the importance of economic and market variables in making investment decisions, Congress believes that it is desirable to retain energy tax credits for certain renewable energy source property in order to maintain an after-tax price differential between renewable and fossil fuel sources. The steep decline in 1986 in petroleum prices has eliminated the incentive to purchase or produce the equipment required to exploit renewable fuel sources. Without the offsetting stimulus from the tax credit to use or produce renewable fuels, the experience gained in the production and use of such fuels and the technological competence developed in their production during the past decade will dissipate and will not be readily available if a fossil fuel shortage recurs. The retained credits are extended through 1987 or 1988 at progressively reduced rates to permit renewable energy technologies to phase into the experience of operating in competitive markets.

 

Explanation of Provision

 

 

Congress extended the energy tax credit for solar energy property at 15 percent in 1986, 12 percent in 1987, and 10 percent in 1988.

The energy tax credit for geothermal energy property is extended at 15 percent in 1986 and 10 percent in 1987 and 1988.

Present law is not changed with respect to dual purpose solar or geothermal energy property. Congress, however, noted with respect to this matter that there are administrative issues which the Secretary of the Treasury should resolve under the regulatory authority provided in the Energy Tax Act of 1978 and in subsequent Acts that have provisions relating to energy tax credits.

The energy tax credit for biomass property is extended at 15 percent in 1986 and at 10 percent in 1987.

The energy tax credit for ocean thermal property is extended at 15 percent through 1988.

It was intended that the 50-percent basis adjustment which is required when an energy tax credit is allowed under section 48(q) would continue in effect for the business energy tax credits which are extended under the Act.26

 

b. Affirmative commitment rules
Prior Law

 

 

The expired 10-percent credit for certain alternative energy property continues to be available for long-term projects which meet rules requiring (1) completion of engineering studies and application for all required permits before 1983, (2) binding contracts for 50 percent of special project equipment before 1986, and (3) project completion before 1991.

 

Reasons for Change

 

 

The affirmative commitment rules are specially constructed transition rules to meet long gestation periods required for planning and constructing such projects as elaborate chemical production complexes. In addition, energy tax credits are subject to the same 50-percent basis reduction as is the regular investment tax credit. Therefore, Congress believes that the energy tax credits earned under the affirmative commitment rules should be treated in the same manner as regular investment tax credits for transition property.

 

Explanation of Provision

 

 

The Act provides that energy tax credits earned under the affirmative commitment rules are treated in the same manner as the regular investment tax credit for transition property, i.e., they are available with a basis adjustment of 100 percent of the credit amount. In addition, such transition property also may be subject to a 35-percent reduction of the regular investment credit. (See Title II., item A.2., above, repeal of the regular investment tax credit.)

 

Effective Date

 

 

The Act provides that the extended energy tax credits apply to property placed in service after December 31, 1985.

Modification of the affirmative commitment rules also applies after December 31, 1985.

2. Neat alcohol fuels

(sec. 422 of the Act and sec. 404(b) of the Code)27

 

Prior Law

 

 

A 9-cents-per-gallon exemption from the excise tax on special motor fuels is provided through 1992 for neat methanol and ethanol fuels which are not derived from petroleum or natural gas. A 4-1/2 cents exemption is provided if the fuels are derived from natural gas. Neat alcohol fuels are at least 85 percent methanol, ethanol, and other alcohol.

Gasohol, which is a mixture of gasoline and ethanol that contains at least 10 percent ethanol, is eligible for a 6-cents-per-gallon exemption from the excise tax on gasoline. In addition, an income tax credit of 60 cents per gallon of ethanol is allowed for ethanol used for blending with gasoline.

 

Explanation of Provision

 

 

The 9-cents-per-gallon exemption is reduced to 6 cents.

 

Effective Date

 

 

This provision applies to sales or use after December 31, 1986.

3. Taxicab fuels tax exemption

(sec. 422 of the Act and sec. 6427(e) of the Code)28

 

Prior Law

 

 

A 4-cents-per-gallon partial exemption from the motor fuels excise taxes (9 cents for gasoline and special motor fuels and 15 cents for diesel fuel) was provided for fuels used in qualifying taxicabs through September 30, 1985. The exemption was effectuated through a credit or refund (without interest). Qualifying taxicabs must meet certain group-ride requirements.

 

Reasons for Change

 

 

Congress believed that continuation of this credit helps to encourage efficient use of this form of motor transportation.

 

Explanation of Provision

 

 

The 4-cents-per-gallon partial exemption from motor fuels excise taxes for qualified taxicabs is extended through September 30, 1988.

 

Effective Date

 

 

This provision is effective as of October 1, 1985.

Revenue Effect of Items 1-3

The changes in energy tax credits and related energy incentives (items 1, 2 and 3) are estimated to decrease fiscal year budget receipts by $227 million in 1987 and $58 million in 1988, and to increase fiscal year budget receipts by $1 million in 1989, $13 million in 1990, and $9 million in 1991.

4. Duty on imported alcohol fuels

(sec. 423 of the Act and general headnote 3(a) and item 901.50 of the Appendix of the Tariff Schedules of the United States)29

 

Prior Law

 

 

A 60-cents-per-gallon duty is imposed through 1992 on alcohol imported into the United States for use as a fuel.

Ethyl alcohol may enter the United States duty-free, if it is imported from a Caribbean Basin Initiative (CBI) country, under the terms of the Caribbean Basin Economic Recovery Act (CBERA).

 

Reasons for Change

 

 

Congress is concerned that the simple distillation process for dehydrating ethyl alcohol does not represent the type of economic activity that will increase employment and productivity in the Caribbean area in the way that was intended in the CBI program. Use of the process, instead, has become a tactic to circumvent the 60-cents-per-gallon duty and to thwart the intent of the U.S. customs laws.

 

Explanation of Provision

 

 

Under the Act, ethyl alcohol (or an ethyl alcohol mixture) may be admitted into the United States duty-free, if it is an indigenous product of a U.S. insular possession or CBI beneficiary country.

Ethyl alcohol (or ethyl alcohol mixture) may be treated as being an indigenous product of an insular possession or beneficiary country only if the ethyl alcohol (or a mixture) has been both dehydrated and produced by a process of full-scale fermentation within that insular possession or beneficiary country. Alternatively, ethyl alcohol (or a mixture) must have been dehydrated within that insular possession or beneficiary country from hydrous ethyl alcohol that includes hydrous ethyl alcohol which is wholly the product or manufacture of any insular possession or beneficiary country and which has a value not less than (1) 30 percent of the value of the ethyl alcohol or mixture, if entered during calendar year 1987, (2) 60 percent of the value of the ethyl alcohol or mixture, if entered during calendar year 1988, and (3) 75 percent of the value of the ethyl alcohol or mixture, if entered after December 31, 1988.

Transitional exemptions are provided during 1987 and 1988 for up to 20 million gallons per year each produced by certain azeotropic distillation facilities: (1) located in a CBI country or insular possession and in operation on January 1, 1986; or (2) the equipment for which was, on January 1, 1986, ready for shipment to and installation in a CBI country. An additional transitional exemption is provided during 1987 to a facility in the Virgin Islands that received authorization prior to May 1, 1986, to operate a full-scale fermentation facility.

In enacting this provision, Congress expresses its disapproval of rulings by the Customs Service that have found the mere dehydration of industrial-grade ethanol into fuel-grade ethanol to constitute a substantial transformation sufficient to qualify the dehydrated ethanol as a product of a CBI country or insular possession and therefore entitled to duty-free treatment. By discouraging such pass-through operations, the conferees seek to encourage meaningful economic investment in CBI countries and insular possessions.

 

Effective Date

 

 

The limitation on duty-free entry of ethyl alcohol that is not an indigenous product of an insular possession or a beneficiary country is effective beginning on January 1, 1987. The two subsequent increases in the indigenous product's minimum value requirement are effective, respectively, on January 1, 1988, and January 1, 1989.

 

Revenue Effect

 

 

The limitation on duty-free entry of ethyl alcohol is estimated to increase fiscal year budget receipts by less than $5 million each fiscal year.

 

TITLE V--TAX SHELTERS; INTEREST EXPENSE

 

 

A. Limitations on Losses and Credits from Passive Activities

 

 

(secs. 501 and 502 of the Act and new sec. 469 of the Code)1

 

Prior Law

 

 

In general, no limitations were placed on the ability of a taxpayer to use deductions from a particular activity to offset income from other activities. Similarly, most tax credits could be used to offset tax attributable to income from any of the taxpayer's activities.

There were some exceptions to this general rule. For example, deductions for capital losses were limited to the extent that there were not offsetting capital gains.2 For purposes of the alternative minimum tax applying to individuals, expensed intangible drilling costs could be used to reduce net oil and gas income to zero, but could not offset other income of the taxpayer. Foreign tax credits could be used to reduce tax on foreign source income, but not U.S. source income. Research and development credits could be used by individuals to reduce tax liability attributable to research and development activities, but not taxes attributable to other income of the taxpayer.

In the absence of more broadly applicable limitations on the use of deductions and credits from one activity to reduce tax liability attributable to other activities, taxpayers with substantial sources of positive income could eliminate or sharply reduce tax liability by using deductions and credits from other activities, frequently by investing in tax shelters. Tax shelters commonly offered the opportunity to reduce or avoid tax liability with respect to salary or other positive income, by making available deductions and credits, possibly exceeding real economic costs or losses currently borne by the taxpayer, in excess or in advance of income from the shelters.

 

Reasons for Change

 

 

Congress concluded that it had become increasingly clear that taxpayers were losing faith in the Federal income tax system. This loss of confidence resulted in large part from the interaction of two of the system's principal features: its high marginal rates (in 1986, 50 percent for a single individual with taxable income in excess of $88,270), and the opportunities it provided for taxpayers to offset income from one source with tax shelter deductions and credits from another.

The increasing prevalence of tax shelters--even after the highest marginal rate for individuals was reduced in 1981 from 70 percent to 50 percent--was well documented. For example, a Treasury study3 revealed that in 1983, out of 260,000 tax returns reporting "total positive income"4 in excess of $250,000, 11 percent paid taxes equaling 5 percent or less of total positive income, and 21 percent paid taxes equaling 10 percent or less of total positive income. Similarly, in the case of tax returns reporting total positive income in excess of $1 million, 11 percent paid tax equaling less than 5 percent of total positive income, and 19 percent paid tax equaling less than 10 percent of total positive income.5

Congress determined that such patterns gave rise to a number of undesirable consequences, even aside from their effect in reducing Federal tax revenues. Extensive shelter activity contributed to public concerns that the tax system was unfair, and to the belief that tax is paid only by the naive and the unsophisticated. This, in turn, not only undermined compliance, but encouraged further expansion of the tax shelter market, in many cases diverting investment capital from productive activities to those principally or exclusively serving tax avoidance goals.

Congress concluded that the most important sources of support for the Federal income tax system were the average citizens who simply reported their income (typically consisting predominantly of items such as salaries, wages, pensions, interest, and dividends) and paid tax under the general rules. To the extent that these citizens felt that they were bearing a disproportionate burden with regard to the costs of government because of their unwillingness or inability to engage in tax-oriented investment activity, the tax system itself was threatened.

Under these circumstances, Congress determined that decisive action was needed to curb the expansion of tax sheltering and to restore to the tax system the degree of equity that was a necessary precondition to a beneficial and widely desired reduction in rates. So long as tax shelters were permitted to erode the Federal tax base, a low-rate system could provide neither sufficient revenues, nor sufficient progressivity, to satisfy the general public that tax liability bore a fair relationship to the ability to pay. In particular, a provision significantly limiting the use of tax shelter losses was viewed as unavoidable if substantial rate reductions were to be provided to high-income taxpayers without disproportionately reducing the share of total liability under the individual income tax borne by high-income taxpayers as a group.

Congress viewed the question of how to prevent harmful and excessive tax sheltering as not a simple one. One way to address the problem would have been to eliminate substantially all tax preferences in the Internal Revenue Code. For two reasons, however, this course was determined by Congress to be inappropriate.

First, while the Act reduces or eliminates some tax preference items that Congress decided did not provide social or economic benefits commensurate with their cost, there were many preferences that Congress concluded were socially or economically beneficial. It was determined that certain preferences were particularly beneficial when used primarily to advance the purposes upon which Congress relied in enacting them, rather than to avoid taxation of income from sources unrelated to the preferred activity.

Second, Congress viewed as prohibitively difficult, and perhaps impossible, the task of designing a tax system that measured income perfectly. For example, the statutory allowance for depreciation, even under the normative system used under the Act for alternative minimum tax purposes, reflects broad industry averages, as opposed to providing precise item-by-item measurements. Accordingly, taxpayers with assets that depreciate less rapidly than the average, or that appreciate over time (as may be the case with certain real estate), could engage in tax sheltering even under the minimum tax, in the absence of direct action regarding the tax shelter problem.

Even to the extent that rules for the accurate measurement of income could theoretically be devised, Congress concluded that such rules would involve undue complexity from the perspective of many taxpayers. For example, a system that required all taxpayers to use a theoretically pure accrual method of accounting (e.g., including unrealized appreciation, and allowing only the amount of depreciation actually incurred for each specific asset in each taxable year) would create serious difficulties in both compliance and administration.

However, Congress concluded that when the tax system permits simpler rules to be applied (e.g., generally not taxing unrealized gain, and allowing depreciation based on broad industry averages), opportunities for manipulation are created. Taxpayers may structure transactions specifically to take advantage of the situations in which the simpler rules lead to under-measurement or deferral of income.

The question of what constituted a tax shelter that should be subject to limitations was viewed as closely related to the question of who Congress intends to benefit when it enacts tax preferences. For example, in providing preferential depreciation for real estate or favorable accounting rules for farming, it was not Congress's primary intent to permit outside investors to avoid tax liability with respect to their salaries by investing in limited partnership syndications. Rather, Congress intended to benefit and provide incentives to taxpayers active in the businesses to which the preferences were directed.

In some cases, the availability of tax preferences to nonparticipating investors was viewed as harmful to the industries that the preferences were intended to benefit. For example, in the case of farming, credits and favorable deductions often encouraged investments by wealthy individuals whose principal or only interest in farming was to receive an investment return, largely in the form of tax benefits to offset tax on positive sources of income. Since such investors often did not need a positive cash return from farming in order to profit from their investments, they had a substantial competitive advantage in relation to active farmers, who commonly were not in a position to use excess tax benefits to shelter unrelated income. This significantly contributed to the serious economic difficulties being experienced by many active farmers.

The availability of tax benefits to shelter positive sources of income also harmed the economy generally, by providing a non-economic return on capital for certain investments. This encouraged a flow of capital away from activities that provided a higher pre-tax economic return, thus retarding the growth of the sectors of the economy with the greatest potential for expansion.

Congress determined that, in order for tax preferences to function as intended, their benefit should be directed primarily to taxpayers with a substantial and bona fide involvement in the activities to which the preferences related. Congress also determined that it was appropriate to encourage nonparticipating investors to invest in particular activities, by permitting the use of preferences to reduce the rate of tax on income from those activities; however, such investors were viewed as not appropriately permitted to use tax benefits to shelter unrelated income.

Congress believed that there were several reasons why it was appropriate to examine the materiality of a taxpayer's participation in an activity in determining the extent to which such taxpayer should be permitted to use tax benefits from the activity. A taxpayer who materially participated in an activity was viewed as more likely than a passive investor to approach the activity with a significant nontax economic profit motive, and to form a sound judgment as to whether the activity had genuine economic significance and value.

A material participation standard identified an important distinction between different types of taxpayer activities. It was thought that, in general, the more passive investor seeks a return on capital invested, including returns in the form of reductions in the taxes owed on unrelated income, rather than an ongoing source of livelihood. A material participation standard reduced the importance, for such investors, of the tax-reduction features of an investment, and thus increased the importance of the economic features in an investor's decision about where to invest his funds.

Moreover, Congress concluded that restricting the use of losses from business activities in which the taxpayer did not materially participate against other sources of positive income (such as salary and portfolio income) would address a fundamental aspect of the tax shelter problem. Instances in which the tax system applies simple rules at the expense of economic accuracy encouraged the structuring of transactions to take advantage of the situations in which such rules gave rise to under-measurement or deferral of income. Such transactions commonly were marketed to investors who did not intend to participate in the transactions, as devices for sheltering unrelated sources of positive income (e.g., salary and portfolio income). Accordingly, by creating a bar against the use of losses from business activities in which the taxpayer does not materially participate to offset positive income sources such as salary and portfolio income, Congress believed that it was possible significantly to reduce the tax shelter problem.

Further, in the case of a nonparticipating investor in a business activity, Congress determined that it was appropriate to treat losses of the activity as not realized by the investor prior to disposition of his interest in the activity. The effort to measure, on an annual basis, real economic losses from passive activities gave rise to distortions, particularly due to the nontaxation of unrealized appreciation and the mismatching of tax deductions and related economic income that could occur, especially where debt financing was used heavily. Only when a taxpayer disposes of his interest in an activity was it considered possible to determine whether a loss was sustained over the entire time that he held the interest.

The relationship to an activity of an investor who did not materially participate was viewed as comparable to the relationship of a shareholder to a corporation. So long as the investor retained an interest in the activity, any reduction in the value of such interest not only might be difficult to measure accurately, but would not have been realized by the investor to a greater extent than in the context of a C corporation. In the case of a C corporation, losses and expenses borne by the corporation, and any decline in the value of the corporation's stock, did not give rise to the recognition of any loss on the part of shareholders prior to disposition of their stock.6

The distinction that Congress determined should be drawn between activities on the basis of material participation was viewed as unrelated to the question of whether, and to what extent, the taxpayer was at risk with respect to the activities.7 In general, the fact that a taxpayer placed a particular amount at risk in an activity did not establish, prior to a disposition of the taxpayer's interest, that the amount invested, or any amount, had as yet been lost. The fact that a taxpayer was potentially liable with respect to future expenses or losses of the activity likewise had no bearing on the question whether any amount had as yet been lost, or otherwise was an appropriate current deduction or credit.

At-risk standards, although important in determining the maximum amount that is subject to being lost, were viewed as not a sufficient basis for determining whether or when net losses from an activity should be deductible against other sources of income, or for determining whether an ultimate economic loss had been realized. Congress concluded that its goal of making tax preferences available principally to active participants in substantial businesses, rather than to investors seeking to shelter unrelated income, was best accomplished by examining material participation, as opposed to the financial stake provided by an investor to purchase tax shelter benefits.

In certain situations, however, Congress concluded that financial risk or other factors, rather than material participation, should be the relevant standard. A situation in which financial risk was viewed as relevant related to the oil and gas industry, which was suffering severe hardship due to the worldwide decline of oil prices. Congress decided that relief for this industry required that tax benefits be provided to attract outside investors and, moreover, that such relief should be provided only with respect to investors who were willing to accept an unlimited and unprotected financial risk proportionate to their ownership interests in the oil and gas activities. Granting tax shelter benefits to investors in oil and gas activities who did not accept unlimited risk, proportionate to their ownership investments in the activities, was viewed as permitting the benefit of this special exception to be diverted unduly to the investors, while providing less benefit to oil and gas activities and threatening the integrity of the entire rule limiting the use of nonparticipatory business losses.

A further area in which the material participation standard was viewed as not wholly adequate was that of rental activities. Such activities predominantly involve the production of income from capital. For this reason, rental income generally was not subject to the self-employment tax, whether or not the activity constituted a trade or business (sec. 1402(a)(1)). Rental activities generally require less ongoing management activity, in proportion to capital invested, than business activities involving the production or sale of goods and services. Thus, for example, an individual who was employed full-time as a professional could more easily provide all necessary management in his spare time with respect to a rental activity than he could with respect to another type of business activity involving the same capital investment. The extensive use of rental activities for tax shelter purposes under prior law, combined with the reduced level of personal involvement necessary to conduct such activities, made clear that the effectiveness of the basic passive loss provision could be seriously compromised if material participation were sufficient to avoid the limitations in the case of rental activities.

Congress believed that a limited measure of relief, however, was appropriate in the case of certain moderate-income investors in rental real estate, who otherwise might experience cash flow difficulties with respect to investments that in many cases were designed to provide financial security, rather than to shelter a substantial amount of other income.

Additional considerations were viewed as relevant with regard to limited partnerships. In order to maintain limited liability status, a limited partner generally is precluded from materially participating in the business activity of the partnership; in virtually all respects, a limited partner more closely resembles a shareholder in a C corporation than an active business entrepreneur. Moreover, limited partnerships commonly were used as vehicles for marketing tax benefits to investors seeking to shelter unrelated income. In light of the widespread use of limited partnership interests in syndicating tax shelters, Congress determined that losses from limited partnership interests should not be permitted, prior to a taxable disposition, to offset positive income sources such as salary.

 

Explanation of Provision

 

 

1. Overview

The Act provides that deductions from passive trade or business activities, to the extent they exceed income from all such passive activities (exclusive of portfolio income), generally may not be deducted against other income. Similarly, credits from passive activities generally are limited to the tax attributable to the passive activities. Suspended losses and credits are carried forward and treated as deductions and credits from passive activities in the next year. Suspended losses from an activity are allowed in full when the taxpayer disposes of his entire interest in the activity.

The provision applies to individuals, estates, trusts, and personal service corporations. A special rule limits the use of passive activity losses and credits against portfolio income in the case of closely held corporations. Special rules also apply to rental activities. Losses from certain working interests in oil and gas property are not limited by the provision. Losses and credits attributable to a limited partnership interest generally are treated as arising from a passive activity. The provision is effective for taxable years beginning after 1986. For certain pre-enactment interests in passive activities, the provision is phased in, and becomes fully effective for taxable years beginning in 1991 and thereafter. Transitional relief is provided for losses from certain existing low-income housing activities.

Losses and credits from a passive activity (taking into account expenses such as interest attributable to acquiring or carrying an interest in the activity) may be applied against income for the taxable year from other passive activities or against income subsequently generated by any passive activity. Such losses (and credits) generally cannot be applied to shelter other income, such as compensation for services or portfolio income (including interest, dividends, royalties, annuities, and gains from the sale of property held for investment). For this purpose, property held for investment generally does not include an interest in a passive activity.

Salary and portfolio income are separated from passive activity losses and credits because the former generally are positive income sources that do not bear deductible expenses to the same extent as passive investments. Since taxpayers commonly can rely upon salary and portfolio income to be positive (and since, when economically profitable, these items generally yield positive taxable income), they are susceptible to sheltering by means of investments in activities that predictably give rise to tax losses (or credits in excess of the tax attributable to income from such investments). The passive loss provision ensures that salary and portfolio income, along with other non-passive income sources, cannot be offset by tax losses from passive activities until the amount of real economic losses from such activities is determined upon disposition.

Under the provision, suspended losses attributable to passive activities are allowed in full upon a taxable disposition of the taxpayer's entire interest in the activity.8 The full amount of gain or loss from the activity can then be ascertained. To the extent the taxpayer's basis in the activity has been reduced by suspended deductions, resulting in gain on disposition, the remaining suspended deductions will, in effect, offset such gain. However, the character of any gain or loss (i.e., as ordinary or capital gain or loss) is not affected by this provision.

Passive activity
An activity generally is a passive activity if it involves the conduct of any trade or business, and if the taxpayer does not materially participate in the activity. A taxpayer who is an individual materially participates in an activity only if he is involved in the operations of the activity on a regular, continuous, and substantial basis. Regardless of whether an individual owns an interest in a trade or business activity directly (e.g., as a proprietorship), or owns an interest in an activity conducted at the entity level by a passthrough entity such as a general partnership or S corporation, he must be involved in the operations of the activity on a regular, continuous, and substantial basis, in order to be treated as materially participating.

In the case of a limited partnership interest, special considerations apply. The form of entity most commonly chosen to maximize tax benefits in a tax shelter investment has been the limited partnership. Moreover, since a limited partner generally is precluded from participating in the partnership's business if he is to retain his limited liability status, Congress concluded that it should not be necessary to examine general facts and circumstances regarding material participation in this context. Therefore, under the Act, a limited partnership interest is treated as intrinsically passive (except as provided in regulations).9 Portfolio income of a partnership (net of directly allocable expenses and properly allocable interest expense), however, is not treated as passive (see sec. 3, below). A share of partnership income, or a guaranteed payment to a partner (including a limited partner) attributable to the performance of personal services (including past or expected future services) is not to be treated as passive. Losses from trade or business activities that are allocable to a limited partnership interest are not permitted, prior to disposition, to be applied against any income other than income from passive activities.

A passive activity under the Act does not include a working interest in oil or gas property where the taxpayer's form of ownership does not limit his liability. Thus, an owner of such a working interest in oil or gas property is permitted to deduct otherwise allowable losses attributable to the working interest whether or not he materially participates in the activity being conducted through the working interest.

A passive activity is defined to include any rental activity, whether or not the taxpayer materially participates. However, an activity where substantial services are provided, and payments are for such services rather than principally for the use of property, is not a rental activity. For example, operating a hotel or similar transient lodging, where substantial services are provided and payments are not principally for the use of tangible property, is not a rental activity. An activity as a dealer in real estate also generally is not treated as a rental activity.10 Long-term rentals or leases of property (e.g., apartments, leased office equipment, or leased cars), on the other hand, generally are considered to be rental activities. Losses from rental activities are allowed against income from other passive activities, but not against other income.

Under the provision, passive activities can include activities generating deductions allowable under section 174 of the Code as research and experimentation expenditures. Thus, if a taxpayer has an interest in an activity with respect to which deductions would be allowed as research and experimentation expenditures, and he does not materially participate in the activity, losses from the activity (including the research and experimentation expenditures) are subject to limitation under the rule.

Passive activities that are not a trade or business.--The Act provides that, to the extent provided in regulations, a passive activity may include an activity conducted for profit (within the meaning of sec. 212), including an activity that is not a trade or business. Congress anticipated that the exercise of this authority would be appropriate in certain situations where activities other than the production of portfolio income are involved. This regulatory authority is meant to cause the passive loss rule to apply with respect to activities that give rise to tax losses that can be used to shelter positive income, but that may not rise to the level of a trade or business.

Interaction with interest deduction limitation.--The Act provides that interest expense allocable to passive activities is treated as a passive activity expense and is not treated as investment interest (see Part C, below). Thus, deductions otherwise allowable for such interest expense are subject to limitation under the passive loss rule, and not under the investment interest limitation. Similarly, income and loss from passive activities generally are not treated as investment income or loss in calculating the amount of the investment interest limitation.11

Interest on debt secured by the taxpayer's residence or a second residence is not subject to limitation under the passive loss rule, so long as the interest meets the definition of qualified residence interest under section 163(h) (as amended by the Act; see Part C, below). Thus, if a taxpayer rents out his vacation home (that he has selected as his second residence) and a portion of the mortgage interest (which meets the definition of qualified residence interest) is allocable to rental use of the home which would otherwise be treated as a passive activity, such interest expense is not subject to disallowance under this provision.

Interaction with other Code sections.--The passive loss rule applies to all deductions that are from passive activities, including deductions allowed under sections 162, 163, 164, and 165. For example, deductions for State and local property taxes incurred with respect to passive activities are subject to limitation under the passive loss rule whether such deductions are claimed above-the-line or as itemized deductions under section 164.

Personal service income not treated as from passive activity.--Income received by an individual from the performance of personal services with respect to a passive activity is not treated as income from a passive activity. Thus, for example, in the case of a limited partner who is paid for performing services for the partnership (whether by way of salary, guaranteed payment, or allocation of partnership income), such payments cannot be sheltered by passive losses from the partnership or from any other passive activity.

Rental real estate in which the taxpayer actively participates.--Under the Act, an individual may annually deduct up to $25,000 of passive activity losses (to the extent they exceed income from passive activities) that are attributable to rental real estate activities in which the taxpayer actively participates. The $25,000 offset is not available to corporations or trusts or, except in limited circumstances, to estates.12 A taxpayer is not treated as actively participating in a rental real estate activity if he has an interest that is less than a 10 percent interest in the activity at any time during the year. Absent a sufficient ownership interest, Congress concluded, the taxpayer's management activity is most likely to relate predominantly to the interests of his co-owners, rather than to the management of his own interest; thus, it does not establish that the taxpayer is active in relation to his interest. A taxpayer is not presumed to be actively participating, however, merely by reason of having a 10 percent or greater interest. As discussed below, the active participation requirement is different from the material participation standard, and generally does not require as much personal involvement.

The $25,000 allowance for losses is phased out ratably as the taxpayer's adjusted gross income (determined without regard to passive activity losses) increases from $100,000 to $150,000. Thus, for example, a middle income taxpayer who has invested in a condominium apartment, and whose involvement in the operations necessary to rent it and maintain it amounts to active participation may deduct up to $25,000 per year of losses from the rental real estate activity.

The $25,000 allowance for rental real estate applies, in a deduction equivalent sense, to credits attributable to rental real estate activities as well. Under a special rule, the $25,000 allowance a plies to low-income housing and rehabilitation credits regardless whether the taxpayer claiming the credit actively participates in the low-income housing or rehabilitation activity (including in the case of a limited partner). In addition, the adjusted gross income phaseout range for the $25,000 allowance for these two credits is $200,000 to $250,000, rather than $100;000 to $150,000 (as for losses). For purposes of calculating the phase-out of the $25,000 allowance at adjusted gross income between $100,000 to $150,000 (or $200,000 to $250,000, in the case of certain credits), adjusted gross income is calculated without regard to IRA contributions and taxable social security benefits.

A single $25,000 amount (and phaseout thereof) applies on an aggregate basis to credits (including the low-income housing and rehabilitation credits) and to deductions, as opposed to allowing $25,000 amount for each. If the total net rental real estate loss and credits (deduction equivalents) exceed the $25,000 amount allowable against other income, the taxpayer generally must allocable the allowable amount among activities to determine which of the) rental real estate losses and credits (including those suspended prior years) are allowable. This allocation is necessary for purposes of determining the total suspended losses and credits attributable to each activity, because losses are allowable in full upon a disposition of the taxpayer's entire interest in the activity, and a special election applies with respect to credits.

In performing this allocation, losses are treated as allowed before credits. Losses are allowed before credits because credits are considered in the nature of incentives which may not bear a relation to accurate measurement of income or loss from an activity. As between activities, when there are excess losses (or credits), allocation is pro rata with respect to the amount of losses (or credits) from each loss activity. Thus, for example, if a taxpayer who qualified for the full $25,000 allowance has $10,000 of losses from one activity and $40,000 of losses from a second activity, then $5,000 is treated as allowed from the first activity and $20,000 is treated as allowed from the second activity.

In order to determine the amount of losses potentially qualifying for the $25,000 allowance, it is necessary first to net income are loss from all of the taxpayer's rental real estate activities in which he actively participates. If there is a net loss for the year from such activities, net passive income (if any) from other activities is the applied against it, in determining the amount eligible for the $25,000 allowance.

 

For example, assume that a taxpayer has $25,000 of losses from rental real estate activity in which he actively participates. If he also actively participates in another rental real estate activity, from which he has $25,000 of gain, resulting in no net loss from rental real estate activities in which he actively participates, then no amount is allowed under the $25,000 allowance for the year. This result follows whether or not the taxpayer has net losses from other passive activities for the year.

 

With respect to active participation, just as with respect to material participation, a change in the nature of the taxpayer's involvement does not trigger the allowance of deductions carried over from prior taxable years. Thus, if a taxpayer begins to actively participate in an activity in which, in prior years, he did not actively participate, the rule allowing up to $25,000 of losses from rental real estate activities against non-passive income does not apply to losses from the activity carried over from such prior years.13 The same rule applies to credits, to the extent that active participation is relevant to their allowability.

Special rule for estates.--In the case of an estate of a taxpayer who, in the taxable year in which he died, owned an interest in a rental real estate activity in which he actively participated, the estate is deemed to actively participate for the two taxable years of the estate following the death of the taxpayer. Thus, the taxpayer's estate may continue to receive the same tax treatment with respect to the rental real estate activity as did the taxpayer in the taxable year of his death. This treatment applies to the taxpayer's estate until the end of the second taxable year of the estate after his death, to facilitate the administration of the estate without requiring the executor or fiduciary to reach decisions with respect to the appropriate disposition of the rental real property within a short period following the taxpayer's death.

Married individuals filing separately.--The amount of the $25,000 allowance, and the adjusted gross income ranges in which the allowance is phased out (i.e., $100,000 to $150,000, except in the case of certain credits where the range is $200,000 to $250,000) generally are halved in the case of married individuals filing separate returns. In the case of married individuals filing separately, who, at any time during the taxable year, do not live apart, the amount of the $25,000 allowance is reduced to zero. Absent such a rule, married taxpayers where one spouse would be eligible for a portion of the $25,000 amount if they filed separately would have an incentive so to file; Congress concluded that rules that encourage filing separate returns give rise to unnecessary complexity and place an unwarranted burden on the administration of the tax system.

Taxpayers subject to the rule
The passive loss rule applies to individuals, estates and trusts. The rule also applies to personal service corporations without regard to certain limitations in the applicable attribution rules. A corporation is not treated as a personal service corporation for this purpose unless the employee/owners together own more than 10 percent, by value, of the corporation's stock. Congress intended that taxpayers not be able to circumvent the passive loss rule merely by virtue of the form in which they conduct their affairs. Thus, the rule was designed to prevent individuals from being able to shelter income derived from the performance of personal services simply by creating personal service corporations and acquiring tax shelter investments at the corporate level.

It also was not intended that incorporation of an individual's portfolio investments be available as a way to avoid the passive loss rule. For this reason, the passive loss rule, in modified form applies to all closely held C corporations (other than personal service corporations, which are subject to the general passive loss rule that are subject to the at-risk rules (generally, where 5 or fewer individuals, directly or indirectly, own more than 50 percent of the stock).14 Such C corporations may not offset losses or credits from passive activities against portfolio income. Such corporations may however, offset passive losses and credits against active business income (i.e., trade or business income which is not from a passive activity).

Thus, for example, if a closely held C corporation has $400,000 of passive losses from a rental activity, $500,000 of active business income, and $100,000 of portfolio income, the passive losses may be applied to reduce the active business income to $100,000, but may not be applied against the portfolio income.15 In determining whether a corporation materially participates in an activity, and hence whether the activity is a passive activity, the material participation in the corporation's activity of corporate employees and owners is examined. As is generally true under the passive loss rule, losses and credits from a non-passive trade or business activity are not subject to any special limitation.

Affiliated groups.--In the case of affiliated groups of corporations filing consolidated returns, Congress determined that the passive loss limitation should be applied on a consolidated group basis. Thus, for example, it was intended that losses from any passive activity within a consolidated group that is treated as closely held under the rule be permitted to offset net active income, but not portfolio income, of the group. In general, under the rule, an activity may be conducted by several corporations, just as one corporation may be engaged in several activities. Portfolio income is accounted for separately from income or loss from each activity.

In determining whether an activity (other than a rental activity) conducted within the closely held consolidated group is a passive activity, the material participation test was intended to be applied on a consolidated basis. Thus, for example, if one or more individual shareholders holding stock representing more than 50 percent of the common parent's stock materially participate in an activity of any member of the group, the group is considered to materially participate. Similarly, if the requirements of section 465(c)(7)(C) (without regard to clause (iv) thereof) are met with respect to an activity by any member (or several members together), then the group is considered to materially participate in the activity.

In the case of a personal service corporation which is a member of a consolidated group, similar principles were intended to apply. For example, a corporation may be treated as a personal service corporation for purposes of the rule where the owners who render the requisite services are employees of a subsidiary, rather than of the parent corporation. The Act provides that the definition of a personal service corporation is applied taking into account attribution of ownership of stock as provided in section 269A(b), with certain modifications.

2. Treatment of losses and credits

In general
Losses.--Losses arising from a passive activity generally are deductible only against income from that or another passive activity. Suspended passive activity losses for the year are carried forward indefinitely, but are not carried back, and are allowed in subsequent years against passive activity income. Suspended losses from an activity are allowed in full upon a taxable disposition of the activity, as discussed below.

If any passive losses are not deductible in any given year, the amount of the suspended losses from each passive activity is determined on a pro rata basis. With respect to each activity, the portion of the loss that is suspended, and carried forward, is determined by the ratio of net losses from that activity to the total net losses from all passive activities for the year. This allocation is necessary in order to determine the suspended losses for any particular activity, which are allowed in full upon a disposition.

In the case of the $25,000 allowance for passive losses from rental real estate activities in which an individual actively participates, a situation could arise in which losses would be allowable for the year under the passive loss rule, but the taxpayer has insufficient (or no) non-passive income against which to apply them. In such a case, the otherwise allowable rental real estate losses are thereupon treated as losses which are not from a passive activity. They may give rise to net operating losses (NOLs) treated as arising in that year, and may be carried forward and back in accordance with the rules applicable to NOLs.

In general, NOL carryovers, like current-year losses other than passive losses, are allowed against any income of the taxpayer.16 In the case of individuals, estates and trusts, and personal service corporations, however, such nonpassive losses and NOLs are taken into account only after reducing income from passive activities by current and suspended deductions from passive activities (but not below zero). Thus, the application of any prior-year suspended passive losses against current year passive income is taken into account before such NOLs are applied against net passive income. This permits the taxpayer to obtain the full benefit of suspended passive activity losses (which are limited in application) before using any losses that are not from passive activities (or NOL carryovers). If a taxpayer has net passive activity income for the year (after the application of all suspended passive losses), the income may be offset by current-year non-passive losses and by NOL carryovers.

In the case of a closely held C corporation (other than a personal service corporation), the passive loss rule applies in modified form: passive losses may be used to offset active business income, but not portfolio income. In applying this rule, losses from passive activities (including such losses carried over from prior years after the effective date) are offset against income from passive activities to determine the aggregate passive loss, if any. If there is such a loss, it may be applied only against active business income, but not portfolio income, of the corporation. As is generally the case, NOLs are applied after the application of the passive loss rule.

The determination of whether a loss is suspended under the passive loss rule is made after the application of the at-risk rules. A loss that would not be allowed for the year because the taxpayer is not at risk with respect to it is suspended under the at-risk provision, not the passive loss rule. Such amounts may become subject to the passive loss rule in subsequent years when they would be allowable under the at-risk rule.17

Under the Act, interest deductions allocable to passive activities are subject to the passive loss rule (as under the Senate amendment), but are not subject to the investment interest limitation (see Part C., below). Thus, for example, if a taxpayer has net passive losses of $100 for a taxable year beginning after 1986, $40 of which consists of interest expense, the entire $100 is subject to limitation under the passive loss rule, and no portion of the loss is subject to limitation under the investment interest limitation.

Credits.--Credits arising with respect to passive activities generally are treated in the same manner as deductions.18 That is, credits may not be used to offset tax attributable to income other than passive income. The amount of tax attributable to net passive income is determined by comparing (i) the amount that the taxpayer would pay with regard to all income, with (ii) the amount that the taxpayer would pay with regard to taxable income other than net passive income (disregarding, in both cases, the effect of credits).

 

For example, if a taxpayer would owe $50,000 of tax disregarding net passive income, and $80,000 of tax considering both net passive and other taxable income (in both cases, disregarding the effect of credits), then the amount of tax attributable to passive income is $30,000. In this case, any passive credits not in excess of $30,000 attributable to the taxpayer's passive activities are allowable. Any passive credits not in excess of $30,000 are, in addition, subject to other limitations applicable to the allowance of credits. In the absence of net passive income for a taxable year, no tax is attributable to passive income, and passive credits generally are not allowable for the year.

 

Passive credits may be allowable to offset tax on income other than passive income with respect to the special rule providing up to $25,000 of benefit for certain rental real estate activities. Under this rule, credits are allowed to offset tax on the portion of the $25,000 (or less, as appropriate) that the taxpayer has not been able to offset by the use of deductions.

The amount of tax on such remaining portion (and thus, the amount of credits that can be used against other income, assuming that there are sufficient credits available) is determined by comparing (i) the amount that the taxpayer would owe (disregarding credits) with respect to income other than any net passive losses, but reduced by rental real estate deductions in the full amount allowable under the $25,000 rule, with (ii) the amount that the taxpayer would owe (again disregarding credits) if the allowable rental real estate deductions equaled $25,000 (or less as appropriate, i.e., in the phaseout range for this amount).

In general, credits arising with respect to passive activities, like deductions relating to such activities, can be carried forward indefinitely, and cannot be carried back. However, the character of a credit relating to a passive activity changes, in effect, when the credit becomes allowable under the passive loss rule (i.e., there either is sufficient passive income to allow its use, or it is within the scope of the $25,000 benefit for rental real estate activities). At such time, such credit is aggregated with credits relating to nonpassive activities of the taxpayer, for purposes of determining whether all such credits are allowable in light of other limitations applying to the use of credits (e.g., the 75 percent tax liability limitation, and the provision that credits cannot be used to reduce regular tax liability to less than tentative minimum tax liability).

In the event that any credits are not allowable because of such other limitations, the passive credits that are allowable under the passive activity rules are thereupon treated as non-passive credits arising in the current taxable year. Thus, the treatment of such credits, then is determined in all respects by the general rules applying to such credits, including carryover periods.19 The credit carryover periods begin to run, with respect to a credit (or portion thereof) theretofore disallowed under the passive loss rule, in the year when the credit (or portion thereof) first is allowable under the passive loss rule. This treatment of credit carryover periods is distinguishable from the treatment of credits under the credit at-risk rules (sec. 46).

The Act provides that for the rehabilitation and low-income housing credits, the phase-out range for offsetting tax on up to $25,000 of non-passive income is increased to between $200,000 and $250,000 of adjusted gross income (calculated without regard to net passive losses, IRA contributions, or taxable social security benefits), and such credits are allowed under the $25,000 rule regardless of whether the taxpayer actively participates in the activity generating the credits. In the case of the low-income housing credit, the increase in the phase-out range (to between $200,000 and $250,000, as opposed to between $100,000 and $150,000 as for other rental real estate losses and credits), and the waiver of the requirement that the taxpayer actively participate in the activity generating the low-income housing credit, apply only with respect to the original credit compliance period for the property, and only to property placed in service before 1990, except if the property is placed in service before 1991, and 10 percent or more of the total project costs are incurred before 1989.

This increase in the adjusted gross income phase-out range may be illustrated as follows. Assume that an individual has $5,000 (deduction equivalent amount) of low-income housing credits from a limited partnership interest (in which, under the passive loss rule, he is considered not to materially or actively participate) in a rental real estate activity. His adjusted gross income (determined without regard to passive losses) is $200,000, and he has no other passive losses, credits or income for the year. The individual is permitted under the $25,000 allowance rule to take the low income housing credit.

Other credit limitations.--The limitation on the credit for research and development activities to the tax on income from such activities is applied before the passive loss limitation is applied to such credits. The overall limitation on credits under the Act (providing that credits generally cannot offset more than 75 percent of the taxpayer's tax liability for the year or reduce regular tax below tentative minimum tax) is applied after the amount of credits allowable under the passive loss rule is determined. Once a credit is allowed for a year under the passive loss rule, it is treated as an active credit arising in that year.

Dispositions
In general.--When a taxpayer disposes of his entire interest in a passive activity, the actual economic gain or loss on his investment can be finally determined. Thus, under the passive loss rule, upon a fully taxable disposition, any overall loss from the activity realized by the taxpayer is recognized and allowed against income (whether active or passive income). This result is accomplished by triggering suspended losses upon disposition.

The reason for this rule is that, prior to a disposition of the taxpayer's interest, it is difficult to determine whether there has actually been gain or loss with respect to the activity. For example, allowable deductions may exceed actual economic costs, or may be exceeded by untaxed appreciation. Upon a taxable disposition, net appreciation or depreciation with respect to the activity can be finally ascertained. Since the purpose of the disposition rule is to allow real economic losses of the taxpayer to be deducted, credits, which are not related to the measurement of such loss, are not specially allowable by reason of a disposition. Disallowed credits are carried forward (but not back) until they become allowable under the passive loss rule, as discussed above.

Taxable dispositions of entire interest in activity.--The type of disposition that triggers full recognition of any loss from a passive activity (and of suspended losses from a former passive activity) is a fully taxable disposition of the taxpayer's entire interest in the activity to an unrelated person. A fully taxable disposition generally includes a sale of the property to a third party at arm's length, and thus, presumably, for a price equal to its fair market value. Gain realized upon a transfer of an interest in a passive activity generally is treated as passive, and is first offset by the suspended losses from that activity. This accomplishes the purpose of the rule to recognize net income or loss with respect to the activity when it can be finally determined.

Where the taxpayer transfers an interest in a passive activity in a transaction in which the form of ownership merely changes, suspended losses generally are not allowed, because the gain or loss he has realized with respect to the activity has not been finally determined. (Such suspended losses are allowed, however, to the extent that any gain recognized on such a transfer, together with other income from passive activities for the year, exceeds losses from passive activities for the year.) Special rules are provided for gifts and in the case of death of the taxpayer. No disposition occurs when the taxpayer is treated as no longer subject to the passive loss rule with respect to the activity (i.e., where the taxpayer does not dispose of his interest in the activity, but it is treated as no longer passive).

The taxpayer must dispose of his entire interest in the activity in order to trigger the recognition of loss. If he disposes of less than his entire interest, then the issue of ultimate economic gain or loss on his investment in the activity remains unresolved. A disposition of the taxpayer's entire interest involves a disposition of the taxpayer's interest in all entities that are engaged in the activity, and to the extent held in proprietorship form, of all assets used or created in the activity. If a partnership or S corporation conducts two separate activities, fully taxable disposition by the entity of all the assets used or created in one activity constitutes a disposition of the partner's or shareholder's entire interest in the activity. Similarly, if a grantor trust conducts two separate activities, and sells all the assets used or created in one activity, the grantor is considered as disposing of his entire interest in that activity. If the taxpayer has adequate records of the suspended losses that are allocable to that activity, and includes in income the gain (if any) allocable to his entire interest in the activity, such losses are allowed in full upon the disposition.

An installment sale of the taxpayer's entire interest in an activity in a fully taxable transaction triggers the allowance of suspended losses. The losses are allowed in the ratio that the gain recognized in each year bears to the total gain on the sale.

A transfer of a taxpayer's interest in an activity by reason of his death causes suspended losses to be allowed to the extent they exceed the amount, if any, by which the basis of the interest in the activity is increased at death under section 1014. Suspended losses are eliminated to the extent of the amount of the basis increase. The losses allowed generally would be reported on the final return of the deceased taxpayer.

A transaction constituting a sale (or other taxable disposition) in form, however, to the extent not treated as a taxable disposition under general tax rules, does not give rise to the allowance of suspended deductions. For example, sham transactions, wash sales, and transfers not properly treated as sales due to the existence of a put, call, or similar right relating to repurchase, do not give rise to the allowance of suspended losses.

Related party transactions.--The Act provides that the taxpayer is not treated as having disposed of an interest in a passive activity, for purposes of triggering suspended losses, if he disposes of it in an otherwise fully taxable transaction to a related party (within the meaning of sec. 267(b) or 707(b)(1), including applicable attribution rules). In the event of such a related party transaction, because it is not treated as a disposition for purposes of the passive loss rule, suspended losses are not triggered, but rather remain with the taxpayer. Such suspended losses may be offset by income from passive activities of the taxpayer.

When the entire interest owned by the taxpayer and the interest transferred to the related transferee in the passive activity are transferred to a party who is not related to the taxpayer (within the meaning of sec. 267(b) or 707(b)(1), including applicable attribution rules) in a fully taxable disposition, then to the extent the transfer would otherwise qualify as a disposition triggering suspended losses, the taxpayer may deduct the suspended losses attributable to his interest in the passive activity.

Certain insurance transactions.--In the case of certain transactions involving dispositions of interests in syndicates that insure U.S. risks, generally, when an owner of an interest in such a syndicate that is treated as a passive activity enters into a transaction whereby he disposes of his interest in the syndicate in a fully taxable closing transaction, he is treated as having made a disposition of his interest in the passive activity.

Abandonment.--The scope of a disposition triggering suspended losses under the passive loss rule includes an abandonment, constituting a fully taxable event under present law, of the taxpayer's entire interest in a passive activity. Thus, for example, if the taxpayer owns rental property which he abandons in a taxable event which would give rise to a deduction under section 165(a), the abandonment constitutes a taxable disposition that triggers the recognition of suspended losses under the passive loss rule.

Similarly, to the extent that the event of the worthlessness of a security is treated under section 165(g) of the Code as a sale or exchange of the security, and the event otherwise represents the disposition of an entire interest in a passive activity, it is treated as a disposition. No inference is intended with respect to whether a security includes an interest in any entity other than a corporation.

Interaction with capital loss limitation.--Upon a fully taxable disposition of a taxpayer's entire interest in a passive activity, the passive loss rule provides that any deductions previously suspended with respect to that activity are allowed in full. However, to the extent that any loss recognized upon such a disposition is a loss from the sale or exchange of a capital asset, it is limited to the amount of gains from the sale or exchange of capital assets plus $3,000 (in the case of individuals). The limitation on the deductibility of capital losses is applied before the determination of the amount of losses allowable upon the disposition under the passive loss rule.

 

Thus, for example, if a taxpayer has a capital loss of $10,000 upon the disposition of a passive activity, and is also allowed to deduct $5,000 of previously suspended ordinary losses as a result of the disposition, the $5,000 of ordinary losses are allowed, but the capital loss deduction is limited to $3,000 for the year (assuming the taxpayer has no other gains or losses from the sale of capital assets for the year). The remainder of the capital loss from the disposition is carried forward and allowed in accordance with the provisions determining the allowance of such capital losses.

 

Basis adjustment for credits.--Under the Act, an election is provided in the case of a fully taxable disposition of an interest in an activity in connection with which a basis adjustment was made as a result of placing in service property for which a credit was taken. Upon such a disposition, the taxpayer may elect to increase the basis of the credit property (by an amount no greater than the amount of the original basis reduction of the property) to the extent that the credit has not theretofore been allowed by reason of the passive loss rule. At the time of the basis adjustment election, the amount of the suspended credit which may thereafter be applied against tax liability is reduced by the amount of the basis adjustment. The purpose for providing this election is to permit the taxpayer to recognize economic gain or loss, taking account of the full cost of property for which no credit was allowed.

This rule may be illustrated as follows. A taxpayer places in service rehabilitation credit property generating an allowable credit of $50, and reduces the basis of the property by $50 as required by the provisions governing the rehabilitation credit, but is prevented under the passive loss rule from taking any portion of the credit. In a later year, having been allowed no portion of the credit by virtue of the passive loss rule, the taxpayer disposes of his entire interest in the activity, including the property whose basis was reduced. Immediately prior to the disposition, the taxpayer may elect to increase basis of the credit property by the amount of the original basis adjustment (to the extent of the amount of the unused credit) with respect to the property.

If the property is disposed of in a transaction that, under the passive loss rule, does not constitute a fully taxable disposition of the taxpayer's entire interest in the passive activity, then no basis adjustment may be elected at any time. To the extent the credit has been suspended by virtue of the passive loss rule, however, it may remain available to offset tax liability attributable to passive income.

Disposition of activity of limited partnership.--In general, under the passive loss rule, suspended deductions are allowed upon a taxable disposition of the taxpayer's entire interest in an activity, because it becomes possible at that time to measure the taxpayer's actual gain or loss from the activity. A disposition of the taxpayer's entire interest in an activity conducted by a limited partnership, like a disposition of an activity conducted in any other form, may constitute a disposition giving rise to the allowance of suspended deductions from the activity.

Nevertheless, it is the intent of Congress that a limited partnership interest in an activity is (except as provided in Treasury regulations) treated as an interest in a passive activity. Because a limited partner generally is precluded from materially participating in the partnership's activities, losses and credits attributable to the limited partnership's activities are generally treated as from passive activities, except that items properly treated as portfolio income and personal service income are not treated as passive.

Changes in nature of activity.--The fact that the nature of an activity changes in the course of its development does not give rise to a disposition for purposes of the passive loss provision. For example, when a real estate construction activity becomes a rental activity upon the completion of construction and the commencement of renting the constructed building, the change is not treated as a disposition.

Other transfers
A gift of all or part of the taxpayer's interest in a passive activity does not trigger suspended losses. However, if he has given away his entire interest, he cannot make a future taxable disposition of it. Suspended losses are therefore added to the basis of the property (i.e., the interest in the activity) immediately before the gift. Similarly, if the taxpayer gives away less than all of his interest, an allocable portion of any suspended losses are added to the donee's basis.20 Suspended losses of the donor are eliminated when added to the donee's basis, and the remainder of the losses continue to be suspended in the donor's hands. The treatment of subsequent deductions from the activity, to the extent of the donee's interest in it, depends on whether the activity is treated as passive in the donee's hands.

An exchange of the taxpayer's interest in an activity in a nonrecognition transaction, such as an exchange governed by sections 351, 721, or 1031 in which no gain or loss is recognized, does not trigger suspended losses. Following such an exchange, the taxpayer retains an interest in the activity (or, e.g., in another like-kind activity), and hence has not realized the ultimate economic gain or loss on his investment in it. To the extent the taxpayer does recognize gain on the transaction (e.g., boot in an otherwise tax-free exchange), the gain is treated as passive activity income, against which passive losses may be deducted.

The suspended losses not allowed upon such a nonrecognition transaction continue to be treated as passive activity losses of the taxpayer, except that in some circumstances they may be applied against income from the property received in the tax-free exchange which is attributable to the original activity.21 Such suspended losses may not be applied against income from the property which is attributable to a different activity from the one which the taxpayer exchanged.22

Activity no longer treated as passive activity
Other circumstances may arise which do not constitute a disposition, but which terminate the application of the passive loss rule to the taxpayer generally, or to the taxpayer with respect to a particular activity. For example, an individual who previously was passive in relation to a trade or business activity which generates net losses may begin materially participating in the activity. When a taxpayer's participation in an activity is material in any year after a year (or years) during which he was not a material participant, previously suspended losses remain suspended and continue to be treated as passive activity losses. Such previously suspended losses, however, unlike passive activity losses generally, are allowed against income from the activity realized after it ceases to be a passive activity with respect to the taxpayer. As with tax-free exchanges of the taxpayer's entire interest in an activity, however, the taxpayer must be able to show that such income is from the same activity in which the taxpayer previously did not materially participate.23

A similar situation arises when a corporation (such as a closely held C corporation or personal service corporation) subject to the passive loss rule ceases to be subject to the passive loss rule because it ceases to meet the definition of an entity subject to the rule. For example, if a closely held C corporation makes a public offering of its stock and thereafter ceases to meet the stock ownership criteria for being closely held, it is no longer subject to the passive loss rule. The corporation's ownership has been so broadened that the reason for limiting the corporation's ability to shelter its portfolio income becomes less compelling. A corporation which is not closely held is less susceptible to treatment as the alter ego of its shareholders, but competing considerations also apply. So as not to encourage tax-motivated transactions involving free transferability of losses, the suspended passive losses are not made more broadly applicable (i.e., against portfolio income) by the change in ownership, but continue to be applicable against all income other than portfolio income of the corporation. Deductions arising in years after the year in which the corporation's status changes are not subject to limitation under the passive loss rule.

The Act provides that the rule applicable to a change in status of a closely held C corporation also applies to a change in status of a personal service corporation. That is, if a personal service corporation ceases to meet the definition of a personal service corporation subject to the passive loss rule in any year, losses from a passive activity conducted by the corporation and previously suspended by reason of the application of the passive loss rule are not triggered by the change in status, but are allowed against income from that activity. Any previously suspended losses and (deduction equivalent) credits in excess of income from the activity continue to be treated as from a passive activity. Losses and credits from an activity arising in a year when the corporation does not meet the definition of a personal service corporation (or a closely held C corporation) are not subject to limitation under the passive loss rule.

3. Treatment of portfolio income

In general
Under the Act, portfolio income is not treated as income from a passive activity, and passive losses and credits generally may not be applied to offset it. Portfolio income generally includes interest, dividends, annuities, and royalties. Also included in portfolio income are gain or loss attributable to disposition of (1) property that is held for investment (and that is not a passive activity) and (2) property that normally produces interest, dividend, annuity, or royalty income.

Portfolio investments ordinarily give rise to positive income, and are not likely to generate losses which could be applied to shelter other income. Therefore, for purposes of the passive loss rule, portfolio income generally is not treated as derived from a passive activity, but rather is treated like other positive income sources such as salary. To permit portfolio income to be offset by passive losses or credits would create the inequitable result of restricting sheltering by individuals dependent for support on wages or active business income, while permitting sheltering by those whose income is derived from an investment portfolio.

Under the Act, dividends on C corporation stock,24 dividends, and income from a REIT, RIC, or REMIC, interest on debt obligations, and royalties from the licensing of property generally are included in portfolio income. Similarly, gains (or losses) from the sale of interests which normally produce such income are treated as portfolio income or losses. These types of assets ordinarily are positive income sources. On the other hand, except as provided below, income from a general or limited partnership interest, from S corporation stock, from a grantor trust, or from a lease of property generally are not treated as portfolio income. Such interests can generate losses which may be applied to shelter unrelated income of the taxpayer. In addition, although such interests might otherwise be considered as held for investment, gains from the sale of such interests, when they are interests in passive activities, are not treated as portfolio income, except to the extent gain on sale of such interests is itself attributable to portfolio income. For example, if a general partnership owns a portfolio of appreciated stocks and bonds and also conducts a business activity, a part of the gain on sale of a partnership interest would be attributable to portfolio income and would, consequently, be treated as portfolio income.

Portfolio income of a passive activity is taken into account separately from other items relating to the activity. Thus, for example, portfolio income of an entity which is not attributable to, or part of, an activity of the entity that constitutes a passive activity is accounted for separately from any passive income or loss. Where a taxpayer has an interest in a passive activity, portfolio income of the activity is not taken into account in determining passive income or loss from the activity. Rather, such portfolio income is treated as non-passive income of the taxpayer. This rule is necessary in part because taxpayers otherwise would be able to shelter portfolio income to the extent that they transferred the assets from which it is derived to passive activities in which they had investment interests.

The application of the rule can be explained with regard to the example of a limited partnership that is engaged in the publication of a magazine. The partnership also holds a portfolio of dividend and interest bearing securities, but the income from them is more than offset by the tax losses of operating the magazine. Each limited partner must separately account for his share of the portfolio income and the losses from the operations of the magazine, and may not offset them against each other in calculating his tax liability. The portfolio income retains its character as income that is not income from a passive activity, despite the fact that non-portfolio income and loss attributable to a limited partnership interest is treated as income or loss from a passive activity.

The rule treating portfolio income as not from a passive activity does not apply to the extent that income, of a type generally regarded as portfolio income, is derived in the ordinary course of a trade or business. For example, the business income of a bank typically is largely interest. Similarly, a securities broker/dealer may earn a substantial portion of the income from the business in the form of dividends and gains on sales of dividend-bearing instruments. Interest income may also arise in the ordinary course of a trade or business with respect to installment sales and interest charges on accounts receivable.

In these cases, the rationale for treating portfolio-type income as not from the passive activity does not apply, since deriving such income is what the business activity actually, in whole or in part, involves. Accordingly, interest, dividend, annuity, or royalty income which is derived in the ordinary course of a trade or business is not treated, for purposes of the passive loss provision, as portfolio income. If a taxpayer directly, or through a passthrough entity, owns an interest in an activity deriving such income, such income is treated as part of the activity, which, as a whole, may or may not be treated as passive, depending on whether the taxpayer materially participates in the activity.

The rationale for treating interest income as portfolio income normally does apply, however, in the case where a taxpayer makes a complete disposition of his interest in a passive activity (triggering suspended losses), and the consideration is an interest-bearing instrument. Although the gain, if any, on such a disposition is generally treated as passive income, the interest on the instrument is appropriately treated as portfolio income, where the disposition (as is likely to be true of disposition of entire interests in passive activities) is not a transaction arising in the ordinary course of a trade or business.

No exception is provided for the treatment of portfolio income arising from working capital, i.e., amounts set aside for the reasonable needs of the business. Although setting aside such amounts may be necessary to the trade or business, earning portfolio income with respect to such amounts is investment-related and not a part of the trade or business itself. Under this rule, for example, interest earned on funds set aside by a limited partnership operating a shopping mall, for the purpose of expanding the mall, is treated as portfolio income and is not taken into account in determining a limited partner's passive income or loss from the activity of operating the shopping mall.

Expenses allocable to portfolio income.--The Act provides that portfolio income is reduced by the deductible expenses (other than interest) that are clearly and directly allocable to such income. Properly allocable interest expense also reduces portfolio income. Such deductions accordingly are not treated as attributable to a passive activity.

The Congress anticipated that the Treasury Department would issue regulations setting forth standards for appropriate allocation of expenses and interest under the passive loss rule. These regulations should be consistent with the purpose of the passive loss rules to prevent sheltering of income from personal services and portfolio income with passive losses. Moreover, the regulations should attempt to avoid inconsistent allocation of interest deductions under different Code provisions.25

In the case of entities, a proper method of allocation may include, for example, allocation of interest to portfolio income on the basis of assets, although there may be situations in which tracing is appropriate because of the integrated nature of the transactions involved. Because of the difficulty of recordkeeping that would be required were interest expense of individuals allocated rather than traced, it is anticipated that, in the case of individuals, interest expense generally will be traced to the asset or activity which is purchased or carried by incurring or continuing the underlying indebtedness.

Self-charged interest.--A further issue with respect to portfolio income arises where an individual receives interest income on debt of a passthrough entity in which he owns an interest. Under certain circumstances, the interest may essentially be "self-charged," and thus lack economic significance. For example, assume that a taxpayer charges $100 of interest on a loan to an S corporation in which he is the sole shareholder. In form, the transaction could be viewed as giving rise to offsetting payments of interest income and passthrough interest expense, although in economic substance the taxpayer has paid the interest to himself.26

Under these circumstances, it is not appropriate to treat the transaction as giving rise both to portfolio interest income and to passive interest expense. Rather, to the extent that a taxpayer receives interest income with respect to a loan to a passthrough entity in which he has an ownership interest, such income should be allowed to offset the interest expense passed through to the taxpayer from the activity for the same taxable year.

The amount of interest income of the partner from the loan that is appropriately offset by the interest expense of the partnership on the loan should not exceed the taxpayer's allocable share of the interest expense to the extent not increased by any special allocation. For example, assume that an individual has a 40-percent interest in a partnership that conducts a business activity in which he does not materially participate, and the individual makes a loan to the partnership on which the partnership pays $100 of interest expense for the year. Since 40 percent of the partnership's interest expense is allocable to the individual, only $40 of the partner's $100 of interest income should be permitted to offset his share of the partnership interest expense, and the remaining $60 is properly treated as portfolio income that cannot be offset by passive losses.

Congress anticipated the issuance of Treasury regulations to provide for the above result. Such regulations may also, to the extent appropriate, identify other situations in which netting of the kind described above is appropriate with respect to a payment to a taxpayer by an entity in which he has an ownership interest. The netting permitted in any such instances should not, however, permit any passive deductions to offset non-passive income except to the extent of the taxpayer's allocable share of the specific payment at issue. Similar considerations should apply in the consolidated return context.

Regulatory authority of Treasury in defining non-passive income.--The Act instructs the Treasury to provide such regulations as may be necessary or appropriate to carry out the purpose of the passive loss provisions, i.e., to prevent the sheltering of positive income sources through the use of tax losses derived from passive activities. Specifically, the Treasury is authorized to provide by regulations that certain items of gross income will not be taken into account in determining income or loss from any activity (and to provide for the appropriate treatment of expenses allocable to such income). The Act also specifically authorizes regulations under which net income or gain from a limited partnership or other passive activity are treated as not from a passive activity.

Congress intended such regulations to prevent taxpayers from structuring income-producing activities (including those that do not bear significant expenses) in ways that are designed to produce passive income that may be offset by unrelated passive losses. For example, regulations may provide that, in order to prevent avoidance of the passive loss rule, a limited partner's share of income from a limited partnership is treated as not from a passive activity. Circumstances in which such treatment could be appropriate would include a transfer by a corporation of an income-producing activity to a limited partnership with a distribution to shareholders of limited partnership interests. The regulations might also treat as not passive those activities that previously generated active business losses and that the taxpayer, with the purpose of circumventing the passive loss rule, intentionally seeks to treat as passive at a time when they generate net income. A further example of a situation where regulatory authority might appropriately be exercised is the case of related party leases or sub-leases, with respect to property used in a business activity, that have the effect of reducing active business income and creating passive income. In addition, regulatory authority could address the situation of ground rents that produce income without significant expenses.

Treatment of closely held corporations
The passive loss rule applies to closely held C corporations (other than personal service corporations) in modified form. Such corporations may offset passive losses and credits against active business income, but not against portfolio income. Portfolio income of a closely held corporation generally has the same definition as portfolio income of any other taxpayer subject to the passive loss rule, except that, for purposes of such a corporation (as well as for a personal service corporation) the dividends received deduction is allowed.

4. Material participation

General rule
In general, a taxpayer's interest in a trade or business activity is not treated as an interest in a passive activity for a taxable year if the taxpayer materially participates in the activity throughout such year.27 In certain instances, however, material participation is not determinative. Working interests in oil and gas properties generally are treated as active whether or not the taxpayer materially participates, and interests in rental activities are treated as passive whether or not the taxpayer materially participates. In the case of rental real estate activities, a separate standard, active participation, is relevant in determining whether the taxpayer is permitted to use losses and credits from such activities to offset up to $25,000 of other income.

Working as an employee, and providing services as part of a personal service business (including professional businesses such as law, accounting, and medicine), intrinsically require personal involvement by the taxpayer. Thus, by their nature, they are not passive activities.28

Material participation of a taxpayer in an activity is determined separately for each taxable year. In most cases, the material participation (or lack thereof) of a taxpayer in an activity is not expected to change from year to year, although there will be instances in which it does change.

Limited partnerships
In the case of a limited partnership interest, except to the extent provided by regulations, it is conclusively presumed that the taxpayer has not materially participated in the activity. In general, under relevant State laws, a limited partnership interest is characterized by limited liability, and in order to maintain limited liability status, a limited partner, as such, cannot be active in the partnership's business. The presumption that a limited partnership interest is passive applies even when the taxpayer possesses the limited partnership interest indirectly through a tiered entity arrangement (e.g., the taxpayer owns a general partnership interest, or stock in an S corporation, and the partnership or corporation in which the taxpayer owns such interest itself owns a limited partnership interest in another entity).

When a taxpayer possesses both a limited partnership interest and another type of interest, such as a general partnership interest, with respect to an activity, except as otherwise provided in regulations, lack of material participation is conclusively presumed with respect to the limited partnership interest (thus limiting the use of deductions and credits allocable thereto). The presence of material participation for purposes of any other interests in the activity owned by the taxpayer is determined with reference to the relevant facts and circumstances.

Under the Act, the Secretary of the Treasury is empowered to provide through regulations that limited partnership interests in certain circumstances will not be treated (other than through the application of the general facts and circumstances test regarding material participation) as interests in passive activities. It is intended that this grant of authority be used to prevent taxpayers from manipulating the rule that limited partnerships generally are passive, in attempting to evade the passive loss provision.29

For example, the exercise of such authority by the Secretary may be appropriate in certain situations where taxpayers divide their interests in activities between limited and general partnership interests, e.g., to facilitate establishing a disposition of the taxpayer's entire interest in an activity, or in connection with special allocations of items of income, deduction, or credit as between limited and general partnership interests. The exercise of such authority by the Secretary would also be appropriate if taxpayers were permitted under State law to establish limited liability entities (that are not taxable as corporations) for personal service or other active businesses, and to denominate as "limited partnership interests" any interests in such businesses related to the rendering of personal services.29A The exercise of regulatory authority might also be appropriate where taxpayers sought to avoid limited partnership status with respect to substantially equivalent entities.

Involvement in operations on a regular, continuous, and substantial basis
Outside of the limited partnership context, the presence or absence of material participation generally is to be determined with reference to all of the relevant facts and circumstances. In order to be treated as materially participating for purposes of the provision, the taxpayer must be involved in the operations of the activity on a regular, continuous, and substantial basis. This standard is based on the material participation standards under Code sections 1402(a) (relating to the self-employment tax) and 2032A (relating to valuation of farm property for purposes of the estate tax). However, the standard is modified consistently with the purposes of the passive loss provision.

Thus, precedents regarding the application of those preexisting legal standards, whether set forth in regulations, rulings, or cases, are not intended to be controlling with regard to the passive loss rule. For example, whether or not, under existing authorities interpreting sections 1402(a) and 2032A, it could be argued that the material participation requirement (for purposes of those sections) is in certain circumstances satisfied by periodic consultation with respect to general management decisions, the standard under this provision is not satisfied thereby in the absence of regular, continuous, and substantial involvement in operations.

In order to satisfy the material participation standard, the individual's involvement must relate to operations. Consider, for example, the case of a general partnership engaged in the business of producing movies. Among the services that may be necessary to this business are the following: writing screenplays; reading and selecting screenplays; actively negotiating with agents who represent writers, actors, or directors; directing, editing, scoring, or acting in the films; actively negotiating with third parties regarding financing and distribution; and actively supervising production (e.g., selecting and negotiating for the purchase or use of sets, costumes, etc.). An individual who does not make a significant contribution regarding these or similar services is not treated as materially participating. For example, merely approving a financing target, accepting a recommendation regarding selection of the screenplay, cast, locations, and director, or appointing others to perform the above functions, generally does not constitute involvement in operations.

In practice, a taxpayer is most likely to have materially participated in an activity for purposes of this provision in cases where involvement in the activity is the taxpayer's principal business. For example, an individual who spends 35 hours per week operating a grocery store, and who does not devote a comparable amount of time to any other business, clearly is materially participating in the business of the grocery store.

By contrast, when an activity is not an individual's principal business, it is less likely that the individual is materially participating. For example, an individual who works full-time as an employee or in a professional service business (such as law, accounting, or medicine), and who has also invested in a general partnership or S corporation engaged in a business involving orange groves, is unlikely to have materially participated in the orange grove business.

However, the fact that an activity is or is not an individual's principal business is not conclusive in determining material participation. An individual may materially participate in no business activities (e.g., someone who does not work or is retired), or in more than one business activity (e.g., a farmer who lives and works on his farm and "moonlights" by operating a gas station).

Another factor that may be highly relevant in showing regular, continuous, and substantial involvement in the operations of an activity, and thereby establishing material participation, is whether, and how regularly, the taxpayer is present at the place or places where the principal operations of the activity are conducted. For example, in the case of an employee or professional who invests in a horse breeding activity, if the taxpayer lives hundreds of miles from the site of the activity, and does not often visit the site, such taxpayer is unlikely to have materially participated in the activity. By contrast, an individual who raises horses on land that includes, or is close to, his primary residence, is more likely to have materially participated.

Again, however, this factor is not conclusive. For example, even if the taxpayer in the above example lived near the site of the horse breeding activity, or visited it on numerous occasions during the year, it would still be necessary for the taxpayer to demonstrate regular, continuous, and substantial involvement in the operations of the activity. Such involvement might be shown, for example, by hiring and from time to time supervising those responsible for taking care of the horses on a daily basis, along with making decisions (i.e., not merely ratifying decisions) regarding the purchase, sale, and breeding of horses.

Moreover, under some circumstances, an individual may materially participate in an activity without being present at the activity's principal place of business. In order for such a taxpayer materially to participate, however, the taxpayer still must be regularly, continuously, and substantially involved in providing services integral to the activity. For example, in the case of an investor in a barge that transports grain along the Mississippi River, one way of materially participating is regularly to travel with the barge (not merely as a passenger, but performing substantial services with respect to the transporting of grain). Another way of materially participating, without being present at the principal place of business, is to work on a regular basis at finding new customers for the barge service, and to negotiate with customers regarding the terms on which the service is provided. In the case of farming, Congress anticipated that an individual who does not perform physical work relating to a farm, but who is treated as having self-employment income with respect to the farm under section 1402, generally will be treated as materially participating.

In determining material participation, the performance of management functions generally is treated no differently than rendering other services or performing physical work with respect to the activity. However, a merely formal and nominal participation in management, in the absence of a genuine exercise of independent discretion and judgment, does not constitute material participation.

For example, in the case of a cattle-feeding activity, the fact that an investor regularly receives and responds to "check-a-box" forms regarding when grain should be purchased, what the cattle should be fed, etc., may have little or no bearing on material participation. If the management decisions being made by the taxpayer are illusory (e.g., whether to feed the cattle or let them starve), or guided by an expert in the absence of any independent exercise of judgment by the taxpayer, or unimportant to the business,30 they are given little weight. Similarly, in situations where the investor's assets are pooled with those of other investors (such as a cattle herd), the fact that the investor's decisions regarding management do not differ or differ only insubstantially from those of other investors is a factor indicating that the investor's involvement in the activity may not rise to the level of material participation.

The fact that a taxpayer has little or no knowledge or experience regarding the cattle-feeding business is highly significant in determining whether such taxpayer's participation in management is likely to amount to material participation. However, even if a taxpayer has such knowledge and experience, if he merely approves management decisions recommended by a paid advisor, the taxpayer's role is not substantial (and he accordingly has not materially participated), since the decisions could have been made without his involvement.

Even an intermittent role in management, while relevant, does not establish material participation in the absence of regular, continuous, and substantial involvement in operations. For example, the fact that one has responsibility for making significant management decisions with respect to an activity does not establish material participation, even if one from time to time exercises such responsibility. It is almost always true (disregarding special cases such as limited partnership interests) that the owner of an interest in an activity has some right to make management decisions regarding the activity, at least to the extent that his interest is not outweighed by that of other owners. Yet many individuals who possess significant ownership interests do not materially participate, and, under present law, have received tax benefits that Congress concluded should be subject to limitation under the passive loss rule.31 Participation in management cannot be relied upon unduly both because its genuineness and substantiality are difficult to verify, and because a general management role, absent more, may fall short of the level of involvement that the material participation standard in the provision is meant to require. Nevertheless, it is likely that, despite the difficulty in many circumstances of ascertaining whether the management services rendered by an individual are substantial and bona fide, such services are likely to be so when the individual is rendering them on a full-time basis and the success of the activity depends in large part upon his exercise of business judgment.

The fact that an individual works full time in a line of business consisting of one or more business activities does not determine his material participation in a particular activity, although his work may rise to the level of material participation with respect to one or more of the activities. An individual's material participation in any activity is determined on the basis of his regular, continuous, and substantial involvement in the operations of the activity. His involvement in the operations of other activities is not determinative. Thus, for example, a taxpayer's material participation in a rental activity (which is treated as passive without regard to the taxpayer's material participation) does not affect his material participation, if any, in other activities.

A taxpayer is likely to be materially participating in an activity, if he does everything that is required to be done to conduct the activity, even though the actual amount of work to be done to conduct the activity is low in comparison to other activities.

Providing legal, tax, or accounting services as an independent contractor (or as an employee thereof), or that the taxpayer commonly provides as an independent contractor, would not ordinarily constitute material participation in an activity other than the activity of providing these services to the public. Thus, for example, a member of a law firm who provides legal services to a client regarding a general partnership engaged in research and development, is not, if he invests in such partnership, treated as materially participating in the research and development activity by reason of such legal services.

The fact that a taxpayer utilizes employees or contract services to perform daily functions in running the business does not prevent such taxpayer from qualifying as materially participating. However, the activities of such agents are not attributed to the taxpayer, and the taxpayer must still personally perform sufficient services to establish material participation.

A special rule, derived from section 2032A, applies with respect to farming activities, permitting taxpayers to qualify as materially participating in certain situations involving retired or disabled individuals who previously were materially participating (as that term is used for purposes of the passive loss rule), or involving a surviving spouse of an individual who was so participating. Thus, to the extent that, under section 2032A(b)(4) or (5), such person would be treated as still materially participating during retirement or disability (or, in the case of a surviving spouse, after the decedent's death), such person shall be treated as materially participating for purposes of the passive loss provision.

With respect to material participation in an agricultural activity, certain decision-making, if bona fide and undertaken on a regular, continuous, and substantial basis, may be relevant to material participation. The types of decision-making that may be relevant in this regard include, without being limited to, decision-making regarding (1) crop rotation, selection, and pricing, (2) the incursion of embryo transplant or breeding expenses, (3) the purchase, sale, and leasing of capital items, such as cropland, animals, machinery, and equipment, (4) breeding and mating decisions, and (5) the selection of herd or crop managers who then act at the behest of the taxpayer, rather than as paid advisors directing the conduct of the taxpayer.

The application of the material participation standard to a condominium hotel that is not a rental activity for purposes of the passive loss rules may be illustrated as follows. Assume that an individual who is an investor in the hotel does not live nearby, has a principal business that is unrelated to operating the hotel, is inexperienced in the hotel business, and employs agents to perform various essential hotel functions. However, such individual's participation in the hotel business involves making frequent visits to the hotel in order to conduct onsite inspections, meet with onsite management, and otherwise participate in integral functions of the business. In addition, the individual on a regular basis uses his independent discretion to make business decisions such as the following: (1) regularly establishing room rental rates, (2) establishing and reviewing hiring and other personnel policies, including review of management personnel, (3) reviewing and approving periodic and annually audited financial reports, (4) participating in budget operating costs and establishing capital expenditures, (5) establishing the need for and level of financial reserves, (6) selecting the banking depository for rental proceeds and reserve funds, (7) participating in frequent meetings at the hotel to review operations and the business plan, and (8) assisting in offsite business promotion activities. The individual is personally assessed his owner association charges and personally pays them, is assessed separately and personally the property taxes against his room or rooms, must personally appeal his assessment if he thinks it incorrect, and personally pays any debt service on his unit when due.

Under these circumstances, if the standard requiring regular, continuous, and substantial involvement is satisfied, then the taxpayer is treated as materially participating in the hotel activity. He is not so treated, however, in the absence of sufficient involvement. No safe harbor should be inferred from the preceding paragraph. For example, if the taxpayer's role in any of the above respects was limited to pro forma ratification of decisions made by management agents, that would tend to rebut material participation. Merely approving decisions made by others does not satisfy the standard.32

Material participation by a corporation subject to the passive loss rule
Special rules apply in the case of corporations that are subject to the passive loss rule. A corporation that is subject to the passive loss provision is treated as materially participating in an activity with respect to which one or more shareholders, owning in the aggregate more than 50 percent of the outstanding stock of the corporation, materially participate. Thus, for example, a corporation with 5 shareholders, each owning 20 percent of the stock, is treated as materially participating in an activity if three or more of such shareholders so participate. If one of the three shareholders who so participated owned only 5 percent of the stock, and as a result the three participating shareholders owned only 45 percent of the stock in the corporation, the corporation would not be treated as materially participating in the activity.33

A closely held C corporation subject to the passive loss provision that is not a personal service corporation (as defined for purposes of the provision) may also be treated as materially participating in an activity if it meets the standard set forth in section 465(c)(7)(C), disregarding clause (iv). This standard generally is satisfied if (i) for the prior 12-month period, at least one full-time employee of the corporation provided sufficient services in active management with respect to the activity, (ii) during the same period, at least 3 full-time nonowner employees provided sufficient services directly related to the activity, and (iii) the amount of business deductions by the taxpayer attributable to the activity exceeded 15 percent of gross income from the activity for the taxable year.

Active participation in a rental real estate activity
Allowance of $25,000 of losses and credits against other income under specified circumstances

For purposes of the passive loss provision, rental activities are treated as passive without regard to whether the taxpayer materially participates. The reasons for this rule are specified above in the section entitled "Reasons for Change."

In the case of rental real estate, however, some specifically targeted relief has been provided because rental real estate is held, in many instances, to provide financial security to individuals with moderate incomes. In some cases, for example, an individual may hold for rental a residence that he uses part time, or that previously was and at some future time may be his primary residence. Even absent any such residential use of the property by the taxpayer, Congress believed that a rental real estate investment in which the taxpayer has significant responsibilities with respect to providing necessary services, and which serves significant nontax purposes of the taxpayer, is different in some respects from the activities that are meant to be fully subject to limitation under the passive loss provision.34

Under the relief provision for rental real estate, an individual may offset up to $25,000 of income that is not treated as passive, by using losses and credits from rental real estate activities with respect to which such individual actively participates.35 (Low-income housing and rehabilitation credits can be so used on a deduction-equivalent basis, as a part of the overall $25,000 amount, whether or not the individual actively participates in the rental real estate activity to which such credits relate.) This relief applies only if the individual does not have sufficient passive income for the year, after considering all other passive deductions and credits, to use fully the losses and credits from such rental real estate activities. No relief is provided under the provision to taxpayers other than individuals (e.g., to trusts, personal service corporations, or closely held C corporations subject to the passive loss provision),36 except for a special 2-year rule for estates, discussed in Section 1, above.

The $25,000 amount is reduced, but not below zero, by 50 percent of the amount by which the taxpayer's adjusted gross income for the year exceeds $100,000 ($200,000 in the case of low-income housing and rehabilitation credits). In the case of a married individual not filing a joint return, no more than $12,500 of such relief is available, reduced by 50 percent of the amount by which such individual's adjusted gross income exceeds $50,000. For these purposes, adjusted gross income is determined without reference to net losses from passive activities (other than losses allowable solely by reason of a fully taxable disposition of an activity).

Since relief under this rule applies only to rental real estate activities, it does not apply to passive real estate activities that are not treated as rental activities under the provision (e.g., an interest in the activity of operating a hotel). Similarly, relief is not provided with regard to the renting of property other than real estate (e.g., equipment leasing).

Scope of active participation
A taxpayer is treated as not having actively participate in a rental real estate activity if the taxpayer (in conjunction with such taxpayer's spouse, even in the absence of a joint return) owns less than 10 percent (by value) of all interests in such activity at any time during the year (or shorter relevant period of ownership).37 This requirement is designed to assist in restricting the relief provided under the $25,000 rule (assuming all other applicable requirement are met) to appropriate circumstances--for example, the case of a home in which the taxpayer formerly lived or plans subsequently to live, as opposed to a syndicated real estate shelter. In addition, the 10 percent rule reflects the fact that active participation by a less than 10 percent owner typically represents services performed predominantly with regard to ownership interest owners.

In the case of a taxpayer owning an interest in a rental real estate activity and meeting the 10-percent ownership requirement, up to $25,000 of relief may be available if the taxpayer actively participates in the activity. This standard is designed to be less stringent than the material participation requirement, in light both the special nature of rental activities, which generally require less in the way of personal services, and the Congress' reasons for providing up to $25,000 of relief in this instance.

The difference between active participation and material participation is that the former can be satisfied without regular, continuous, and substantial involvement in operations, so long as payer participates, e.g., in the making of management decision arranging for others to provide services (such as repairs), in a significant and bona fide sense. Management decisions that are relevant in this context include approving new tenants, deciding on rental terms, approving capital or repair expenditures, other similar decisions.

Thus, for example, a taxpayer who owns and rents out apartment that formerly was his primary residence, or that he uses as a part-time vacation home, may be treated as actively part participating even if he hires a rental agent and others provide services such as repairs. So long as the taxpayer participates in the manner described above, a lack of material participation in operation does not lead to the denial of relief.

A limited partner, to the extent of his limited partnership interest, is treated as not meeting the active participation standard.38 In addition, a lessor under a net lease is unlikely to have the degree of involvement which active participation entails. Moreover, as with regard to the material participation standard, services provided by an agent are not attributed to the principal, and merely formal and nominal participation in management, in the absence of a genuine exercise of independent discretion and judgment, is insufficient.

In this regard, it is useful to compare the above example of a taxpayer who owns and rents out an apartment that formerly was his primary residence with a tax shelter investor. The former taxpayer, even if he hires a rental agent and uses contract or other services to handle day-to-day problems such as routine repairs, still is likely to participate actively in light of the fact that he likely is not using it principally to generate tax losses.

By contrast, consider the case of a taxpayer who purchases an undivided interest in a shopping mall. The taxpayer purchased his interest from a promoter, based on a prospectus describing the investment opportunity and stressing the tax benefits of the $25,000 rule. Since one of the taxpayer's principal interests in the investment is to shelter income, he relies on a professional management company which also holds an interest in the shopping mall to make all significant management decisions. In order to create an evidentiary record purporting to show active participation, the management company sends letters to the investor detailing operating expenses, changes in tenants and new lease terms. The management company also informs the investor as to market trends, and requests approval of decisions to seek certain types of retailers as tenants. The investor ratifies such judgments without independently exercising judgment. The investor has not actively participated in the activity.

5. Definition of activity

In applying the passive loss rule, one of the most important determinations that must be made is the scope of a particular activity. This determination is important for several reasons. For example, if two undertakings are part of the same activity, the taxpayer need only establish material participation with respect to the activity as a whole, whereas if they are separate activities he must establish such participation separately for each. In the case of a disposition, knowing the scope of the activity is critical to determining whether the taxpayer has disposed of his entire interest in the activity, or only of a portion thereof.39

Defining separate activities either too narrowly or too broadly could lead to evasion of the passive loss rule. For example, an overly narrow definition would permit taxpayers to claim losses against salary, portfolio, or active business income by selectively disposing of portions of their interests in activities with respect to which there has been depreciation or loss of value, while retaining any portions with respect to which there has been appreciation. An overly broad definition would permit taxpayers to amalgamate undertakings that in fact are separate, and thus to use material participation in one undertaking as a basis for claiming without limitation losses and credits from another undertaking.

The determination of what constitutes a separate activity is intended to be made in a realistic economic sense. The question to be answered is what undertakings consist of an integrated and inter-related economic unit, conducted in coordination with or reliance upon each other, and constituting an appropriate unit for the measurement of gain or loss.

Section 183, relating to hobby losses, involves issues similar to those arising with respect to passive losses.40 Section 188 requires that separate activities be identified in order to determine whether a specific activity constitutes a hobby. Treasury Regulations interpreting this provision note that all facts and circumstances of a specific case must be taken into account, and then identify as the most significant facts and circumstances: "the degree of organizational and economic interrelationship in various undertakings, the business purpose which is (or might be) served by carrying on the various undertakings separately or together ... and the similarity of the various undertakings." These facts and circumstances likewise are relevant to determining the scope of an activity for purposes of the passive loss rule.41

In general, providing two or more substantially different products or services involves engaging in more than one activity (unless customarily or for business reasons provided together--e.g., the appliance and clothing sections of a department store). For example, operating a restaurant and engaging in research and development are objectively so different that they are extremely unlikely to be part of the same activity. In addition, different stages in the production and sale of a particular product that are not carried on in an integrated fashion generally are not part of the same activity. For example, operating a retail gas station and engaging in oil and gas drilling generally are not part of the same activity. In general, normal commercial practices are highly probative in determining whether two or more undertakings are or may be parts of a single activity.

On the other hand, the fact that two undertakings involve providing the same products or services does not establish that they are part of the same activity absent the requisite degree of economic interrelationship or integration. For example, separate real estate rental projects built and managed in different locations by a real estate operator generally will constitute separate activities. Similarly, in the case of farming, each farm generally will constitute a separate activity. On the other hand, an integrated apartment project or shopping center generally will be treated as a single activity.

Separate research and development projects may constitute separate activities in the absence of a sufficient interrelationship between the activities (e.g., with regard to personnel, facilities used, or the common use of know-how developed in specific undertakings). When sufficient interrelationship exists, however, the projects are part of the same activity. For example, if a particular research project is terminated, but know-how developed from the project contributes to a subsequent project, it may be inaccurate to view the termination as establishing a loss. Any economic success realized by the second project may be attributable in part to amounts spent on the first project, and thus may establish that such amounts were not lost upon termination.

Certain types of integration among undertakings are not sufficient to establish that they are part of the same activity. For example, the fact that the taxpayer has ultimate management responsibilities with respect to different undertakings does not establish that they are part of the same activity, nor does the fact that the undertakings have access to common sources of financing, or benefit for goodwill purposes from sharing a common name. These common features may often be shared by all of the undertakings in which a particular individual is engaged, without establishing, in a substantial economic sense, that all such undertakings are part of the same activity.

The fact that two undertakings are conducted by the same entity (such as a partnership or S corporation) does not establish that they are part of the same activity. Conversely, the fact that two undertakings are conducted by different entities does not establish that they are different activities. Rather, the activity rules generally are applied by disregarding the scope of passthrough entities such as partnerships and S corporations.

With respect to limited partnerships, an additional rule applies in light of the special status of limited partnership interests with respect to material participation. An interest in a limited partnership is not treated as being part of the same activity as any activity in which the taxpayer is treated as materially participating. However, when otherwise appropriate, a limited partnership interest is treated as part of a larger activity in which the taxpayer does not materially participate (e.g., when two limited partnerships are conducting the same activity, or an individual is both a limited partner and a nonparticipating general partner with respect to the same activity).42

In applying the facts and circumstances test regarding what constitutes an activity, any undertaking that is accorded special treatment under the passive loss rule (e.g., treatment as always being active or as always being passive) is not treated as part of the same activity as any undertaking that does not receive identical treatment under the passive loss rule. For example, providing services as an employee or in a personal service business intrinsically is not passive, without requiring the examination of further facts and circumstances. Thus, such an undertaking generally is not part of the same activity as an undertaking in which further facts and circumstances must be examined. An oil and gas working interest is treated as not passive without regard to material participation, and thus is treated as separate from any undertaking not relating to oil and gas working interests.43 This rule is necessary so that the special rules for particular undertakings will not in effect be extended to other types of undertakings (e.g., through the argument that an undertaking that is not a working interest is part of the same activity as a working interest, and hence should not be treated as passive even in the absence of material participation).

6. Rental activity

In general
Under the passive loss rule, a rental activity is generally treated as a passive activity regardless of whether the taxpayer materially participates in the activity. Deductions and credits from a rental activity generally may be applied to offset only other income from passive activities. In the case of rental real estate activities in which the taxpayer actively participates, a special rule permits the application of losses and credits from the activity against up to $25,000 of non-passive income of the taxpayer, for individual taxpayers. A taxpayer is not considered to actively participate in the activity if he owns less than a 10 percent interest in it at any time during the year (or relevant shorter period of ownership).

In determining what is a rental activity for purposes of these rules, prior law applicable in determining when an S corporation had passive rental income, as opposed to active business income, for purposes of continuing to qualify as an S corporation, provides a useful analogy.44 The purpose of the prior law rule, like the passive loss rule, is to distinguish between rental activity that is passive in nature and nonrental activity which may not be passive. Thus, under the passive loss rule, a rental activity generally is an activity, the income from which consists of payments principally for the use of tangible property, rather than for the performance of substantial services.45

Some activities are not treated as rental activities under the passive loss rule even though they may involve the receipt of payments for the use of tangible property, because significant services are rendered in connection with such payments. Payments for the use of tangible property for short periods, with heavy turnover among the users of the property, may cause an activity not to be a rental activity, especially if significant services are performed in connection with each new user of the property. Another factor indicating that an activity should not be treated as a rental activity is that expenses of day-to-day operations are not insignificant in relation to rents produced by the property, or in relation to the amount of depreciation and the cost of carrying the rental property.

On the other hand, although the period for which property is rented is not in itself determinative of whether the activity is a rental activity, a long-term rental period (in comparison to the useful life of the property) and low turnover in the lessees of the property, is indicative that the activity is a rental activity.

For example, an activity consisting of the short-term leasing of motor vehicles, where the lessor furnishes services including maintenance of gas and oil, tire repair and changing, cleaning and polishing, oil changing and lubrication and engine and body repair, is not treated as a rental activity. By contrast, furnishing a boat under a bare boat charter, or a plane under a dry lease (i.e., without pilot, fuel or oil), constitutes a rental activity under the passive loss rule, because no significant services are performed in connection with providing the property.

Based on similar considerations, renting hotel rooms or similar space used primarily for lodging of transients where significant services are provided generally is not a rental activity under the passive loss rule. By contrast, renting apartments to tenants pursuant to leases (with, e.g., month-to-month or yearly lease terms) is treated as a rental activity. Similarly, being the lessor of property subject to a net lease is a rental activity.

A rental activity may include the performance of services that are incidental to the activity (e.g., a laundry room in a rental apartment building). However, if a sufficient amount of such services are rendered, they may rise to the level of a separate activity, or the entire activity may not constitute a rental activity under the provision (e.g., a hotel).

Scope of rental activity
Some businesses involve the conduct of rental activities in association with other activities not involving renting tangible property. Although the other activities may immediately precede the rental activity, be conducted by the same persons, or take place in the same general location, they are not treated as a part of the rental activity, because under the passive loss rule rental activities are considered passive activities without regard to the taxpayer's material participation. In the case of other activities, an examination of the taxpayer's material participation generally determines whether an activity is passive. Rental activities generally are treated as separate from nonrental activities involving the same persons or property. Thus, for example, automobile leasing is treated as a different activity from automobile manufacturing, and real estate construction and development is a different activity from renting the newly constructed building.

Similarly, suppose a travel agency operated in the form of a general partnership has its offices on three floors of a 10-story building that it owns. The remainder of the space in the building is rented out to tenants. The travel agency expects to take over another floor for its own use in a year. The partnership is treated as being engaged in two separate activities: a travel agency activity and a rental real estate activity. Deductions and credits attributable to the building are allocable to the travel agency activity only to the extent that they relate to the space occupied by the travel agency during the taxable year.

Separate rental real estate activity
Because only rental real estate activities are eligible for the $25,000 offset of losses and credits against non-passive income, a rental real estate undertaking is not considered as part of the same activity as any undertaking other than another rental real estate undertaking. For these purposes, the word "rental" is interpreted consistently with its meaning in other respects for purposes of the passive loss provision. Thus, for example, a hotel is treated neither as a rental real estate undertaking, nor as consisting of two activities only one of which is a rental real estate undertaking.

To be eligible for the $25,000 offset, a taxpayer must actively participate in the rental real estate activity. He is not considered to actively participate unless he has at least a 10 percent interest in the activity, because without a significant ownership interest his participation in the activity is likely to be for the benefit of other owners. For purposes of determining whether his interest in the activity amounts to at least 10 percent, separate buildings are treated as separate rental real estate activities if the degree of integration of the business and other relevant factors do not require treating them as parts of a larger activity (e.g., an integrated shopping center).

In the case of units smaller than an entire building, it similarly is necessary to assess the degree of business and functional integration among the units in determining whether they are separate activities. A cooperative apartment in an apartment building, owned by a taxpayer unrelated to those owning the other apartments in the building, generally will qualify as a separate activity, despite the fact that ownership of the building may be shared with owners of other apartments in the building, and despite the sharing with other apartments of such services as management and maintenance of common areas. By contrast, ownership of an undivided interest in a building, or of an area too small to be rented as a separate unit (or that is not rented as a separate unit) does not qualify as a separate activity.

In the case of a commercial building, for example, that is rented out to various tenants, and in which different parties own different floors, it again is necessary to examine the degree of integration with which business relating to different floors is conducted. An arrangement in which the rights to the various floors are separately sold to different parties, but rental of the building is handled in a centralized fashion, generally constitutes a single activity, whereas such treatment might not be appropriate if the owners of different floors separately manage their own rental businesses.

7. Working interest in oil and gas property

When a taxpayer owns a working interest in an oil and gas property, the working interest is not treated as a passive activity, whether or not the taxpayer materially participates. Thus, losses and credits derived from such activity can be used to offset other income of the taxpayer without limitation under the passive loss rule.

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.46 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 income.

A working interest generally has characteristics such as responsibility for signing authorizations for expenditures with respect to the activity, receiving periodic drilling and completion reports, receiving periodic reports regarding the amount of oil extracted, possession of voting rights proportionate to the percentage of the working interest possessed by the taxpayer, the right to continue activities if the present operator decides to discontinue operations, a proportionate share of tort liability with respect to the property (e.g., if a well catches fire), and some responsibility to share in further costs with respect to the property in the event that a decision is made to spend more than amounts already contributed.

However, the fact that a taxpayer is entitled to decline, or does decline, to make additional contributions under a buyout, nonparticipation, or similar arrangement, does not contradict such taxpayer's possessing a working interest. In addition, the fact that tort liability may be insured against does not contradict such taxpayer's possessing a working interest.

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. 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.47 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 in a passive activity. Thus, for example, a limited partner's interest generally is treated as in 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.

In determining whether the taxpayer's form of ownership limits his liability, the rule described in the two prior paragraphs is applied by looking through tiered entities. For example, a general partner in a partnership that owns a limited partnership interest in a partnership that owns a working interest is not treated as owning a working interest.

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. 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 sec. 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.48

Under some circumstances, deductions relating to a working interest may be subject to limitation under other provisions in the Internal Revenue Code. For example, protection against loss through nonrecourse financing, guarantees, stop-loss agreements or other similar arrangements, may cause certain deductions allocable to the taxpayer to be disallowed under section 465. Such limitations are applied prior to and independently of the passive loss rule.

 

Effective Date

 

 

The passive loss rule is effective in taxable years beginning on or after January 1, 1987. It applies to all passive activity losses incurred in taxable years beginning on or after that date, and to passive activity credits for property placed in service in taxable years beginning on or after that date. However, in the case of certain pre-enactment interests, the rule is phased in. The amount disallowed under the passive loss provision during any year in the transitional period cannot exceed the applicable percentage of the amount that would be disallowed for that year under the provision if fully effective. The applicable percentage is 35 percent for 1987, 60 percent for 1988, 80 percent for 1989, 90 percent for 1990, and 100 percent for 1991 and thereafter.

Interests in passive activities acquired by the taxpayer on or before the date of enactment of the Act (October 22, 1986) are eligible for the phase-in of the passive loss rule. Interests in activities acquired after October 22, 1986, however, are not eligible for the phase-in, but rather are fully subject to the passive loss rule.

The Congress intended that a contractual obligation to purchase an interest in a passive activity that is binding on October 22, 1986 be treated as an acquisition of the interest in the activity for this purpose. A binding contract qualifies under this rule, even if the taxpayer's obligation to acquire an interest is subject to contingencies, so long as the contingencies are beyond the reasonable control of the taxpayer. Thus, if the taxpayer has, by October 22, 1986, signed a subscription agreement to purchase a limited partnership interest contingent upon the agreement of other purchasers to acquire interests in the limited partnership amounting to a particular total, then if the contingency is satisfied, he is eligible for the phase-in rule with respect to the interest he was contractually bound to acquire. On the other hand, a conditional obligation to purchase, or one subject to contingencies within the taxpayer's control, does not give rise to eligibility under the phase-in rule.

In the case where, after October 22, 1986, investors in an activity contribute additional capital to the activity, their interests still qualify in full for relief under the phase-in to the extent that their percentage ownership interests do not change as a result of the contribution. However, if a taxpayer's ownership interest is increased after October 22, 1986, then (except to the extent the increase in the taxpayer's interest arises pursuant to a pre-October 23, 1986 binding contract or partnership agreement), the portion of his interest attributable to such increase does not qualify for the phase-in relief. For example, if a taxpayer, after October 22, 1986, increases his ownership interest in a partnership from 25 percent to 50 percent, then only the losses attributable to the 25 percent interest held prior to October 23, 1986 will qualify for transitional relief.49

In general, in order to qualify for phase-in relief, the interest acquired by a taxpayer must be in an activity which has commenced by October 22, 1986. For example, a rental activity has commenced when the rental property has been placed in service in the activity. When an entity in which the taxpayer owns an interest liquidates or disposes of one activity and commences another after October 22, 1986, the new activity does not qualify for phase-in relief. In the case of property purchased for personal use but converted to business use (e.g., a home that the taxpayer converts to rental use), similar rules apply. The activity qualifies for phase-in relief if it commences by October 22, 1986. In the case of a residence converted to rental use, for example, the residence must be held out for rental by October 22, 1986.

However, in the case of an activity that has not commenced by October 22, 1986, phase-in treatment nevertheless applies if the entity (or an individual owning the activity directly) has entered into a binding contract effective on or before August 16, 1986, to acquire the assets used to conduct the activity. Similarly, phase-in treatment applies in the case of self-constructed business property of an entity (or direct owner), where construction of the property to be used in the activity has commenced on or before August 16, 1986.

In the case of a taxpayer owning both pre-October 23, 1986 and post-October 22, 1986 interests in passive activities, it is necessary to calculate the amount of passive loss qualifying for the phase-in. In order to determine this amount, it is necessary first to determine the amount that would be disallowed absent the phase-in. Phase-in relief then applies to the lesser of the taxpayer's total passive loss, or the passive loss taking into account only pre-enactment interests. Thus, for example, if a taxpayer has $100 of passive loss relating to pre-October 23, 1986 interests that would be disallowed in the absence of the phase-in, and has $60 of net passive income from post-October 22, 1986 interests, resulting in a total passive loss of $40, then the phase-in treatment applies to the lesser of $100 or $40 (i.e., $40). For purposes of this rule, the pre-October 23, 1986 and post-October 22, 1986 losses are calculated by including credits, in a deduction-equivalent sense.

Under the Act, any passive loss that is disallowed for a taxable year during the phase-in period and carried forward is allowable in a subsequent year only to the extent that there is net passive income in the subsequent year (or there is a fully taxable disposition of the activity).

 

For example, assume that a taxpayer has a passive loss of $100 in 1987, $65 of which is allowed under the applicable phase-in percentage for the year and $35 of which is carried forward. Such $35 is not allowed in part in a subsequent year under the phase-in percentage applying for such year. If the taxpayer has a passive loss of $35 in 1988, including the amount carried over from 1987, then no relief under the phase-in is provided. If the taxpayer has a passive loss of $50 in 1988 (consisting of the $35 from 1987 and $15 from 1988, all of which is attributable to pre-October 23, 1986 interests), then $6 of losses (40 percent of the $15 loss arising in 1988) is allowed against active income under the phase-in rule. The $35 loss carryover from 1987 is disallowed in 1988 and is carried forward (along with the disallowed $9 from 1988) and allowed in any subsequent year in which the taxpayer has net passive income.

 

The applicable phase-in percentage applies to the passive loss net of any portion of such loss that may be allowed against non-passive income under the $25,000 rule.

Transition relief is provided in the case of low-income housing activities. Losses from certain investments after 1983 in low income housing are not treated as from a passive activity, applicable for a period of up to 7 years from the taxpayer's original investment.50

 

Revenue Effect

 

 

This provision is estimated to increase fiscal year budget receipts by $753 million in 1987, $3,008 million in 1988, $4,831 million in 1989, $6,811 million in 1990, and $8,003 million in 1991.

 

B. Extension of At-Risk Rules to Real Estate Activities

 

 

(sec. 503 of the Act and sec. 465 of the Code)51

 

Prior Law

 

 

Loss limitation rules

Prior and present law (Code sec. 465) provide an at-risk limitation on losses from business and income-producing activities other than real estate and certain corporate active business activities, applicable to individuals and to certain closely held corporations.52 The rule is designed to prevent a taxpayer from deducting losses in excess of the taxpayer's actual economic investment in an activity.

Under the loss limitation at-risk rules applicable to activities other than the holding of real property under prior and present law, a taxpayer's deductible losses from an activity for any taxable year are limited to the amount the taxpayer has placed at risk (i.e., the amount the taxpayer could actually lose) in the activity. The initial amount at risk is generally the sum of (1) the taxpayer's cash contributions to the activity; (2) the adjusted basis of other property contributed to the activity; and (3) amounts borrowed for use in the activity with respect to which the taxpayer has personal liability or has pledged as security for repayment property not used in the activity. This amount is generally increased each year by the taxpayer's share of income and is decreased by the taxpayer's share of losses and withdrawals from the activity.

In the case of activities other than holding real property, a taxpayer is generally not considered at risk with respect to borrowed amounts if (1) the taxpayer is not personally liable for repayment of the debt (nonrecourse loans); or (2) the lender has an interest (other than as a creditor) in the activity (except to the extent provided in Treasury regulations). The taxpayer is also not considered at risk with respect to amounts for which the taxpayer is protected against loss by guarantees, stop-loss arrangements, insurance (other than casualty insurance) or similar arrangements. Losses which may not be deducted for any taxable year because of the loss limitation at-risk rule may be deducted in the first succeeding year in which the rule does not prevent the deduction.

The loss limitation at-risk rule for activities other than holding real property under prior and present law is applicable to individuals and to closely held corporations more than 50 percent in value of the stock in which was owned, at any time during the last half of the taxable year, by or for 5 or fewer individuals. Stock ownership is generally determined according to the rules applicable for purposes of identifying a personal holding company (sec. 542(a)(2)). In the case of a partnership or S corporation, the rules apply at the partner or shareholder level respectively.

Generally, a taxpayer's amount at risk is separately determined with respect to separate activities. Nevertheless, activities are treated as one activity (i.e., aggregated) if the activities constitute a trade or business and (1) the taxpayer actively participates in the management of that trade or business, or (2) in the case of a trade or business carried on by a partnership or S corporation, 65 percent or more of losses is allocable to persons who actively participate in the management of the trade or business. Authority is provided to prescribe regulations under which activities are aggregated or treated as separate activities.53 In addition, an exception from the at-risk rules is provided for certain active business activities of closely held corporations, and for this purpose, the component members of an affiliated group are treated as a single taxpayer (sec. 465(c)(7)(F)).

Investment tax credit rules

Prior law also provided rules requiring the taxpayer to be at-risk with respect to property in order to qualify for the investment tax credit (sec. 46(c)(8)). These rules provided an exception where the property is financed by certain third party nonrecourse loans.

The investment tax credit at-risk rules limited the credit base of property used in an activity that was subject to the loss limitation at-risk rules, and generally provided that nonrecourse debt was treated as an amount at risk for investment credit purposes where (1) it was borrowed from an unrelated commercial lender, or represented a loan from or was guaranteed by certain governmental entities; (2) the property was acquired from an unrelated person; (3) the lender was unrelated to the seller; (4) the lender or a related person did not receive a fee with respect to the taxpayer's investment in the property; (5) the debt was not convertible debt; and (6) the nonrecourse debt did not exceed 80 percent of the credit base of the property.

 

Reasons for Change

 

 

Congress concluded that it is appropriate to apply the at-risk rules to real estate activities so as to limit the opportunity for over-valuation of property (resulting in inflated deductions), and to prevent the transfer of tax benefits arising from real estate activities to taxpayers with little or no real equity in the property.

The Act therefore extends the at-risk rules to real estate, with an exception for certain nonrecourse financing provided by organizations in the business of lending.

Nonrecourse financing by the seller of real property or a promoter (or a person related to either the seller or promoter) is not treated as an amount at risk under the Act, because there may be little or no incentive to limit the amount of such financing to the value of the property. In the case of third party commercial financing secured solely by the real property, however, the lender is much less likely to make loans which exceed the property's value or which cannot be serviced by the property; it is more likely that such financing will be repaid and that the purchaser consequently has or will have real equity in the activity, and therefore that the financing may appropriately be treated as an amount at risk. Where the lender is a related person with respect to the taxpayer (other than the seller or the promoter, or a person related to either of them), however, Congress was concerned about opportunities for overvaluation of property (resulting in inflated deductions) and for the transfer of tax benefits attributable to amounts that resemble equity. Accordingly, financing from such a related person may be treated as an amount at risk under the Act only if the terms of the loan are commercially reasonable and on substantially the same terms as loans involving unrelated persons.

 

Explanation of Provision

 

 

Under the Act, the at-risk rules (which continue to apply to activities other than holding real property) are extended to the activity of holding real property. In the case of such a real estate activity, the Act provides an exception for qualified nonrecourse financing which is secured by real property used in the activity; the taxpayer is treated at-risk with respect to such financing. In the case of a real estate activity involving nonrecourse financing from related persons (not including the seller, a person receiving a fee for the investment (such as a promoter), or a person related to either of them), the financing can be treated as an amount at risk only if the terms of the loan are commercially reasonable and on substantially the same terms as loans involving unrelated persons.

Qualified nonrecourse financing

The exception provided for qualified nonrecourse financing is similar to the rules for qualified commercial financing under the investment tax credit at-risk rules of prior law, with certain modifications. Qualified nonrecourse financing generally includes financing that is secured by real property used in the activity and that is loaned by a Federal, State or local government or instrumentality thereof or guaranteed by a Federal, State, or local government, or is borrowed by the taxpayer from a qualified person, with respect to the activity of holding real property (other than mineral property). Convertible debt is not treated as qualified nonrecourse financing.

Generally, to the extent an activity was not subject to the at-risk rules (by virtue of section 465(c)(3)(D) of prior law), it will be treated under the Act as the activity of holding real property. The provision of services and the holding of personal property which is merely incidental to the activity of making real property available as living accommodations is treated as part of the activity of holding real property.

For purposes of the provision, nonrecourse financing means financing with respect to which no person is personally liable, except to the extent otherwise provided in regulations. Regulations may set forth the circumstances in which guarantees, indemnities, or personal liability (or the like) of a person other than the taxpayer will not cause the financing to be treated as other than qualified nonrecourse financing.

Qualified persons include any person actively and regularly engaged in the business of lending money. Such persons generally include, for example, a bank, savings and loan association, credit union, or insurance company regulated under Federal, State, or local law, or a pension trust. However, qualified persons do not include (1) any person from which the taxpayer acquired the property (or a person related to such person), or (2) any person who receives a fee (e.g., a promoter) with respect to the taxpayer's investment in the property (or a person related to such person). Thus, for example, no portion of seller financing and promoter financing is qualified nonrecourse financing.

The Act adopts the definition of related person applicable under the prior law investment tax credit at-risk rules, with modifications. Under this rule, related persons generally include family members, fiduciaries, and corporations or partnerships in which a person has at least a 10-percent interest.

In the case of a real estate activity where nonrecourse financing is from a related person (other than seller or promoter financing, which cannot be treated as qualified nonrecourse financing), additional requirements are imposed. Such amounts can be treated as at risk if the terms of the loan are commercially reasonable and on substantially the same terms as loans involving unrelated persons. Congress imposed these additional requirements in the case of related party nonrecourse financing in real estate activities because of concern not only about the opportunity for overvaluation in related party financing, but also about the transfer of tax benefits attributable to amounts that are in the nature of equity contributions (rather than loans) supplied by related persons.

Congress intends that terms of nonrecourse financing are commercially reasonable if the financing is a written unconditional promise to pay on demand or on a specified date or dates a sum or sums certain in money, and the interest rate is a reasonable market rate of interest (taking into account the maturity of the obligation). If the interest rate is below a reasonable market rate, a portion of the principal may in fact represent interest, with the result that the stated principal amount may exceed the fair market value of the financed property (or the amount that actually is debt for tax purposes, if the property is less than 100 percent debt financed). Generally, an interest rate will not be considered commercially reasonable if it is significantly below the market rate on comparable loans by qualified persons who are not related (within the meaning of sec. 465(b)(3)(C)) to the borrowers under the comparable loans. In addition, it is likely that a loan which would be treated as a "below-market loan" within the meaning of section 7872(e) of the Code is not commercially reasonable.

Similarly, if the interest rate exceeds a reasonable market rate, or is contingent on profits or gross receipts, a portion of the principal amount may in fact represent a disguised equity interest (and a portion of the interest in fact is a return on equity) with the result that the stated principal amount may exceed the fair market value of the financed property (or the amount that actually is debt for tax purposes, if the property is not 100 percent debt financed). Thus, generally, an interest rate will not be considered commercially reasonable if it significantly exceeds the market rate on comparable loans by unrelated qualified persons. Nor will an interest rate be considered commercially reasonable if it is contingent. Congress does not intend, however, to limit the use of interest rates that are not fixed rates, provided that interest is calculated with respect to a market interest index such as the prime rate charged by a major commercial bank, LIBOR, the rate on government securities (such as Treasury bills or notes), or the applicable Federal rate (within the meaning of sec. 1274(d)). For example, an interest rate floating at 1 point above the prime rate charged by a major commercial bank will not generally be considered contingent.

The terms of the financing will also not be considered commercially reasonable if, for example, the term of the loan exceeds the useful life of the property, or if the right to foreclosure or collection with respect to the debt is limited (except to the extent provided under applicable State law).

Generally, Congress intended that the financing be debt with arms' length terms, to carry out the purpose of the at-risk rule to limit deductions to the taxpayer's amount at risk. Thus, nonrecourse financing from a person related to the taxpayer must be on substantially the same terms as financing involving unrelated persons.

Congress also intended that no inference is to be drawn from this provision (permitting certain nonrecourse financing to be treated as at risk without regard to whether the lender is a related person) as to the determination of a partner's distributive share of partnership items of a partnership under section 704, or a partner's share of partnership liabilities under section 752.

Under the Act, convertible debt is not treated as qualified nonrecourse financing. Congress has concluded that it is not appropriate to treat investors as at risk with respect to nonrecourse debt that is convertible and that consequently represents a right to an equity interest, because taxpayers are not intended to be treated as at risk for amounts representing others' rights to equity investments.

A special rule for partnerships provides that partnership-level qualified nonrecourse financing may increase a partner's (including a limited partner's) amount at risk, determined in accordance with his share of the liability (within the meaning of sec. 752), provided the financing is qualified nonrecourse financing with respect to that partner as well as with respect to the partnership. For the purpose of determining whether partnership borrowings are treated as qualified nonrecourse financing with respect to the partnership, the partnership is treated as the taxpayer. For the purpose of determining whether a share of partnership borrowings is treated as qualified nonrecourse financing with respect to a partner, the partner is also treated as the borrower. The amount for which partners are treated as at risk under this rule may not exceed the total amount of the qualified nonrecourse financing at the partnership level.

In the case of property taken subject to a nonrecourse debt which constituted qualified nonrecourse financing in the hands of the original borrower, such debt may be considered as qualified nonrecourse financing as to the original borrower's transferee, provided that all the criteria for qualified nonrecourse financing are satisfied for that debt with respect to the transferee. The same rule applies to subsequent transfers of the property taken subject to the debt, and to the admission of new partners to a partnership (or sale or exchange of a partnership interest), so long as the debt constitutes qualified nonrecourse financing with respect to each transferee or new partner.

Aggregation rules

The prior and present law at-risk aggregation rules (sec. 465(c)(3)(B)) generally apply to the activity of holding real property. Under these rules, Congress intended that if a taxpayer actively participates in the management of several partnerships each engaged in the real estate business, the real estate activities of the various partnerships may be aggregated and treated as one activity with respect to that partner for purposes of the at-risk rules. Also it was intended that the regulations relating to the treatment of at-risk amounts in the case of an affiliated group of corporations (Treasury Reg. sec. 1.1502-45) be appropriately modified, in the case of an affiliated group which is engaged principally in the real estate business, to allow aggregation of the real estate activities, where the component members of the group are actively engaged in the management of the real estate business (not including real estate financing other than between members of the affiliated group).

Credit at-risk rules

The Act extends the investment tax credit at-risk rules (sec. 46(c)(8)) to activities involving real estate where a credit is otherwise allowable.54 In applying the credit at-risk requirement that the financing not exceed 80 percent of the credit base, in the case of property where only a portion of the basis is eligible for a credit, under regulations, only the financing with respect to that portion shall be taken into account.

 

Effective Date

 

 

The extension of the at-risk rules to the activity of holding real property is effective for property placed in service after December 31, 1986, and for losses attributable to an interest in a partnership or S corporation or other pass-through entity that is acquired after December 31, 1986. One specific transition rule is provided.

 

Revenue Effect

 

 

The provision is estimated to reduce fiscal year budget receipts by $24 million in 1987 and $15 million in 1988, and increase fiscal year budget receipts by $30 million in 1989, $23 million in 1990, and $33 million in 1991.

 

C. Interest Deduction Limitations

 

 

(sec. 511 of the Act and secs. 163(d) and (h) of the Code)55

 

Prior Law

 

 

In general

Under prior law (Code sec. 163(d)), in the case of a noncorporate taxpayer, deductions for interest on indebtedness incurred or continued to purchase or carry property held for investment were generally limited to $10,000 per year, plus the taxpayer's net investment income. Under prior and present law, investment interest paid or accrued during the year which exceeds the limitation on investment interest is not permanently disallowed, but is subject to an unlimited carryover and may be deducted in future years (subject to the applicable limitation) (prior-law sec. 163(d)(2)). Under prior law, interest incurred to purchase or carry certain property subject to a net lease generally was treated as investment interest, if certain trade or business deductions were less than 15 percent of the rental income, or if the lessor was guaranteed a specific return or guaranteed against loss of income.

Income and interest of partnerships and S corporations generally retained their entity level character (as either investment or noninvestment interest or income) in the hands of the partners and shareholders. The prior-law treatment of interest incurred to purchase or carry a partnership interest or S corporation stock was not entirely clear.56

Investment income and expenses

Investment income
Investment income under prior law was income from interest, dividends, rents, royalties, short-term capital gains arising from the disposition of investment assets, and any amount of gain treated as ordinary income pursuant to the depreciation recapture provisions (secs. 1245, 1250, and 1254), but only if the income was not derived from the conduct of a trade or business (sec. 163(d)(3)(A)).
Investment expenses
In determining net investment income, the investment expenses taken into account were trade or business expenses, real and personal property taxes, bad debts, depreciation amortizable bond premiums, expenses for the production of income, and depletion, to the extent these expenses were directly connected with the production of investment income.

For purposes of this determination, depreciation with respect to any property was taken into account on a straight-line basis over the useful life of the property, and depletion was taken into account on a cost basis.

Other interest

Under prior law, no limitation was imposed under section 163(d) on the deductibility of interest on indebtedness incurred for other purposes, e.g. to purchase or carry consumption goods. Under prior and present law, interest on indebtedness incurred in connection with the taxpayer's trade or business is also not subject to the limitation on the deductibility of interest expense under section 163.

 

Reasons for Change

 

 

Investment interest

Under prior law, leveraged investment property was subject to an interest limitation, for the purpose of preventing taxpayers from sheltering or reducing tax on other, non-investment income by means of the unrelated interest deduction. Congress concluded that the interest limitation should be strengthened so as to reduce the mismeasurement of income which can result from the deduction of investment interest expense in excess of current investment income, and from deduction of current investment expenses with respect to investment property on which appreciation has not been recognized.

Under prior law, no part of long-term capital gains were included in net investment income. Congress concluded that the continuation of this rule was inappropriate because long-term capital gains are generally taxed at the same effective rate as ordinary income when the Act is fully phased in.

Personal interest

Prior law excluded or mismeasured income arising from the ownership of housing and other consumer durables. Investment in such goods allowed consumers to avoid the tax that would apply if funds were invested in assets producing taxable income and to avoid the cost of renting these items, a cost which would not be deductible in computing tax liability. Thus, the tax system under prior law provided an incentive to invest in consumer durables rather than assets which produce taxable income and, therefore, an incentive to consume rather than save.

Although Congress believed that it would not be advisable to subject to income tax imputed rental income with respect to consumer durables owned by the taxpayer, it nevertheless concluded that it is appropriate and practical to address situations where personal expenditures are financed by borrowing. By phasing out the present deductibility of personal interest, Congress intended to eliminate from the prior tax law a significant disincentive to saving.

While Congress recognized that the imputed rental value of owner-occupied housing may be a significant source of untaxed income, the Congress nevertheless determined that encouraging home ownership is an important policy goal, achieved in part by providing a deduction for residential mortgage interest. Therefore, the personal interest limit does not affect the deductibility of interest on debt secured by the taxpayer's principal residence or second residence, to the extent of the basis of the principal residence (or second residence). In addition, because the Congress intended to provide special treatment to taxpayers who borrow to finance medical or educational expenses, interest on debt secured by the taxpayer's principal residence or second residence that is used to pay educational or medical expenses of the taxpayer or a family member is deductible, even though such borrowings cause the total debt secured by the residence to exceed the taxpayer's basis in the residence, provided the total debt does not exceed the fair market value of the residence.

 

Explanation of Provisions

 

 

In general

In general, under the Act, personal interest is not deductible, and the deduction for investment interest is limited to investment income for the year with an indefinite carryforward of disallowed investment interest. The personal interest limitation does not apply to interest on debt secured by the taxpayer's principal residence (to the extent of its basis plus the amount of such debt used to pay certain educational or medical expenses) and interest on debt secured by a second residence of the taxpayer (to the extent of its basis plus the amount of such debt used to pay certain educational or medical expenses), provided the total amount of such debt does not exceed the fair market value of such residence.

The Act provides that the deduction for investment interest is limited to the amount of net investment income. Interest disallowed under the provision is carried forward and treated as investment interest in the succeeding taxable year. Interest disallowed under the provision is allowed in a subsequent year only to the extent the taxpayer has net investment income in such year. Interest expense that is paid or incurred in carrying on a trade or business is not subject to the interest deduction limitations under the Act but may be subject to the passive loss limitation (Act sec. 501) in some circumstances.

Definition of investment interest

Investment interest is defined to include interest paid or accrued on indebtedness incurred or continued to purchase or carry property held for investment. For this purpose, any interest held by the taxpayer in an activity involving a trade or business which is not a passive activity under the passive loss rule (as added by sec. 501 of the Act) and in which the taxpayer does not materially participate is treated as held for investment. Investment interest also includes interest expense properly allocable to portfolio income under the passive loss rule.

In addition, investment interest includes the portion of interest expense on indebtedness incurred or continued to purchase or carry an interest in a passive activity, to the extent attributable to portfolio income (within the meaning of the passive loss rule).

Investment interest does not include any interest that is taken into account in determining the taxpayer's income or loss from a passive activity.57 Investment interest does not include interest properly allocable to a rental real estate activity in which the taxpayer actively participates, within the meaning of the passive loss rule. Investment interest also does not include any qualified residence interest, as described below.

Net investment income

Investment income includes gross income from property held for investment, gain (whether long term or short term) attributable to the disposition of property held for investment, and amounts treated as gross portfolio income under the passive loss rule.58 Investment income also includes income from interests in activities, involving a trade or business, in which the taxpayer does not materially participate, if that activity is not treated as a passive activity under the passive loss rule.

Net investment income is investment income net of investment expenses. Investment expenses are deductible expenses (other than interest) directly connected with the production of investment income. Under the Act, if depreciation or depletion deductions are allowed with respect to assets that produce investment income, investment expense is determined utilizing the actual depreciation or depletion deductions allowable. In determining other deductible investment expenses, it is intended that investment expenses be considered as those allowed after application of the rule limiting deductions for miscellaneous expenses to those expenses exceeding two percent of adjusted gross income. In computing the amount of expenses that exceed the 2-percent floor, expenses that are not investment expenses are intended to be disallowed before any investment expenses are disallowed.

Property subject to a net lease is not treated as investment property under this provision, to the extent it constitutes a rental activity that is treated as a passive activity under the passive loss rule. Income from a rental real estate activity in which the taxpayer actively participates is not included in investment income.

The investment interest limitation is not intended to disallow a deduction for interest expense which in the same year is required to be capitalized (e.g., construction interest subject to sec. 263A) or is disallowed (e.g., under sec. 265 (relating to tax-exempt interest)).

Personal interest

Under the Act, personal interest is not deductible. Personal interest is any interest, other than interest incurred or continued in connection with the conduct of a trade or business (other than the trade or business or performing services as an employee),59 investment interest, or interest taken into account in computing the taxpayer's income or loss from passive activities for the year. Thus, personal interest includes, for example, interest on a loan to purchase an automobile, interest on a loan to purchase a life insurance policy, and credit card interest, where such interest is not incurred or continued in connection with the conduct of a trade or business. Personal interest also includes interest on underpayments of individual Federal, State or local income taxes notwithstanding that all or a portion of the income may have arisen in a trade or business, because such taxes are not considered derived from the conduct of a trade or business.60 However, personal interest does not include interest payable on estate tax deferred under sections 6163 or 6166.

Personal interest does not include qualified residence interest of the taxpayer, as discussed below.

Qualified residence interest

Under the Act, qualified residence interest is not subject to the limitation on personal interest. Qualified residence interest generally means interest on debt secured by a security interest valid against a subsequent purchaser under local law on the taxpayer's principal residence or a second residence of the taxpayer.61 Qualified residence interest means interest on such debt to the extent that the debt does not exceed the amount of the taxpayer's basis for the residence (including the cost of home improvements), plus the amount of qualified medical and qualified educational expenses. Qualified residence interest does not include interest on any portion of such debt in excess of the fair market value of the residence. Interest on a loan secured by a recorded deed of trust, mortgage, or other security interest in a taxpayer's principal or second residence, in a State such as Texas where such recorded security instrument will be rendered ineffective or the enforceability of such instrument will be otherwise restricted by State and local laws such as the Texas homestead law, shall be treated as qualified residence interest, provided that such interest is otherwise qualified residence interest.62 The fact that, under applicable State or local law, a buyer does not acquire legal title to a residence he has purchased by means of debt until the debt is fully paid is not intended to have the result that the debt is treated as not secured by the residence, for purposes of this provision. Qualified residence interest is not subject to the limitation on personal interest even though the borrowed funds are used for personal expenditures.

Residences of the taxpayer
The taxpayer's principal residence is intended to be the residence that would qualify for rollover of gain under section 1034 if it were sold. A principal residence may be a condominium or cooperative unit.63 A dwelling unit will qualify as a residence only if it meets the requirements for use as a residence under section 280A. A second residence of the taxpayer includes a dwelling unit used by the taxpayer as a residence within the meaning of section 280A (gain on which could qualify for rollover treatment under section 1034 if the residence were used as a principal residence). If a second residence is not rented at any time during the taxable year, the taxpayer need not meet the requirement of section 280A(d)(1) that the residence be used for personal (nonrental) purposes for the greater of 14 days or 10 percent of the number of days it is rented.64 In the case of a joint return, a second residence includes a residence used by the taxpayer or his spouse and which is owned by either or both spouses.

Qualified residence interest may include interest paid by the taxpayer on debt secured by a residence of the taxpayer that he owns jointly or as a tenant in common, provided that all the requirements for qualified residence interest are met.

Qualified residence interest not treated as personal interest under the provision may include all or a portion of the interest on debt secured by the taxpayer's stock in a housing cooperative unit that is a residence of the taxpayer, or by his proprietary lease with respect to the unit. In addition, qualified residence interest not treated as personal interest under the provision may include all or a portion of the taxpayer's share under section 216 of interest expense of the housing cooperative allocable to his unit and to his share of common residential (but not commercial) areas of the co-operative. In applying the qualified residence interest exception where the taxpayer's residence is a cooperative housing unit, it is intended that regulations will be issued providing that the basis and fair market value limitations will apply in such a way as to achieve a result comparable to that which would occur if the taxpayer owned his share of the assets of the cooperative directly.

In the case of housing cooperatives, debt secured by stock held by the taxpayer as a tenant-stockholder is treated as secured by the residence the taxpayer is entitled to occupy as a tenant-stockholder. Where the stock may not be used as security by virtue of restrictions arising, for example, pursuant to local or State law, or pursuant to reasonable restrictions in the cooperative agreement, the stock may be treated as securing such debt, if the taxpayer establishes to the satisfaction of the Internal Revenue Service that the debt was incurred to acquire the stock.

In the case of a husband and wife filing separate returns, each spouse may deduct interest on debt secured by one residence. Alternatively the spouses may consent in writing to allow one spouse to claim interest on debt secured by two residences at least one of which is a principal residence. In the latter case, any interest of the other spouse on debt secured by a residence is treated as interest which may be subject to disallowance.

In the case of a taxpayer who owns more than two residences, the taxpayer may designate each year which residence (other than the taxpayer's principal residence) the taxpayer wishes to have treated as the second residence.

Amount of limitation
Qualified residence interest is calculated as interest on debt secured by the residence, up to the amount of the basis of the residence, plus the amount incurred after August 16, 1986, for qualified medical and educational expenses. If the amount of any debt incurred on or before August 16, 1986, and secured by the residence on August 16, 1986 (reduced by any principal payments thereon) exceeds the taxpayer's basis for the residence, then such amount (reduced by any principal payments thereon) shall be substituted for the taxpayer's basis in applying the preceding sentence. Increases after August 16, 1986 in the amount of debt secured by the residence on August 16, 1986 (for example, in the case of a line of credit) are treated as incurred after August 16, 1986. Thus, interest on outstanding debt secured by the taxpayer's principal or second residence, incurred on or before August 16, 1986, is treated as fully deductible (to the extent the debt does not exceed the fair market value of the residence), regardless of whether the borrowed funds are used for personal expenditures. Interest on debt secured by the taxpayer's principal or second residence, incurred after August 16, 1986, which debt exceeds the taxpayer's basis in the residence, is allowed only if the debt is incurred for qualified medical or educational expenses.

For purposes of determining qualified residence interest, the amount of the taxpayer's basis is determined without taking into account adjustments to basis under section 1034(e) (relating to rollover of gain upon the sale of the taxpayer's principal residence), or 1033(b) (relating to involuntary conversions). The basis for the residence includes the cost of improvements to the residence that are added to the basis of the residence.65 The taxpayer's basis is determined without regard to other adjustments to basis, such as depreciation. Thus, for example, if a taxpayer's second residence is rented to tenants for a portion of the year, and its basis is reduced by deductions for depreciation allowed in connection with the rental use of the property, the amount of his basis for the residence is not reduced by such deductions for purposes of this provision. Where the basis of a residence is determined under section 1014 (relating to the basis of property acquired from a decedent), the basis under this provision is the basis determined under section 1014 (plus the cost of home improvements made by the taxpayer that are included in basis). In general, under this provision, the amount of debt on which the taxpayer may deduct interest as qualified interest will not be less than his purchase price for the residence.

Generally, interest on debt secured by the taxpayer's principal or second residence (up to the amount of the taxpayer's basis) is treated as qualified residence interest. Thus, for example, if the taxpayer's basis in his principal residence is $100,000 (and this amount does not exceed fair market value), and the residence is secured by debt in the amount of $60,000, interest on a refinancing for a total of $100,000 (including the original $60,000 plus an additional $40,000) is treated as qualified residence interest, regardless of the fact that the borrowed funds are used for personal expenditures by the taxpayer.

Qualified medical expenses are those amounts paid for medical care within the meaning of sec. 213(d)(1)(A) and (B) (not including amounts paid for insurance covering medical care under sec. 213(d)(1)(C), of the taxpayer, his spouse and dependents.

Qualified educational expenses are those amounts paid for reasonable living expenses while away from home, and for any tuition and related expenses incurred that would qualify as scholarships (under sec. 117(b) as amended by the Act), for the taxpayer, his spouse or dependent, while a student at an educational organization described in section 170(b)(1). Thus, tuition expenses for primary, secondary, college and graduate level education are generally included in qualified educational expenses. The qualified educational expenses or qualified medical expenses must be incurred within a reasonable period of time before or after the debt is incurred. Medical or educational expenses that are reimbursed are not intended to be treated as qualified medical or educational expenses.

Interest on debt that is used to pay qualified medical or educational expenses, to be deductible as qualified residence interest, must be secured by the taxpayer's principal residence or second residence. Interest expense is so treated if the debt is so secured at the time the interest is paid or accrued.

 

Effective Date

 

 

The investment and personal interest limitations, as amended by the Act, are effective for taxable years beginning on or after January 1, 1987, regardless of when the obligation was incurred. The limitations are phased in. The personal interest limitation and the investment interest limitation are each phased in separately at the same rate.

Investment interest

Under the Act, the amount of investment interest disallowed during the phase-in period is generally the sum of (i) the amount of investment interest that would have been disallowed under prior law plus (ii) the applicable portion of the additional amount of investment interest that would be disallowed once the provision is fully phased in. The amount of passive losses allowed under the passive loss phase-in rule (supra) that are subtracted from investment income are subject the investment interest phase-in applicable percentages.66

The applicable percentage under the investment interest phase-in rule is 35 percent in 1987, 60 percent in 1988, 80 percent in 1989, 90 percent in 1990 and 100 percent in 1991 and thereafter. Thus, for example, if an individual taxpayer has $20,000 of investment interest expense in excess of investment income in 1987, 35 percent of the amount that does not exceed $10,000 or $3,500, plus the amount in excess of the $10,000 allowance would be disallowed. Thus, $13,500 would be disallowed, and $6,500 would be allowed for 1987 (assuming the taxpayer had no net passive loss for the year).

With respect to the investment interest limitation, for taxable years beginning on or after January 1, 1987 and before January 1, 1991, the amount of net investment income is reduced by the amount of losses from passive activities that is allowed as a deduction by virtue of the phase-in of the passive loss rule (other than net losses from rental real estate in which the taxpayer actively participates). For example, if a taxpayer has a passive loss which would be disallowed were the passive loss rule fully phased in (as in taxable years beginning after December 31, 1990), but a percentage of which is allowed under the passive loss phase-in rule, the amount of loss so allowed reduces the amount of the taxpayer's net investment income under the investment interest limitation for that year.

Further, any amount of investment interest that is disallowed under the investment interest limitation during the period that the investment interest limitation is phased in (that is, taxable years beginning on or after January 1, 1987 and before January 1, 1991) is not allowed as a deduction in a subsequent year except to the extent the taxpayer has net investment income in excess of investment interest in the subsequent year.67

Personal interest

The limitation on personal interest is phased in over the same period and applying the same percentages as for the investment interest limitation. No carryforwards are permitted for disallowed personal interest.

 

Revenue Effect

 

 

This provision is estimated to increase fiscal year budget receipts by $620 million in 1987, $4,511 million in 1988, $6,260 million in 1989, $8,370 million in 1990, and $9,597 million in 1991.

 

TITLE VI--CORPORATE TAXATION

 

 

A. Corporate Tax Rates

 

 

(sec. 601 of the Act and sec. 11 of the Code)1

 

Prior Law

 

 

Under prior law, corporate taxable income was subject to tax under a 5-step graduated rate structure. The top corporate tax rate was 46 percent on taxable income over $100,000. The corporate taxable income brackets and tax rates were as set forth in the table below.

 Taxable income                            Tax rate

 

                                           (percent)

 

 

 Not over $25,000                             15

 

 Over $25,000 but not over $50,000            18

 

 Over $50,000 but not over $75,000            39

 

 Over $75,000 but not over $100,000           40

 

 Over $100,000                                46

 

 

This schedule of corporate tax rates was originally enacted in the Economic Recovery Tax Act of 1981 (ERTA), effective for 1983 and later years. For 1982, the applicable rates were 16 percent for taxable income not over $25,000, and 19 percent for taxable income over $25,000 but not over $50,000. For taxable years after 1978 and before 1982, the rates were 17 percent and 20 percent, respectively, for the lowest two brackets.

An additional 5-percent corporate tax was imposed on a corporation's taxable income in excess of $1 million. The maximum additional tax was $20,250. This provision phased out the benefit of graduated rates for corporations with taxable income between $1,000,000 and $1,405,000; corporations with taxable income in excess of $1,405,000, in effect, paid a flat tax at a 46-percent rate. This provision was enacted in the Deficit Reduction Act of 1984, effective for taxable years beginning after 1983.2

 

Reasons for Change

 

 

A principal objective of the Act was to reduce marginal tax rates on income earned by individuals and by corporations. Congress believed that lower tax rates promote economic growth by increasing the rate of return on investment. Lower tax rates also improve the allocation of resources within the economy by reducing the impact of tax considerations on business and investment decisions. In addition, lower tax rates promote compliance by reducing the potential gain from engaging in transactions designed to avoid or evade income tax. Under the Act, the maximum corporate rate is reduced from 46 percent to 34 percent.

Although Congress believed that the graduated rate structure should be retained to encourage growth in small business, it felt that the benefit of the lower rates should be limited to smaller corporations. Accordingly, under the Act the benefit of the graduated rate structure is phased out beginning at $100,000 of taxable income as compared to $1 million under prior law. In addition, Congress simplified the graduated rate structure for corporations by reducing the number of brackets from five to three.

 

Explanation of Provision

 

 

Under the Act, tax would be imposed on corporations under the schedule shown in the following table.

 Taxable income            Tax rate

 

                           (percent)

 

 

 Not over $50,000             15

 

 $50,000 to $75,000           25

 

 Over $75,000                 34

 

 

An additional 5-percent tax is imposed on a corporation's taxable income in excess of $100,000. The maximum additional tax is $11,750. This provision phases out the benefit of graduated rates for corporations with taxable income between $100,000 and $335,000; corporations with income in excess of $335,000, in effect, will pay a flat tax at a 34-percent rate.

 

Effective Date

 

 

The revised corporate tax rates are effective for taxable years beginning on or after July 1, 1987. Income in taxable years that include July 1, 1987 (other than as the first date of such year) is subject to a blended rate under the rules specified in section 15 of the Code.

Under section 15, tentative taxes for the entire taxable year are first computed by 1) applying the rates (including the applicable phaseout of the graduated rates) for the period before July 1, 1987 to the taxable income for the entire taxable year, and 2) applying the rates (including the applicable phaseout of the graduated rates) for the period on and after July 1, 1987 to the entire taxable year. The actual tax for the taxable year is then computed as the sum of that proportion of each tentative tax which the number of days in each period bears to the number of days in the entire taxable year.3

As one example, in the case of a calendar year corporate taxpayer with $2 million of ordinary taxable income, the tax for 1987 is computed by first determining a tentative tax under prior law of $920,000 (46 percent of $2 million) and a tentative tax under the amended law of $680,000 (34 percent of $2 million). The actual tax equals the sum of $456,219.18 (181/365 of $920,000) and $342,794.52 (184/365 of $680,000) or $799,013.70.4

 

Revenue Effect

 

 

The provision is estimated to reduce fiscal year budget receipts by $6,711 million in 1987, $20,068 million in 1988, $27,505 million in 1989, $29,999 million in 1990, and $32,415 million in 1991.

 

B. Corporate Dividends Received Deduction

 

 

(sec. 611 of the Act and secs. 243-246A of the Code)5

 

Prior Law

 

 

Under prior law, corporations that received dividends generally were entitled to a deduction equal to 85 percent of the dividends received (sec. 243(a)(1)). Under prior and present law, dividends received from a small business investment company operating under the Small Business Investment Act of 1958 (sec. 243(a)(2)), and "qualifying dividends" received from certain members of an affiliated group, are eligible for a 100-percent dividends received deduction (sec. 243(a)(3)). In addition, under prior and present law, pursuant to Treasury regulations, dividends received by one member of an affiliated group filing a consolidated return from another member of the group are not taxed to the recipient (Treas. Reg. sec. 1.1502-14).

There are exceptions for certain dividends received by a U.S. corporation from a foreign corporation and from certain other entities. The dividends received deduction is limited in certain other circumstances.

 

Reasons for Change

 

 

Under prior law, dividends eligible for the 85-percent dividends received deduction were taxed at a maximum rate of 6.9 percent (15 percent of the top corporate rate of 46 percent). The Congress did not believe that the reduction in corporate tax rates generally should result in a significant reduction in this effective rate. Thus, the dividends received deduction has been reduced to 80 percent, resulting in a maximum rate of 6.8 percent on dividends subject to the reduced top corporate rate (20 percent of the top corporate rate of 34 percent).

 

Explanation of Provision

 

 

Under the Act, the 85-percent dividends received deduction is lowered to 80 percent.

 

Effective Date

 

 

The reduction in the dividends received deduction is applicable to dividends received or accrued after December 31, 1986, in taxable years ending after such date.

 

Revenue Effect

 

 

The provision is estimated to increase fiscal year budget receipts by $140 million in 1987, $223 million in 1988, $225 million in 1989, $239 million in 1990, and $253 million in 1991.

 

C. Dividend Exclusion for Individuals

 

 

(sec. 612 of the Act and sec. 116 of the Code)6

 

Prior Law

 

 

Under prior law, the first $100 of qualified dividends received by an individual shareholder ($200 by a married couple filing jointly) from domestic corporations was excluded from income (sec. 116(a)).

The dividend exclusion for individuals did not apply to dividends received from an organization that was exempt from tax under section 501 or a tax-exempt farmers' cooperative in either the year of distribution or the preceding year (sec. 166(b)(1)), dividends received from a real estate investment trust (sec. 116(b)(2)), dividends received from a mutual savings bank that received a deduction for the dividend under section 591 (sec. 116(c)(1)), or to an ESOP dividend for which the corporation received a deduction (sec. 116(e)). The exclusion was limited with respect to dividends received from a regulated investment company (sec. 116(c)(2)).

 

Reasons for Change

 

 

The Congress believed that the dividend exclusion for individuals under prior law provided little relief from the two-tier corporate income tax because of the low limitation. As an exclusion from income, it also tended to benefit high-bracket taxpayers more than low-bracket taxpayers. On balance, the Congress believed it is preferable to eliminate the exclusion and use the revenues to reduce tax rates.

 

Explanation of Provision

 

 

Under the Act, the dividend exclusion for individuals is repealed.

 

Effective Date

 

 

The provision is effective for taxable years beginning after December 31, 1986.

 

Revenue Effect

 

 

The provision is expected to increase fiscal year budget receipts by $212 million in 1987, $573 million in 1988, $580 million in 1989, $605 million in 1990, and $631 million in 1991.

 

D. Stock Redemption Payments

 

 

(sec. 613 of the Act and section 162(l) of the Code)7

 

Prior Law

 

 

Under prior and present law, a deduction is allowed for all ordinary and necessary business expenses incurred during the taxable year in carrying on a trade or business (sec. 162(a)). A deduction is not allowed currently, however, for the costs of acquiring property whose life extends substantially beyond the close of the taxable year; such costs must be capitalized (sec. 263).

The purchase of stock, including the repurchase by an issuing corporation of its own stock, is generally treated as a capital transaction that does not give rise to a current deduction. Some authority existed under prior law for the proposition that, in certain extraordinary circumstances, amounts paid by a corporation to repurchase its stock may be fully deductible in the year paid. The validity of this authority, however, has been questioned. Thus, in Five Star Manufacturing Co. v. Comm'r, 355 F.2d 724 (5th Cir. 1966), the court relied on the fact that liquidation of the corporation was imminent in the absence of the repurchase, and that no value would have been realized by the shareholders on such a liquidation, in upholding the deduction of the payments. Subsequent cases, however, strictly limited the holding in Five Star to its peculiar facts,8 or questioned its validity.9

The Supreme Court has held that the requirement that stock redemption payments be capitalized extends not only to amounts representing consideration for the stock itself, but also to expenses such as legal, brokerage, and accounting fees incident to the acquisition.10

 

Reasons for Change

 

 

Congress understood that some corporate taxpayers were taking the position that expenditures incurred to repurchase stock from stockholders to prevent a hostile takeover of the corporation by such shareholders--so-called "greenmail" payments--were deductible business expenses. Congress wished to provide expressly that all expenditures by a corporation incurred in purchasing its own stock, whether representing direct consideration for the stock, a premium payment above the apparent stock value, or costs incident to the purchase, and whether incurred in a hostile takeover situation or otherwise, are nonamortizable capital expenditures.

 

Explanation of Provision

 

 

The Act denies a deduction for any amount paid or incurred by a corporation in connection with the redemption of its stock. Congress intended that amounts subject to this provision will include amounts paid to repurchase stock; premiums paid for the stock; legal, accounting, brokerage, transfer agent, appraisal, and similar fees incurred in connection with the repurchase; and any other expenditure that is necessary or incident to the repurchase, whether representing costs incurred by the purchasing corporation or by the selling shareholder (and paid or reimbursed by the purchasing corporation), or incurred by persons or entities related to either.11 The provision was also intended to apply to any amount paid by a corporation to a selling shareholder (or any related person) pursuant to an agreement entered into as part of or in connection with a repurchase of stock, whereunder the seller agrees not to purchase, finance a purchase, acquire, or in any way be a party or agent to the acquisition of stock of the corporation for a specified or indefinite period of time (so-called "standstill" agreements).

The provision does not apply to interest deductible under section 163. In addition, it does not apply to amounts constituting dividends within the meaning of section 561, relating to payments (or deemed payments) for purposes of the accumulated earnings, personal holding company, and foreign personal holding company taxes, and for purposes of the regular income tax in the case of regulated investment companies and real estate investment trusts.12 Thus, such amounts continue to qualify for the dividends paid deduction to the same extent as under prior law.

Further, the provision does not apply to otherwise deductible expenses incurred by a regulated investment company that is an open-end mutual fund in connection with the redemption of its stock upon the demand of a shareholder. Thus, for example, costs incurred by such a company in processing applications for redemption and issuing checks in payment for redeemed shares are deductible to the same extent as under prior law.13

While the phrase "in connection with [a] redemption" was intended to be construed broadly, Congress did not intend the provision to deny a deduction for otherwise deductible amounts paid in a transaction that has no nexus with the redemption other than being proximate in time or arising out of the same general circumstances. For example, if a corporation redeems a departing employee's stock and makes a payment to the employee in discharge of the corporation's obligations under an employment contract, the payment in discharge of the contractual obligation is not subject to disallowance under this provision.14 Payments in discharge of other types of contractual obligations, in settlement of litigation, or pursuant to other actual or potential legal obligations or rights, may also be outside the intended scope of the provision to the extent it is clearly established that the payment does not represent consideration for the stock or expenses related to its acquisition, and is not a payment that is a fundamental part of a "standstill" or similar agreement.

Congress anticipated that where a transaction is not directly related to a redemption but is proximate in time, the Internal Revenue Service will scrutinize the transaction to determine whether the amount purportedly paid in the transaction is reasonable. Thus, even where the parties have countervailing tax interests, the parties' stated allocation of the total consideration between the redemption and the unrelated transaction will be respected only if it is supported by all the facts and circumstances.15

However, Congress intended that agreements to refrain from purchasing stock of a corporation or other similar types of "standstill" agreements in all events will be considered related to any redemption of the payee's stock. Accordingly, payments pursuant to such agreements are nondeductible under this provision provided there is an actual purchase of all or part of the payee's stock. Congress intended no inference regarding the deductibility of payments under standstill or similar agreements that are unrelated to any redemption of stock owned by the payee.

In denying a deduction for payments in connection with redemptions of stock, Congress intended no inference regarding the deductibility of such payments under prior law. Moreover, no inference was intended as to the character of such payments in the hands of the payee.

 

Effective Date

 

 

The provision is effective for amounts paid or incurred after February 28, 1986.

 

Revenue Effect

 

 

The provision is estimated to have no effect on fiscal year budget receipts.

 

E. Extraordinary Dividends Received by Corporate Shareholders

 

 

(sec. 614 of the Act and sec. 1059 of the Code)16

 

Prior Law

 

 

Under prior (and present) law, if a corporate shareholder received an "extraordinary dividend" on stock and disposed of the stock without having held it for more than one year, the basis of the stock was reduced by the amount of the nontaxed portion of the dividend (sec. 1059). If the nontaxed portion of an extraordinary dividend exceeded the shareholder's adjusted basis in the stock with respect to which it was paid, the excess was treated as gain from the sale or exchange of property at the date on which the stock became ex-dividend.

An extraordinary dividend was defined in terms of the size of the dividend in relation to the shareholder's adjusted basis of the share of stock with respect to which it was distributed. A dividend was extraordinary if it equaled or exceeded a "threshold percentage" of 10 percent (5 percent in the case of a share of stock preferred as to dividends) of the shareholder's basis in the share, determined without regard to this provision.

In the case of a cash distribution, the nontaxed portion of the dividend was the amount offset by the dividends received deduction. In the case of a distribution of property, the nontaxed portion was the fair market value of the property (reduced, as provided in section 301(b)(2), for liabilities assumed by the shareholder or to which the shareholder is subject), less any portion of such amount that is not offset by the dividends received deduction.

In general, under both prior and present law, a distribution in redemption of stock that is essentially equivalent to a dividend is treated as a dividend for tax purposes (sec. 302). A redemption of the stock of a shareholder is essentially equivalent to a dividend if it does not result in a meaningful reduction in the shareholder's proportionate interest in the distributing corporation. In some situations it is unclear what constitutes a meaningful reduction in interest. Distributions in partial liquidation of the distributing corporation are not treated as dividends if the recipient is a non-corporate shareholder.

 

Reasons for Change

 

 

Congress believed that the extraordinary dividend provision, as enacted in 1984, had not been an adequate deterrent to the tax-motivated transactions at which the provision was directed. Taxpayers were able to obtain the tax benefits that Congress intended to curtail, simply by holding stock beyond the one-year period.

For example, under prior law, a corporation could acquire stock in another corporation following or in anticipation of the latter's announcement that it would pay a large dividend and could hold the stock with the intention of disposing of it shortly after the expiration of the one-year holding period necessary to avoid a basis reduction under section 1059. After the distribution, the shareholder would have dividend income taxable under prior law at a maximum rate of 6.9 percent, and the market price of the dividend-paying stock would have declined by approximately the value of the dividend. However, provided the stock was held for more than one year, the shareholder's basis in the shares would reflect its full cost, since no reduction in the basis was required. The taxpayer could then dispose of the stock for an amount reflecting the decrease in market price due to payment of the dividend. Since the taxpayer's basis in the stock was not reduced, this disposition could either create a long-term capital loss for tax purposes (which the taxpayer could use to offset other capital gains), or it might reduce any long-term capital gain the taxpayer would otherwise have realized on disposition of the stock. Under the prior law maximum 28 percent long-term capital gains rate, the taxpayer could thus receive a tax benefit of 28 percent of the amount of the dividend. Since the dividend was taxed at a maximum rate of 6.9 percent, the taxpayer could thus obtain a 21.1 percent tax "arbitrage" benefit at essentially no actual economic cost.17 The Act's reduction of the maximum rate on intercorporate dividends to 6.8 percent and the elimination of a preferential rate for long-term capital gains (thus making long-term capital losses relatively more valuable) increases the potential arbitrage benefit for a corporation.

Congress believed that the circumstances should be expanded in which a corporate shareholder is required to reduce its basis in stock for the nontaxed portion of an extraordinary dividend. However, in light of the longer holding period, Congress believed it appropriate to mitigate the application of the definition of extraordinary dividends by reference to basis under prior law, if the shareholder can establish a higher fair market value of the stock to the satisfaction of the Commissioner.

Congress understood that because the law is not entirely clear when a redemption is essentially equivalent to a dividend, there are cases in which individual distributees take the position that a redemption is a sale or exchange, while corporate distributees take the position the redemption is a dividend. Similar differences might occur in the case of partial liquidation distributions that individual distributees must treat as a sale or exchange, if corporate distributees take the position the distribution is a dividend.

 

Explanation of Provisions

 

 

Under the Act, a corporation that disposes of a share of stock must reduce its basis in the stock (but not below zero) by the nontaxed portion of any extraordinary dividend paid with respect to the share, if a holding period requirement described below, is not met. Except for purposes of determining whether subsequent distributions are extraordinary, this basis reduction is required only for purposes of determining gain or loss on the disposition of the share. If the aggregate nontaxed portions of extraordinary dividends exceed the shareholder's basis, the excess is treated as gain from a sale or exchange at the time of disposition.

The determination whether a dividend is extraordinary is generally made under the prior law percentage-of-adjusted-basis test. Thus, under the Act, a dividend is extraordinary if it equals or exceeds the "threshold percentage" of 10 percent (5 percent in the case of preferred stock) of the shareholder's basis in the share. However, unlike prior law, for purposes of this determination basis is reduced by the nontaxed portion of any prior extraordinary dividends under the provision. Also, the Act provides a taxpayer the option of determining the status of a distribution as an extraordinary dividend by reference to the fair market value of the share on the day before the ex-dividend date, in lieu of the adjusted basis of the share. This special rule applies only if the taxpayer establishes the fair market value of the share to the satisfaction of the Commissioner.

Instead of the one-year post-acquisition holding period requirement of prior law, the Act provides a test based on the holding period of the distributee as of the date the distribution is declared, announced, or agreed to by the distributing corporation, whichever is earliest. Under this test, an extraordinary dividend distribution with respect to stock will require a basis reduction if the taxpayer has not held the stock for more than two years on the earliest of the date of declaration, announcement, or agreement.

For purposes of determining whether the two-year holding period requirement has been met, a distribution is announced if the amount thereof has been announced, even though legal declaration of the dividend may not have occurred, and even though the distribution may be scheduled to occur at some time in the future, or its payment may otherwise be deferred. Similarly, if there is a formal or informal agreement to pay the particular dividend prior to the declaration date, the date of such agreement shall be treated as the dividend announcement date. Whether there is such a formal or informal agreement is determined based on all the facts and circumstances. In general, a broad agreement in a joint venture arrangement that dividends will be paid as funds are available will not be considered an agreement to pay a particular dividend in the absence of other facts, such as facts showing a particular expectation that a large dividend would be paid after the acquisition of a new interest in the venture.

Although any fixed dividend on preferred stock is in a sense "announced" by the terms of the stock at the time the stock is acquired, it is not intended that all such fixed dividends on the stock, however long it is held, would thus be considered to be "announced or agreed to" within the 2-year period. However, it is intended that the fixed dividends attributable to the first 2 years the preferred stock is held will be considered "announced or agreed to" within the first 2 years, even though a payment date might be missed or there might otherwise be a delay in paying such dividends beyond the first 2 years to which they are attributable. As one example, if newly issued preferred stock provides an annual fixed dividend of 12 percent of its issue price but with the dividends for the first two years to be payable only in the third year after issuance, the dividends attributable to the first two years will be considered "announced or agreed to" within the first two years, and will require basis reduction even if paid to an original holder in the third year after issuance, unless the special relief rule for qualified preferred dividends (described below) applies.

Similarly, if preferred stock provides for a cumulative dividend of 12 percent of annual profits, the dividends attributable to the first 2 years' profits will be subject to the extraordinary dividend tests, and will require basis reduction if the threshold percentage is exceeded, even if the dividends are not paid until the third year. Since such dividends would not be "fixed", in amount, special relief would not be available under the qualified preferred dividend rule described below.

The basis reduction rules are also intended to apply in other situations that attempt to avoid the threshold amount or holding period requirements by deferring or staggering dividend payments.

The Act provides a special rule for certain qualified preferred dividends. Absent this special rule, the basic definition of extraordinary dividend would create an extraordinary dividend if a preferred stock pays, within any period of 85 days or less, dividends equal to or exceeding 5 percent of the shareholder's adjusted basis (or, if applicable, the fair market value of the stock). Thus, for example, under the basic definition, a fixed 6-percent preferred stock dividend that is paid once annually will be extraordinary. On the other hand, under the same basic definition, if the preferred stock paid four quarterly 4.9-percent dividends, none of the dividends will be considered extraordinary.

The special rule for qualified preferred dividends is intended to provide relief for certain transactions to the extent that there is no potential for effectively purchasing a dividend that accrued prior to the date of purchase ("dividend-stripping"). Under the special rule, those dividends that qualify for relief are treated as extraordinary dividends only to the lesser of the extent required by the basic rule or the extent that the aggregate eligible dividends received by the taxpayer during the period it owns the stock exceed the dividends it "earned." Furthermore, if the taxpayer holds the stock for more than 5 years, no basis reduction is required for such dividends.

Preferred stock dividends qualify for relief only if (1) they are fixed (i.e., not varying in amount) preferred dividends, payable not less often than annually; and (2) dividends were not in arrears when the taxpayer acquired the stock. Also, no relief is available if the aggregate dividends received by the taxpayer during the period it owns the stock exceed an annualized rate of 15 percent of the lower of (a) the taxpayer's adjusted basis or (b) the liquidation preference of the stock.18

To determine whether the taxpayer's fixed dividends qualify for relief under the above rules and, if they do, to determine the extent of such relief by determining whether such dividends exceed the dividends "earned," the taxpayer's "actual rate of return" is first computed. The actual rate of return is the average annual amount of dividends received (or deemed received under section 305 or any other provision) during the period the taxpayer owned the stock, computed as a return on the taxpayer's adjusted basis or, if lesser, the stock's liquidation preference.

If this actual rate of return exceeds 15 percent, no dividends are eligible for relief. Accordingly, the normal operation of the basic rule requires reduction of basis for any otherwise extraordinary dividends declared, announced, or agreed to within the 2-year holding period.

On the other hand, if the actual rate of return does not exceed 15 percent, relief may be available for otherwise qualified preferred dividends. If the stock is held more than 5 years, no basis reduction is required for such dividends. Even if the stock is held less than 5 years, no basis reduction is required if the actual rate of return does not exceed the stated rate of return, because the taxpayer is not considered to have received more dividends than it "earned." However, if the stock is held less than 5 years and the actual rate of return during the entire holding period exceeds the stated rate, a basis reduction will occur, but limiting the extraordinary dividend amount that would otherwise require basis reduction to the aggregate "excess" amount of dividends for the entire holding period. The required basis reduction will thus be the lesser of: (a) the full amount required under the basic rule with respect to the dividends that do not satisfy the 2-year holding period; or (b) the amount required if the aggregate amount of excess dividends for the entire holding period (up to five years) is treated as being an extraordinary dividend declared, announced, or agreed to prior to the expiration of the 2-year holding period.

 

The following is an example of the general operation of the special qualifying preferred stock rule: assume that on January 1, 1987, a corporation purchases for $1,000 ten shares of preferred stock having a liquidation preference of $100 per share and paying only fixed preferred dividends of $6 per share to shareholders of record semi-annually on March 31 and September 30 of each year. The basic extraordinary dividend rule would generally require the taxpayer to reduce the basis in the stock by the untaxed portion of each dividend attributable to the period prior to the expiration of the two-year holding period (in this case, the first four dividends, or $24 per share). This is because a dividend equaling or exceeding 5 percent of adjusted basis (or fair market value, if shown to the satisfaction of the Secretary) paid semi-annually is an extraordinary dividend under the general rule.19 However, the special rule will apply to the preferred stock. Under this provision, the taxpayer's stated rate of return per share is 12 percent per year ($12/$100). If the taxpayer sells the stock on October 1, 1988, (after holding the stock for 1.75 years) the taxpayer's actual rate of return would not have exceeded the stated rate of return if the taxpayer had received dividends up to $21 per share (12/100 x 1.75). However, the taxpayer has received dividends of $24 per share, for an actual rate of return per share of 13.7 percent ($24/$100 divided by 1.75). The amount by which the actual rate of return exceeds the stated rate of return is $3 per share. Accordingly, this amount of the total aggregate dividends ($30 total, or 12.5 percent of the aggregate total dividends) will be treated as an extraordinary dividend described in section 1059(a) and will require basis reduction. However, if the corporation does not sell the stock until January 1, 1989, its actual rate of return per share will be 12 percent ($24/$100 divided by 2.0). This does not exceed the stated dividend rate; accordingly, no portion of the qualified preferred dividends will be treated as an extraordinary dividend.

 

Under the Act the term "extraordinary dividend" is also expanded to include any distribution (without regard to the holding period for the stock) to a corporate shareholder in partial liquidation of the distributing corporation. Congress thus intended the nontaxed portion of any partial liquidation distribution that is treated as a dividend to reduce basis, without regard to whether the two-year holding period is otherwise satisfied and without regard to whether the distribution is less than the "threshold percentage" otherwise required for an extraordinary dividend. For this purpose, a distribution will be treated as in partial liquidation if it satisfies the requirements of section 302(e) of the Code. Since the determination whether a distribution is in partial liquidation is made at the corporate rather than the shareholder level, Congress intended that the Treasury Department will have the authority to require the distributing corporation to advise its shareholders (with notice to the Internal Revenue Service) as to the character of the distribution. This characterization will generally be binding on the shareholders.20 The Internal Revenue Service, however, will be free to challenge the characterization of the distribution, provided it takes a consistent position with respect to corporate and noncorporate shareholders.

Finally, under the Act the term "extraordinary dividend" includes any redemption of stock that is non-pro rata (again, without regard to the holding period of the stock or the relative size of the distribution). Congress thus intended the nontaxed portion of any non-pro rata redemption that is treated as a dividend to reduce basis, without regard to whether the two-year holding period is otherwise satisfied and without regard to whether the distribution is less than the "threshold percentage" otherwise required for an extraordinary dividend.

Under a special relief provision, a distribution that would otherwise constitute an extraordinary dividend is not considered to extraordinary if the distributee has held the stock for the period the distributing corporation (and any predecessor corporation) has been in existence, the earnings and profits of the corporation were accumulated only during such period, and the application of this exception to the dividend is not inconsistent with the purposes of the extraordinary dividend rules. This relief provision was intended to permit distributions without basis reduction, even though the distributions exceed the threshold percentage and are declared, announced or agreed to within the 2-year holding period, only in those cases in which the earnings and profits from which the dividend is paid could not have been attributable to any person other than the original shareholder receiving the distribution. For this purpose, earnings and profits would not be considered attributable solely to such shareholder if any more than de minimis part of such earnings and profits is derived, directly or indirectly, from any other entity in which the shareholder was not an original shareholder with an interest at least as great as such shareholder's original and continuing interest in the distributing corporation at the time of the distribution.

Thus, for example, the relief provision would not apply if any more than a de minimis part of the earnings and profits from which the dividend is paid were derived (e.g., by distribution or by a transaction described in sec. 381) directly or indirectly from other corporation in which the original shareholder did not at times hold at least as great an interest as such shareholder's interest in the distributing corporation at the time of the distribution.

However, the fact that the distributing corporation directly or directly received de minimis amounts of earnings and profits from other entities (such as non-extraordinary dividends received from temporary portfolio investments of funds), would not generally expected to preclude the application of the relief provision.

For similar reasons, due to Congress' expectation that earn and profits would be solely attributable to the distributee shareholders, the extraordinary dividend provision generally would apply to distributions that constitute qualifying dividends within the meaning of section 243(b)(1), or to similar distributions between members of an affiliated group filing a consolidated return. Also, to the extent the consolidated return regulations would require basis reduction in any event, the provision would not simultaneously apply to dividend distributions (or deemed dividend distributions) between members of an affiliated group filing consolidated returns.

In order to prevent double inclusions in earnings and profits, Congress expected that the amount, if any, of earnings and profits resulting from gain on the disposition of stock shall be determined without regard to the basis adjustments made under this section.

 

Effective Date

 

 

The provision is generally effective for dividends declared July 18, 1986. However, distributions constituting extraordinary dividends by virtue of being a distribution in partial liquidation or a non-pro rata distribution are subject to the provision only if announced or declared after October 22, 1986 (the date of enactment).

 

Revenue Effect

 

 

This provision is estimated to increase fiscal year budget receipts by $32 million in 1987, $55 million in 1988, $57 million in 1989, $60 million in 1990, and $63 million in 1991.

 

F. Special Limitations on Net Operating Loss and Other Carryforwards

 

 

(sec. 621 of the Act and secs. 382 and 383 of the Code)21

 

Prior Law

 

 

Overview

In general, a corporate taxpayer is allowed to carry a net operating loss ("NOL(s)") forward for deduction in a future taxable year, as long as the corporation's legal identity is maintained. After certain nontaxable asset acquisitions in which the acquired corporation goes out of existence, the acquired corporation's NOL carryforwards are inherited by the acquiring corporation. Similar rules apply to tax attributes other than NOLs, such as net capital losses and unused tax credits. Historically, the use of NOL and other carryforwards has been subject to special limitations after specified transactions involving the corporation in which the carryforwards arose (referred to as the "loss corporation"). Prior law also provided other rules that were intended to limit tax-motivated acquisitions of loss corporations.

The operation of the special limitations on the use of carryforwards turned on whether the transaction that caused the limitations to apply took the form of a taxable sale or exchange of stock in the loss corporation or one of certain specified tax-free reorganizations in which the loss corporation's tax attributes carried over to a corporate successor. After a purchase (or other taxable acquisition) of a controlling stock interest in a loss corporation, NOL and other carryforwards were disallowed unless the loss corporation continued to conduct its historical trade or business. In the case of a tax-free reorganization, NOL and other carryforwards were generally allowed in full if the loss corporation's shareholders received stock representing at least 20 percent of the value of the acquiring corporation.

NOL and other carryforwards

Although the Federal income tax system generally requires an annual accounting, a corporate taxpayer was allowed to carry NOLs back to the three taxable years preceding the loss and then forward to each of the 15 taxable years following the loss year (sec. 172). The rationale for allowing the deduction of NOL carryforwards (and carrybacks) was that a taxpayer should be able to average income and losses over a period of years to reduce the disparity between the taxation of businesses that have stable income and businesses that experience fluctuations in income.22

In addition to NOLs, other tax attributes eligible to be carried back or forward include unused investment tax credits (secs. 30 and 39), excess foreign tax credits (sec. 904(c)), and net capital losses (sec. 1212). Like NOLs, unused investment tax credits were allowed a three-year carryback and a 15-year carryforward. Subject to an overall limitation based on a taxpayer's U.S. tax attributable to foreign-source income, excess foreign tax credits were allowed a two-year carryback and a five-year carryforward. For net capital losses, generally, corporations had a three-year carryback (but only to the extent the carrybacks did not increase or create a NOL) and a five-year carryforward.

NOL and other carryforwards that were not used before the end of a carryforward period expired.

Carryovers to corporate successors

In general, a corporation's tax history (e.g., carryforwards and asset basis) was preserved as long as the corporation's legal identity was continued. Thus, under the general rules of prior law, changes in the stock ownership of a corporation did not affect the corporation's tax attributes. Following are examples of transactions that effected ownership changes without altering the legal identity of a corporation:

 

(1) A taxable purchase of a corporation's stock from its shareholders (a "purchase"),

(2) A type "B" reorganization, in which stock representing control of the acquired corporation is acquired solely in exchange for voting stock of the acquiring corporation (or a corporation in control of the acquiring corporation) (sec. 368(a)(1)(B)),

(3) A transfer of property to a corporation after which the transferors own 80 percent or more of the corporation's stock (a "section 351 exchange"),

(4) A contribution to the capital of a corporation, in exchange for the issuance of stock, and

(5) A type "E" reorganization, in which interests of investors (shareholders and bondholders) are restructured (sec. 368(a)(1)(E)).

 

Statutory rules also provided for the carryover of tax attributes (including NOL and other carryforwards) from one corporation to another in certain tax-free acquisitions in which the acquired corporation went out of existence (sec. 381). These rules applied if a corporation's assets were acquired by another corporation in one of the following transactions:

 

(1) The liquidation of an 80-percent owned subsidiary (sec. 332),

(2) A statutory merger or consolidation, or type "A" reorganization (sec. 368(a)(1)(A)),

(3) A type "C" reorganization, in which substantially all of the assets of one corporation is transferred to another corporation in exchange for voting stock, and the transferor completely liquidates (sec. 368(a)(1)(C)),

(4) A "nondivisive D reorganization," in which substantially all of a corporation's assets are transferred to a controlled corporation, and the transferor completely liquidates (secs. 368(a)(1)(D) and 354(b)(1)),

(5) A mere change in identity, form, or place of organization of a single corporation, or type "F" reorganization (sec. 368(a)(1)(F)), and

(6) A type "G" reorganization, in which substantially all of a corporation's assets are transferred to another corporation pursuant to a court approved insolvency or bankruptcy reorganization plan, and stock or securities of the transferee are distributed pursuant to the plan (sec. 368(a)(1)(G)).

 

In general, to qualify an acquisitive transaction (including a B reorganization) as a tax-free reorganization, the shareholders of the acquired corporation had to retain "continuity of interest." Thus, a principal part of the consideration used by the acquiring corporation had to consist of stock, and the holdings of all shareholders had to be traced. Further, a tax-free reorganization was required to satisfy a "continuity of business enterprise" test. Generally, continuity of business enterprise requires that a significant portion of an acquired corporation's assets be used in a business activity (see Treas. reg. sec. 1.368-1(d)).

Acquisitions to evade or avoid income tax

The Secretary of the Treasury was authorized to disallow deductions, credits, or other allowances following an acquisition of control of a corporation or a tax-free acquisition of a corporation's assets if the principal purpose of the acquisition was tax avoidance (sec. 269). This provision applied in the following cases:

 

(1) where any person or persons acquired (by purchase or in a tax-free transaction) at least 50 percent of a corporation's voting stock, or stock representing 50 percent of the value of the corporation's outstanding stock;

(2) where a corporation acquired property from a previously unrelated corporation and the acquiring corporation's basis for the property was determined by reference to the transferor's basis; and

(3) where a corporation purchased the stock of another corporation in a transaction that qualified for elective treatment as a direct asset purchase (sec. 338), a section 338 election was not made, and the acquired corporation was liquidated into the acquiring corporation (under sec. 332).

 

Treasury regulations under section 269 provided that the acquisition of assets with an aggregate basis that is materially greater than their value (i.e., assets with built-in losses), coupled with the utilization of the basis to create tax-reducing losses, is indicative of a tax-avoidance motive (Treas. reg. sec. 1.269-3(c)(1)).

Consolidated return regulations

To the extent that NOL carryforwards were not limited by the application of section 382 or section 269, after an acquisition, the use of such losses might be limited under the consolidated return regulations. In general, if an acquired corporation joined the acquiring corporation in the filing of a consolidated tax return by an affiliated group of corporations, the use of the acquired corporation's pre-acquisition NOL carryforwards against income generated by other members of the group was limited by the "separate return limitation year" ("SRLY") rules (Treas. reg. sec. 1.1502-21(c)). An acquired corporation was permitted to use pre-acquisition NOLs only up to the amount of its own contribution to the consolidated group's taxable income. Section 269 was available to prevent taxpayers from avoiding the SRLY rules by diverting income-producing activities (or contributing income-producing assets) from elsewhere in the group to a newly acquired corporation (see Treas. reg. sec. 1.269-3(c)(2), to the effect that the transfer of income-producing assets by a parent corporation to a loss subsidiary filing a separate return may be deemed to have tax avoidance as a principal purpose).

Applicable Treasury regulations provided rules to prevent taxpayers from circumventing the SRLY rules by structuring a transaction as a "reverse acquisition" (defined in regulations as an acquisition where the "acquired" corporation's shareholders end up owning more than 50 percent of the value of the "acquiring" corporation) (Treas. reg. sec. 1.1502-75(d)(3)). Similarly, under the "consolidated return change of ownership" ("CRCO") rules, if more than 50 percent of the value of stock in the common parent of an affiliated group changed hands, tax attributes (such as NOL carry-forwards) of the group were limited to use against post-acquisition income of the members of the group (Treas. reg. sec. 1.1502-21(d)).

Treasury regulations also prohibited the use of an acquired corporation's built-in losses to reduce the taxable income of other members of an affiliated group (Treas. reg. sec. 1.1502-15). Under the regulations, built-in losses were subject to the SRLY rules. In general, built-in losses were defined as deductions or losses that economically accrued prior to the acquisition but were recognized for tax purposes after the acquisition, including depreciation deductions attributable to a built-in loss (Treas. reg. sec. 1.1502-15(a)(2)). The built-in loss limitations did not apply unless, among other things, the aggregate basis of the acquired corporation's assets (other than cash, marketable securities, and goodwill) exceeded the value of those assets by more than 15 percent.

Allocation of income and deductions among related taxpayers

The Secretary of the Treasury was authorized to apportion or allocate gross income, deductions, credits, or allowances, between or among related taxpayers (including corporations), if such action was necessary to prevent evasion of tax or to clearly reflect the income of a taxpayer (sec. 482). Section 482 could apply to prevent the diversion of income to a loss corporation in order to absorb NOL carryforwards.

Libson Shops doctrine

In Libson Shops v. Koehler, 353 U.S. 382 (1957) (decided under the 1939 Code), the U.S. Supreme Court adopted a test of business continuity for use in determining the availability of NOL carryovers. The court denied NOL carryovers following the merger of 16 identically owned corporations (engaged in the same business at different locations) into one corporation, on the ground that the business generating post-merger income was not substantially the same business that incurred the loss (three corporations that generated the NOL carryovers continued to produce losses after the merger).

There was uncertainty whether the Libson Shops doctrine had continuing application as a separate nonstatutory test under the 1954 Code. Compare Maxwell Hardware Co. v. Commissioner, 343 F.2d 713 (9th Cir. 1965) (holding that Libson Shops is inapplicable to years governed by the 1954 Code) with Rev. Rul. 63-40, 1963-1 C.B. 46, as modified by T.I.R. 773 (October 13, 1965) (indicating that Libson Shops may have continuing vitality where, inter alia there is a shift in the "benefits" of an NOL carryover).23

1954 Code special limitations

The application of the special limitations on NOL carryforwards was triggered under the 1954 Code by specified changes in stock ownership of the loss corporation (sec. 382). In measuring changes in stock ownership, section 382(c) specifically excluded "nonvoting stock which is limited and preferred as to dividends." Different rules were provided for the application of special limitations on the use of carryovers after a purchase and after a tax-free reorganization. Section 382 did not address the treatment of built-in losses.

If the principal purpose of the acquisition of a loss corporation was tax avoidance, section 269 would apply to disallow NOL carryforwards even if section 382 was inapplicable. Similarly, SRLY rules could apply even if section 382 did not apply.

Taxable purchases
If the special limitations applied after a purchase, NOL carryforwards were disallowed entirely under the 1954 Code. The rule for purchases applied if (1) one or more of the loss corporation's ten largest shareholders increased their common stock ownership within a two-year period by at least 50 percentage points.(2) the change in stock ownership resulted from a purchase or a decrease in the amount of outstanding stock, and (3) the loss corporation failed to continue the conduct of a trade or business substantially the same as that conducted before the proscribed change in ownership (sec. 382(a)). An exception to the purchase rule was provided for acquisitions from related persons.
Tax-free reorganizations
After a tax-free reorganization to which section 382(b) applied, NOL carryovers were allowed in full under the 1954 Code so long as the loss corporation's shareholders received stock representing 20 percent or more of the value of the successor corporation (and section 269 did not apply). For each percentage point less than 20 percent received by the loss corporation's shareholders, the NOL carryover was reduced by five percent (e.g., if the loss corporation's shareholders received 15 percent of the acquiring corporation's stock, 25 percent of the NOL carryover was disallowed). The reorganizations described in section 382(b) were those referred to in section 381(a)(2), in which the loss corporation goes out of existence and NOL carryforwards carry over to a corporate successor. Where an acquiring corporation used stock of a parent corporation as consideration (in a triangular reorganization), the 20-percent test was applied by treating the loss corporation's shareholders as if they received stock of the acquiring corporation with an equivalent value rather than stock of the parent corporation. An exception to the reorganization rule was provided for mergers of corporations that are owned substantially by the same persons in the same proportion (thus, the result in the Libson Shops case was reversed).
Bankruptcy proceedings and stock-for-debt exchanges
In the case of a G reorganization, a creditor who received stock in the reorganization was treated as a shareholder immediately before the reorganization. Thus, NOL carryforwards were generally available without limitation following changes in stock ownership resulting from a G reorganization.

If security holders exchanged securities for stock in a loss corporation, the transaction could qualify as an E reorganization or a section 351 exchange. If unsecured creditors (e.g., trade creditors) exchanged their debt claims for stock in a loss corporation, such creditors recognized gain or loss: (1) indebtedness of the transferee corporation not evidenced by a security was not considered as issued for property for purposes of section 351, and (2) the definition of an E reorganization required an exchange involving stock or securities. Thus, a stock-for-debt exchange by unsecured creditors was treated as a taxable purchase that triggered the special limitation.

Transactions involving "thrifts"
The general rules applied to taxable purchases of stock in a savings and loan association or savings bank (referred to as a "thrift"). Thus, after an ownership change resulting from a taxable purchase, a thrift's NOL carryforwards were unaffected if the thrift continued its business. Moreover, section 382 did not apply to a section 351 transfer to a thrift.

Where the acquisition of a thrift resulted from a reorganization described in section 368(a)(3)(D)(ii),24 depositors were treated as stockholders and their deposits were treated as stock for purposes of the special limitations applicable to reorganizations (prior law sec. 382(b)(7)). Thus, a thrift's NOL carryforwards were unaffected if the depositors' interests (including the face amount of their deposits) represented at least 20 percent of the acquiring corporation's value after the merger.

Special limitations on other tax attributes
Section 383 incorporated by reference the same limitations contained in section 382 for carryforwards of investment credits, foreign tax credits, and capital losses.

1976 Act amendments

The Tax Reform Act of 1976 extensively revised section 382 to provide more nearly parallel rules for taxable purchases and tax-free reorganizations and to address technical problems arising under the 1954 Code. The 1976 Act amendments were to be effective in 1978; however, the effective date was delayed several time. The 1976 Act amendments to the rule for purchases technically became effective for taxable years beginning after December 31, 1985. The amended reorganization rules technically became effective for reorganizations pursuant to plans adopted on or after January 1, 1986.

 

Reasons for Change

 

 

The Act draws heavily on the recommendations regarding limitations on NOL carryforwards that were made by the Finance Committee Staff as part of its comprehensive final report regarding reform of subchapter C of the Internal Revenue Code. (See S. P 99-47, 99th Cong., 1st Sess. (1985), "The Subchapter C Revision A of 1985, A Final Report Prepared by the Staff").

Preservation of the averaging function of carryovers

The primary purpose of the special limitations is the preservation of the integrity of the carryover provisions. The carryover provisions perform a needed averaging function by reducing the distortion caused by the annual accounting system. If, on the other hand, carryovers can be transferred in a way that permits a loss to offset unrelated income, no legitimate averaging function is performed. With completely free transferability of tax losses, the carryover provisions become a mechanism for partial recoupment of losses through the tax system. Under such a system, the Federal Government would effectively be required to reimburse a portion all corporate tax losses. Regardless of the merits of such a reimbursement program, the carryover rules appear to be an inappropriate and inefficient mechanism for delivery of the reimbursement.

Appropriate matching of loss to income

The 1976 Act amendments reflect the view that the relationship of one year's loss to another year's income should be largely a function of whether and how much the stock ownership changed in the interim, while the Libson Shops business continuation rule measures the relationship according to whether the loss and the income were generated by the same business. The Act acknowledges the merit in both approaches, while seeking to avoid the economic distortion and administrative problems that a strict application of either approach would entail.

A limitation based strictly on ownership would create a tax bias against sales of corporate businesses, and could prevent sales that would increase economic efficiency. For example, if a prospective buyer could increase the income from a corporate business to a moderate extent, but not enough to overcome the loss of all carryovers, no sale would take place because the business would be worth more to the less-efficient current owner than the prospective buyer would reasonably pay. A strict ownership limitation also would distort the measurement of taxable income generated capital assets purchased before the corporation was acquired, if the tax deductions for capital costs economically allocable to post-acquisition years were accelerated into pre-acquisition years, creating carryovers that would be lost as a result of the acquisition.

Strict application of a business continuation rule would also be undesirable, because it would discourage efforts to rehabilitate troubled businesses. Such a rule would create an incentive to maintain obsolete and inefficient business practices if the needed changes would create the risk of discontinuing the old business for tax purposes, thus losing the benefit of the carryovers.

Permitting the carryover of all losses following an acquisition, as is permitted under the 1954 Code if the loss business is continued following a purchase, provides an improper matching of income and loss. Income generated under different corporate owners, from capital over and above the capital used in the loss business, is related to a pre-acquisition loss only in the formal sense that it is housed in the same corporate entity. Furthermore, the ability to use acquired losses against such unrelated income creates a tax bias in favor of acquisitions. For example, a prospective buyer of a loss corporation might be a less efficient operator of the business than the current owner, but the ability to use acquired losses could make the loss corporation more valuable to the less efficient user and thereby encourage a sale.

Reflecting the policies described above, the Act addresses three general concerns: (1) the approach of prior law (viz., the disallowance or reduction of NOL and other carryforwards), which is criticized as being too harsh where there are continuing loss-corporation shareholders, and ineffective to the extent that NOL carryforwards may be available for use without limitation after substantial ownership changes, (2) the discontinuities in the prior law treatment of taxable purchases and tax-free reorganizations, and (3) defects in the prior law rules that presented opportunities for tax avoidance.

General approach

After reviewing various options for identifying events that present the opportunity for a tax benefit transfer (e.g., changes in a loss corporation's business), it was concluded that changes in a loss corporation's stock ownership continue to be the best indicator of a potentially abusive transaction. Under the Act, the special limitations generally apply when shareholders who bore the economic burden of a corporation's NOLs no longer hold a controlling interest in the corporation. In such a case, the possibility arises that new shareholders will contribute income-producing assets (or divert income opportunities) to the loss corporation, and the corporation will obtain greater utilization of carryforwards than it could have had there been no change in ownership.

To address the concerns described above, the Act adopts the following approach: After a substantial ownership change, rather than reducing the NOL carryforward itself, the earnings against which an NOL carryforward can be deducted are limited. This general approach has received wide acceptance among tax scholars and practitioners. This "limitation on earnings" approach is intended to permit the survival of NOL carryforwards after an acquisition, while limiting the ability to utilize the carryforwards against unrelated income.

The limitation on earnings approach is intended to approximate the results that would occur if a loss corporation's assets were combined with those of a profitable corporation in a partnership. This treatment can be justified on the ground that the option of contributing assets to a partnership is available to a loss corporation. In such a case, only the loss corporation's share of the partnership's income could be offset by the corporation's NOL carryforward. Presumably, except in the case of tax-motivated partnership agreements, the loss corporation's share of the partnership's income would be limited to earnings generated by the assets contributed by the loss corporation.

For purposes of determining the income attributable to a loss corporation's assets, the Act prescribes an objective rate of return on the value of the corporation's equity. Consideration was given to the arguments made in favor of computing the prescribed rate of return by reference to the gross value of a loss corporation's assets, without regard to outstanding debt. It was concluded that it would be inappropriate to permit the use of NOL carryforwards to shelter earnings that are used (or would be used in the absence of an acquisition) to service a loss corporation's debt. The effect of taking a loss corporation's gross value into account would be to accelerate the rate at which NOL carryforwards would be used had there been no change in ownership, because interest paid on indebtedness is deductible in its own right (thereby deferring the use of a corresponding amount of NOLs). There is a fundamental difference between debt capitalization and equity capitalization: true debt represents a claim against a loss corporation's assets.

Annual limitation
The annual limitation on the use of pre-acquisition NOL carryforwards is the product of the prescribed rate and the value of the loss corporation's equity immediately before a proscribed ownership change. The average yield for long-term marketable obligations of the U.S. government was selected as the measure of a loss corporation's expected return on its assets.

The rate prescribed by the Act is higher than the average rate at which loss corporations actually absorb NOL carryforwards. Indeed, many loss corporations continue to experience NOLs, thereby increasing--rather than absorbing--NOL carryforwards. On the other hand, the adoption of the average absorption rate may be too restrictive for loss corporations that out-perform the average. Therefore, it would be inappropriate to set a rate at the lowest rate that is theoretically justified. The use of the long-term rate for Federal obligations was justified as a reasonable risk-free rate of return a loss corporation could obtain in the absence of a change in ownership.

Anti-abuse rules
The mechanical rules described above could present unintended tax-planning opportunities and might foster certain transactions that many would perceive to be violative of the legislative intent. Therefore, the Act includes several rules that are designed to prevent taxpayers from circumventing the special limitations or otherwise appearing to traffic in loss corporations by (1) reducing a loss corporation's assets to cash or other passive assets and then selling off a corporate shell consisting primarily of NOLs and cash or other passive assets, or (2) making pre-acquisition infusions of assets to inflate artificially a loss corporation's value (and thereby accelerate the use of NOL carryforwards). In addition, the Act retains the prior law principles that are intended to limit tax-motivated acquisitions of loss corporations (e.g., section 269, relating to acquisitions to evade or avoid taxes, and the regulatory SRLY and CRCO rules).

Consideration also was given to transactions in which taxpayers effectively attempt to purchase the NOLs of a loss corporation by the use of a partnership in which the loss corporation, as a partner, is allocated a large percentage of taxable income for a limited time period. During this time, the NOL partner's losses are expected to shelter the partnership's income while the cash flow from the partnership's assets is used for other purposes. Later the NOL partner's share of income is reduced. When all the facts and circumstances are considered, including the arrangements and actual transactions with respect to capital accounts, it often appears to be questionable whether the economic benefit that corresponds to the initial special allocation to the NOL partner is fully received by such partner. Nevertheless, some taxpayers take the position that such allocations have substantial economic effect under section 704(b). The Act contemplates that the Treasury Department will review this situation under section 704(b).

The Act provides that the Treasury Department shall prescribe such regulations as may be necessary or appropriate to prevent the avoidance of section 382 through the use of related parties, pass-through entities, or other intermediaries. For example, regardless of whether a special allocation has substantial economic effect under section 704(b), special allocations of income to a loss partner, or other arrangements shifting taxable income, will not be permitted to result in a greater use of losses than would occur if the principles of section 382 were applied to the arrangement.

Technical problems

The Act addresses the technical problems of prior law by (1) coordinating the rules for taxable purchases with the rules for tax-free transactions, (2) expanding the scope of the rules to cover economically similar transactions that effect ownership changes (such as capital contributions, section 351 exchanges, and B reorganizations), (3) refining the definition of the term "stock," and (4) applying the special limitations to built-in losses and taking into account built-in gains.

Discontinuities
Because the 1954 Code threshold for purchases was 50 percent, but the threshold for reorganizations was 20 percent, those rules presented the possibility that economically similar transactions would receive disparate tax treatment. Further, the special limitations applied after a purchase only if a pre-acquisition trade or business was discontinued, while the reorganization rule looked solely to changes in ownership. Finally, if the purchase rule applied, all NOL carryforwards were disallowed. In contrast, the rule for reorganizations merely reduced NOL carryforwards in proportion to the ownership change. The Act eliminates such discontinuities.
Continuity-of-business enterprise
The requirement under the 1954 Code rules that a loss corporation continue substantially the same business after a purchase presented potentially difficult definitional issues. Specifically, taxpayers and the courts were required to determine at what point a change in merchandise, location, size, or the use of assets should be treated as a change in the loss corporation's business. It was also difficult to identify a particular business where assets and activities were constantly combined, separated, or rearranged. Further, there was a concern that the prior law requirement induced taxpayers to continue uneconomic businesses.

The Act eliminates the business-continuation rule. The continuity-of-business-enterprise rule generally applicable to tax-free reorganizations also applies to taxable transactions.

Participating stock
The Act addresses the treatment of transactions in which the beneficial ownership of an NOL carryforward does not follow stock ownership. This problem is illustrated by the case of Maxwell Hardware Co., in which a loss corporation's old shareholders retained common stock representing more than 50 percent of the corporation's value, but new shareholders received specially tailored preferred stock that carried with it a 90-percent participation in the corporation's earnings attributable to income-producing assets contributed by the new shareholders.25
Built-in gains and losses
Built-in losses should be subject to special limitations because they are economically equivalent to pre-acquisition NOL carryforwards. If built-in losses were not subject to limitations, taxpayers could reduce or eliminate the impact of the general rules by causing a loss corporation (following an ownership change) to recognize its built-in losses free of the special limitations (and then invest the proceeds in assets similar to the assets sold).

The Act also provides relief for loss corporations with built-in gain assets. Built-in gains are often the product of special tax provisions that accelerate deductions or defer income (e.g., accelerated depreciation or installment sales reporting). Absent a special rule, the use of NOL carryforwards to offset built-in gains recognized after an acquisition would be limited, even though the carryforwards would have been fully available to offset such gains had the gains been recognized before the change in ownership occurred. (Similarly, a partnership is required to allocate built-in gain or loss to the contributing partner.)

Although the special treatment of built-in gains and losses may require valuations of a loss corporation's assets, the Act limits the circumstances in which valuations will be required by providing a generous de minimis rule.

Other technical gaps
The Act also corrects the following defects in the 1954 Code rules: (1) only NOL deductions from prior taxable years were limited; thus, NOLs incurred in the year of a substantial ownership change were unaffected, (2) the rule for purchases was inapplicable to ownership changes resulting from section 351 exchanges, capital contributions, the liquidation of a partner's interest in a partnership that owns stock in a loss corporation, and nontaxable acquisitions of interests in a partnership (e.g., by contribution) that owns stock in a loss corporation, (3) the reorganization rule was inapplicable to B reorganizations, (4) the measurement of the continuing interest of a loss corporation's shareholders after a triangular reorganization enabled taxpayers to circumvent the 20-percent-continuity-of-interest rule, and (5) taxpayers took the position that the reorganization rule did not apply to reverse mergers (where an acquiring corporation's subsidiary merged into a loss corporation and the loss corporation's shareholders received stock of the acquiring corporation in the exchange).
Insolvent corporations
Under the general rule of the Act, no carryforwards would be usable after the acquisition of an insolvent corporation because the corporation's value immediately before the acquisition would be zero. In such a case, however, the loss corporation's creditors are the true owners of the corporation, although it may be impossible to identify the point in time when ownership shifted from the corporation's shareholders.26 Relief from a strict application of the general rule is provided, as the creditors of an insolvent corporation frequently have borne the losses reflected in an NOL carryforward. There was a concern, however, about the potential for abusive transactions if an exception were generally available. For example, if there were a general stock-for-debt exception, an acquiring corporation could purchase a loss corporation's debt immediately before or during a bankruptcy proceeding, exchange the debt for stock without triggering the special limitations, and then use the loss corporation's NOL carryforwards immediately and without limitation. Alternatively, an acquiring corporation could purchase stock from the creditors after the bankruptcy proceeding, and after the loss corporation's value has been increased by capital contributions.

For these reasons, the Act provides an exception for ownership changes that occur as part of a G reorganization or a stock-for-debt exchange in a Title 11 or similar proceeding, but includes appropriate safeguards intended to limit tax-motivated acquisitions of debt issued by loss corporations.

 

Explanation of Provisions

 

 

Overview

The Act alters the character of the special limitations on the use of NOL carryforwards. After an ownership change, as described below, the taxable income of a loss corporation available for offset by pre-acquisition NOL carryforwards is limited annually to a prescribed rate times the value of the loss corporation's stock immediately before the ownership change. In addition, NOL carryforwards are disallowed entirely unless the loss corporation satisfies continuity-of-business enterprise requirements for the two-year period following any ownership change. The Act also expands the scope of the special limitations to include built-in losses and allows loss corporations to take into account built-in gains. The Act includes numerous technical changes and several anti-avoidance rules. Finally, the Act applies similar rules to carryforwards other than NOLs, such as net capital losses and excess foreign tax credits.

Ownership change

The special limitations apply after any ownership change. An ownership change occurs, in general, if the percentage of stock of the new loss corporation owned by any one or more 5-percent shareholders (described below) has increased by more than 50 percentage points relative to the lowest percentage of stock of the old loss corporation owned by those 5-percent shareholders at any time during the testing period (generally a three-year period) (new sec. 382(g)(1)).27 The determination of whether an ownership change has occurred is made by aggregating the increases in percentage ownership for each 5-percent shareholder whose percentage ownership has increased during the testing period. For this purpose, all stock owned by persons who own less than five percent of a corporation's stock generally is treated as stock owned by a single 5-percent shareholder (new sec. 382(g)(4)(A)). The determination of whether an ownership change has occurred is made after any owner shift involving a 5-percent shareholder or any equity structure shift.

Determinations of the percentage of stock in a loss corporation owned by any person are made on the basis of value. Except as provided in regulations to be prescribed by the Secretary, changes in proportionate ownership attributable solely to fluctuations in the relative fair market values of different classes of stock are not taken into account (new sec. 382(1)(3)(D)).

In determining whether an ownership change has occurred, changes in the holdings of certain preferred stock are disregarded. Except as provided in regulations, all "stock" (not including stock described in section 1504(a)(4)) is taken into account (new sec. 382(k)(6)(A)). Under this standard, the term stock does not include stock that (1) is not entitled to vote, (2) is limited and preferred as to dividends and does not participate in corporate growth to any significant extent, (3) has redemption and liquidation rights that do not exceed the stock's issue price upon issuance (except for a reasonable redemption premium), and (4) is not convertible to any other class of stock. If preferred stock carries a dividend rate materially in excess of a market rate, this may indicate that it would not be disregarded.

Under grants of regulatory authority, the Treasury Department is expected to publish regulations disregarding, in appropriate cases, certain stock that would otherwise be counted in determining whether an ownership change has occurred, when necessary to prevent avoidance of the special limitations (new sec. 382(k)(6)(B)). For example, it may be appropriate to disregard preferred stock (even though voting) or common stock where the likely percentage participation of such stock in future corporate growth is disproportionately small compared to the percentage value of the stock as a proportion of total stock value, at the time of the issuance or transfer. Similarly, there is a concern that the inclusion of voting preferred stock (which is not described in section 1504(a)(4) solely because it carries the right to vote) in the definition of stock presents the potential for avoidance of section 382. As another example, stock such as that issued to the old loss company shareholders and retained by them in the case of Maxwell Hardware Company v. Commissioner, 343 F.2d 716 (9th Cir. 1969), is not intended to be counted in determining whether an ownership change has occurred.

In addition, the Treasury Department will promulgate regulations regarding the extent to which stock that is not described in section 1504(a)(4) should nevertheless not be considered stock. For example, the Treasury Department may issue regulations providing that preferred stock otherwise described in section 1504(a)(4) will not be considered stock simply because the dividends are in arrears and the preferred shareholders thus become entitled to vote.

Owner shift involving a 5-percent shareholder

An owner shift involving a 5-percent shareholder is defined as any change in the respective ownership of stock of a corporation that affects the percentage of stock held by any person who holds five percent or more of the stock of the corporation (a "5-percent shareholder") before or after the change (new sec. 382(g)(2)). For purposes of this rule, all less-than-5-percent shareholders are aggregated and treated as one 5-percent shareholder. Thus, an owner shift involving a 5-percent shareholder includes (but is not limited to) the following transactions

 

(1) A taxable purchase of loss corporation stock by a person who holds at least five percent of the stock before the purchase;

(2) A disposition of stock by a person who holds at least five percent of stock of the loss corporation either before or after the disposition;

(3) A taxable purchase of loss corporation stock by a person who becomes a 5-percent shareholder as a result of the purchase;

(4) A section 351 exchange that affects the percentage of stock ownership of a loss corporation by one or more 5-percent shareholders;

(5) A decrease in the outstanding stock of a loss corporation (e.g., by virtue of a redemption) that affects the percentage of stock ownership of the loss corporation by one or more 5-percent shareholders;

(6) A conversion of debt (or pure preferred stock that is excluded from the definition of stock) to stock where the percentage of stock ownership of the loss corporation by one or more 5-percent shareholders is affected; and

(7) An issuance of stock by a loss corporation that affects the percentage of stock ownership by one or more 5-percent shareholders.

Example 1.--The stock of L corporation is publicly traded; no shareholder holds five percent or more of L stock. During the three-year period between January 1, 1987 and January 1, 1990, there are numerous trades involving L stock. No ownership change will occur as a result of such purchases, provided that no person (or persons) becomes a 5-percent shareholder, either directly or indirectly, and increases his (or their) ownership of L stock by more than 50 percentage points.

Example 2.--On January 1, 1987, the stock of L corporation is publicly traded; no shareholder holds five percent or more of L stock. On September 1, 1987, individuals A, B, and C, who were not previously L shareholders and are unrelated to each other or any L shareholders, each acquire one-third of L stock. A, B, and C each have become 5-percent shareholders of L and, in the aggregate, hold 100 percent of the L stock. Accordingly, an ownership change has occurred, because the percentage of L stock owned by the three 5-percent shareholders after the owner shift (100 percent) has increased by more than 50 percentage points over the lowest percentage of L stock owned by A, B, and C at any time during the testing period (0 percent prior to September 1, 1987).

Example 3.--On January 1, 1987, individual I owns all 1,000 shares of corporation L. On June 15, 1987, I sells 300 of his L shares to unrelated individual A. On June 15, 1988, L issues 100 shares to each of B, C, and D. After these owner shifts involving I, A, B, C, and D, each of whom is a 5-percent shareholder, there is no ownership change, because the percentage of stock owned by A, B, C, and D after the owner shifts (approximately 46 percent--A-23 percent; B, C, and D-7.7 percent each) has not increased by more than 50 percentage points over the lowest percentage of stock owned by those shareholders during the testing period (0 percent prior to June 15, 1987). On December 15, 1988, L redeems 200 of the shares owned by I. Following this owner shift affecting I, a 5-percent shareholder, there is an ownership change, because the percentage of L stock owned by A, B, C, and D (approximately 55 percent--A-27.3 percent; B, C, and D-9.1 percent each) has increased by more than 50 percentage points over the lowest percentage owned by those shareholders during the testing period (0 percent prior to June 15, 1987).

Example 4.--L corporation is closely held by four unrelated individuals, A, B, C, and D. On January 1, 1987, there is a public offering of L stock. No person who acquires stock in a public offering acquires five percent or more, and neither A, B, C, nor D acquires any additional stock. As a result of the offering, less-than-5-percent shareholders own stock representing 80 percent of the outstanding L stock. The stock ownership of the less-than-5-percent shareholders are aggregated and treated as owned by a single 5-percent shareholder for purposes of determining whether an ownership change has occurred. The percentage of stock owned by the less-than-5-percent shareholders after the owner shift (80 percent) has increased by more than 50 percentage points over the lowest percentage of stock owned by those shareholders at any time during the testing period (0 percent prior to January 1, 1987). Thus, an ownership change has occurred.

Example 5.--On January 1, 1987, L corporation is wholly owned by individual X. On January 1, 1988, X sells 50 percent of his stock to 1,000 shareholders, all of whom are unrelated to him. On January 1, 1989, X sells his remaining 50-percent interest to an additional 1,000 shareholders, all of whom also are unrelated to him. Based on these facts, there is not an ownership change immediately following the initial sales by X, because the percentage of L stock owned by the group of less-than-5-percent shareholders (who are treated as a single 5-percent shareholder) after the owner shift (50 percent) has not increased by more than 50 percentage points over the lowest percentage of stock owned by this group at any time during the testing period (0 percent prior to January 1, 1988). On January 1, 1989, however, there is an ownership change, because the percentage of L stock owned by the group of less-than-5-percent shareholders after the owner shift (100 percent) has increased by more than 50 percentage points over their lowest percentage ownership at any time during the testing period (0 percent prior to January 1, 1988).

Example 6.--The stock of L corporation is publicly traded; no shareholder owns five percent or more. On January 1, 1987, there is a stock offering as a result of which stock representing 60 percent of L's value is acquired by an investor group consisting of 12 unrelated individuals, each of whom acquires five percent of L stock. Based on these facts, there has been an ownership change, because the percentage of L stock owned after the owner shift by the 12 5-percent shareholders in the investor group (60 percent) has increased by more than 50 percentage points over the lowest percentage of stock owned by those shareholders at any time during the testing period (0 percent prior to January 1, 1987).

Example 7.--On January 1, 1987, L corporation is owned by two unrelated shareholders, A (60 percent) and C (40 percent). LS corporation is a wholly owned subsidiary of L corporation and is therefore deemed to be owned by A and C in the same proportions as their ownership of L (after application of the attribution rules, as discussed below). On January 1, 1988, L distributes all the stock of LS to A in exchange for all of A's L stock in a section 355 transaction. There has been an ownership change of L, because the percentage of L stock owned by C (100 percent) has increased by more than 50 percentage points over the lowest percentage of L stock owned by C at any time during the testing period (40 percent prior to the distribution of LS stock). There has not been an ownership change of LS, because the percentage of LS stock owned by A (100 percent) has not increased by more than 50 percentage points over the lowest percentage of stock owned by A at any time during the testing period (60 percent, after application of the attribution rules, as discussed below), prior to January 1, 1988.

 

Equity structure shift

An equity structure shift is defined as any tax-free reorganization within the meaning of section 368, other than a divisive "D" or "G" reorganization or an "F" reorganization (new sec. 382(g)(3)(A)). In addition, to the extent provided in regulations, the term equity structure shift may include other transactions, such as public offerings not involving a 5-percent shareholder or taxable reorganization-type transactions (e.g., mergers or other reorganization-type transactions that do not qualify for tax-free treatment due to the nature of the consideration or the failure to satisfy any of the other requirements for a tax-free transaction) (new secs. 382(g)(3)(B), (g)(4), and (m)(5)).28A purpose of the provision that considers only owner shifts involving a 5-percent shareholder is to relieve widely held companies from the burden of keeping track of trades among less-than-5-percent shareholders. For example, a publicly traded company that is 60 percent owned by less-than-5-percent shareholders would not experience an ownership change merely because, within a three-year period, every one of such shareholders sold his stock to a person who was not a 5-percent shareholder. There are situations involving transfers of stock involving less-than-5-percent shareholders, other than tax-free reorganizations (for example, public offerings), in which it will be feasible to identify changes in ownership involving such shareholders, because, unlike public trading, the changes occur as part of a single, integrated transaction. Where identification is reasonably feasible or a reasonable presumption can be applied, the Treasury Department is expected to treat such transactions under the rules applicable to equity structure shifts.

For purposes of determining whether an ownership change has occurred following an equity structure shift, the less-than-5-percent shareholders of each corporation that was a party to the reorganization will be segregated and treated as a single, separate 5-percent shareholder (new sec. 382(g)(4)(B)(i)). The Act contemplates that this segregation rule will similarly apply to acquisitions by groups of less-than-5 percent shareholders through corporations as well as other entities (e.g., partnerships) and in transactions that do not constitute equity structure shifts (new sec. 382(g)(4)(C)). Moreover, the Act provides regulatory authority to apply similar segregation rules to segregate groups of less than 5-percent shareholders in cases that involve only a single corporation, (for example, a public offering or a recapitalization). (new sec. 382(m)(5)).

 

Example 8.--On January 1, 1988, L corporation (a loss corporation) is merged (in a transaction described in section 368(a)(1)(A)) into P corporation (not a loss corporation), with P surviving. Both L and P are publicly traded corporations with no shareholder owning five percent or more of either corporation or the surviving corporation. In the merger, L shareholders receive 30 percent of the stock of P. There has been an ownership change of L, because the percentage of P stock owned by the former P shareholders (all of whom are less-than-5-percent shareholders who are treated as a separate, single 5-percent shareholder) after the equity structure shift (70 percent) has increased by more than 50 percentage points over the lowest percentage of L stock owned by such shareholders at any time during the testing period (0 percent prior to the merger). If, however, the former shareholders of L had received at least 50 percent of the stock of P in the merger, there would not have been an ownership change of L.

An ownership change would similarly occur after a taxable merger in which L acquires P (in which L's losses are not affected other than by the special limitations), if L's former shareholders receive only 30 percent of the combined company, pursuant to new section 382(g)(4)(C). The Congress expected that section 382(g)(4)(C) would by its terms generally cause the segregation of the less-than 5-percent shareholders of separate entities where an entity other than a single corporation is involved in a transaction. Section 382(g)(3)(B) and section 382(m)(5) provide additional authority for Treasury to segregate groups of less than 5 percent shareholders where there is only one corporation involved.

Example 9.--On January 1, 1987, L corporation is owned by two unrelated shareholders, A (60 percent) and C (40 percent). On January 1, 1988, L redeems all of A's L stock in exchange for nonvoting preferred stock described in section 1504(a)(4). Following this recapitalization (which is both an equity structure shift and an owner shift involving a 5-percent shareholder), there has been an ownership change of L, because the percentage of L stock (which does not include preferred stock within the meaning of section 1504(a)(4)) owned by C following the equity structure shift (100 percent) has increased by more than 50 percentage points over the lowest percentage of L stock owned by C at any time during the testing period (40 percent prior to the recapitalization).

Assume, alternatively, that on January 1, 1987, the stock of L corporation was widely held, with no shareholder owning as much as five percent, and that 60 percent of the stock was redeemed in exchange for non-voting preferred stock in a transaction that is otherwise identical to the transaction described above (which would be an equity structure shift, but not an owner shift involving a 5-percent shareholder because of the existence of only a single 5-percent shareholder, the aggregated less-than-5-percent shareholders, who owns 100 percent of L both before and after the exchange). In such a case, the Secretary will prescribe regulations segregating the less-than-5-percent shareholders of the single corporation, so that the group of shareholders who retain common stock in the recapitalization will be treated as a separate, single 5-percent shareholder. Accordingly, such a transaction would constitute an ownership change, because the percentage of L stock owned by the continuing common shareholders (100 percent) has increased by more than 50 percentage points over the lowest percent of stock owned by such shareholders at any time during the testing period (40 percent prior to the recapitalization).

Example 10.--L corporation stock is widely held; no shareholder owns as much as five percent of L stock. On January 1, 1988, L corporation, which has a value of $1 million, directly issues stock with a value of $2 million to the public; no one person acquired as much as five percent in the public offering. No ownership change has occurred, because a public offering in which no person acquires as much as five percent of the corporation's stock, however large, by a corporation that has no five-percent shareholder before the offering would not affect the percentage of stock owned by a 5-percent shareholder.29 In other words, the percentage of stock owned by less-than-5-percent shareholders of L immediately after the public offering (100 percent) has not increased by more than 50 percentage points over the lowest percentage of stock owned by the less-than-5-percent shareholders of L at any time during the testing period (100 percent).

To the extent provided in regulations that will apply prospectively from the date the regulations are issued, a public offering can be treated, in effect, as an equity structure shift with the result that the offering is a measuring event, even if there is otherwise no change in ownership of a person who owns 5-percent of the stock before or after the transaction. Rules also would be provided to segregate the group of less-than-5-percent shareholders prior to the offering and the new group of less than-5-percent shareholders that acquire stock pursuant to the offering. Under such regulations, therefore, the less-than-5-percent shareholders who receive stock in the public offering could be segregated and treated as a separate 5-percent shareholder. Thus, an ownership change may result from the public offering described above, because the percentage of stock owned by the group of less-than-5-percent shareholders who acquire stock in the public offering, who are treated as a separate 5-percent shareholder (66.67 percent), has increased by more than 50 percentage points over the lowest percentage of L stock owned by such shareholders at any time during the testing period (0 percent prior to the public offering). The Act contemplates that the regulations may provide rules to allow the corporation to establish the extent, if any, to which existing shareholders acquire stock in the public offering.

 

Multiple transactions

As described above, the determination of whether an ownership change has occurred is made by comparing the relevant shareholders' stock ownership immediately after either an owner shift involving a 5-percent shareholder or an equity structure shift with the lowest percentage of such shareholders' ownership at any time during the testing period. Thus, changes in ownership that occur by reason of a series of transactions including both owner shifts involving a 5-percent shareholder and equity structure shifts may constitute an ownership change. Where the segregation rule applies, for purposes of determining whether an ownership change has occurred as a result of any transaction, the acquisition of stock shall be treated as being made proportionately from all the shareholders immediately before the acquisition, unless a different proportion is established (new section 382(g)(4)(B)(ii) and (C)).

 

Example 11.--On January 1, 1988, I (an individual) purchased 40 percent of the stock of L. The remaining stock of L is owned by 25 shareholders, none of whom own as much as five percent. On July 1, 1988, L is merged into P--which is wholly owned by I--in a tax-free reorganization. In exchange for their stock in L, the L shareholders (immediately before the merger) receive stock with a value representing 60 percent of the P stock that is outstanding immediately after the merger (24 percent to I; 36 percent to the less-than-5-percent shareholders of L). No other transactions occurred with respect to L stock during the testing period preceding the merger. There is an ownership change with respect to L immediately following the merger, because the percentage of stock owned by I in the combined entity (64 percent--40 percent by virtue of I's ownership of P prior to the merger plus 24 percent received in the merger) has increased by more than 50 percentage points over the lowest percentage of stock in L owned by I during the testing period (0 percent prior to January 1, 1988).

Example 12.--On July 12, 1989, L corporation is owned 45 percent by P, a publicly traded corporation (with no 5-percent shareholders), 40 percent by individual A, and 15 percent by individual B. All of the L shareholders have owned their stock since L's organization in 1984. Neither A nor B owns any P stock. On July 30, 1989, B sells his entire 15-percent interest to C for cash. On August 13, 1989, P acquires A's entire 40-percent interest in exchange for P stock representing an insignificant percentage of the outstanding P voting stock in a "B" reorganization.

There is an ownership change immediately following the B reorganization, because the percentage of L stock held (through attribution, as described below) by P shareholders (all of whom are less than-5-percent shareholders who are treated as one 5-percent shareholder) and C (100 percent--P shareholders-85 percent; C-15 percent) has increased by more than 50 percentage points over the lowest percentage of stock owned by P shareholders and C at any time during the testing period (45 percent held constructively by P shareholders prior to August 13, 1989).

Example 13.--The stock of L corporation is widely held by the public; no single shareholder owns five percent or more of L stock. G corporation also is widely held with no shareholder owning five percent or more. On January 1, 1988, L corporation and G corporation merge (in a tax-free transaction), with L surviving, and G shareholders receive 49 percent of L stock. On July 1, 1988, B, an individual who has never owned stock in L or G, purchases five percent of L stock in a transaction on a public stock exchange.

The merger of L and G is not an ownership change of L, because the percentage of stock owned by the less-than-5-percent shareholders of G (who are aggregated and treated as a single 5-percent shareholder) (49 percent) has not increased by more than 50 percentage points over the lowest percentage of L stock owned by such shareholders during the testing period (0 percent prior to the merger). The purchase of L stock by B is an owner shift involving a five-percent shareholder, which is presumed (unless otherwise established) to have been made proportionately from the groups of former G and L shareholders (49 percent from the G shareholders and 51 percent from the L shareholders). There is an ownership change of L because, immediately after the owner shift involving B, the percentage of stock owned by the G shareholders (presumed to be 46.55 percent--49 percent actually acquired in the merger less 2.45 percent presumed sold to B) and B (5 percent) has increased by more than 50 percentage points over the lowest percentage of L stock owned by those shareholders at any time during the testing period (0 percent prior to the merger).

Example 14.--The stock of L corporation and G corporation is widely held by the public; neither corporation has any shareholder owning as much as five percent of its stock. On January 1, 1988, B purchases 10 percent of L stock. On July 1, 1988, L and G merge (in a tax-free transaction), with L surviving, and G shareholders receiving 49 percent of L stock.

The merger of L and G is an ownership change because, immediately after the merger, the percentage of stock owned by G shareholders (49 percent) and B (5.1 percent) has increased by more than 50 percentage points over the lowest percentage of L stock owned by such shareholders at any time during the testing period (0 percent prior to the stock purchase by B).

 

Attribution and aggregation of stock ownership
Attribution from entities
In determining whether an ownership change has occurred, the constructive ownership rules of section 318, with several modifications, are applied (new sec. 382(1)(3)). Except to the extent provided in regulations, the rules for attributing ownership of stock (within the meaning of new section 382(k)(6)) from corporations to their shareholders are applied without regard to the extent of the shareholders' ownership in the corporation.30 Thus, any stock owned by a corporation is treated as being owned proportionately by its shareholders. Moreover, except as provided in regulations, any stock attributed to a corporation's shareholders is not treated as being held by such corporation. Stock attributed from a partnership, estate or trust similarly shall not be treated as being held by such entity. The effect of the attribution rules is to prevent application of the special limitations after an acquisition that does not result in a more than 50 percent change in the ultimate beneficial ownership of a loss corporation.31 Conversely, the attribution rules result in an ownership change where more than 50 percent of a loss corporation's stock is acquired indirectly through an acquisition of stock in the corporation's parent corporation.

 

Example 15.--L corporation is publicly traded; no shareholder owns as much as five percent. P corporation is publicly traded; no shareholder owns as much as five percent. On January 1, 1988, P corporation purchases 100 percent of L corporation stock on the open market. The L stock owned by P is attributed to the shareholders of P, all of whom are less-than-5-percent shareholders who are treated as a single, separate 5-percent shareholder under section 382(g)(4)(C). Accordingly, there has been an ownership change of L, because the percentage of stock owned by the P shareholders after the purchase (100 percent) has increased by more than 50 percentage points over the lowest percentage of L stock owned by that group at any time during the testing period (0 percent prior to January 1, 1988).

 

Aggregation rules
Special aggregation rules are applied for all stock ownership, actual or deemed, by shareholders of a corporation who are less-than-5-percent shareholders. Except as provided in regulations, stock owned by such persons is treated as being held by a single, separate 5-percent shareholder. For purposes of determining whether transactions following an equity structure shift or owner shift involving a 5-percent shareholder constitute an ownership change, the aggregation rules trace any subsequent change in ownership by a group of less-than-5-percent shareholders. In analyzing subsequent shifts in ownership, unless a different proportion is established otherwise, acquisitions of stock shall be treated as being made proportionately from all shareholders immediately before such acquisition.

 

Example 16.--Corporation A is widely held by a group of less-than-5-percent shareholders ("Shareholder Group A"). Corporation A owns 80 percent of both corporation B and corporation C, which respectively own 100 percent of corporation L and corporation P. Individual X owns the remaining stock in B (20 percent) and individual Y owns the remaining stock in C (20 percent). On January 1, 1988, L and P are, respectively, the only assets of B and C; and B and C are of equal value. On January 1, 1988, B merges into C with C surviving. After the merger, X owns 10 percent of C stock, Y owns 10 percent of C stock, and A owns 80 percent of C stock. The attribution rules (see sec. 382(1)(3)) and special aggregation rules (see sec. 382(g)(4)) apply to treat Shareholder Group A as a single, separate 5-percent shareholder owning 80 percent of the stock of L prior to the merger. Following the merger, Shareholder Group A still owns 80 percent of the stock of L, X owns 10 percent of the stock of L, and Y owns 10 percent of the stock of L. No ownership change occurs as a result of the merger, because the stock of L owned by Shareholder Group A is the same before and after the merger (80 percent), the stock of L owned by X has not increased but has decreased, and the stock of L owned by Y (0 percent before the merger and 10 percent after the merger) has not increased by more than 50 percentage points.

Example 17.--L corporation is publicly traded; no shareholder owns more than five percent. LS is a wholly owned subsidiary of L corporation. On January 1, 1988, L distributes all the stock of LS pro rata to the L shareholders. There has not been any change in the respective ownership of the stock of LS, because the less-than-5-percent shareholders of L, who are aggregated and treated as a single, separate 5-percent shareholder, are treated as owning 100 percent of LS (by attribution) before the distribution and directly own 100 percent of LS after the distribution. Thus, no owner shift involving a 5-percent shareholder has occurred; accordingly, there has not been an ownership change.

Example 18.--L Corporation is valued at $600. Individual A owns 30 percent of L stock, with its remaining ownership widely held by less-than-5-percent shareholders ("Shareholder Group L"). P corporation is widely held by less-than-5-percent shareholders ("Shareholder Group P"), and is valued at $400. On January 1, 1988, L and P consolidate in a tax free reorganization into L/P Corporation, with 60 percent of the value of such stock being distributed to former L corporation shareholders. On June 15, 1988, 17 percent of L/P corporation stock is acquired in a series of open market transactions by individual B. At all times between January 1, 1988 and June 15, 1988, A's ownership interest in L/P Corporation remained unchanged.

The consolidation by L and P on January 1, 1988 is an equity structure shift, but not an ownership change with respect to L. Under the attribution and aggregation rules, the ownership interest in new loss corporation, L/P Corporation, is as follows: A owns 18 percent (60 percent of 30 percent), Shareholder Group L owns 42 percent (60 percent of 70 percent) and Shareholder Group P owns 40 percent. The only 5-percent shareholder whose stock interest in new loss corporation increased relative to the lowest percentage of stock ownership in old loss corporation during the testing period, Shareholder Group P, did not increase by more than 50 percentage points.

 

The Act provides that, unless a different proportion is established by the taxpayer or the Internal Revenue Service, acquisitions of stock following the consolidation are treated as being made proportionately from all shareholders immediately before such transaction. Thus, under the general rule, B's open market purchase on June 15, 1988 of L/P Corporation stock would be treated as being made proportionately from A, Shareholder Group L, and Shareholder Group P. As a result, the application of this convention without modification would result in an ownership change, because the interests of B (17 percent) and Shareholder Group P (40 percent less the 6.8 percent deemed acquired by B) in new loss corporation would have increased by more than 50 percentage points during the testing period (50.2 percent). A's ownership interest in L/P corporation, however, has in fact remained unchanged. Because L/P Corporation could thus establish that the acquisition by B was not proportionate from all existing shareholders, however, it would be permitted to establish a different proportion for the deemed shareholder composition following B's purchase as follows: (1) A actually owns 18 percent, (2) B actually owns 17 percent, (3) Shareholder Group L is deemed to own 33.3 percent (42 percent less (17 percent x 42/82)), and (4) Shareholder Group P is deemed to own 31.7 percent (40 percent less (17 percent x 40/82)). If L/P Corporation properly establishes these facts, no ownership change has occurred, because B and Shareholder Group P have a stock interest in L/P Corporation (48.7 percent) that has not increased by more than 50 percentage points over the lowest percentage of stock owned by such shareholders in L/P Corporation, or L Corporation at any time during the testing period (0 percent).

If B purchased eleven percent from A, there would be an ownership change. The presumption does not apply in the case of subsequent purchases from persons who are 5-percent shareholders without regard to the aggregation rules.

Other attribution rules
The family attribution rules of sections 318(a)(1) and 318(a)(5)(B) do not apply, but an individual, his spouse, his parents, his children, and his grandparents are treated as a single shareholder. "Back" attribution to partnerships, trusts, estates, and corporations from partners, beneficiaries, and shareholders will not apply except as provided in regulations.

The Act does not provide rules for attributing stock that is owned by a government. For example, stock that is owned by a foreign government is not treated as owned by any other person. Thus, if a government of a country owned 100% of the stock of a corporation and, within the testing period, sold all of such stock to members of the public who were citizens of the country, an ownership change would result. Governmental units, agencies, and instrumentalities that derive their powers, rights, and duties from the same sovereign authority will be treated as a single shareholder.

Finally, except as provided in regulations, the holder of an option is treated as owning the underlying stock if such a presumption would result in an ownership change.32 This rule is intended to apply to options relating to stock in a loss corporation as well as any other instrument relating to the direct or indirect ownership in a loss corporation. The subsequent exercise of an option is disregarded if the holder of the option has been treated as owning the underlying stock. On the other hand, if the holder of the option was not treated as owning the underlying stock, the subsequent exercise will be taken into account in determining whether there is an owner shift at time of exercise. This rule is to be applied on an option-by-option basis so that, in appropriate cases, certain options will be deemed exercised while others may not. Similarly, a person will be treated as owning stock that may be acquired pursuant to any contingency, warrant, right to acquire stock, conversion feature, put, or similar interest, if such a presumption results in an ownership change.33 If the option or other contingency expires without a transfer of stock ownership, but the existence of the option or other contingency resulted in an ownership change under this rule, the loss corporation will be able to file amended tax returns (subject to any applicable statute of limitations) for prior years as if the corporation had not been subject to the special limitations.

 

Example 19.--L corporation has 1,000 shares of stock outstanding, which are owned by 25 unrelated shareholders, none of whom own five percent or more. P corporation is wholly owned by individual A. On January 1, 1987, L corporation acquires 100 percent of P stock from A. In exchange, A receives 750 shares of L stock and a contingent right to receive up to an additional 500 shares of L stock, depending on the earnings of P corporation over the next five years.

Except as provided in regulations, A would be treated as owning all the L stock that he might receive on occurrence of the contingency (and such stock is thus treated as additional outstanding stock). Accordingly, an ownership change of L would occur, because the percentage of stock owned (and treated as owned) by A (1,250 shares--55.5 percent (33.3 percent (750 of 2,250 shares) directly and 22.2 percent (500 of 2,250 shares) by attribution)) increased by more than 50 percentage points over the lowest percentage of stock owned by A at any time during the testing period (0 percent prior to January 1, 1987).

Example 20.--L corporation and P corporation are publicly traded; no shareholder owns five percent or more of either corporation. On January 1, 1989, P corporation purchases 40 percent of the stock in L corporation and an option to acquire the remaining 60 percent of L corporation stock. The option is exercisable three years after the date on which the option is issued.

Under the Act, if P is treated as owning the L corporation stock obtainable on exercise of the option, then P corporation would be treated as owning 100 percent of L corporation. Thus, the presumption provided by section 382(1)(3)(A) would apply, and an ownership change would result. The same result would apply even if the option were exercisable only in the event of a contingency such as the attaining of a specified earnings level by the end of a specified period.

 

Stock acquired by reason of death, gift, divorce or separation
If (i) the basis of any stock in the hands of any person is determined under section 1014 (relating to property acquired from a decedent), section 1015 (relating to property acquired by a gift or transfer in trust), or section 1041(b) (relating to transfers of property between spouses or incident to divorce), (ii) stock is received by any person in satisfaction of a right to receive a pecuniary bequest, or (iii) stock is acquired by a person pursuant to any divorce or separation instrument (within the meaning of section 71(b)(2)), then such persons shall be treated as owning such stock during the period such stock was owned by the person from whom it was acquired (new sec. 382(1)(3)(B)). Such transfers, therefore, would not constitute owner shifts.
Special rule for employee stock ownership plans
If certain ownership and allocation requirements are satisfied, the acquisition of employer securities (within the meaning of section 409(1)) by either a tax credit employee stock ownership plan or an employee stock ownership plan (within the meaning of section 4975(e)(7)) shall not be taken into account in determining whether an ownership change has occurred (new sec. 382(1)(3)(C)). The acquisition of employer securities from any such plan by a participant of any such plan pursuant to the requirements of section 409(h) also will not be taken into account in determining whether an ownership change has occurred.
Utilization of holding company structures
The mere formation of a holding company unaccompanied by a change in the beneficial ownership of the loss corporation will not result in an ownership change. The attribution rules of section 318, as modified for purposes of applying these special limitations, achieve this result by generally disregarding any corporate owner of stock as the owner of any loss corporation stock (new sec. 382(1)(3)(A)(ii)(II)). Instead, the attribution rules are designed to provide a mechanism for tracking the changes in ownership by the ultimate beneficial owners of the loss corporation. The creation of a holding company structure is significant to the determination of whether an ownership change has occurred only if it is accompanied by a change in the ultimate beneficial ownership of the loss corporation.

 

Example 21.--The stock of L corporation is owned equally by unrelated individuals, A, B, C, and D. On January 1, 1988, A, B, C, and D contribute their L corporation stock to a newly formed holding company ("HC") in exchange for equal interests in stock and securities of HC in a transaction that qualifies under section 351.

The formation of HC does not result in an ownership change with respect to L. Under the attribution rules, A, B, C, and D following the incorporation of L corporation are considered to own 25 percent of the stock of L corporation and, unless provided otherwise in regulations, HC is treated as not holding any stock in L corporation. Accordingly, the respective holdings in L corporation were not altered to any extent and there is thus no owner shift involving a 5-percent shareholder. The result would be the same if L corporation were owned by less-than-5-percent shareholders prior to the formation of the holding company.

Example 22.--The stock of L corporation is widely held by the public ("Public/L") and is valued at $600. P is also widely held by the public ("Public/P") and is valued at $400. On January 1, 1988, P forms Newco with a contribution of P stock. Immediately thereafter, Newco acquires all of the properties of L corporation in exchange for its P stock in a forward triangular merger qualifying under section 368(a)(2)(D). Following the transaction, Public/L and Public/P respectively are deemed to own 60 percent and 40 percent of P stock.

Inserting P between Public/L and L corporation (which becomes Newco in the merger) does not result in an ownership change with respect to Newco, the new loss corporation. Under new section 382(g)(4)(B)(i), Public/L and Public/P are each treated as a separate 5-percent shareholder of Newco, the new loss corporation.34 Unless regulations provide otherwise, P's direct ownership interest in L corporation is disregarded. Because the percentage of Newco stock owned by Public/P shareholders after the equity structure shift (40 percent) has not increased by more than 50 percentage points over the lowest percentage of stock of L (the old loss corporation) owned by such shareholders at any time during the testing period (0 percent prior to January 1, 1988), the transaction does not constitute an ownership change with respect to Newco.

 

3-year testing period

In general, the relevant testing period for determining whether an ownership change has occurred is the three-year period preceding any owner shift involving a 5-percent shareholder or any equity structure shift (new sec. 382(i)(1)). Thus, a series of unrelated transactions occurring during a three-year period may constitute an ownership change. A shorter period, however, may be applicable following any ownership change. In such a case, the testing period for determining whether a second ownership change has occurred does not begin before the day following the first ownership change (new sec. 382(i)(2)).

In addition, the testing period does not begin before the first day of the first taxable year from which there is a loss carryforward (including a current NOL that is defined as a pre-change loss) or excess credit (new sec. 382(i)(3)). Thus, transactions that occur prior to the creation of any attribute subject to limitation under section 382 or section 383 are disregarded. Except as provided in regulations, the special rule described above does not apply to any corporation with a net unrealized built-in loss. The Act contemplates, however, that the regulations will permit such corporations to disregard transactions that occur before the year for which such a corporation establishes that a net unrealized built-in loss first arose.

Effect of ownership change

Section 382 limitation
For any taxable year ending after the change date (i.e., the date on which an owner shift resulting in an ownership change occurs or the date of the reorganization in the case of an equity structure shift resulting in an ownership change), the amount of a loss corporation's (or a successor corporation's) taxable income that can be offset by a pre-change loss (described below) cannot exceed the section 382 limitation for such year (new sec. 382(a)). The section 382 limitation for any taxable year is generally the amount equal to the value of the loss corporation immediately before the ownership change multiplied by the long-term tax-exempt rate (described below) (new sec. 382(b)(1)).

The Treasury Department is required to prescribe regulations regarding the application of the section 382 limitation in the case of a short taxable year. These regulations will generally provide that the section 382 limitation applicable in a short taxable year will be determined by multiplying the full section 382 limitation by the ratio of the number of days in the year to 365. Thus, taxable income realized by a new loss corporation during a short taxable year may be offset by pre-change losses not exceeding a ratable portion of the full section 382 limitation.

If there is a net unrealized built-in gain, the section 382 limitation for any taxable year is increased by the amount of any recognized built-in gains (determined under rules described below). Also, the section 382 limitation is increased by built-in gain recognized by virtue of a section 338 election (to the extent such gain is not otherwise taken into account as a built-in gain). Finally, if the section 382 limitation for a taxable year exceeds the taxable income for the year, the section 382 limitation for the next taxable year is increased by such excess.

If two or more loss corporations are merged or otherwise reorganized into a single entity, separate section 382 limitations are determined and applied to each loss corporation that experiences an ownership change.

 

Example 23.--X corporation is wholly owned by individual A and its stock has a value of $3,000; X has NOL carryforwards of $10,000. Y corporation is wholly owned by individual B and its stock has a value of $9,000; Y has NOL carryforwards of $100. Z corporation is owned by individual C and its stock has a value of $18,000; Z has no NOL carryforwards. On July 22, 1988, X, Y and Z consolidate into W corporation in a transaction that qualifies as a tax-free reorganization under section 368(a)(1)(A). The applicable long-term tax-exempt rate on such date is 10 percent. As a result of the consolidation, A receives 10 percent of W stock, B receives 30 percent and C receives 60 percent.

The consolidation of X, Y and Z results in an ownership change for old loss corporations X and Y. The Act applies a separate section 382 limitation to the utilization of the NOL carryforwards of each loss corporation that experiences an ownership change. Therefore, the annual limitation on X's NOL carryforwards is $300 and the annual limitation Y's NOL carryforwards is $900.

For W's taxable year ending on December 31, 1989, W's taxable income before any reduction for its NOLs is $1,400. The amount of taxable income of W that may be offset by X and Y's pre-change losses (without regard to any unused section 382 limitation) is $400 (the $300 section 382 limitation for X's NOL carryforwards and all $100 of Y's NOL carryforwards because that amount is less than Y's $900 section 382 limitation). The unused portion of Y's section 382 limitation may not be used to augment X's section 382 limitation for 1989 or in any subsequent year.

 

Special rule for post-change year that includes the change date.--In general, the section 382 limitation with respect to an ownership change that occurs during a taxable year does not apply to the utilization of losses against the portion of the loss corporation's taxable income, if any, allocable to the period before the change. For this purpose, except as provided in regulations, taxable income (not including built-in gains or losses, if there is a net unrealized built-in gain or loss) realized during the change year is allocated ratably to each day in the year. The regulations may provide that income realized before the change date from discrete sales of assets would be excluded from the ratable allocation and could be offset without limit by pre-change losses. Moreover, these regulations may provide a loss corporation with an option to determine the taxable income allocable to the period before the change by closing its books on the change date and thus forgoing the ratable allocation.
Value of loss corporation
The value of a loss corporation is generally the fair market value of the corporation's stock (including preferred stock described in section 1504(a)(4)) immediately before the ownership change (new sec. 382(e)(1)). If a redemption occurs in connection with an ownership change--either before or after the change--the value of the loss corporation is determined after taking the redemption into account (new sec. 382(e)(2)).35 The Treasury Department is given regulatory authority to treat other corporate contractions in the same manner as redemptions for purposes of determining the loss corporation's value. The Treasury Department also is required to prescribe such regulations as are necessary to treat warrants, options, contracts to acquire stock, convertible debt, and similar interests as stock for purposes of determining the value of the loss corporation (new sec. 382(k)(6)(B)(i)).

In determining value, the price at which loss corporation stock changes hands in an arms-length transaction would be evidence, but not conclusive evidence, of the value of the stock. Assume, for example, that an acquiring corporation purchased 40 percent of loss corporation stock over a 12-month period. Six months following this 40 percent acquisition, the acquiring corporation purchased an additional 20 percent of loss corporation stock at a price that reflected a premium over the stock's proportionate amount of the value of all the loss corporation stock; the premium is paid because the 20-percent block carries with it effective control of the loss corporation. Based on these facts, it would be inappropriate to simply gross-up the amount paid for the 20-percent interest to determine the value of the corporation's stock. Under regulations, it is anticipated that the Treasury Department will permit the loss corporation to be valued based upon a formula that grosses up the purchase price of all of the acquired loss corporation stock if a control block of such stock is acquired within a 12-month period.

 

Example 24.--All of the outstanding stock of L corporation is owned by individual A and has a value of $1,000. On June 15, 1988, A sells 51 percent of his stock in L to unrelated individual B. On January 1, 1989, L and A enter into a 15-year management contract and L redeems A's remaining stock interest in such corporation. The latter transactions were contemplated in connection with B's earlier acquisition of stock in 1988.

The acquisition of 51 percent of the stock of L on June 15, 1988, constituted an ownership change. The value of L for purposes of computing the section 382 limitation is the value of the stock of such corporation immediately before the ownership change. Although the value of such stock was $1,000 at that time, the value must be reduced by the value of A's stock that was subsequently redeemed in connection with the ownership change.

 

Long-term tax-exempt rate
The long-term tax-exempt rate is defined as the highest of the Federal long-term rates determined under section 1274(d), as adjusted to reflect differences between rates on long-term taxable and tax-exempt obligations, in effect for the month in which the change date occurs or the two prior months (new sec. 382(f)). The Treasury Department will publish the long-term tax-exempt rate by revenue ruling within 30 days after the date of enactment and monthly thereafter. The long-term tax-exempt rate will be computed as the yield on a diversified pool of prime, general obligation tax-exempt bonds with remaining periods to maturity of more than nine years.

The use of a rate lower than the long-term Federal rate is necessary to ensure that the value of NOL carryforwards to the buying corporation is not more than their value to the loss corporation. Otherwise there would be a tax incentive to acquire loss corporations. If the loss corporation were to sell its assets and invest in long-term Treasury obligations, it could absorb its NOL carryforwards at a rate equal to the yield on long-term government obligations. Since the price paid by the buyer is larger than the value of the loss company's assets (because the value of NOL carryforwards are taken into account), applying the long-term Treasury rate to the purchase price would result in faster utilization of NOL carryforwards by the buying corporation. The long-term tax-exempt rate normally will fall between 66 (1 minus the maximum corporate tax rate of 34 percent) and 100 percent of the long-term Federal rate.

 

Example 25.--Corporation L has $1 million of net operating loss carryforwards. L's taxable year is the calendar year, and on July 1, 1987, all of the stock of L is sold in a transaction constituting an ownership change of L. (Assume the transaction does not terminate L's taxable year.) On that date, the value of L's stock was $500,000 and the long-term tax-exempt rate was 10 percent. Finally, L incurred net operating loss during 1987 of $100,000, and L had no built-in gains or losses.

On these facts, the taxable income of L after July 1, 1987, that could be offset by L's losses incurred prior to July 1, 1987, would generally be limited. In particular, for all taxable years after 1987, the pre-change losses of L generally could be used to offset no more than $50,000 of L's taxable income each year. (For L's 1987 taxable year, the limit would be $25,000 (1/2 x the $50,000 section 382 limitation)). The pre-change losses of L would constitute the $1 million of NOL carryforwards plus one-half of the 1987 net operating loss, or a total of $1,050,000. If, in taxable year 1988, L had $30,000 of taxable income to be offset by L's losses, it could be fully offset by L's pre-change NOLs and the amount of L's 1989 taxable income that could be offset by pre-change losses would be limited to $95,000 ($50,000 annual limit plus $45,000 carryover).

If L had income of $100,000 in 1987, instead of a net operating loss, L's 1987 taxable income that could be offset by pre-change losses would generally be limited to $75,000 (1/2 x the $50,000 section 382 limitation plus 1/2 x $100,000 1987 income). (In appropriate circumstances, the Secretary could, by regulations, require allocation of income using a method other than daily proration. Such circumstances might include, for example, an instance in which substantial income-producing assets are contributed to capital after the change date.)

 

Continuity of business enterprise requirements
Following an ownership change, a loss corporation's NOL carryforwards (including any recognized built-in losses, described below) are subject to complete disallowance (except to the extent of any recognized built-in gains or section 338 gain, described below), unless the loss corporation's business enterprise is continued at all times during the two-year period following the ownership change. If a loss corporation fails to satisfy the continuity of business enterprise requirements, no NOL carryforwards would be allowed to the new loss corporation for any post-change year. This continuity of business enterprise requirement is the same requirement that must be satisfied to qualify a transaction as a tax-free reorganization under section 368. (See Treasury regulation section 1.368-1(d)). Under these continuity of business enterprise requirements, a loss corporation (or a successor corporation) must either continue the old loss corporation's historic business or use a significant portion of the old loss corporation's assets in a business. Thus, the requirements may be satisfied even though the old loss corporation discontinues more than a minor portion of its historic business. Changes in the location of a loss corporation's business or the loss corporation's key employees, in contrast to the results under the business-continuation rule in the 1954 Code version of section 382(a), will not constitute a failure to satisfy the continuity of business enterprise requirements under the conference agreement.
Reduction in loss corporation's value for certain capital contributions
Any capital contribution (including a section 351 transfer) that is made to a loss corporation as part of a plan a principal purpose of which is to avoid any of the special limitations under section 382 shall not be taken into account for any purpose under section 382. For purposes of this rule, except as provided in regulations, a capital contribution made during the two-year period ending on the change date is irrebuttably presumed to be part of a plan to avoid the limitations. The application of this rule will result in a reduction of a loss corporation's value for purposes of determining the section 382 limitation. The term "capital contribution" is to be interpreted broadly to encompass any direct or indirect infusion of capital into a loss corporation (e.g., the merger of one corporation into a commonly owned loss corporation). Regulations generally will except (i) capital contributions received on the formation of a loss corporation (not accompanied by the incorporation of assets with a net unrealized built-in loss) where an ownership change occurs within two years of incorporation, (ii) capital contributions received before the first year from which there is an NOL or excess credit carryforward (or in which a net unrealized built-in loss arose), and (iii) capital contributions made to continue basic operations of the corporation's business (e.g. to meet the monthly payroll or fund other operating expenses of the loss corporation). The regulations also may take into account, under appropriate circumstances, the existence of substantial nonbusiness assets on the change date (as described below) and distributions made to shareholders subsequent to capital contributions, as offsets to such contributions.
Reduction in value for corporations having substantial non-business assets
If at least one-third of the fair market value of a corporation's assets consists of nonbusiness assets, the value of the loss corporation, for purposes of determining the section 382 limitation, is reduced by the excess of the value of the nonbusiness assets over the portion of the corporation's indebtedness attributable to such assets. The term nonbusiness assets includes any asset held for investment, including cash and marketable stock or securities. Assets held as an integral part of the conduct of a trade or business (e.g., assets funding reserves of an insurance company or similar assets of a bank) would not be considered nonbusiness assets. In addition, stock or securities in a corporation that is at least 50 percent owned (voting power and value) by a loss corporation are not treated as nonbusiness assets. Instead, the parent loss corporation is deemed to own its ratable share of the subsidiary's assets. The portion of a corporation's indebtedness attributable to nonbusiness assets is determined on the basis of the ratio of the value of nonbusiness assets to the value of all the loss corporation's assets.

Regulated investment companies, real estate investment trusts, and real estate mortgage investment conduits are not treated as having substantial nonbusiness assets.

Losses subject to limitation
The term "pre-change loss" includes (i) for the taxable year in which an ownership change occurs, the portion of the loss corporation's NOL that is allocable (determined on a daily pro rata basis, without regard to recognized built-in gains or losses, as described below) to the period in such year before the change date, (ii) NOL carryforwards that arose in a taxable year preceding the taxable year of the ownership change and (iii) certain recognized built-in losses and deductions (described below).

For any taxable year in which a corporation has income that, under section 172, may be offset by both a pre-change loss (i.e., an NOL subject to limitation) and an NOL that is not subject to limitation, taxable income is treated as having been first offset by the pre-change loss (new sec. 382(1)(2)(B)). This rule minimizes the NOLs that are subject to the special limitations. For purposes of determining the amount of a pre-change loss that may be carried to a taxable year (under section 172(b)), taxable income for a taxable year is treated as not greater than the section 382 limitation for such year reduced by the unused pre-change losses for prior taxable years. (new sec. 382(1)(2)(A)).

Built-in losses
If a loss corporation has a net unrealized built-in loss, the recognized built-in loss for any taxable year ending within the five-year period ending at the close of the fifth post-change year (the "recognition period") is treated as a pre-change loss (new sec. 382(h)(1)(B)).

Net unrealized built-in losses.--The term "net unrealized built-in loss" is defined as the amount by which the fair market value of the loss corporation's assets immediately before the ownership change is less than the aggregate adjusted bases of a corporation's assets at that time. Under a de minimis exception, the special rule for built-in losses is not applied if the amount of a net unrealized built-in loss does not exceed 25 percent of the value of the corporation's assets immediately before the ownership change. For purposes of the de minimis exception, the value of a corporation's assets is determined by excluding any (1) cash, (2) cash items (as determined for purposes of section 368(a)(2)(F)(iv)), or (3) marketable securities that have a value that does not substantially differ from adjusted basis.

 

Example 26.--L corporation owns two assets: asset X, with a basis of $150 and a value of $50 (a built-in loss asset), and asset Y, with a basis of zero and a value of $50 (a built-in gain asset, described below). L has a net unrealized built-in loss of $50 (the excess of the aggregate bases of $150 over the aggregate value of $100).

 

Recognized built-in losses.--The term "recognized built-in loss" is defined as any loss that is recognized on the disposition of an asset during the recognition period, except to the extent that the new loss corporation establishes that (1) the asset was not held by the loss corporation immediately before the change date, or (2) the loss (or a portion of such loss) is greater than the excess of the adjusted basis of the asset on the change date over the asset's fair market value on that date. The recognized built-in loss for a taxable year cannot exceed the net unrealized built-in loss reduced by recognized built-in losses for prior taxable years ending in the recognition period.

The amount of any recognized built-in loss that exceeds the section 382 limitation for any post-change year must be carried forward (not carried back) under rules similar to the rules applicable to net operating loss carryforwards and will be subject to the special limitations in the same manner as a pre-change loss.

Accrued deductions.--The Treasury Department is authorized to issue regulations under which amounts that accrue before the change date, but are allowable as a deduction on or after such date (e.g., deductions deferred by section 267 or section 465), will be treated as built-in losses. Depreciation deductions cannot be treated as accrued deductions or built-in losses;36 however, the Secretary of the Treasury is required to conduct a study of whether built-in depreciation deductions should be subject to section 382, and report to the tax-writing committees of the Congress before January 1, 1989.

Built-in gains
If a loss corporation has a net unrealized built-in gain, the section 382 limitation for any taxable year ending within the five-year recognition period is increased by the recognized built-in gain for the taxable year (new sec. 382(h)(1)(A)).

Net unrealized built-in gains.--The term "net unrealized built-in gain" is defined as the amount by which the value of a corporation's assets exceeds the aggregate bases of such assets immediately before the ownership change. Under the de minimis exception described above, the special rule for built-in gains is not applied if the amount of a net unrealized built-in gain does not exceed 25 percent of the value of a loss corporation's assets.

Recognized built-in gains.--The term "recognized built-in gain" is defined as any gain recognized on the disposition of an asset during the recognition period, if the taxpayer establishes that the asset was held by the loss corporation immediately before the change date, to the extent the gain does not exceed the excess of the fair market value of such asset on the change date over the adjusted basis of the asset on that date. The recognized built-in gain for a taxable year cannot exceed the net unrealized built-in gain reduced by the recognized built-in gains for prior years in the recognition period.

Bankruptcy proceedings
The special limitations do not apply after any ownership change of a loss corporation if (1) such corporation was under the jurisdiction of a bankruptcy court in a Title 11 or similar case immediately before the ownership change, and (2) the corporation's historic shareholders and creditors (determined immediately before the ownership change) own 50 percent of the value and voting power of the loss corporation's stock immediately after the ownership change (new sec. 382(1)(5)). The 50-percent test is satisfied if the corporation's shareholders and creditors own stock of a controlling corporation that is also in bankruptcy (new sec. 382(1)(5)(A)(ii).

This special rule applies only if the stock-for-debt exchange, reorganization, or other transaction is ordered by the court or is pursuant to a plan approved by the court. For purposes of the 50-percent test, stock of a creditor that was converted from indebtedness is taken into account only if such indebtedness was held by the creditor for at least 18 months before the date the bankruptcy case was filed or arose in the ordinary course of the loss corporation's trade or business and is held by the person who has at all times held the beneficial interest in the claim. Indebtedness will be considered as having arisen in the ordinary course of the loss corporation's business only if the indebtedness was incurred by the loss corporation in connection with the normal, usual, or customary conduct of its business. It is not relevant for this purpose whether the debt was related to ordinary or capital expenditures of the loss corporation. In addition, stock of a shareholder is taken into account only to the extent such stock was received in exchange for stock that was held immediately before the ownership change.

If the exception for bankruptcy proceedings applies, several special rules are applicable. First, the pre-change losses and excess credits that may be carried to a post-change year are reduced by one-half of the amount of any cancellation of indebtedness income that would have been included in the loss corporation's income as a result of any stock-for-debt exchanges that occur as part of the Title 11 or similar proceeding under the principles of section 108(e)(10) (without applying section 108(e)(10)(B)). Thus, the NOL carryforwards would be reduced by 50 percent of the excess of the amount of the indebtedness canceled over the fair market value of the stock exchanged. Second, the loss corporation's pre-change NOL carryforwards are reduced by the interest on the indebtedness that was converted to stock in the bankruptcy proceeding and paid or accrued during the period beginning on the first day of the third taxable year preceding the taxable year in which the ownership change occurs and ending on the change date. Finally, after an ownership change that qualifies for the bankruptcy exception, a second ownership change during the following two-year period will result in the elimination of NOL carryforwards that arose before the first ownership change. The special bankruptcy provisions do not apply to stock-for-debt exchanges in informal workouts, but the Secretary of the Treasury is required to study informal bankruptcy workouts under sections 108 and 382, and report to the tax-writing committees of the Congress before January 1, 1988.

The Act provides an election, subject to such terms and conditions as the Secretary may prescribe, to forgo the exception for title 11 or similar cases (new sec. 382(1)(5)(H)). If this election is made, the general rules described above will apply except that the value of the loss corporation will reflect any increase in value resulting from any surrender or cancellation of creditors' claims in the transaction (for purposes of applying new section 382(e)).

Thrift institutions
A modified version of the bankruptcy exception (described above) applies to certain ownership changes of a thrift institution involved in a G reorganization by virtue of section 368(a)(3)(D)(ii). This rule also applies to ownership changes resulting from an issuance of stock or equity structure shift that is an integral part of a transaction involving such a reorganization, provided that the transaction would not have resulted in limitations under prior law.37 The bankruptcy exception is applied to qualified thrift reorganizations by requiring shareholders and creditors (including depositors) to retain a 20-percent (rather than 50-percent) interest. For this purpose, the fair market value of the outstanding stock of the new loss corporation includes the amount of deposits in such corporation immediately after the change, as under prior law.38 The general bankruptcy rules that eliminate from the NOL carryforwards both interest deductions on debt that was converted and income that would be recognized under the principles of section 108(e)(10) are not applicable to thrifts.

Transactions involving solvent thrifts, including a purchase of the stock of a thrift, or merger of a thrift into another corporation, will be subject to the general rules relating to ownership changes. The conversion of a solvent mutual savings and loan association into a stock savings and loan (or other transactions involving a savings and loan not entitled to special treatment), although not within the special rules applicable to troubled thrifts, will not necessarily constitute an ownership change. In such a conversion, the mutual thrift converts to stock form as a preliminary step to the issuance of stock to investors for purposes of raising capital. Under prior law IRS rulings, the entire transaction may qualify as a tax-free reorganization if certain conditions are met. For purposes of determining whether there has been an ownership change causing a limitation on the use of losses, the issuance of stock generally will be treated under the rules applicable to owner shifts. For example, the depositors holding liquidation accounts would generally be considered a group of less-than-5-percent shareholders, and if the stock were issued entirely to less-than-5-percent shareholders, or 5-percent shareholders acquired less than 50 percent, no ownership change would occur. Treasury regulations may be issued, on a prospective basis, that would treat public offerings generally in the same manner as equity structure shifts and treat the old shareholders and the persons acquiring stock in the offering as separate 5-percent shareholder groups. If such regulations are issued and apply this same approach to the conversion of a solvent mutual savings and loan association to stock form and the issuance of new stock, an ownership change could result, however, if the value of the stock issued in the public offering exceeds the equity of the depositors in the mutual represented by liquidation accounts. The application of any such regulations to thrift institutions (whether solvent or insolvent) would not be effective before January 1, 1989.

Carryforwards other than NOLs
The Act also amends section 383, relating to special limitations on unused business credits and research credits, excess foreign tax credits, and capital loss carryforwards. Under regulations to be prescribed by the Secretary, capital loss carryforwards will be limited to an amount determined on the basis of the tax liability that is attributable to so much of the taxable income as does not exceed the section 382 limitation for the taxable year, with the same ordering rules that apply under present law. Thus, any capital loss carryforward used in a post-change year will reduce the section 382 limitation that is applied to pre-change losses. In addition, the amount of any excess credit that may be used following an ownership change will be limited, under regulations, on the basis of the tax liability attributable to an amount of taxable income that does not exceed the applicable section 382 limitation, after any NOL carryforwards, capital loss carryforwards, or foreign tax credits are taken into account. The Act also expands the scope of section 383 to include passive activity losses and credits and minimum tax credits.
Anti-abuse rules
The Act does not alter the continuing application of section 269, relating to acquisitions made to evade or avoid taxes, as under prior law. Similarly, the SRLY and CRCO principles under the regulations governing the filing of consolidated returns will continue to apply. The Libson Shops doctrine will have no application to transactions subject to the provisions of the Act.

The Act provides that the Treasury Department shall prescribe regulations preventing the avoidance of the purposes of section 382 through the use of, among other things, pass-through entities. For example, a special allocation of income to a loss partner should not be permitted to result in a greater utilization of losses than would occur if the principles of section 382 were applicable.

In the case of partnerships, for example, the regulations are expected to limit the tax benefits that may be derived from transactions in which allocations of partnership income are made to a loss partner or to a corporation that is a member of a consolidated group with NOL carryovers (a "loss corporation partner") under an arrangement that contemplates the diversion of any more than an insignificant portion of the economic benefit corresponding to such allocation (or any portion of the economic benefit of the loss corporation partner's NOL) to a higher tax bracket partner.

This grant of authority contemplates any rules that the Treasury Department considers appropriate to achieve this objective. For example, regulations may provide, as a general rule, that the limitations of section 382 (and section 383) should be made applicable to restrict a loss corporation partner's use of losses against its distributive share of each item of partnership income and that any portion of the distributive share of partnership income so allocated which may not be offset by the loss corporation's NOLs should be taxed at the highest marginal tax rate. Such regulations could also provide that the allocation of income to the loss corporation may, in the discretion of the Secretary, be reallocated to the extent that other partners in the partnership have not been reasonably compensated for their services to the partnership. If the Treasury Department uses such a format to restrict the utilization of NOLs, it may be appropriate to exempt from these rules any partnership with respect to which, throughout the term of the partnership, (i) every allocation to every partner would be a qualified allocation as described in section 168(j)(9)(B) if it were made to a tax-exempt entity, with appropriate exceptions (e.g., section 704(c) allocations) and (ii) distributions are made to one partner only if there is a simultaneous pro rata distribution to all partners at the same time. Special rules would, of course, have to be provided to apply section 382 (and section 383) in this context.

No inference was intended regarding whether allocations made to loss corporations by partnerships that involve transfers of the economic benefit of a loss partner's loss to another partner have substantial economic effect. As described in the report of the Committee on Finance, there are circumstances in which it appears to be questionable whether the economic benefit that corresponds to a special allocation to the NOL partner is fully received by such partner; however, some taxpayers nevertheless take the position that such allocations have substantial economic effect under section 704(b). The Treasury Department is expected to review this situation.

The regulations issued under this grant of authority with respect to partnerships should be effective for transactions after the date of enactment. Any regulations addressing other situations, under the Treasury Department's general authority to limit the ability of other parties to obtain any portion of the benefit of a loss corporation's losses, may be prospective within the general discretion of the Secretary.

1976 Act amendments

The Act generally repeals the amendments to section 382 and 383 made by the Tax Reform Act of 1976, effective retroactively as of January 1, 1986. Thus, the law that was in effect as of December 31, 1985, applies to transactions that are not subject to the new provisions because of the effective dates of the conference agreement. The Act, by repealing the 1976 Act amendments, also retroactively repeals section 108(e)(10)(C), as included by the Tax Reform Act of 1984.

 

Effective Dates

 

 

The provisions of the Act generally apply to ownership changes that occur on or after January 1, 1987. In the case of equity structure shifts (notwithstanding the fact that the transaction falls within the definition of an owner shift), the new rules apply to reorganizations pursuant to plans adopted on or after January 1, 1987. In the case of an ownership change occurring immediately after an owner shift (other than an equity structure shift) completed on or after January 1, 1987, new section 382 shall apply. In the case of an equity structure shift (including equity structure shifts that are also owner shifts), Congress intended that new section 382 shall apply to any post-1986 ownership change occurring immediately after the completion of any reorganization pursuant to a plan adopted on or after January 1, 1987. Congress also intended that new section 382 shall apply to any post-1986 ownership change occurring immediately after the completion of a reorganization pursuant to a plan adopted before January 1, 1987, unless the shift in ownership caused by such reorganization, when considered together only with any other shifts in ownership that may have occurred on or after May 6, 1986, and before December 31, 1986, would have caused an ownership change.38a

For purposes of the effective date rules, if there is an ownership change with respect to a subsidiary corporation as the result of the acquisition of the parent corporation, the subsidiary's treatment is governed by the nature of the parent-level transaction. For example, if all the stock of a parent corporation is acquired in a tax-free reorganization pursuant to a plan adopted before January 1, 1987, then the resulting indirect ownership change with respect to a subsidiary loss corporation will be treated as having occurred by reason of a reorganization pursuant to a plan adopted before January 1, 1987.

A reorganization plan will be considered adopted on the date that the boards of directors of all parties to the reorganization adopt the plans or recommend adoption to the shareholders, or on the date the shareholders approve, whichever is earlier. The parties' boards of directors may approve a plan of reorganization based on principles, and negotiations to date, and delegate to corporate officials the power to refine and execute a binding reorganization agreement, including a binding agreement subject to regulatory approval. Any subsequent board approval or ratification taken at the time of consummating the transaction as a formality (i.e., that is not required, because the reorganization agreement is already legally binding under prior board approval) may occur without affecting the application of the effective date rule for reorganizations. In the case of a reorganization described in section 368(a)(1)(G) or an exchange of debt for stock in a Title 11 or similar case, the amendments do not apply to any ownership change resulting from such a reorganization or proceeding if a petition in such case was filed with the court before August 14, 1986.

The earliest testing period under the Act begins on May 6, 1986 (the date of Senate Finance Committee action).39 If an ownership change occurs after May 5, 1986, but before January 1, 1987, and section 382 and 383 (as amended by the Act) do not apply, then the earliest testing date will not begin before the first day following the date of such ownership change. For example, assume 60 percent of a loss corporation's stock (wholly owned by X) is purchased by B on May 29, 1986, and section 382 under the 1954 Code does not apply (because, for example, the loss corporation's business is continued and section 269 is not implicated). Assume further that X's remaining 40 percent stock interest is acquired by B on February 1, 1987. Under the Act, no ownership change occurs after the second purchase because the testing period begins on May 30, 1986, the day immediately after the ownership change; thus, an ownership change would not result from the second purchase. Conversely, if 40 percent of a loss corporation's stock (wholly owned by X) is purchased by D on July 1, 1986, and an additional 15 percent is purchased by P on January 15, 1987, then an ownership change would result from the second purchase, and the amendments would apply to limit the use of the loss corporation's NOL carryforwards.

Moreover, if an ownership change that occurs after December 31, 1986 is not affected by the amendments to section 382 (because, for example, in the foregoing example the initial 40 percent stock purchase occurred on May 5, 1986, prior to the commencement of the testing period), the 1954 Code version of section 382 will remain applicable to the transaction. The 1954 Code version of section 382 is generally intended to have continuing application to any increase in percentage points to which the amendments made by the Act do not apply by application of any transitional rule, including the rules prescribing measurement of the testing period by reference only to transactions after May 5, 1986, and the rules grandfathering or disregarding ownership changes following or resulting from certain transactions.40

For purposes of determining whether shifts in ownership have occurred on or after May 6, 1986 and before December 31, 1986, the rule of section 382(1)(3)(A)(iv) in the case of options, and the similar rule in the case of any contingent purchase, warrant, convertible debt, stock subject to a risk of forfeiture, contract to acquire stock, or similar interests, shall apply. For example, in the case of such interests issued on or after May 6, 1986,41a the underlying stock could generally be treated as acquired at the time the interest was issued. However, for this transition period, it is expected that the Treasury Department may provide for a different treatment in the case of an acquisition of an option or other interest that is not in fact exercised, as appropriate where the effect of treating the underlying stock as if it were acquired would be to cause an ownership change that would be grandfathered under the transition rules and start a new testing period.

Contingent interests arising prior to January 1, 1987, for example, contingent options created in business transactions occurring prior to that date, are not treated as ownership changes merely by operation of the January 1, 1987, effective date. No inference is intended regarding the treatment of such contingent interests under the Act, other than to clarify that they are not treated as ownership changes merely by operation of the January 1, 1987 effective date.41

Special transitional rules are provided under which prior law continues to apply to certain ownership changes after January 1, 1987.

 

Revenue Effect

 

 

These provisions are estimated to increase fiscal year budget receipts by $9 million in 1987, $29 million in 1988, $39 million in 1989, $38 million in 1990, and $29 million in 1991.

 

G. Recognition of Gain or Loss on Liquidating Sales and Distributions of Property (General Utilities)

 

 

(secs. 631, 632, and 633 of the Act and secs. 336, 337, and 1374 of the Code)42

 

Prior Law

 

 

Overview

As a general rule, under prior law (as under present law) corporate earnings from sales of appreciated property were taxed twice first to the corporation when the sale occurred, and again to the shareholders when the net proceeds were distributed as dividends. At the corporate level, the income was taxed at ordinary rates if it resulted from the sale of inventory or other ordinary income assets or at capital gains rates if it resulted from the sale of a capital asset held for more than six months. With certain exceptions shareholders were taxed at ordinary income rates to the extent of their pro rata share of the distributing corporation's current and accumulated earnings and profits.

An important exception to this two-level taxation of corporate earnings was the so-called General Utilities rule.43 The General Utilities rule permitted nonrecognition of gain by corporations on certain distributions of appreciated property44 to their shareholders and on certain liquidating sales of property. Thus, its effect was to allow appreciation in property accruing during the period it was held by a corporation to escape tax at the corporate level. At the same time, the transferee (the shareholder or third-party purchaser) obtained a stepped-up, fair market value basis under other provisions of the Code, with associated additional depreciation, depletion, or amortization deductions. Accordingly, the "price" of a step up in the basis of property subject to the General Utilities rule was typically a single capital gains tax paid by the shareholder on receipt of a liquidating distribution from the corporation.

Although the General Utilities case involved a dividend distribution of appreciated property by an ongoing business, the term "General Utilities rule" was often used in a broader sense to refer to the nonrecognition treatment accorded in certain situations to liquidating as well as nonliquidating distributions to shareholders and to liquidating sales. The rule was reflected in Code sections 311, 336, and 337 of prior law.45 Section 311 governed the treatment of nonliquidating distributions of property (dividends and redemptions), while section 336 governed the treatment of liquidating distributions in kind. Section 337 provided nonrecognition treatment for certain sales of property pursuant to a plan of complete liquidation.

Numerous limitations on the General Utilities rule, both statutory and judicial, developed over the years following its codification. Some directly limited the statutory provisions embodying the rule, while others, including the collapsible corporation provisions, the recapture provisions, and the tax benefit doctrine, did so indirectly.

Case law and statutory background

Genesis of the General Utilities rule
The precise meaning of General Utilities was a matter of considerable debate in the years following the 1935 decision. The essential facts were as follows. General Utilities had purchased 50 percent of the stock of Islands Edison Co. in 1927 for $2,000. In 1928, a prospective buyer offered to buy all of General Utilities' shares in Islands Edison, which apparently had a fair market value at that time of more than $1 million. Seeking to avoid the large corporate-level tax that would be imposed if it sold the stock itself, General Utilities offered to distribute the Islands Edison stock to its shareholders with the understanding that they would then sell the stock to the buyer. The company's officers and the buyer negotiated the terms of the sale but did not sign a contract. The shareholders of General Utilities had no binding commitment upon receipt of the Islands Edison shares to sell them to the buyer on these terms.

General Utilities declared a dividend in an amount equal to the value of the Islands Edison stock, payable in shares of that stock. The corporation distributed the Islands Edison shares and, four days later, the shareholders sold the shares to the buyer on the terms previously negotiated by the company's officers.

The Internal Revenue Service took the position that the distribution of the Islands Edison shares was a taxable transaction to General Utilities. Before the Supreme Court, the Commissioner argued that the company had created an indebtedness to its shareholders in declaring a dividend, and that the discharge of this indebtedness using appreciated property produced taxable income to the company under the holding in Kirby Lumber Co. v. United States.46 Alternatively, he argued, the sale of the Islands Edison stock was in reality made by General Utilities rather than by its shareholders following distribution of the stock. Finally, the Commissioner contended that a distribution of appreciated property by a corporation in and of itself constitutes a realization event. All dividends are distributed in satisfaction of the corporation's general obligation to pay out earnings to shareholders, he argued, and the satisfaction of that obligation with appreciated property causes a realization of the gain.

The Supreme Court held that the distribution did not give rise to taxable income under a discharge of indebtedness rationale. The Court did not directly address the Commissioner's third argument, that the company realized income simply by distributing appreciated property as a dividend. There is disagreement over whether the Court rejected this argument on substantive grounds or merely on the ground it was not timely made. Despite the ambiguity of the Supreme Court's decision, however, subsequent cases interpreted the decision as rejecting the Commissioner's third argument and as holding that no gain is realized on corporate distributions of appreciated property to its shareholders.

Five years after the decision in General Utilities, in a case in which the corporation played a substantial role in the sale of distributed property by its shareholders, the Commissioner successfully advanced the imputed sale argument the Court had reject earlier on procedural grounds. In Commissioner v. Court Holding Co.,47 the Court upheld the Commissioner's determination that, in substance, the corporation rather than the shareholders had executed the sale and, accordingly, was required to recognize gain.

In United States v. Cumberland Public Service Co.,48 The Supreme Court reached a contrary result where the facts showed the shareholders had in fact negotiated a sale on their own behalf. The Court stated that Congress had imposed no tax on liquidating distributions in kind or on dissolution, and that a corporation could liquidate without subjecting itself to corporate gains tax notwithstanding the primary motive is to avoid the corporate tax.49

In its 1954 revision of the Internal Revenue Code, Congress reviewed General Utilities and its progeny and decided to address the corporate-level consequences of distributions statutorily. It essentially codified the result in General Utilities by enacting 311(a) of prior law, which provided that a corporation recognized no gain or loss on a nonliquidating distribution of property with respect to its stock. Congress also enacted section 336, which in its original form provided for nonrecognition of gain or loss to a corporation on distributions of property in partial or complete liquidation. Although distributions in partial liquidations were eventually removed from the jurisdiction of section 336, in certain limited circumstances a distribution in partial liquidation could, prior to the Act, still qualify for nonrecognition at the corporate level.50

Finally, Congress in the 1954 Act provided that a corporation did not recognize gain or loss on a sale of property if it adopted a plan of complete liquidation and distributed all of its assets to holders within twelve months of the date of adoption of (sec. 337). Thus, the distinction drawn in Court Holding Co. and Cumberland Public Service Co., between a sale of assets followed by liquidating distribution of the proceeds and a liquidating distribution in kind followed by a shareholder sale, was in large part eliminated. Regulations subsequently issued under section 311 acknowledged that a distribution in redemption of stock constituted a "distribution with respect to ... stock" within the meaning of the statute.51 The 1954 Code in its original form, therefore, generally exempted all forms of nonliquidating as well as liquidating distributions to shareholders from the corporate-level tax.

Nonliquidating distributions: section 311
Congress subsequently enacted a number of statutory exceptions to the General Utilities rule. Under prior law (as under present law), the presumption under General Utilities was reversed for nonliquidating distributions: the general rule was that a corporation recognized gain (but not loss) on a distribution of property as a dividend or in redemption of stock.52 The distributing corporation is treated as if it sold the property for its fair market value on the date of the distribution. A number of exceptions to the general rule were provided. First, no gain was generally recognized to the distributing corporation with respect to distributions in partial liquidation made with respect to "qualified stock." Qualified stock was defined as stock held by noncorporate shareholders who at all times during the five-year period prior to the distribution (or the period the corporation had been in existence, if shorter) owned 10 percent or more in value of the distributing corporation's outstanding stock.53

Second, an exception from the general gain recognition rule was provided for a distribution with respect to qualified stock that constituted a "qualified dividend." A "qualified dividend" for this purpose was a dividend of property (other than inventory or receivables) used in the active conduct of certain "qualified businesses."54 A "qualified business" was any trade or business that had been actively conducted for the five-year period ending on the date of the distribution and was not acquired in a transaction in which gain or loss was recognized in whole or in part during such period.55 Thus, nonrecognition under this exception did not apply to distributions from holding companies or consisting of ordinary income property, and was limited to distributions to certain long-term, 10-percent shareholders other than corporations.

Third, an exception was provided for distributions with respect to qualified stock of stock or obligations in a subsidiary if substantially all of the assets of the subsidiary consisted of the assets of one or more qualified businesses, no substantial part of the subsidiary's nonbusiness assets were acquired in a section 351 transaction or as a capital contribution from the distributing corporation within the five-year period ending on the date of the distribution, and more than 50 percent in value of the stock of the subsidiary was distributed with respect to qualified stock.56

Finally, exceptions were provided for redemptions to pay death taxes, certain distributions to private foundations, and distributions by certain regulated investment companies in redemption of stock upon the demand of a shareholder.57

Section 311 also provided under separate rules that a corporation recognized gain on the distribution of encumbered property to the extent the liabilities assumed or to which the property was subject exceeded the distributing corporation's adjusted basis;58 on the distribution of LIFO inventory, to the extent the basis of the inventory determined under a FIFO method exceeded its LIFO value;59 and on the distribution of an installment obligation, to the extent of the excess of the face value of the obligation over the distributing corporation's adjusted basis in the obligation.60

Liquidating distributions and sales: sections 336 and 337
The rules regarding nonrecognition of gain on distributions in liquidation of a corporation were less restrictive than those applicable to nonliquidating distributions under prior law. Section 336 of prior law generally provided for nonrecognition of gain or loss by a corporation on the distribution of property in complete liquidation of the corporation. Gain was recognized, however, on a distribution of an installment obligation, unless the obligation was acquired in a liquidating sale that would have been tax-free under section 337, or the distribution was by a controlled subsidiary in a section 332 liquidation where the parent took a carryover basis under section 334(b)(1).61 Section 336 also required recognition of the LIFO recapture amount in liquidating distributions.

Section 337 of prior law provided that if a corporation adopted a plan of complete liquidation and within twelve months distributed all of its assets in complete liquidation, gain or loss on any sales by the corporation during that period generally was not recognized. Section 337 did not apply, and recognition was required, on sales of inventory (other than inventory sold in bulk), stock in trade, and property held primarily for sale to customers in the ordinary course of business. If the corporation accounted for inventory on a LIFO basis, section 337 required that the LIFO recapture amount be included in income.

Distributions by S corporations
Under both prior and present law, a closely-held business operating in corporate form may elect to have business gains and losses taxed directly to or deducted directly by its individual shareholders. This election is available under subchapter S of the Code (secs. 1361-1379). The principal advantage of a subchapter S election to the owners of a business is the ability to retain the advantages of operating in corporate form while avoiding taxation of corporate earnings at both the corporate and shareholder levels.

Prior to 1983, shareholders of corporations making a subchapter S election were taxed on actual cash dividend distributions of current earnings and profits of the corporation, and on undistributed taxable income as a deemed dividend. Accordingly, all of the taxable income of a corporation taxable under subchapter S passed through to its shareholders as dividends. A shareholder increased his basis in his stock by the amount of his pro rata share of undistributed taxable income.

The Subchapter S Revision Act of 1982 substantially modified these rules. The dividends-earnings and profits system was abandoned in favor of a pass-through approach based more closely on the system under which partnership income is taxed. Under these new rules, gain must be recognized by an S corporation (which gain is passed through to its shareholders) on a nonliquidating distribution of appreciated property as if it had sold the property for its fair market value (sec. 1363(d)). The purpose of this rule is to assure that the appreciation does not escape tax entirely. A shareholder in an S corporation generally does not recognize gain on receipt of property from the corporation, but simply reduces his basis in his stock by the fair market value of the property, taking a basis in the property equal to that value. The shareholder can then sell the property without recognizing any gain. Thus, unless the distribution triggered gain at the corporate level, no current tax would be paid on the appreciation in the distributed property.

Under prior law, liquidating distributions by an S corporation were taxed in the same manner as liquidating distributions of C corporations. Thus, no gain was recognized by the corporation (secs. 1363(e) and 336). Although the General Utilities rule in this context was not responsible for the imposition of only a single, shareholder-level tax on appreciation in corporate property,62 it could allow a portion of the gain that would otherwise be ordinary to receive capital gains treatment under prior law.

Statutory law and judicial doctrines affecting application of General Utilities rule

Recapture rules
The nonrecognition provisions of sections 311, 336, and 337 were subject to several additional limitations beyond those expressly set forth in those sections. These limitations included the statutory "recapture" rules for depreciation deductions, investment tax credits, and certain other items that might have produced a tax benefit for the transferor-taxpayer in prior years.63

The depreciation recapture rules (sec. 1245) required inclusion, as ordinary income, of any gain attributable to depreciation deductions previously claimed by the taxpayer with respect to "section 1245 property"--essentially, depreciable personal property--disposed of during the year, to the extent the depreciation claimed exceeded the property's actual decline in value.64

A more limited depreciation recapture rule applied to real estate. Under section 1250, gain on disposition of residential real property held for more than one year was recaptured as ordinary income to the extent prior depreciation deductions exceeded depreciation computed on the straight-line method. Gain on disposition of nonresidential real property held for more than one year, however, was generally subject to recapture of all depreciation unless a straight-line method had been elected, in which case there was no recapture.65

A number of other statutory recapture provisions could apply to a liquidating or nonliquidating distribution of property, including section 617(d) (providing for recapture of post-1965 mining exploration expenditures), section 1252 (soil and water conservation and land-clearing expenditures), and section 1254 (post-1975 intangible drilling and development costs).

Collapsible corporation rules
Under prior law (as under present law), section 341 modified the tax treatment of transactions involving stock in or property held by "collapsible" corporations. In general, a collapsible corporation was one the purpose of which was to convert ordinary income into capital gain through the sale of stock by its shareholders, or through liquidation of the corporation, before substantial income had been realized.

Under section 341, if a shareholder disposed of stock in a collapsible corporation in a transaction that would ordinarily produce long-term capital gain, the gain was treated as ordinary income. Likewise, any gain realized by a shareholder on a liquidating distribution of property from a collapsible corporation was ordinary income. Finally, prior law section 337 was inapplicable in the case of a collapsible corporation. Thus, liquidating sales of appreciated inventory or other property held by the corporation for sale to customers generated ordinary income that was fully recognized at the corporate level.66

Certain stock purchases treated as asset purchases
Under both prior and present law, section 338 permits a corporation that purchases a controlling stock interest in another corporation (the "target" corporation) within a twelve-month period to elect to treat the transaction as a purchase of the assets of that corporation for tax purposes. If the election is made, the target is treated as if it had sold all of its assets pursuant to a plan of complete liquidation on the date the purchaser obtained a controlling interest in the target (the "acquisition date"), for an amount essentially equal to the purchase price of the stock plus its liabilities. Under prior law, this deemed sale was regarded as occurring under 337. Accordingly, no gain was recognized on the deemed sale other than gain attributable to section 1245 or other provisions that overrode section 337. The target was then treated as a newly organized corporation which purchased all of the "old" target's assets for a price essentially equal to the purchase price of the stock plus the old target's liabilities on the beginning of the day after the qualified stock purchase. Thus, the new target corporation was able to obtain a stepped-up basis in its assets equal to their fair market value.

Prior to the enactment of section 338, similar results could be achieved under section 332 and former section 334(b)(2) by liquidating the acquired corporation into its parent within a specified period of time. One abuse Congress sought to prevent in enacting section 338 was selective tax treatment of corporate acquisitions. Taxpayers were able to take a stepped-up basis in some assets held by a target corporation or its affiliates while avoiding recapture tax and other unfavorable tax consequences with respect to other assets.67 Section 338 contains elaborate "consistency" rules designed to prevent selectivity with respect to acquisitions of stock and assets of a target corporation (and its affiliates) by an acquiring corporation (and its affiliates). All such purchases by the acquiring group must be treated consistently as either asset purchases or stock purchases if they occur within the period beginning one year before and ending one year after the twelve-month acquisition period.68

Section 338 of prior (and present) law contained an alternative election under which, in certain circumstances, a corporate purchaser and a seller of an 80-percent-controlled subsidiary could elect to treat the sale of the subsidiary stock as if it had been a sale of the underlying assets. Among the requirements for the filing of an election under section 338(h)(10) were that the selling corporation and its target subsidiary must be members of an affiliated group filing a consolidated return for the taxable year that included the acquisition date. If an election was made, the underlying assets of the corporation that was sold received a stepped-up, fair market value basis; the selling consolidated group recognized the gain or loss attributable to the assets; and there was no separate tax on the seller's gain attributable to the stock. This provision offered taxpayers relief from a potential multiple taxation at the corporate level of the same economic gain, which could result when a transfer of appreciated corporate stock was taxed without providing a corresponding step-up in basis of the assets of the corporation.

Judicially created doctrines
Under prior law, the courts applied nonstatutory doctrines from other areas of the tax law to in-kind distributions to shareholders. These doctrines also apply under present law. For example, it was held that, where the cost of property distributed in a liquidation or sold pursuant to a section 337 plan of liquidation had previously been deducted by the corporation, the tax benefit doctrine overrode the statutory rules to cause recognition of income.69 The application of the tax benefit doctrine turns on whether there is a "fundamental inconsistency" between the prior deduction and some subsequent event.70

The courts also applied the assignment of income doctrine to require a corporation to recognize income on liquidating and nonliquidating distributions of its property.71

 

Reasons for Change

 

 

In general

Congress believed that the General Utilities rule, even in its more limited form, produced many incongruities and inequities in the tax system. First, the rule could create significant distortions in business behavior. Economically, a liquidating distribution is indistinguishable from a nonliquidating distribution; yet the Code provided a substantial preference for the former. A corporation acquiring the assets of a liquidating corporation was able to obtain a basis in assets equal to their fair market value, although the transferor recognized no gain (other than possibly recapture amounts) on the sale. The tax benefits made the assets potentially more valuable in the hands of a transferee than in the hands of the current owner. This might induce corporations with substantial appreciated assets to liquidate and transfer their assets to other corporations for tax reasons, when economic considerations might indicate a different course of action. Accordingly, Congress reasoned, the General Utilities rule could be at least partly responsible for the dramatic increase in corporate mergers and acquisitions in recent years. Congress believed that the Code should not artificially encourage corporate liquidations and acquisitions, and that repeal of the General Utilities rule was a major step towards that goal.

Second, the General Utilities rule tended to undermine the corporate income tax. Under normally applicable tax principles, nonrecognition of gain is available only if the transferee taken a carryover basis in the transferred property, thus assuring that a tax will eventually be collected on the appreciation. Where the General Utilities rule applied, assets generally were permitted to leave corporate solution and to take a stepped-up basis in the hands of the transferee without the imposition of a corporate-level tax.72 Thus, the effect of the rule was to grant a permanent exemption from the corporate income tax.

Anti-tax avoidance provisions

In repealing the General Utilities rule, which provided for nonrecognition of losses as well as gains on distributions, Congress was concerned that taxpayers might utilize various means (including other provisions of the Code or the Treasury regulations) to circumvent repeal of the rule or, alternatively, might exploit the provision to realize losses in inappropriate situations or inflate the amount of the losses actually sustained. For example, under the general rule permitting loss recognition on liquidating distributions, taxpayers might be able to create artificial losses at the corporate level or to duplicate shareholder losses in corporate solution through contributions of property having previously accrued ("built-in") losses. In an effort to prevent these potential abuses, Congress included in the Act regulatory authority to prevent circumvention of the purposes of the amendments through use of any provision of law or regulations. In addition, it included specific statutory provisions designed to prevent avoidance of tax on corporate-level gains through conversions to subchapter S corporation status and unwarranted recognition of losses at the corporate level.

Conforming changes to provisions relating to nonliquidating distributions

The tax treatment of corporations with respect to nonliquidating distributions of appreciated property historically has been the same as liquidating distributions. In recent years, however, nonliquidating distributions have been subjected to stricter rules than liquidating distributions, and corporations have generally been required to recognize gain as a result of nonliquidating distributions of appreciated property. Consistent with this relationship, the Act generally conforms the treatment of nonliquidating distributions with liquidating distributions.

Relief from repeal of the General Utilities rule

Several exceptions to the recognition requirement are provided in the Act. The first relates to distributions of the stock and securities of a controlled subsidiary which under prior law (as under the Act) the distributee shareholder may receive tax-free pursuant to section 355. Congress felt that the same policy rationale that justifies nonrecognition by the shareholder on receipt of the stock--namely, that the transfer merely effects a readjustment of the shareholder's continuing interest in the corporation in modified form and subject to certain statutory and other constraints--also justifies nonrecognition of gain (or loss) to the distributing corporation in this situation. Similarly, certain distributions pursuant to a plan of reorganization also are not subject to recognition.73

Another exception relates to certain section 332 liquidations in which an 80-percent corporate shareholder receives property with a carryover basis. Congress believed that this exception was justified on the ground that the property (together with the other attributes of the liquidated subsidiary) is retained within the economic unit of the affiliated group. Because such an intercorporate transfer within the group is a nonrecognition event, carryover basis follows. As a result of the carryover basis, the corporate level tax will be paid if the distributed property is disposed of by the recipient corporation to a person outside of the group. Where gain recognition with respect to the distributed property would not be preserved (e.g., certain transfers to a tax-exempt or foreign corporate parent), the exception for liquidating distributions to an 80-percent corporate shareholder does not apply.74

Election to treat sales or distributions of certain subsidiary stock as asset transfers

Congress believed it was appropriate to conform the treatment of liquidating and nonliquidating sales or distributions and to require recognition when appreciated property, including stock of a subsidiary, is transferred to a corporate or individual recipient outside the economic unit of the selling or distributing affiliated group. Thus, the Act provides that such transactions result in the recognition of gain or loss to the parent corporation on the appreciation in the stock (that is, on the "outside" gain). There is a potential multiple taxation at the corporate level of the same economic gain, which may result when a transfer of appreciated corporate stock is taxed without providing a corresponding step-up in basis of the "inside" assets of the corporation. (In many cases, however, the "outside" gain may be less than the "inside" gain; furthermore, the deferral of such "inside" gain may significantly reduce any actual economic multiple corporate taxation effect). Congress believed it was appropriate to permit an election to recognize the inside gain immediately in lieu of the outside gain, thus in effect treating the transaction as a transfer of the underlying assets. Such an election was already available under prior law in some circumstances under section 338(h)(10).75 However, this election was not available, for example, when the subsidiary did not file a consolidated return with the selling shareholder, or when the stock of the subsidiary was distributed to shareholders.76 Congress granted regulatory authority to the Treasury Department to expand the scope of the election to treat the sale of a corporation's stock as a sale of its underlying assets to include sales not covered by section 338(h)(10) and distributions of stock in a controlled subsidiary.

 

Explanation of Provisions

 

 

Overview

The Act provides that gain or loss generally is recognized by a corporation on liquidating distributions of its property as if the property had been sold at fair market value to the distributee. Gain or loss is also recognized by a corporation on liquidating sales of its property. Exceptions are provided for distributions in which an 80-percent corporate shareholder receives property with a carryover basis in a liquidation under section 332, and certain distributions and exchanges involving property that may be received tax-free by the shareholder under subchapter C of the Code.

The Act also makes certain conforming changes in the provisions relating to nonliquidating distributions of property to shareholders, and in the provisions relating to corporations taxable under subchapter S.

Distributions in complete liquidation

General rule
The Act provides that, in general, gain or loss is recognized to a corporation on a distribution of its property in complete liquidation. The distributing corporation is treated as if it had sold the property at fair market value to the distributee-shareholders.

If the distributed property is subject to a liability, the fair market value of the property for this purpose is deemed to be no less than the amount of the liability. Thus, for example, if the amount of the liability exceeds the value of the property that secures it, the selling corporation will recognize gain in an amount equal to the excess of the liability over the adjusted basis of the property.77 Likewise, if the shareholders of the liquidating corporation assume liabilities of the corporation and the amount of liabilities assumed exceeds the fair market value of the distributed property, the corporation will recognize gain to the extent the assumed liabilities exceed the adjusted basis of the property. However, the provision does not affect, and no inference was intended regarding, the amount realized by or basis of property received by the distributee-shareholders in these circumstances.

Exceptions
Section 332 liquidations78

An exception to the recognition rule is provided for certain distributions in connection with the liquidation of a controlled subsidiary into its parent corporation. Under new section 337 of the Code, no gain or loss is generally recognized with respect to property distributed to a corporate shareholder (an "80-percent distributee") in a liquidation to which section 332 applies. If a minority shareholder receives property in such a liquidation, the distribution to the minority shareholder is treated in the same manner as a distribution in a nonliquidating redemption. Accordingly, gain (but not loss) is recognized to the distributing corporation.79

The exception for 80-percent corporate shareholders does not apply where the shareholder is a tax-exempt organization unless the property received in the distribution is used by the organization in an activity, the income from which is subject to tax as unrelated business taxable income (UBTI), immediately after the distribution. If such property later ceases to be used in an activity of the organization acquiring the property, the income from which is subject to tax as UBTI, the organization will be taxed at that time (in addition to any other tax imposed, for example, on depreciation recapture under section 1245) on the lesser of (a) the built-in gain in the property at the time of the distribution, or (b) the difference between the adjusted basis of the property and its fair market value at the time of the cessation.

The exception for liquidations into a controlling corporate shareholder is also inapplicable where the parent is a foreign corporation. The Act amends section 367 of the Code to require recognition in a liquidation into a controlling foreign corporation, unless regulations provide otherwise. Congress expected that such regulations may permit nonrecognition if the potential gain on the distributed property at the time of the distribution is not being removed from the U.S. taxing jurisdiction prior to recognition.

If gain is recognized on a distribution of property in a liquidation described in section 332(a), a corresponding increase in the distributee's basis in the property will be permitted.80

The Act relocates the provisions of section 332(c) to section 337(c) of the Code. Distributions of property to the controlling parent corporation in liquidations to which section 332 applies in exchange for debt obligations of the subsidiary are treated in the same manner as distributions in exchange for stock of the subsidiary, as under prior law section 332(c).

Tax-free reorganizations and distributions

The general rule requiring gain or loss recognition on liquidating distributions of property is inapplicable to transactions governed by Part III of subchapter C of the Code, relating to corporate organizations and reorganizations, to the extent the recipient may receive the property without recognition of gain (i.e., to the extent the recipient does not receive "boot").81 In addition, the provision is not intended to apply to nonreorganization transactions described in section 355 of the Code to the extent the recipient may receive the distribution without recognition of gain under Part III of subchapter C.82 Thus, on a liquidating distribution of boot in a transaction qualifying under section 355 that is not pursuant to a plan of reorganization, the distributing corporation recognizes gain (but not loss) with respect to any "boot" distributed to shareholders.83

Limitations on recognition of losses
The Act includes two provisions designed to prevent inappropriate corporate-level recognition of losses on liquidating dispositions of property. In enacting these provisions, Congress did not intend to create any inference regarding the deductibility of such losses under other statutory provisions or judicially created doctrines, or to preclude the application of such provisions or doctrines where appropriate.84

Distributions to related persons

Under the first loss limitation rule, a liquidating corporation may not recognize loss with respect to a distribution of property to a related person within the meaning of section 267,85 unless (i) the property is distributed to all shareholders on a pro rata basis and (ii) the property was not acquired by the liquidating corporation in a section 351 transaction or as a contribution to capital during the five years preceding the distribution.

Thus, for example, a liquidating corporation may not recognize loss on a distribution of recently acquired property to a shareholder who, directly or indirectly, owns more than 50 percent in value of the stock of the corporation. Similarly, a liquidating corporation may not recognize a loss on any property, regardless of when or how acquired, that is distributed to such a shareholder on a non-pro rata basis.

Dispositions of certain carryover basis property acquired for tax-avoidance purpose

Under the second loss limitation rule, recognition of loss may be limited if property whose adjusted basis exceeds its value is contributed to a liquidating corporation, in a carryover basis transaction, with a principal purpose of recognizing the loss upon the sale or distribution of the property (and thus eliminating or otherwise limiting corporate level gain). In these circumstances, the basis of the property for purposes of determining loss is reduced, but not below zero, by the excess of the adjusted basis of the property on the date of contribution over its fair market value on such date.86

If the adoption of a plan of complete liquidation occurs in a taxable year following the date on which the tax return including the loss disallowed by this provision is filed, except as provided in regulations, the liquidating corporation will recapture the disallowed loss on the tax return for the taxable year in which such plan of liquidation is adopted. In the alternative, regulations may provide for the corporation to file an amended return for the taxable year in which the loss was reported.87

 

Example

The application of the basis reduction rule can be illustrated by the following example:

Assume that on June 1, 1987, a shareholder who owns 10 percent of the stock of a corporation (which is a calendar year taxpayer) participates with other shareholders in a contribution of property to the corporation that qualifies for nonrecognition under section 351, contributing nondepreciable property with a basis of $1,000 and a value of $100 to the corporation. Also assume that a principal purpose of the acquisition of the property by the corporation was to recognize loss by the corporation and offset corporate-level income or gain in anticipation of the liquidation. On September 30, 1987, the corporation sells the property to an unrelated third party for $200, and includes the resulting $800 loss on its 1987 tax return. Finally, the corporation adopts a plan of liquidation on December 31, 1988.

For purposes of determining the corporation's loss on the sale of the property in 1987, the property's basis is reduced to $100 -- that is, $1,000 (the transferred basis under section 362) minus $900 (the excess of the property's basis over its value on the date of contribution). No loss would be realized on the sale, since the corporation received $200 for the property. Likewise, the corporation would recognize no gain on the sale, since its basis for purposes of computing gain is $1,000. Congress expected that regulations might provide for the corporation to file an amended return for 1987 reflecting no gain or loss on the sale of the property. Otherwise, the corporation would be required to reflect the disallowance of the loss by including the amount of the disallowed loss on its 1988 tax return.88

 

Presumption of tax-avoidance purpose in case of contributions within two years of liquidation

For purposes of the loss limitation rule, there is a statutory presumption that the tax-avoidance purpose is present with respect to any section 351 transfer or contribution to capital of built-in loss property within the two-year period prior to the adoption of the plan of liquidation (or at any time thereafter). Although Congress recognized that a contribution more than two years before the adoption of a plan of liquidation might have been made for such a tax-avoidance purpose, Congress also recognized that the determination that such purpose existed in such circumstances might be difficult for the Internal Revenue Service to establish and therefore as a practical matter might occur infrequently or in relatively unusual cases.

Congress intended that the Treasury Department will issue regulations generally providing that the presumed prohibited purpose for contributions of property within two years of the adoption of a plan of liquidation will be disregarded unless there is no clear and substantial relationship between the contributed property and the conduct of the corporation's current or future business enterprises.

A clear and substantial relationship between the contributed property and the conduct of the corporation's business enterprises would generally include a requirement of a corporate business purpose for placing the property in the particular corporation to which it was contributed, rather than retaining the property outside that corporation. If the contributed property has a built-in loss at the time of contribution that is significant in amount as a proportion of the built-in corporate gain at that time, special scrutiny of the business purpose would be appropriate.

 

As one example, assume that A owns Z Corporation which operates a widget business in New Jersey. That business operates exclusively in the northeastern region of the United States and there are no plans to expand those operations. In his individual capacity, A had acquired unimproved real estate in New Mexico that has declined in value. On March 22, 1988, A contributes such real estate to Z and six months later a plan of complete liquidation is adopted. Thereafter, all of Z's assets are sold to an unrelated party and the liquidation proceeds are distributed. A contributed no other property to Z during the two-year period prior to the adoption of the plan of liquidation. Because A contributed the property to Z less than two years prior to the adoption of the plan of liquidation, it is presumed to have been contributed with a prohibited purpose. Moreover, because there is no clear and substantial relationship between the contributed property and the conduct of Z's business, Congress did not expect that any loss arising from the disposition of the New Mexico real estate would be allowed under the Treasury regulations.

 

However, Congress expected that such regulations will permit the allowance of any resulting loss from the disposition of any of the assets of a trade or business (or a line of business) that are contributed to a corporation where prior law would have permitted the allowance of the loss and the clear and substantial relationship test is satisfied. In such circumstances, application of the loss disallowance rule is inappropriate assuming there is a meaningful (i.e., clear and substantial) relationship between the contribution and the utilization of the particular corporate form to conduct a business enterprise. If the contributed business is disposed of immediately after the contribution it is expected that it would be particularly difficult to show that the clear and substantial relationship test was satisfied. Congress also anticipated that the basis adjustment rules will generally not apply to a corporation's acquisition of property as part of its ordinary start-up or expansion of operations during its first two years of existence. However, if a corporation has substantial gain assets during its first two years of operation, a contribution of substantial built-in loss property followed by a sale or liquidation of the corporation would be expected to be closely scrutinized.

Conversions from C to S corporation status

The Act modifies the treatment of an S corporation that was formerly a C corporation. A corporate-level tax is imposed on any gain that arose prior to the conversion ("built-in" gain) and is recognized by the S corporation, through sale, distribution or other disposition89 within ten years after the date on which the S election took effect. The total amount of gain that must be recognized by the corporation, however, is limited to the aggregate net built-in gain of the corporation at the time of conversion to S corporation status.90 Congress expected that the Treasury Department could prevent avoidance of the built-in gain rule by contributions of built-in loss property prior to the conversion for the purpose of reducing the net built-in gain.

Gains on sales or distributions of assets by the S corporation are presumed to be built-in gains, except to the extent the taxpayer establishes that the appreciation accrued after the conversion, such as where the asset was acquired by the corporation in a taxable acquisition after the conversion. Built-in gains are taxed at the maximum corporate rate applicable to the particular type of income (i.e., the maximum rate on ordinary income under section 11 or, if applicable, the alternative rate on capital gain income under section 1201) for the year in which the disposition occurs. The corporation may take into account all of its subchapter C tax attributes in computing the amount of the tax on recognized built-in gains. Thus, for example, it may use unexpired net operating losses, capital loss carryovers, and similar items to offset the gain or the resulting tax.91

Congress intended that in a carryover basis transfer of property with built-in gain to an S corporation from a C corporation, the built-in gain with respect to property will be preserved in the hands of the transferee for the 10-year period. Similarly, in the case of a transfer of built-in gain property in a substituted basis transaction, the property received by the transferor will assume the built-in gain taint of the transferred property. If a C corporation converts to S status and is subject to the built-in gain rule, built-in gain assets that such corporation transfers to another S corporation in a carryover basis transaction will retain their original 10-year taint in the hands of the transferee.

Regulatory authority to