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Tax Reform Act of 1986 (P.L. 99-514)

OCT. 22, 1986

Tax Reform Act of 1986 (P.L. 99-514)

DATED OCT. 22, 1986
DOCUMENT ATTRIBUTES

 

Conference Report--H. Rept. 99-841

 

 

99TH CONGRESS 2d Session

 

REPORT 99-841

 

 

HOUSE OF REPRESENTATIVES

 

 

TAX REFORM ACT OF 1986

 

 

CONFERENCE REPORT

 

to accompany

 

H.R. 3838

 

 

VOLUME II OF 2 VOLUMES

 

 

SEPTEMBER 18, 1986.--Ordered to be printed

 

 

JOINT EXPLANATORY STATEMENT OF THE COMMITTEE OF CONFERENCE

 

 

The managers on the part of the House and the Senate at the conference on the disagreeing votes of the two Houses on the amendment of the Senate to the bill (H.R. 3838) to reform the internal revenue laws of the United States, submit the following joint statement to the House and the Senate in explanation of the effect of the action agreed upon by the managers and recommended in the accompanying conference report:

The Senate amendment struck out all of the House bill after the enacting clause and inserted a substitute text.

The House recedes from its disagreement to the amendment of the Senate with an amendment which is a substitute for the House bill and the Senate amendment. The differences between the House bill, the Senate amendment, and the substitute agreed to in conference are noted below, except for clerical corrections, conforming changes made necessary for agreements reached by the conferees, and minor drafting and clarifying changes.

 

SUMMARY CONTENTS OF STATEMENT OF MANAGERS

 

 

TITLE I. INDIVIDUAL INCOME TAX PROVISIONS

TITLE II. CAPITAL COST PROVISIONS

TITLE III. CAPITAL GAINS AND LOSSES

TITLE IV. AGRICULTURE, TIMBER, ENERGY, AND NATURAL RESOURCES

TITLE V. TAX SHELTERS; INTEREST EXPENSE

TITLE VI. CORPORATE TAXATION

TITLE VII. MINIMUM TAX PROVISIONS

TITLE VIII. ACCOUNTING PROVISIONS

TITLE IX. FINANCIAL INSTITUTIONS

TITLE X. INSURANCE PRODUCTS AND COMPANIES

TITLE XI. PENSIONS AND DEFERRED COMPENSATION; EMPLOYEE BENEFITS; ESOPs

TITLE XII. FOREIGN TAX PROVISIONS

TITLE XIII. TAX-EXEMPT BONDS

TITLE XIV. TRUSTS AND ESTATES; MINOR CHILDREN; GIFT AND ESTATE TAXES; GENERATION SKIPPING TRANSFER TAX

TITLE XV. COMPLIANCE AND TAX ADMINISTRATION

TITLE XVI. EXEMPT AND NONPROFIT ORGANIZATIONS

TITLE XVII. MISCELLANEOUS PROVISIONS

TITLE XVIII. TECHNICAL CORRECTIONS

CONTENTS OF STATEMENT OF MANAGERS

 

 

TITLE I. INDIVIDUAL INCOME TAX PROVISIONS

 

TITLE II. CAPITAL COST PROVISIONS

 

TITLE III. CAPITAL GAINS AND LOSSES

 

TITLE IV. AGRICULTURE, TIMBER, ENERGY, AND NATURAL RESOURCES TITLE V. TAX SHELTERS; INTEREST EXPENSE

 

TITLE VI. CORPORATE TAXATION

 

TITLE VII. MINIMUM TAX PROVISIONS

 

TITLE VIII. ACCOUNTING PROVISIONS TITLE IX. FINANCIAL INSTITUTIONS

 

TITLE X. INSURANCE PRODUCTS AND COMPANIES TITLE XI. PENSIONS AND DEFERRED COMPENSATION; EMPLOYEE BENEFITS; ESOPs

 

A. LIMITATIONS ON TREATMENT OF TAX-FAVORED SAVINGS

 

B. NONDISCRIMINATION REQUIREMENTS

 

C. TREATMENT OF DISTRIBUTIONS

 

D. TAX DEFERRAL UNDER QUALIFIED PLANS

 

E. MISCELLANEOUS PENSION AND DEFERRED COMPENSATION PROVISIONS

 

F. EMPLOYEE BENEFIT PROVISIONS

 

G. EMPLOYEE STOCK OWNERSHIP PLANS (ESOPs)

 

TITLE XII. FOREIGN TAX PROVISIONS

 

A. FOREIGN TAX CREDIT

 

B. SOURCE RULES

 

C. U.S. TAXATION OF INCOME EARNED THROUGH FOREIGN CORPORATIONS

 

D. SPECIAL TAX PROVISIONS FOR U.S. PERSONS

 

E. TREATMENT OF FOREIGN TAXPAYERS

 

F. FOREIGN CURRENCY EXCHANGE RATE GAINS AND LOSSES

 

G. OTHER RULES APPLICABLE TO U.S. POSSESSIONS

 

TITLE XIII. TAX-EXEMPT BONDS

 

TITLE XIV. TRUSTS AND ESTATES; MINOR CHILDREN; GIFT AND ESTATE TAXES; GENERATION-SKIPPING TRANSFER TAX

 

TITLE XV. COMPLIANCE AND TAX ADMINISTRATION

 

A. PENALTIES

 

B. INTEREST PROVISIONS

 

C. INFORMATION REPORTING PROVISIONS

 

D. TAX SHELTERS

 

E. ESTIMATED TAX PAYMENTS

 

F. TAX LITIGATION AND TAX COURT

 

G. TAX ADMINISTRATION TRUST FUND

H. TAX ADMINISTRATION PROVISIONS

 

I. MODIFICATION OF WITHHOLDING SCHEDULES

J. REPORT ON RETURN-FREE TAX SYSTEM

 

TITLE XVI. EXEMPT AND NONPROFIT ORGANIZATIONS

 

TITLE XVII. MISCELLANEOUS PROVISIONS TITLE XVIII. TECHNICAL CORRECTIONS

 

TITLE I. INDIVIDUAL INCOME TAX PROVISIONS

 

 

A. Basic Rate Structure

 

 

1. Tax rate schedules

 

Present Law

 

 

The present-law rate structure consists of up to 15 taxable income brackets and tax rates beginning above the zero bracket amount (ZBA). The following provisions apply for 1986 and reflect an adjustment for 1985 inflation.

Married individuals filing jointly and surviving spouses

There are 14 taxable income brackets above the ZBA of $3,670. The minimum 11-percent rate starts at taxable income above $3,670; the maximum 50-percent rate starts at taxable income above $175,250. (For married individuals filing separate returns, the ZBA is one-half the ZBA on joint returns, and the taxable income bracket amounts begin at one-half the amounts for joint returns.)

Head of household

There are 14 taxable income brackets above the $2,480 ZBA. The minimum 11-percent tax rate starts at taxable income above $2,480; the maximum 50-percent rate starts at taxable income above $116,870.

Single individuals

There are 15 taxable income brackets above the $2,480 ZBA. The minimum 11-percent tax rate starts at taxable income above $2,480; the maximum 50-percent rate starts at taxable income above $88,270.

 

House Bill

 

 

In general

The tax structure under the House bill consists of four brackets and tax rates--15, 25, 35, and 38 percent--beginning at zero taxable income, with a standard deduction replacing the ZBA.

Married individuals filing jointly and surviving spouses

                Tax rate    Brackets

 

 

                  ZBA       Replaced by standard deduction

 

                  15%       $0 to $22,500

 

                  25%       $22,500 to $43,000

 

                  35%       $43,000 to $100,000

 

                  38%       Over $100,000

 

 

(For married individuals filing separate returns, the taxable income bracket amounts begin at one-half the amounts for joint returns.)

Heads of household

                Tax rate    Brackets

 

 

                  ZBA       Replaced by standard deduction

 

                  15%       $0 to $16,000

 

                  25%       $16,000 to $34,000

 

                  35%       $34,000 to $75,000

 

                  38%       Over $75,000

 

 

Single individuals

                Tax rate    Brackets

 

 

                  ZBA       Replaced by standard deduction

 

                  15%       $0 to $12,500

 

                  25%       $12,500 to $30,000

 

                  35%       $30,000 to $60,000

 

                  38%       Over $60,000

 

Effective Date

 

 

The changed tax rates and taxable income brackets are effective July 1, 1986. For 1986 returns, tax rate schedules are to blend equally the present-law schedules for 1986 (i.e., the 1985 schedules as adjusted for inflation) with the new schedules.

 

Senate Amendment

 

 

In general

The tax structure under the Senate amendment consists of two brackets and tax rates--15 and 27 percent--beginning at zero taxable income, with a standard deduction replacing the ZBA.

 

Married individuals filing jointly and surviving spouses

 

                Tax rate    Brackets

 

 

                  ZBA       Replaced by standard deduction

 

                  15%       $0 to $29,300

 

                  27%       Over $29,300

 

 

(For married individuals filing separate returns, the 27-percent bracket begins at $14,650, i.e., one-half the taxable income amount for joint returns.)

 

Heads of household

 

                Tax rate    Brackets

 

 

                  ZBA       Replaced by standard deduction

 

                  15%       0 to $23,500

 

                  27%       Over $23,500

 

Single individuals

 

                Tax rate    Brackets

 

 

                  ZBA       Replaced by standard deduction

 

                  15%       0 to $17,600

 

                  27%       Over $17,600

 

 

Rate adjustment

Under the Senate amendment, the benefit of the 15-percent bracket is phased out for taxpayers above certain income levels, through a rate adjustment imposing additional tax liability equal to five percent of the income within a specified phase-out range. The rate adjustment applies over the following ranges of adjusted gross income (AGI) levels:

 Filing status                            AGI phase-out

 

                                          level

 

 

 Joint returns and surviving spouses      $75,000-$145,320

 

 Heads of household                       $55,000-$111,400

 

 Single individuals                       $45,000-$87,240

 

 Married individuals filing separately    $37,500-$72,660

 

 

The phase-out levels are to be adjusted for inflation beginning in 1988.

If it results in less additional tax liability, the five-percent rate adjustment is computed with respect to the taxpayer's taxable income in the 27-percent bracket. (For example, for joint returns with AGI exceeding $75,000, the rate adjustment applies over a taxable income range of $29,300 to $99,620, if that computation produces a lower additional tax liability than the computation based on AGI.)

 

Effective Date

 

 

The changed tax rates and taxable income brackets are effective July 1, 1987. For 1987 returns, tax rate schedules are to blend equally the present-law schedules for 1987 (i.e., the 1986 schedules as adjusted for inflation) with the new schedules.

 

Conference Agreement

 

 

In general

The tax structure under the conference agreement consists of two brackets and tax rates--15 and 28 percent--beginning at zero taxable income, with a standard deduction replacing the ZBA.

 

Married individuals filing jointly and surviving spouses

 

                Tax rate    Brackets

 

 

                  ZBA       Replaced by standard deduction

 

                  15%       0 to $29,750

 

                  28%       Over $29,750

 

 

(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.)

 

Heads of household

 

                Tax rate    Brackets

 

 

                  ZBA       Replaced by standard deduction

 

                  15%       0 to $23,900

 

                  28%       Over $23,900

 

Single individuals

 

                Tax rates   Brackets

 

 

                  ZBA       Replaced by standard deduction

 

                  15%       0 to $17,850

 

                  28%       Over $17,850

 

 

Beginning in 1989, the taxable income amounts at which the 28-percent rate starts will be 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.

The rate adjustment occurs between $71,900 and $149,250 of taxable income for married individuals filing jointly; 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 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, within 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 breakpoint.

Transitional rate structure for 1987

For taxable years beginning in 1987, five-bracket rate schedules 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    Heads of         Single

 

             joint returns      household        individuals

 

 

 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 amounts 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 (zero bracket amount)

 

Present Law

 

 

The following zero bracket amounts apply for 1986 and reflect 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 is adjusted annually for changes in the consumer price index.

 

House Bill

 

 

Increased deduction

The House bill replaces the ZBA with a standard deduction. In 1987, the standard deduction is increased to the following amounts:

                                          Standard

 

           Filing status                  deduction

 

 

 Joint returns and surviving spouses      $4,800

 

 Heads of household                        4,200

 

 Single individuals                        2,950

 

 Married individuals filing separately     2,400

 

 

These increased standard deduction amounts are to be adjusted for inflation beginning in 1988. For 1986, the standard deduction is to be the same amount as the ZBA for 1986 under present law.

Elderly or blind individuals

An additional standard deduction amount of $600 (to be indexed for inflation beginning in 1988) is allowed for an elderly or blind individual; the additional amount is $1,200 for a blind and elderly individual. For elderly or blind individuals only, the new standard deduction amounts listed above (effective for all other taxpayers in 1987) and the additional $600 standard deduction amount are to be effective on January 1, 1986.

Floor under itemized deductions

Individuals who itemize their deductions must reduce their total itemized deductions by $500 times the number of personal exemptions claimed, effective beginning in 1986. The $500 floor will be adjusted for inflation beginning in 1987.

 

Senate Amendment

 

 

Increased deduction

The Senate amendment replaces the ZBA with a standard deduction. In 1988, the standard deduction is increased to the following amounts:

                                          Standard

 

           Filing status                  deduction

 

 

 Joint returns and surviving spouses      $5,000

 

 Heads of household                        4,400

 

 Single individuals                        3,000

 

 Married individuals filing separately     2,500

 

 

These increased standard deduction amounts are to be adjusted for inflation beginning in 1989. For 1987, the standard deduction is to be the same amount as the ZBA that would have applied for 1987 under present law (i.e., the 1986 ZBA as adjusted for inflation in 1986).

Elderly or blind individuals

An additional standard deduction amount of $600 (to be indexed for inflation beginning in 1989) is allowed for an elderly or blind individual; the additional amount is $1,200 for a blind and elderly individual. For elderly or blind individuals only, the new standard deduction amounts listed above (effective for all other taxpayers in 1988) and the additional $600 standard deduction amount are to be effective on January 1, 1987.

 

Conference Agreement

 

 

Increased deduction

Under the conference agreement, the standard deduction is increased to the following amounts, effective beginning in 1988:

                                          Standard

 

           Filing status                  deduction

 

 

 Joint returns and 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 are to be adjusted for inflation.

Elderly or blind individuals

An additional standard deduction amount of $600 is allowed for an elderly or blind individual who is married (whether filing jointly or separately) or is a surviving spouse ($1,200 for such an individual who is both elderly and blind), An additional standard deduction amount of $750 is allowed for an unmarried individual (other than a surviving spouse), or for a head of household, who is elderly or blind ($1,500 if both). For elderly or blind taxpayers only, the new standard deduction amounts (listed above) and the additional $600 or $750 standard deduction amounts are effective beginning in 1987. 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.

Floor under itemized deductions

The conference agreement follows the Senate amendment (i.e., there is no general floor under total itemized deductions).

3. Personal exemptions

 

Present Law

 

 

Exemption amount

The personal exemption amount for an individual, the individual's spouse, and each dependent is $1,080 for 1986 (reflecting an inflation adjustment for 1985). One additional personal exemption is provided for a taxpayer who is age 65 or older, and for a taxpayer who is blind.

Rules for dependents

Each taxpayer may claim a personal exemption for himself or herself and for a dependent child (or other dependent) whose gross income does not exceed the personal exemption amount ($1,080 for 1986). In addition, parents may claim a personal exemption for a dependent child who has income exceeding the personal exemption amount if the dependent child is under age 19 or a full-time student. The child or other dependent also may 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 may use the ZBA only to offset earned income. Thus, a child with unearned income exceeding the personal exemption amount must file a return and pay tax on the excess (reduced by any allowable itemized deductions).

 

House Bill

 

 

Exemption amount

The personal exemption amount for an individual, an individual's spouse, and each dependent is increased to $2,000 for 1986; beginning in 1987, the $2,000 amount is to be adjusted for inflation. The additional exemption for elderly or blind individuals is repealed starting in 1986. (As described above, an additional standard deduction amount is provided by the House bill for an elderly or blind individual.)

Rules for dependents

The House bill provides that in the case of an individual who is eligible to be claimed as a dependent on another taxpayer's return, no more than $1,000 Of the personal exemption amount can be used to reduce the taxable amount of unearned income on the dependent's return. This provision is effective beginning in 1986. As under the present-law ZBA rule, the dependent may use the standard deduction only to offset earned income.

 

Senate Amendment

 

 

Exemption amount

The personal exemption amount for an individual, an individual's spouse, and each dependent is increased to $1,900 for 1987 and $2,000 for 1988; beginning in 1989, the $2,000 amount is to be adjusted for inflation. The additional exemption for elderly or blind individuals is repealed starting in 1987. (As described above, an additional standard deduction amount is provided by the Senate amendment for an elderly or blind individual.)

Phase-out

All personal exemption amounts claimed by a taxpayer (including exemptions for the taxpayer's spouse and dependents) are reduced, at a five-percent rate, over a range of $40,000 (adjusted for inflation) starting at the AGI level at which the benefit of the 15-percent rate is totally phased out (see I.A.1, above). Thus, no personal exemption amounts are allowed for taxpayers with AGI exceeding the top of the exemption phase-out range. This provision is effective for taxable years beginning on or after January 1, 1987.

Rules for dependents

Under the Senate amendment, no personal exemption amount is allowable on the return of an individual who is eligible to be claimed as a dependent on another taxpayer's return. Thus, for example, an exemption amount cannot be claimed by a child on the child s return if the child is eligible to be claimed as a dependent on the parents' return. This provision is effective for taxable years beginning on or after January 1, 1987.

If a child or other dependent who is not allowed a personal exemption under this provision has gross income of less than $100 for the year, the individual is not subject to tax on that amount and is not required to file a Federal income tax return for that year. Thus, for example, if a child's gross income consists of $85 in interest on a savings account, there would be no tax due and no return would have to be filed. If the child's gross income consists of $300 of interest, the de minimis rule would not apply, and the tax would be computed from the first dollar of taxable income (i.e., without subtracting $100). As under the present-law ZBA rule and the House bill, a child or other individual eligible to be claimed as a dependent on another person's return may use the standard deduction only to offset earned income.

 

Conference Agreement

 

 

Exemption amount

The conference agreement increases the personal exemption for each individual, the individual's spouse, and each eligible dependent to $1,900 for 1987, $1,950 for 1988, and $2,000 in 1989. Beginning in 1990, the $2,000 personal exemption amount will be adjusted for inflation. The conference agreement follows the House bill and the Senate amendment in repealing the additional exemption for an elderly or blind individual, beginning in 1987. (As described above, an additional standard deduction amount is provided by the conference agreement for an elderly or blind individual, beginning in 1987.)

Phase-out

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 15-percent rate is totally phased out (see "Rate adjustment," I.A.1., 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. The phase-out occurs serially; e.g., the phaseout of the benefit of the second personal exemption on a joint return does not begin until the phaseout of the first is complete. Thus, in the case of a married couple filing jointly who have two children, in 1988 the benefit of the four personal exemptions 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 $11,200.

Rules for dependents

The conference agreement follows the Senate amendment in providing that no personal exemption amount is allowable on the return of an individual who is eligible to be claimed as a dependent on another taxpayer's return (for example, on the return of a child who is eligible to be claimed as a dependent on the return of his or her parents).

As in the present-law rule that the ZBA may be used by such a dependent individual only to offset earned income, the conference agreement generally follows the House bill and the Senate amendment in providing that the standard deduction may be used by such a dependent individual only to offset earned income. However, the conference agreement liberalizes this limitation (in lieu of the $100 de minimus rule in the Senate amendment) by providing that for such a dependent individual, the individual's 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 up to the basic standard deduction amount (in 1988, $3,000 for a single individual). Under the conference agreement, such a dependent child must file a Federal income tax return only if he or she either has gross income exceeding the standard deduction amount for such a dependent child (i.e., the greater of earned income or $500) or has unearned income exceeding $500.

These rules for dependents are effective beginning in 1987.

4. Adjustments for inflation

 

Present Law

 

 

The dollar amounts defining the tax rate brackets, the ZBA (standard deduction), and the personal exemption amount are adjusted annually for inflation, measured by 12-month periods ending September 30 of the prior calendar year. If the inflation adjustment is not a multiple of $10, the increase is rounded to the nearest multiple of $10 (sec. 1(f)).

 

House Bill

 

 

The House bill continues inflation adjustments as under present law, except that the 12-month measuring periods end August 31, effective for taxable years beginning on or after January 1, 1986.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that inflation adjustments to the rate brackets, the standard deduction (and the $600 or $750 additional standard deduction for elderly or blind individuals), and personal exemption amounts are to be rounded down to the nearest multiple of $50. The Senate amendment provisions with respect to the 12-month measuring period and rounding down are effective for taxable years beginning on or after January 1, 1987.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

5. Two-earner deduction

 

Present Law

 

 

Under present law, married individuals filing a joint return are 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 is $3,000 (sec. 221).

 

House Bill

 

 

The two-earner deduction is repealed, effective for taxable years beginning on or after January 1, 1986.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that the two-earner deduction is repealed effective for taxable years beginning on or after January 1, 1987.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

6. Income averaging

 

Present Law

 

 

An eligible individual can elect to have a lower marginal rate apply to the portion of the current year's taxable income that is more than 40 percent higher than the average of his or her taxable income for the prior three years (secs. 1301-1305).

 

House Bill

 

 

Income averaging is repealed, effective for taxable years beginning on or after January 1, 1986.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that (1) income averaging is retained for individuals who are actively engaged in the trade or business of farming and (2) the repeal of income averaging for other individuals is effective for taxable years beginning on or after January 1, 1987.

 

Conference Agreement

 

 

The conference agreement follows the House bill, with the modification that the repeal of income averaging (for all taxpayers) is effective for taxable years beginning on or after January 1, 1987.

 

B. Earned Income Credit

 

 

Present Law

 

 

Eligible individuals with one or more children are allowed a refundable income tax credit of 11 percent of the first $5,000 of earned income (maximum credit of $550). The amount of the credit is reduced if the individual's income exceeds $6,500, and no credit is available for individuals with income of $11,000 or more (sec. 32).

To relieve eligible individuals of the burden of computing the amount of credit to be claimed on their returns, the IRS publishes tables for determining the credit amount. Eligible individuals may receive the benefit of the credit in their paychecks throughout the year by electing advance payments (sec. 3507).

 

House Bill

 

 

The House bill increases the earned income credit to 14 percent of the first $5,000 of earned income (maximum credit of $700), effective for taxable years beginning on or after January 1, 1986.

The income level at which the credit is completely phased out is raised to $13,500, effective for taxable years beginning on or after January 1, 1986. These income phase-out levels are raised to $9,000/$16,000 for taxable years beginning on or after January 1, 1987.

Under the House bill, the maximum amount of the credit and the phaseout income range are adjusted for inflation occurring after the 12-month period ending on August 31, 1984. Thus, for example, the maximum earned income eligible for the credit beginning in 1986 is to equal $5,000 as adjusted for inflation between August 31, 1984 and August 31, 1985.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that the increase in the credit rate to 14 percent and the higher phase-out range or $6,500/$13,500 are effective for taxable years beginning on or after January 1, 1987, and except that the income phase-out range is raised to $10,000/$17,000 effective for taxable years beginning on or after January 1, 1988.

Also, the Senate amendment directs that Treasury regulations are to require employers to notify (at such time and in such manner as prescribed in such regulations) employees whose wages are not subject to income tax withholding that they may be eligible for the refundable earned income credit.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment, except that (1) the base against which the increased 14-percent credit applies is raised to $5,7141 (increasing the maximum credit to $800), and (2) the income phase-out levels, effective for taxable years starting on or after January 1, 1988, are raised to $9,000/$17,000, Also, the conference agreement clarifies that the notice that must be given by an employer to employees whose wages are not subject to withholding 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, in the case of high school or college students who have summer jobs).

 

C. Exclusions From Income

 

 

1. Unemployment compensation

 

Present Law

 

 

Present law provides a limited exclusion from gross income for unemployment compensation benefits received under a Federal or State program (sec. 85). If the sum of the taxpayer's unemployment compensation benefits and AGI does not exceed a base amount, then the entire benefit amount is excluded from income. The base amount is $12,000 in the case of an unmarried individual; $18,000, in the case of married individuals filing a joint return; and zero, in the case of married individuals filing separate returns.

If the base amount is exceeded, then the amount of unemployment compensation benefits that is includible in gross income equals the lesser of (1) one-half of the excess of the taxpayer's combined income (modified AGI plus benefits) over the base amount, or (2) the amount of the unemployment compensation benefits.

 

House Bill

 

 

Under the House bill, all unemployment compensation benefits are includible in gross income, effective for amounts received after December 31, 1986, in taxable years ending after that date.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

2. Scholarships and fellowships

 

Present Law

 

 

In general

Present law provides an exclusion from gross income for (1) amounts received 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 and spent for travel, research, clerical help, or equipment (sec. 117).

In the case of an individual who is not a candidate for a degree, the exclusion applies only if the grantor of the scholarship or fellowship is a tax-exempt organization, international organization, or government agency, and the amount of the exclusion is limited to (1) $300 per month up to a maximum lifetime exclusion of $10,800 plus (2) the amount of incidental expenses for travel, research, clerical help, or equipment.

An educational institution is described in section 170(b)(l)(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 not noneducational institutions, on-the-job training, correspondence schools, night schools, and so forth (Reg. secs. 1.117-3(b), 1.151-3(c)). The term candidate for a degree means (1) 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 (2) a student who receives a scholarship for study at a secondary school or other educational institution (Reg. sec. 1.117-3(e)).

Payments for services

In general, amounts paid to an individual to enable pursuit of 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.2 In the case of degree candidates, the statute specifically provides that the exclusion does not apply to any portion of an otherwise qualifying scholarship or fellowship grant that represents 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. However, an exception permits the exclusion for payments for services if all candidates for a particular degree must perform such services.

Federal grants

Under another exception, grants received under a Federal program requiring the recipient to perform future services as a Federal employee nonetheless are excludable to the extent used for tuition and required fees, books, supplies, and equipment.

 

House Bill

 

 

In general

The House bill limits the section 117 exclusion for scholarships or fellowship grants (1) to a scholarship or fellowship grant received by an individual who is a candidate for a degree at an educational institution (described in sec. 170(b)(l)(A)(ii)), and (2) to the amount of the scholarship or fellowship grant received by the degree candidate that is required to be used, and in fact is used, for tuition and course-required fees, books, supplies, and equipment ("course-related expenses"). Any other amount of a scholarship or fellowship grant received by a degree candidate (for example, amounts for room, board, or incidental expenses) is includible in gross income, as is the full amount of any scholarship or fellowship grant received by an individual who is not a degree candidate. The repeal of the exclusion in the case of nondegree candidates does not affect whether the section 127 exclusion may apply to employer-provided educational assistance to nondegree candidates, or whether unreimbursed educational expenses of some nondegree candidates may be deductible as trade or business expenses if the requirements of section 162 are met.

Payments for services

The House bill repeals the exception under present law permitting scholarship or fellowship grants received by degree candidates representing payment for services to be excludable under section 117 if all candidates for the particular degree are required to perform such services. Thus, under the House bill, the general rule applies requiring inclusion in gross income and wages of amounts received that represent payment for services required as a condition of receiving the grant. This inclusion rule applies both to such grants received in cash and 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 section 117(d).

Federal grants

The House bill also repeals the present-law exception permitting the exclusion of certain Federal grants under section 117 even though the recipient is required to perform future service as a Federal employee. Thus, to the extent the amount received represents payments for past, present, or future services required to be performed as a condition of the grant, then the amount received is not excludable under the House bill.

 

Effective Date

 

 

These provisions are effective for scholarships and fellowships granted after September 25, 1985.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the House bill, with a modification to the definition of a qualified scholarship or fellowship grant ("qualified scholarship") and a modification to the effective date. The exclusion as allowed under the conference agreement for an otherwise qualified scholarship is not limited to a grant that by its express terms is required to be used for tuition and course-related expenses. Instead, the amount of an otherwise qualified scholarship received by a degree candidate is excludable (taking into account the amount of any other grant to the individual 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, provided that the terms of the grant do not earmark or designate its use for other purposes (such as room or board) and do not specify that the grant cannot be used for tuition or course-related expenses. The conference agreement clarifies that in the case of individuals other than students attending a primary or secondary school or pursuing a degree at a college or university, the term candidate for a degree means 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.

The amendments made by the conference agreement are effective for taxable years beginning on or after January 1, 1987, except that present law continues to apply to scholarships and fellowships granted before August 17, 1986. 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 is attributable to expenditures incurred prior to January 1, 1987 (such as tuition, room, and board attributable to the period prior to January 1, 1987) is eligible for the present-law exclusion under section 117.

The conference agreement also clarifies that only for purposes of the rule that 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), any amount of a noncompensatory scholarship or fellowship grant that is includible in gross income as a result of these amendment to section 117 (including the repeal of any section 117 exclusion for nondegree candidates) constitutes earned income. (Amounts received as payment for teaching or other services also constitute earned income.)

3. Prizes and awards

 

Present Law

 

 

Scientific, etc. achievement awards

Prizes and awards received by the taxpayer, other than scholarships and fellowship grants excludable under section 117, generally are includible in gross income (sec. 74(a)). However, a limited exclusion applies for prizes and awards (other than scholarships or fellowship grants) received for achievements in fields such as the sciences, charity, or the arts, but only if the recipient (1) has not applied specifically for the prize or award (e.g., by entering a contest), and (2) is not required to render services as a condition of receiving it (sec. 74(b)).

Employee awards

Section 61 provides 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, an item transferred from an employer to an employee, other than a prize or award that is includible under section 74, may be excludable from gross income if it qualifies as a gift under section 102.

The U.S. Supreme Court, in a case involving payments made "in a context with business overtones," has 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 constitute gifts only in the "extraordinary" instance.

If an award to an employee constitutes a gift excludable from income under section 102, the employer's deduction is limited pursuant to section 274(b). That provision 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, the ceiling on the deduction is $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 ceiling on the employer's business gift deduction is $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 does not exceed $400.

Section 132(e) excludes from income certain de minimis fringe benefits, i.e., any property or service the value of which is so small (taking into account the frequency with which similar fringes are provided by the employer to the employer's employees) as to make accounting for it unreasonable or administratively impracticable.

 

House Bill

 

 

Scientific, etc. achievement awards

The House bill repeals the limited exclusion under present law (sec. 74(b)) for prizes or awards for scientific, etc. achievement, except where the recipient assigns the prize or award to a governmental unit (sec. 170(c)(1)) or tax-exempt charitable organization (sec. 170(c)(2)). If a qualifying assignment is made, the prize or award is not included in the winner's gross income, and no charitable deduction is allowed to the winner or to the payor. This provision is effective for taxable years beginning after December 31, 1985.

Employee awards

Under the House bill, employee awards are not excludable from the recipient's income either under section 74 or under section 102. (In conformity with this rule, the present-law deduction limitation provisions in sec. 274(b) are repealed.) The committee report clarifies that employee awards of low value (such as certain traditional retirement gifts) are excludable if qualifying as de minimis fringe benefits as defined in section 132(e).

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

 

Senate Amendment

 

 

Scientific, etc. achievement awards

The Senate amendment is the same as the House bill, except that the provision is effective for taxable years beginning after December 31, 1986.

Employee awards

Under the Senate amendment, employee awards of tangible personal property for length of service or safety achievement are excludable by the employee from gross income for income tax purposes, and are deductible by the employer, to the extent that during the year the aggregate cost of awards (safety and length of service) made to the same employee does not exceed $1,600 for all awards and $400 for all awards that are not qualified plan awards, subject to certain additional requirements, limitations, and computation rules. To the extent that the new exclusion does not apply, all prizes or awards by employers to employees are includible in gross income other than (as under the House bill) items of low value that are excludable as de minimis fringe benefits (as defined in sec. 132(e)). The latter term would include, for example, (1) 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, and (2) a traditional retirement gift presented to an employee on his or her retirement after completing lengthy service. The new employee achievement award exclusion is not available for any award made by a sole proprietorship to the sole proprietor.

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

 

Conference Agreement

 

 

Scientific, etc. achievement awards

The conference agreement follows the Senate amendment, effective for such awards made after December 31, 1986.

Employee awards

The conference agreement follows the Senate amendment, with a modification that an employee award is excludable from wages for employment tax purposes and from the social security benefit base to the same extent that the award is excludable under the conference agreement from gross income for income tax purposes. The conference agreement is effective for such awards made after December 31, 1986.

 

D. Deductions for Personal Expenditures

 

 

1. Itemized deductions for certain State and local taxes

 

Present Law

 

 

Individuals may claim itemized deductions with respect to the following State and local taxes: income taxes, real property taxes, personal property taxes, and general sales taxes (sec. 164). Other State and local taxes and foreign taxes generally are deductible by individuals if incurred in a business or in an income producing (investment) activity, including such taxes that are allocable to a purchase or disposition of property and thus otherwise would have to be added to basis on purchase or applied to reduce gain on disposition. However, specific Code provisions (such as secs. 189 and 263) may require capitalization of certain taxes.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

Under the Senate amendment, the itemized deduction for State and local general sales taxes paid or accrued during a year is limited to 60 percent of the excess of such taxes over the amount of State and local income taxes paid or accrued by the taxpayer during the year. No change is made in the itemized deductions for State and local income, real property, and personal property taxes.

The Senate amendment also provides that State, local, or foreign taxes (other than real property taxes or certain other specified taxes) that are incurred in a trade or business (or in a section 212 activity) in connection with the acquisition or disposition of property are not deductible. Instead, such taxes are to be treated, respectively, as part of the cost of the property on acquisition or as a deduction in the amount realized on disposition.

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

 

Conference Agreement

 

 

Under the conference agreement, the itemized deduction for State and local sales taxes is repealed. The conference agreement follows the Senate amendment with respect to capitalization of certain taxes. (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 conference agreement as part of the cost of the acquired property for depreciation purposes.) These provisions are effective for taxable years beginning on or after January 1, 1987.

2. Charitable deduction for nonitemizers

 

Present Law

 

 

Beginning in 1982, nonitemizers have been allowed a deduction for charitable contributions in addition to the ZBA (standard deduction) (sec. 170(i)). The maximum charitable deduction for nonitemizers was $25 for 1982 and 1983, and $75 for 1984. For 1985, 50 percent of the amount contributed was deductible, without a dollar cap. For 1986, the full amount of contributions is deductible, subject to the limitations and other rules generally applicable to charitable deductions for itemizers.

Under present law, no deduction (beyond the standard deduction) is provided for charitable contributions by nonitemizers made after 1986.

 

House Bill

 

 

The nonitemizer charitable deduction is made permanent. Also, the House bill modifies the deduction by providing that, for taxable years beginning after December 31, 1985, the deduction is subject to a $100 floor.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement does not include the House bill provision. Thus, pursuant to present law, the nonitemizer charitable deduction terminates for contributions made after December 31, 1986.

3. Medical expense deduction

 

Present Law

 

 

Floor under deduction

Itemizers may deduct unreimbursed medical care expenses to the extent the total of such expenses exceeds five percent of the taxpayer's adjusted gross income (AGI) (sec. 213).

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 medical care. In addition, the cost of a permanent improvement to property that ordinarily would not have a medical purpose may be deductible as a medical expense if 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, eligible medical expenses include the additional costs of modifying an automobile to accommodate wheelchair passengers, and certain capital expenditures to accommodate a residence to a handicapped individual.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

Floor under deduction

The floor under the itemized medical expense deduction is increased from five to approximately nine percent of the taxpayer's AGI, effective for taxable years beginning on or after January 1, 1987.

Capital expenditures

The committee report clarifies that the full costs of specified capital expenditures incurred to accommodate a personal residence to the needs of a physically handicapped individual, such as construction of entrance ramps or widening of doorways to allow use of wheelchairs, constitute medical expenses eligible for the deduction.

 

Conference Agreement

 

 

Floor under deduction

The conference agreement follows the Senate amendment, except that the floor under the itemized medical expense deduction is increased from five to 7.5 percent of the taxpayer's AGI.

Capital expenditures

The conferees intend to reaffirm that the full costs of specified capital expenditures incurred to accommodate a personal residence to the needs of a physically handicapped individual, such as construction of entrance ramps or widening of doorways to allow use of wheelchairs, constitute medical expenses eligible for the deduction, as described in the Senate Finance Committee Report.

4. Adoption expenses

 

Present Law

 

 

An itemized deduction is allowed for up to $1,500 of adoption fees and expenses (such as court costs and attorneys' fees) for the adoption of a child with special needs, i.e., a handicapped or other child eligible for adoption assistance payments under the Social Security Act (sec. 222).

 

House Bill

 

 

The House bill repeals the itemized adoption expense deduction, generally effective for adoption expenses paid after 1986. Present law continues to apply in 1987 for adoptions as to which deductible expenses were incurred in 1986.

In addition, the House bill 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. Such expenses include all qualified adoption expenses to which the present-law tax deduction provision applies. The effective date of amending the adoption assistance program is coordinated with repeal of the deduction.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the House bill in repealing the itemized adoption expense deduction and amending the adoption assistance program in Title IV-E of the Social Security Act, with the modification that these provisions are effective, respectively, for taxable years beginning on or after January 1, 1987 and for expenditures made after December 31, 1986.

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

 

Present Law

 

 

The IRS has ruled that a minister may not deduct mortgage interest and property taxes allocable to a parsonage allowance that is excludable from gross income under Code section 107 (Rev. Rul. 83-3, 1983-1 C.B. 72). This ruling was based on section 265(1), which disallows deductions for expenses allocable to tax-exempt income. This ruling applied effective July 1, 1983, subject to transitional relief (extended through 1986) for ministers owning homes before 1983.

 

House Bill

 

 

The House bill provides a permanent rule (effective retroactively) that ministers receiving excludable parsonage allowances, as well as military personnel receiving excludable military housing allowances, are not precluded by Code section 265 from deducting mortgage interest or real property taxes on their residence.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, with a clarification that military personnel means members of the Army, Navy, Air Force, Marine Corps, Coast Guard, National Oceanic and Atmospheric Administration, and Public Health Service.

 

Conference Agreement

 

 

The conference agreement is the same as the House bill and the Senate amendment, with the Senate amendment clarification that defines military personnel.

 

E. Expenses for Business or Investment

 

 

1. Meals, travel, and entertainment expenses

 

a. Meal expenses
Present Law

 

 

Food and beverage expenses that constitute ordinary and necessary business expenses generally are deductible if the meal takes place in an atmosphere conducive to business discussion, whether or not business is discussed before, during, or after the meal (sec. 274(e)(1)). In contrast to the rules for deducting other entertainment expenses (see item b., below), the taxpayer need not also establish that such meal expenses are either directly related to or associated with the active conduct of a trade or business. No deduction is allowed for personal, family, or living expenses (sec. 262), or for otherwise deductible traveling expenses (including meals) that are lavish and extravagant under the circumstances (sec. 162(a)(2)).

Present law (sec. 274(d)) imposes specific substantiation requirements as a condition for deductibility of (1) traveling expenses (including meals and lodging while away from home); (2) expenses with respect to entertainment, amusement, or recreation activities or facilities; (3) business gifts; and (4) expenses with respect to listed property (as defined in sec. 280F(d)(4)). To deduct such expenses, the taxpayer must substantiate by adequate records, or sufficient evidence corroborating the taxpayer's statement, (1) the amount of the expense or item; (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. A business entertainment expenditure that is deductible only if directly related to or associated with the active conduct of the taxpayer's trade or business must be substantiated as provided in Treas. Reg. sec. 1.274-5(b)(4).

To meet the adequate records standard, documentary evidence (such as receipts or paid bills) 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.3

 

House Bill

 

 

Reduction rule

The bill generally reduces to 80 percent the amount of any deduction otherwise allowable for meal expenses, including meals away from home and meals furnished on an employer's premises to its employees (whether or not such meals are excludable from the employee's gross income under sec. 119). The bill provides exceptions allowing full deductibility for (1) reimbursed meal expenses (in which case the employer or person making the reimbursement is subject to the 80-percent rule); (2) employer-furnished meals that are excludable from the employee's gross income as de minimis fringes under Code section 132(e) (including meals at certain eating facilities excludable under sec. 132(e)(2)); (3) meals fully taxed to the recipient as compensation; and (4) items sold to the public (such as expenses incurred by restaurants or dinner theaters for food or entertainment provided to their customers), or furnished to the public as samples or for promotion (such as expenses incurred by a hotel in furnishing complimentary lodging to potential customers). 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 the work site by employees of the restaurant or caterer.

Business-connection requirement

The House bill also provides that deductions for meals are subject to the same business-connection requirement as applies under present law (sec. 274(a)) for other entertainment expenses (see item E.1.b., below). Thus, a food or beverage expense is not deductible unless the taxpayer 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. Under this standard, no deduction is allowed unless business is discussed during, or directly before or after, the meal (except 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).

Disallowance of lavish or extravagant expenditures

The House bill explicitly provides, apart from the present-law statutory rule 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. Thus, 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 reduction rule is applied only after determining the otherwise allowable deduction under sections 162 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.

Presence of taxpayer requirement

Under the House bill, no deduction for food or beverage expenses is allowed unless the taxpayer or an employee of the taxpayer is present at the furnishing of the food or beverages (except 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). For purposes of this rule, an independent contractor who renders significant services to the taxpayer (such as an attorney representing the taxpayer in a legal proceeding) is treated as an employee if he or she attends the meal in connection with such performance of services.

Additional rules

As an additional requirement that is not applicable to other entertainment expenses, the House bill provides that no deduction for business meals is allowable unless the meal has a clear business purpose presently related to the active conduct of the taxpayer's business--i.e., unless the required business discussion concerns a specific business transaction or arrangement. The Treasury is instructed to adopt stricter substantiation requirements for business meals, including expenses of less than $25 per day. Also, the bill imposes special negligence or fraud penalties on negligently or fraudulently overstated deductions for business meals.

 

Effective Date

 

 

These provisions are effective for taxable years beginning on or after January 1, 1986.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill with respect to meal expenses, except that full deductibility is allowed in 1987 and 1988 for costs of meals (if not separately stated) that are provided as an integral part of a qualified banquet meeting. The latter term means a convention, seminar, annual meeting, or similar business meeting (including meetings held at an employee training facility) if (1) the program includes the meal, (2) more than 50 percent of the participants are away from home, (3) there are at least 40 attendees, and (4) the meal event includes a speaker. The Senate amendment is effective for taxable years beginning on or after January 1, 1987.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment with respect to food or beverage expenses, except that (1) the business-connection requirement for deducting food or beverage expenses is conformed to the business-connection requirement applicable to other entertainment expenses (i.e., the conference agreement does not include the additional "clear business purpose" requirement under which a specific business transaction or arrangement would have to be discussed); (2) present law regarding substantiation of meal expenses under $25 is retained; and (3) there are no special negligence and fraud penalties applicable only to claimed deductions for business meals.

Thus, under the conference agreement, deductions for meals are subject to the same business-connection requirement as applies under present law for other entertainment expenses. 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, 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, no deduction is allowed unless business is discussed during, or directly before or after, the meal (except 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).

The conference agreement includes the separate statutory rule disallowing lavish or extravagant expenditures for food or beverages, whether or not incurred while the taxpayer is on business travel, thereby emphasizing an intent that this standard is to be enforced by the Internal Revenue Service and the courts. Also, the conference agreement includes the requirement relating to the presence of the taxpayer or an employee of the taxpayer at the furnishing of the food or beverages. These two rules are subject to certain exceptions listed in the statute (e.g., where the full value of the food or beverages is taxed as compensation to the recipient).

Since the conference agreement provides that deductions for meals are subject to the same business-connection requirement as applies under present law for other entertainment expenses, the present-law 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 deductibility standard) also will apply to all meal expenses. In addition, the conference agreement instructs the Treasury to adopt stricter substantiation requirements for business meals, except that the present-law rule relating to certain expenditures of less than $25 is to be retained. It is reemphasized that under the conference agreement, as under present 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.

 

b. Entertainment expenses other than for meals
Present Law

 

 

In general

Entertainment expenses (other than certain food or beverage expenses) generally are deductible only if, in addition to constituting ordinary and necessary business expenses, they are either (1) directly related to the active conduct of the taxpayer's business, or (2) if directly preceding or following a substantial and bona fide business discussion, associated with the active conduct of the taxpayer's business.

Facilities

No deduction or credit generally is allowed for the cost of purchasing or constructing certain entertainment facilities (e.g., skyboxes).

 

House Bill

 

 

In general

The House bill generally reduces to 80 percent the amount of deduction otherwise allowable for business entertainment expenses. The bill provides exceptions allowing full deductibility for (1) reimbursed entertainment expenses (in which case the employer or person making the reimbursement is subject to the 80-percent rule); (2) traditional employer-paid recreational expenses for employees (e.g., a holiday party); (3) items fully taxed to the recipient as compensation, or excludable from income as section 132(e) de minimis fringe benefits; (4) items sold to or made available to the general public (e.g., as promotional activities); and (5) tickets and related expenses at certain charitable fundraising sports events. In addition, no amount of ticket costs in excess of the face value of the ticket is deductible, except in the case of tickets for certain charitable fundraising sports events; the limitation to the face value amount applies prior to application of the 80-percent rule.

Facilities

Apart from the generally applicable entertainment facility rules, the House bill disallows deductions for costs of rental or other use of a skybox or other private luxury box ("skybox") at a sports arena (to the extent in excess of the cost of regular box seat tickets) by the taxpayer or a related party for more than one event (as determined taking into account all skybox rentals by the taxpayer in the same arena, along with any related rentals).

 

Effective Date

 

 

The House bill provisions are effective for taxable years beginning on or after January 1, 1986.

 

Senate Amendment

 

 

In general

The Senate amendment is the same as House bill.

Facilities

The Senate amendment does not provide a special rule disallowing deductions for certain rental costs of skyboxes (general entertainment facility rules continue to apply).

 

Effective Date

 

 

The Senate amendment is effective for taxable years beginning on or after January 1, 1987.

 

Conference Agreement

 

 

In general

The conference agreement follows the House bill and the Senate amendment.

Facilities

The conference agreement follows the House bill, except that the skybox deduction disallowance rule is phased in. Under this provision, the 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 conference agreement if the provision were fully effective in those years. For taxable years beginning after 1989, the conference agreement follows the House bill, i.e., no deduction is allowed for costs of rental or other use of a skybox at a sports arena by the taxpayer or a related party for more than one event.4

 

Effective Date

 

 

The conference agreement follows the Senate amendment.

 

c. Travel expenses (other than for attending conventions)
Present Law

 

 

Luxury water transportation

Travel expenses, other than lavish and extravagant expenditures for meals or lodging, incurred by a taxpayer while away from home in the conduct of a trade or business generally are deductible if substantiated pursuant to section 274. No special rules limit otherwise allowable deductions for the costs of luxury water transportation, although limitations apply with respect to cruise ship conventions (sec. 274(h)(2)) or foreign conventions (secs. 274(c),(h)).

Educational travel

Traveling expenses may be deductible as business expenses if the taxpayer establishes that the travel (i) directly maintains or improves existing employment skills and (ii) directly relates to the taxpayer's duties in his or her employment or trade or business, and if the taxpayer substantiates the expenses pursuant to section 274. No deduction is allowable unless the travel is undertaken primarily to obtain education the expenses of which are deductible as trade or business expenses; in the case of travel expenses meeting this test, no deduction is allowable for expenses allocable to personal activity incidental to the primary business activity.

Charitable travel

Traveling expenses away from home may give rise to a charitable deduction if the taxpayer establishes that the travel expenses (whether paid directly by the individual or indirectly through a contribution by the individual to the charity, which then pays for the individual's travel) are incurred in rendering services to a qualified charitable organization, and if the taxpayer verifies such expenses as required pursuant to section 170(a)(1) and Treasury regulations thereunder.

 

House Bill

 

 

Luxury water transportation

The amount of any otherwise allowable deduction for costs of cruise ship or other luxury water transportation is limited to twice the highest Federal per diem for travel in the United States, times the number of days in transit. This limitation does not apply with respect to expenses of cruise ship conventions, which remain subject to present-law limitations (sec. 274(h)(2)), or where an exception to the 80-percent deduction rule (above) applies.

Educational travel

No deduction is allowed for costs of travel that would be deductible only on the ground that the travel itself constitutes a form of education (e.g., where a teacher of French travels to France to maintain general familiarity with the French language and culture, or where a social studies teacher travels to another State to learn about or photograph its people, customs, geography, etc.). This provision overrules Treas. Reg. sec. 1.162-5(d) to the extent that such regulation allows deductions for travel as a form of education.

Charitable travel

The present-law rule applicable to medical deductions for lodging costs away from home (sec. 213(d)(2)(B)) is extended to charitable deductions claimed for transportation and other travel expenses incurred in performing services away from home on behalf of a qualified charitable organization. Thus, no deduction is allowed for such expenses (whether paid directly by the individual or indirectly through a contribution to the organization) unless there is no significant element of personal pleasure, recreation, or vacation in the travel away from home. As under present law, an otherwise qualifying charitable deduction is deductible only if verified pursuant to Treasury regulations (Code sec. 170(a)(1)), and no charitable deduction is allowable for a contribution of services to a charitable organization.

 

Effective Date

 

 

The provisions in the House bill are effective for taxable years beginning on or after January 1, 1986.

 

Senate Amendment

 

 

Luxury water transportation

The Senate amendment is the same as the House bill.

Educational travel

The Senate amendment is the same as the House bill.

Charitable travel

No provision.

 

Effective Date

 

 

The provisions in the Senate amendment are effective for taxable years beginning on or after January 1, 1987.

 

Conference Agreement

 

 

Luxury water transportation

The conference agreement follows the House bill and the Senate amendment.

Educational travel

The conference agreement follows the House bill and the Senate amendment.

Charitable travel

The conference agreement follows the House bill, except that the provision is effective for taxable years beginning on or after January 1, 1987.

 

Effective Date

 

 

The conference agreement follows the Senate amendment.

 

d. Travel expenses for attending conventions
Present Law

 

 

In general

The costs of attending a convention or seminar incurred in carrying on a trade or business generally are deductible under section 162, subject to substantiation pursuant to section 274. In some circumstances, the costs of attending a convention, seminar, or similar meeting in connection with the taxpayer's income-producing (investment) activities may be deductible under section 212.

Foreign conventions

No deduction is allowed for the cost of attending a convention outside of the North American area (i.e., not in the United States, Canada, Mexico, or certain Caribbean countries) unless the taxpayer can show that it was as reasonable to hold the convention there as in the North American areas (sec. 274(h)). Certain Caribbean countries, including Bermuda, are treated as in the North American area if they make available certain tax information to U.S. authorities and other specified requirements are met (sec. 274(h)(6)).

 

House Bill

 

 

In general

Under the House bill, no deduction is allowed under section 212 for travel or other costs of attending a convention, seminar, or similar meeting, effective for taxable years beginning on or after January 1, 1986. Thus, registration fees, travel and transportation costs, meal and lodging expenses, etc. incurred in connection with attending a convention, seminar, or similar meeting relating to investments, financial planning, or other income-production or section 212 activities are not deductible. 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 (within the meaning of sec. 162) of the taxpayer.

Foreign conventions

No provision.

 

Senate Amendment

 

 

In general

The Senate amendment is the same as the House bill, except that it is effective for taxable years beginning on or after January 1, 1987.

Foreign conventions

The Senate amendment provides that Bermuda may be treated as within the North American area for purposes of the foreign convention deductibility rules in certain circumstances.

 

Conference Agreement

 

 

In general

The conference agreement follows the Senate amendment.

The conferees also are 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 purposes as business expenses, the conferees wish to make clear that no deduction is allowable under section 162 for travel or related costs 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. Also, this clarification does not disallow deductions for costs, other than travel, meal, or entertainment expenses, of renting or using business-related video tape materials.

Foreign conventions

The conference agreement does not include the Senate amendment relating to Bermuda.

2. Employee business expenses, investment expenses, and other miscellaneous itemized deductions

 

a. In general
Present Law

 

 

Under present law, four types of employee business expenses are deductible "above-the-line" in calculating an individual's adjusted gross income (sec. 62(2)): (1) certain employee expenses reimbursed by the employer; (2) employee expenses for travel away from home; (3) employee transportation expenses; and (4) business expenses of employees who are outside salespersons. Moving expenses of an employee or self-employed individual are deductible above-the-line, within certain limitations (secs. 62(8), 217).

In addition to the itemized deductions for medical expenses, charitable donations, interest, taxes, and casualty losses, itemizers may deduct certain "miscellaneous deductions." This category includes (1) unreimbursed employee business expenses (other than those deductible above-the-line), including union and professional dues and home office expenses of an employee; (2) certain expenses related to investment income or property (such as investment counsel fees) if deductible under section 212; (3) tax return preparation costs and related expenditures if deductible under section 212(3); (4) gambling or hobby losses up to the amounts, respectively, of gambling or hobby income; (5) certain adjustments where a taxpayer restores amounts held under claim of right (sec. 1341)); (6) amortizable bond premiums (sec. 171); and (7) certain costs of cooperative housing corporations (sec. 216). (The miscellaneous itemized deduction for certain costs of adopting children with special needs is discussed in I.D.4., above.)

 

House Bill

 

 

Under the House bill, employee travel and transportation expenses deductible above-the-line under present law pursuant to sections 62(2)(B) and (C), and expenses of outside salespersons deductible above-the-line under present law pursuant to section 62(2)(D), are allowable only as itemized deductions and are subject to a floor as described below,

The total of the taxpayer's miscellaneous itemized deductions, including the employee business expenses described above, is allowable only to the extent exceeding one percent of the taxpayer's adjusted gross income. The floor does not apply to deductions for gambling losses up to, but not exceeding, gambling income (sec. 165(d)) or for the estate tax in the case of income in respect of a decedent (sec. 691(c)). These provisions are effective for taxable years beginning on or after January 1, 1986.

 

Senate Amendment

 

 

All miscellaneous itemized deductions allowable under present law are repealed under the Senate amendment, except deductions for (1) impairment-related work expenses of handicapped employees; (2) certain costs of adopting children with special needs (sec. 222); (3) estate tax in the case of income in respect of a decedent (sec. 691(c)); (4) gambling losses up to, but not exceeding, gambling income (sec. 165(d)); (5) certain adjustments where a taxpayer restores amounts held under claim of right (sec. 1341); (6) amortizable bond premiums (sec. 171); (7) certain terminated annuity payments (new sec. 72(b)(3)); and (8) certain costs of cooperative housing corporations (sec. 216). (The Senate amendment provides that Treasury regulations are to disallow indirect deductions through pass-through entities of the repealed miscellaneous itemized deductions.) In addition, a miscellaneous itemized deduction is allowed for employee travel and transportation expenses deductible above-the-line under present law pursuant to sections 62(2)(B) and (C), and expenses of outside salespersons deductible above-the-line under present law pursuant to section 62(2)(D)), but only to the extent that the aggregate of such expenses of the taxpayer exceeds one percent of adjusted gross income. These provisions are effective for taxable years beginning on or after January 1, 1987.

 

Conference Agreement

 

 

Under the conference agreement, employee business expenses, other than reimbursed expenses described in section 62(2)(A)4 [5], are to be allowed only as itemized deductions and are subject to a floor as described below. Moving expenses of an employee or self-employed individual are to be allowed (subject to the present-law limitations in sec. 217) only as an itemized deduction; this deduction is not subject to the new floor.

The miscellaneous itemized deductions, including the employee business expenses described above, generally are subject to a floor of two percent of the taxpayer's adjusted gross income. However, the floor does not apply to deductions otherwise allowable for impairment-related work expenses for handicapped employees (new Code sec. 67(d)); 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)).

Pursuant to Treasury regulations, the floor is to apply with respect to indirect deductions through pass-through entities (including mutual funds) other than estates, nongrantor trusts, cooperatives, and REITs. The floor also applies with respect to indirect deductions through grantor trusts, partnerships, and S corporations by virtue of present-law grantor trust and pass-through rules. In the case of an estate or trust, the conference agreement provides that the 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 relating to application of the floor with respect to indirect deductions through certain pass-through entities are to include such reporting requirements as may be necessary to effectuate this provision.

Under the conference agreement, an actor or other 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) in the performing arts, (2) incurred allowable section 162 expenses in connection with such services as an employee in an amount exceeding 10 percent of gross income from such services, and (3) did not have adjusted gross income, as determined before deducting such expenses, exceeding $16,000.

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

 

b. Home office expenses
Present Law

 

 

Expenses attributable to using part of one's home as an office are deductible subject to the following limitations: (1) the use of the home office must be for the convenience of the employer, (2) the home office must be used regularly and exclusively either as the taxpayer's principal place of business, or to meet patients, clients, or customers, and (3) the deduction cannot exceed the taxpayer's gross income from the business (sec. 280A). A recent case held that these limits do not apply when the taxpayer leases a portion of the home to his or her employer.

 

House Bill

 

 

Under the House bill, the present-law limitations (listed above) are to apply when an employee leases a portion of the home to his or her employer, In addition, the amount of an otherwise allowable home office deduction is limited to the taxpayer's net income from the business (i.e., gross income minus deductions attributable to the business). Disallowed home office deductions may be carried forward to later years, subject to the new income limitation in such years. These provisions are effective for taxable years beginning on or after January 1, 1986,

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that the effective date is taxable years beginning on or after January 1, 1987.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate Amendment, with the effective date in the Senate amendment.

 

c. Hobby losses
Present Law

 

 

Hobby losses are deductible only up to the amount of hobby income. An activity is presumed not to be a hobby, and therefore expenses incurred in the activity generally are not subject to this deduction limitation, if it is profitable in two out of five consecutive years, or two out of seven years for horse breeding or racing (sec. 183). However, an activity need not meet this standard in order to avoid treatment as a hobby.

 

House Bill

 

 

An activity (other than horse breeding or racing) is presumed not to be a hobby if it is profitable in three out of five consecutive years, effective for taxable years beginning on or after January 1, 1986. The present-law presumption rules are retained for horse activities.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that the effective date is taxable years beginning on or after January 1, 1987. Thus, for example, an activity carried on during 1987 by a taxpayer is presumed not to be a hobby in that year if the activity is profitable in any three years out of the five calendar years 1983 through 1987.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment, with the effective date in the Senate amendment.

 

F. Political Contributions Tax Credit

 

 

Present Law

 

 

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

 

House Bill

 

 

Under the House bill, a tax credit is allowed to individual for the full amount of political contributions, up to a maximum of $100 ($200 for a joint return), made to a congressional candidate for election in the State in which the taxpayer resides. This provision is effective for taxable years beginning or after January 1, 1986.

 

Senate Amendment

 

 

The Senate amendment repeals the political contributions tax credit, effective for taxable years beginning on or after January 1, 1987.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

TITLE II. CAPITAL COST PROVISIONS

 

 

A. Cost Recovery: Depreciation; ITC; Finance Leases

 

 

1. Accelerated depreciation

 

a. Cost recovery classes
Present Law

 

 

Under the Accelerated Cost Recovery System ("ACRS"), recovery deductions are determined by applying a statutory percentage to an asset's original cost (adjusted for allowable investment tax credit). The classification of assets under ACRS generally is based on the Asset Depreciation Range ("ADR") system of prior law. Under the ADR system, a present class life ("mid-point") was provided for all assets used in the same activity, other than certain assets with common characteristics (e.g., automobiles).

The cost of eligible personal property is recovered over a three-year, five-year, 10-year, or 15-year recovery period, using statutory percentages based on the 150-percent declining balance method. The cost of real property generally is recovered over a 19-year recovery period (15 years for low-income housing), using statutory percentages based on the 175-percent declining balance method (200-percent declining balance method for low-income housing).

 

House Bill

 

 

ACRS is replaced by the Incentive Depreciation System ("IDS"). Under IDS, assets are grouped into 10 different classes according to present class lives (or ADR midpoint lives).

Recovery deductions are determined through prescribed depreciation methods. The cost of most personal property is recovered using the 200-percent declining balance method over periods ranging from three to 30 years. The cost of real property generally is recovered using the straight-line method over 30 years.

 

Senate Amendment

 

 

ACRS is modified by (1) prescribing depreciation methods for each ACRS class (in lieu of providing statutory tables), (2) creating a second three-year class to which the straight-line method of depreciation applies, (3) reclassifying assets based on their ADR midpoint lives, (4) applying the 200-percent declining balance method to property in the five- and 10-year ACRS classes (as revised by the bill), and (5) requiring the cost of residential rental property to be recovered over 27.5 years and most other real property to be recovered over 31.5 years, using the straight-line method.

 

Conference Agreement

 

 

In general

The conference agreement modifies the Accelerated Cost Recovery System (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 conference agreement 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", Rev. Proc. 83-35, 1983-1 C.B. 745), and creates a seven-year class, a 20-year class, a 27.5-year class, and a 31.5-year class. The conference agreement prescribes depreciation methods for each ACRS class (in lieu of providing statutory tables). Eligible personal property and certain real property are assigned among a three-year class, a five-year class, a seven-year class, a 10-year class, a 15-year class, or a 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 conference agreement applies 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.

Classes of property

Property is classified as follows:

Three-year class.--ADR midpoints of 4 years or less, except automobiles and light trucks, and adding horses which are assigned to the three-year class under present law.

Five-year class.--ADR midpoints of more than 4 years and less than 10 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 that constitute qualifying small power production facilities (within the meaning of section 3(17)(C) of the Federal Power Act).

Seven-year class.--ADR midpoints of 10 years and less than 16 years, and adding single-purpose agricultural or horticultural structures and property with no ADR midpoint that is not classified elsewhere.

10-year class.--ADR midpoints of 16 years and less than 20 years.

15-year class.--ADR midpoints of 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.--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.

27.5-year class.--Residential rental property (including manufactured homes that are residential rental property and elevators and escalators).

31.5-year class.--Nonresidential real property (section 1250 real property that is not residential rental property and that either does not have an ADR midpoint or whose ADR midpoint is 27.5 years or more, including elevators and escalators).

The conference agreement provides new 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) which functions are those of a computer or peripheral equipment (as defined in section 168(j)(5)(D)) 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 plants, 25 years; and

(7) Municipal sewers, 50 years.

 

Classifications under the ADR system occasionally are made on the basis of regulated accounts. All assets described in these accounts are to be included, without regard to the fact that the taxpayer owning the described assets may not be subject to any regulatory authority.

The conferees wish to clarify 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 conference agreement.

As under present law, property which 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.

 

b. Luxury automobiles
Present Law

 

 

Recovery deductions for automobiles are subject to the following dollar limitations: $3,200 for the first recovery year; and $4,800 for each succeeding taxable year in the recovery period.

 

House Bill

 

 

Retains present law.

 

Senate Amendment

 

 

The Senate amendment conforms the fixed limitations on deductions so that the price range of affected cars is unchanged. Additionally, the amendment clarifies that the fixed limitations apply to all deductions claimed for depreciation of automobiles, not just ACRS deductions.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment and conforms the fixed limitations on deductions 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. The conference agreement clarifies that the fixed limitations apply to all deductions.

 

c. Changes in classification
Present Law

 

 

Under ACRS, recovery periods are fixed.

 

House Bill

 

 

Under the House bill, Treasury has the authority to adjust class lives based on actual experience with certain depreciable assets (other than 30-year real property or low-income housing) and any new class life will be used for determining the class of such property and in applying an alternative depreciation system.

 

Senate Amendment

 

 

The Senate amendment follows the House bill, except the class lives of certain other property in addition to residential rental property and nonresidential real property may not be changed.

 

Conference Agreement

 

 

Under the conference agreement, the Treasury Department has the authority to adjust class lives of most assets (other than residential rental property and nonresidential real property) based on actual experience. Any new class life will be used for determining the classification of such property and in applying an alternative depreciation system.

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. It also includes 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 should 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.

2. Alternative cost recovery system

 

a. In general
Present Law

 

 

(i) In general

ACRS deductions are reduced for property that is (1) used predominantly outside the United States or (2) tax-exempt use property.

Different depreciation methods are also used for purposes of (1) computing earnings and profits of a domestic corporation, and (2) applying the minimum tax provisions.

(ii) Tax-exempt bond financed property

Property, other than low-income housing, to the extent it is financed with industrial development bonds, the interest on which is tax-exempt, is depreciated using the straight-line method over the ACRS recovery period.

(iii) Elective alternative recovery system

Taxpayers can 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.

 

House Bill

 

 

(i) In general

An alternative cost recovery system is provided for the following purposes: (1) property used predominantly outside the United States, (2) tax-exempt use property, (3) for computing earnings and profits of a domestic corporation, and (4) for applying the minimum tax provisions.

Depreciation deductions are computed under the method that is used under present law for property that is leased to a tax-exempt entity, which generally is straight-line over the ADR midpoint life. Qualified technological equipment, cars, and light trucks are recovered over 5 years and most section 1250 real property over 40 years.

(ii) Tax-exempt bond property

If all or part of property, other than low-income housing, is financed with bonds, the interest on which is tax-exempt, the property is depreciated using the straight-line method over the next longest IDS class (40 years for most real property).

(iii) Elective alternative recovery system

Taxpayers may elect an alternative cost recovery system described in (i) for property that is otherwise eligible for incentive depreciation on a class-by-class, year-by-year basis.

 

Senate Amendment

 

 

(i) In general

Generally, the Senate amendment follows the House bill.

(ii) Tax-exempt bond property

Generally, property to the extent it is financed with bonds, the interest on which is tax-exempt, is depreciated using the same method as in (i). The recovery period for solid waste disposal facilities and hazardous waste treatment facilities is 8 years, and for low-income housing is 27.5 years.

(iii) Elective alternative recovery system

Taxpayers may elect either the alternative cost recovery system or the straight-line method over the ACRS recovery period for property that is otherwise eligible for ACRS on a class-by-class, year-by-year basis.

 

Conference Agreement

 

 

(i) In general

The conference agreement provides an alternative cost recovery system for: (1) property used predominantly outside the United States, (2) tax-exempt use property, (3) for computing earnings and profits of a domestic corporation or an "80/20" company, and (4) for applying the minimum tax provisions.

For purposes of (1), (2) and (3), the conference agreement follows the House bill and the Senate amendment. 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, shall be made only by including tax-exempt entities which hold 5 percent or more (in value) of the stock in such corporation.

For purposes of the depreciation preference under the minimum tax, the cost of property other than section 1250 real property is recovered using the 150-percent declining balance method, switching to the straight-line method, over the same lives as provided for the purposes of (1), (2) and (3). The cost of section 1250 real property and other property for which the straight-line method is either elected or required to be used for regular tax purposes is recovered using the straight-line method for minimum tax purposes.

(ii) Tax-exempt bond property

The conference agreement generally follows the Senate amendment. Property, to the extent it is financed with tax-exempt bonds, is depreciated using the straight-line method over the same lives as provided in (i). Only the portion of the cost of property which 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 property 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.

(iii) Elective alternative recovery system

The conference agreement follows the Senate amendment.

 

b. Property predominantly of foreign origin
Present Law

 

 

Under present law, there is Presidential authority to deny the investment tax credit, but not to deny accelerated depreciation.

 

House Bill

 

 

The House bill provides Presidential authority to deny accelerated depreciation to property produced abroad, similar to present-law rules applicable to the investment tax credit.

 

Senate Amendment

 

 

The Senate amendment follows the House bill, except it limits the Presidential authority to assets that have not yet been ordered.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

c. Property used in outer space
Present Law

 

 

No provision.

 

House Bill

 

 

Property launched by a U.S. person from the United States and used in outer space is not treated as foreign use property.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

3. Indexing

 

Present Law

 

 

Under present law, the basis of depreciable property is not adjusted for inflation.

 

House Bill

 

 

Beginning in 1988, IDS deductions are increased for half the annual inflation in excess of 5 percent since the second year an asset is placed in service.

 

Senate Amendment

 

 

The Senate amendment retains present law.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

4. Accounting conventions

 

a. Half-year convention
Present Law

 

 

Under present law, the statutory schedules for personal property reflect a half-year convention that results in a half-year depreciation allowance for the first recovery year, regardless of when property is placed in service during the year.

 

House Bill

 

 

For personal property, both the first and last depreciation allowances for an asset reflect the half-year convention.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment. 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. 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.

 

b. Mid-month convention
Present Law

 

 

Under a mid-month convention, real property (other than low-income housing) placed in service or disposed of at any time during a month is treated as having been placed in service or disposed of in the middle of the month.

 

House Bill

 

 

The House bill extends the use of the mid-month convention to low-income housing and certain other property.

 

Senate Amendment

 

 

The Senate amendment generally follows the House bill and applies the mid-month convention to all residential rental property and nonresidential real property.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

c. Special rule where substantial property placed in service during last three months of the year
Present Law

 

 

No provision.

 

House Bill

 

 

Under the House bill, a mid-month convention is applied to all property if more than 40 percent of all property (other than class 10 property and low-income housing) is placed in service by a taxpayer during the last quarter of the taxable year.

 

Senate Amendment

 

 

The Senate amendment generally follows the House bill.

 

Conference Agreement

 

 

The conference agreement provides that a mid-quarter convention is applied to all property if more than 40 percent of all property is placed in service by a taxpayer 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 the taxpayer is a member of an affiliated group (within the meaning of sec. 1504, without regard to sec. 1504(b)), all such members are treated as one taxpayer 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 in which property is placed in service subject both to present-law ACRS and to the conference agreement, the 40-percent determination is made with respect to all such property. The mid-quarter convention, however, applies only to property subject to the conference agreement.

5. Gain on disposition

 

a. Residential real property
Present Law

 

 

For residential real property held for more than one year, gain realized on a disposition is recaptured only to the extent that accelerated depreciation deductions exceed straight-line deductions. Recapture for low-income housing is phased out after property has been held for a prescribed period.

 

House Bill

 

 

For residential real property that is 30-year property, there is no recapture. For low-income housing, only the excess of IDS deductions over straight line deductions (over the applicable recovery period) is recaptured, and the phaseout of recapture is repealed. For property that ceases to qualify as low-income housing after a sale-leaseback, Treasury is granted regulatory authority to determine the recapture amount by reference to straight-line depreciation over 30 years.

 

Senate Amendment

 

 

For all residential rental property, there is no recapture.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment. Any capital gain is treated under the rules provided in Title III.

 

b. Nonresidential real property
Present Law

 

 

There is no recapture on a disposition if the taxpayer elected to recover the property's cost using the straight-line method. Otherwise, the full amount of depreciation--to extent of gain--is recaptured.

 

House Bill

 

 

Under the House bill, there is no recapture for nonresidential (30-year) real property.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

6. Lessee leasehold improvements

 

Present Law

 

 

A lessee recovers the cost of leasehold improvements over the shorter of the property's ACRS recovery period or the portion of the lease term remaining on the date the property is acquired. Under statutory rules provided for use in determining the term of a lease, in certain cases, a lease term includes periods during which the lease may be renewed pursuant to an option held by the lessee, unless the lessee establishes that it is more probable than not that the lease will not be renewed. In other cases, the statute provides that a lease term is determined by excluding renewal options held by the lessee, unless the facts show with reasonable certainty that the lease will be renewed. These rules also apply in determining the amortization period for lease acquisition costs.

 

House Bill

 

 

Under the House bill, a lessee recovers capital costs under the general rules in every case.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill. Additionally, the statutory rules for determining the term of a lease--the only future relevance of which would be in determining the amortization period for lease acquisition costs--is amended to provide that the term of a lease is determined by including all renewal options as well as any period for which the parties reasonably expect the lease to be renewed.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

7. Expensing

 

Present Law

 

 

Taxpayers can elect to expense up to $5,000 of the cost of personal property that is purchased and used in a trade or business. The $5,000 ceiling is scheduled to increase to $7,500 for taxable years beginning in 1988 and 1989, and to $10,000 for years beginning after 1989. The dollar limitation is subject to apportionment among certain related entities. If expensed property is 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 is recaptured as ordinary income.

 

House Bill

 

 

The House bill provides a $10,000 ceiling for expensing and limits eligibility for expensing to taxpayers whose total investment in tangible personal property for the taxable year is $200,000 or less.

 

Senate Amendment

 

 

The Senate amendment provides a $10,000 ceiling for expensing for taxpayers whose total investment in tangible personal property is $200,000 or less. For other taxpayers, for every dollar of investment in excess of $200,000, the $10,000 ceiling is reduced by one dollar. The amount eligible to be expensed is limited to the taxable income derived from the active trade or business in which the property is used. The difference between expensing and ACRS deductions is recaptured if property is converted to nonbusiness use at any time before the end of the property's recovery period.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment, but provides that the amount eligible to be expensed is limited to the taxable income derived from any trade or business. Married individuals filing separate returns are treated as one taxpayer for purposes of determining the amount which may be expensed and the total amount of investment in tangible personal property.

8. Vintage accounts

 

Present Law

 

 

Under present law, taxpayers generally compute depreciation deductions on an asset-by-asset basis. Under regulations prescribed by the Secretary, there is an election to establish mass asset vintage accounts for assets in the same recovery class and placed in service in the same year. The definition of assets eligible for inclusion in mass asset accounts is limited, primarily because of concern about the mechanics of recapturing investment tax credit.

 

House Bill

 

 

With repeal of the investment tax credit, the House bill authorizes regulations that would expand the definition of eligible property to include all property.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment and clarifies that diverse assets can be included in these accounts.

9. Public utility property

 

Present Law

 

 

The benefits of accelerated depreciation must be normalized.

 

House Bill

 

 

The House bill retains present law and additionally applies special normalization rules to excess deferred tax reserves resulting from the reduction of corporate income tax rates.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

10. Regular investment tax credit

 

Present Law

 

 

General rule

A credit against income tax liability is 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 is based on the ACRS recovery class to which the property is assigned. The 10-percent credit is allowed for eligible property in the 5-year and 10-year classes, and the 15-year public utility property class. Three-year ACRS property is eligible for a six-percent regular credit (even if the taxpayer elects to use a longer recovery period). The maximum amount of a taxpayer's investment in used property that is eligible for the regular investment credit is $125,000 per year; the limitation on used property is scheduled to increase to $150,000 for taxable years beginning after 1987.

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

Unused credits for a taxable year can 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 is eligible for the regular investment credit only if the tax benefits of the credit are 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 is denied for public utility property if the regulatory commission's treatment of the credit results 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.

 

House Bill

 

 

The House bill repeals the regular investment tax credit.

 

Senate Amendment

 

 

The Senate amendment follows the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendments.

11. Finance leases

 

Present Law

 

 

The Tax Equity and Fiscal Responsibility Act of 1982 provided rules (finance leasing rules) that liberalized the leasing rules with respect to certain property. Under the finance leasing rules, the fact that (1) the lessee has 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 can be used only by the lessee is not taken into account in determining whether the agreement is a lease.

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 is 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 which 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.

 

House Bill

 

 

The House bill repeals the finance leasing rules.

 

Senate Amendment

 

 

The Senate amendment follows the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

12. Effective dates

 

a. In general
House Bill

 

 

The depreciation provisions apply to property placed in service after December 31, 1985. The provision that repeals the regular investment tax credit is effective for property placed in service after December 31, 1985. Repeal of the finance leasing rules is effective for agreements entered into after December 31, 1985.

 

Senate Amendment

 

 

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 agreements entered into after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment except that the conference agreement also provides an election to apply the modified ACRS to certain property that is placed in service after July 31, 1986. 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.

 

b. Transitional rules
House Bill

 

 

The House bill 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 September 25, 1985, and in other transitional situations. Except in the case of certain qualified waste disposal facilities, the application of the transitional rules is conditioned on property being placed in service by a prescribed date.

 

Senate Amendment

 

 

The Senate amendment generally follows the House bill, except that (1) the binding contract date is March 1, 1986, for depreciation and December 31, 1985, for the investment tax credit (2) certain satellites are excepted from the placed-in-service requirement, and (3) additional transitional relief is provided.

 

Conference Agreement

 

 

In general

The conference agreement 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. Except 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.

The conferees are aware that 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, (December 31, 1985, 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. 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 prescribed date.

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.

Anti-churning rules

The conference agreement expands the scope of the present 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 present law. The conference agreement retains the anti-churning rules applicable to property that was originally placed in service before January 1, 1981. The anti-churning rules will not apply to property that is placed in service before January 1, 1987, for personal use and converted to business use on or after January 1, 1987.

Binding contracts

The conference agreement does 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 bill does not apply to the property in the hands of the transferee, as long as the property was not placed in service by the transferee 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.

The conferees wish to clarify the general binding contract rule with respect to investment credit and ACRS allowances. 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 conferees also wish to clarify that 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 conference agreement does not apply 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 all of the normal and customary components that are purchased from others and installed without significant modification (e.g., light fixtures).

Equipped buildings

Under the conference agreement, 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 bill's application.1 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 is treated separately for purposes of determining whether the item qualifies for transitional relief.

Under the equipped building rule, the conference agreement 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 bill would not apply to these appurtenances since the 50-percent test is met as to the equipped building.

Plant facilities

The conference agreement 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 conferees wish to clarify the application of the plant facility rule 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.

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 committee intends that the special rule for sale-leasebacks apply to any property that qualifies for transitional relief under the bill 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 bill. 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 bill 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 bill. 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 bill 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). The conferees wish to clarify that 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 conference agreement 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 conference agreement 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).

The committee is informed that 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 committee 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 conference agreement 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 conference agreement 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,2 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 conference agreement also provides other special transitional rules of limited application. The conference agreement 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 rules, (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 excepted from the 35-percent reduction of the investment credit and the full-basis adjustment (described below).

 

Master plans

 

Under the special rule for master plans for integrated projects, the conferees intend that, (1) in the case of multi-step plans described in sec. 203(a)(5)(E) of the bill, 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. 203(a)(5)(E) of the bill, 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. The conferees understand that each of the projects described in this rule had a master plan in existence on March 1, 1986, and does not intend the existence of such a plan to be a separate requirement for transitional relief for property comprising these projects.

 

Satellites

 

The conference agreement 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.

 

Commercial passenger airliners

 

The conference agreement 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), 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.

 

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 conference agreement, the investment tax credit allowable for carryovers is reduced by 35 percent. The reduction in investment tax credit carryovers is phased in with the corporate rate reduction. 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 calendar year taxable year, the reduction for 1987 is 17.5 percent. The investment tax credit earned on transition property is reduced in the same manner as carryovers.

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. Thus, for transition property that is 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 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.

Estimated tax payments

The conferees are aware that 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 conferees intend that no penalties be imposed under section 6655 on underpayments of estimated tax, but only to the extent that (1) the underpayment of an installment results from a taxpayer taking into account investment tax credits on property placed in service after December 31, 1985, and before the date of enactment of the Act, and (2) the taxpayer actually pays such underpayment within 30 days after the enactment of the Act.

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 engaged in the manufacture and production of steel. 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. If a taxpayer elected to take a reduced rate of credit on a QPE basis in lieu of the 50-percent basis adjustment of present 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). 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.

 

B. Limitation on General Business Credit

 

 

Present Law

 

 

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

 

House Bill

 

 

The House bill reduces the 85-percent limitation on the general business credit to 75 percent, effective for taxable years that begin after December 31, 1985.

 

Senate Amendment

 

 

The Senate amendment follows the House bill, except the provision is effective for taxable years that begin after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement follows the House bill.

 

C. Research and Development

 

 

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

 

Present Law

 

 

a. Expiration date

Under present law, the incremental research tax credit does not apply to expenses paid or incurred after December 31, 1985 (Code sec. 30).

b. Rate

The taxpayer may claim a 25-percent tax credit for the excess of (1) qualified research expenditures for the taxable year incurred in carrying on a business over (2) the average amount of the taxpayer's yearly qualified research expenditures in the preceding three taxable years.

c. Research definition

The credit provision adopts the definition of research used for purposes of the expensing provision (sec. 174), but subject to three exclusions: (1) research conducted outside the United States; (2) research in the social sciences or humanities; and (3) research to the extent funded, through grant, contract, or otherwise, by another person or governmental entity.

d. Qualified expenditures

Research expenditures eligible for the credit consist of (a) in-house expenditures for research wages and supplies; (b) rental or other payments for research use of laboratory equipment, computers, or other personal property; (c) 65 percent of amounts paid by the taxpayer for contract research conducted on the taxpayer's behalf; and (d) 65 percent of a corporate taxpayer's expenditures (including grants or contributions) for basic research performed by universities or certain scientific research organizations.

e. University basic research

Expenditures eligible for the 25-percent incremental research credit include 65 percent of a corporate taxpayer's expenditures (including grants or contributions) for basic research performed by universities or certain scientific research organizations.

f. Credit use limitation

The research credit is not subject to the general limitation on use of business credits (under present law, 85 percent of tax liability over $25,000).

 

House Bill

 

 

a. Expiration date

The House bill extends the research tax credit for an additional three years (i.e., for expenditures through December 31, 1988), with modifications.

b. Rate

The rate of the credit is reduced from 25 percent to 20 percent.

c. Research definition

The committee report on the House bill clarifies that the credit does not apply to expenditures for certain nonresearch activities (activities occurring after the beginning of production; adaptation of an existing product; and studies and surveys). In addition, the report modifies the definition of credit-eligible research (effective for taxable years beginning after 1985) to target the credit to research undertaken to discover information that is technological in nature and that pertains to functional aspects of products.

d. Qualified expenditures

The House bill generally repeals the present-law provision under which rental or other payments for the right to use personal property in conducting qualified research are eligible for the credit. However, under regulations prescribed by the Treasury, payments to persons other than the taxpayer for the right to use (time-sharing) a computer in the conduct of a qualified research will remain eligible for the incremental research credit to the extent allowable under present law.

e. University basic research credit

Under the House bill, a 20-percent tax credit applies to the excess of (1) 100 percent of corporate cash expenditures (including grants or contributions) paid 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.1

The amount of credit-eligible basic research expenditures to which the new university basic research credit applies does not enter into the computation of the incremental credit. The remaining amount of credit-eligible basic research expenditures--i.e., the amount to which the new credit does not apply--enters into the incremental credit computation (and in subsequent years enters into the base period amounts for purposes of computing the incremental credit).

f. Credit use limitation

The House bill makes the credit subject to the general limitation on business credits, as amended by the bill (seeII. B., above).

g. Effective date

These provisions are effective for taxable years beginning after December 31, 1985.

 

Senate Amendment

 

 

a. Expiration date

The Senate amendment extends the research tax credit for an additional four years (i.e., for expenditures through December 31, 1989), with modifications.

b. Rate

No provision (i.e., the rate of the incremental credit remains at 25 percent).

c. Research definition

The Senate amendment adopts the same general approach as under the House bill, except that the principal definitional rules (effective for taxable years beginning after 1985) are set forth in statutory language. Thus, the credit is targeted to research undertaken to discover information that is technological in nature and that pertains to functional aspects of products. Also, the Senate amendment expands the present-law statutory list of credit exclusions to include expenditures for the types of nonresearch activities excluded under the language of the House committee report.

d. Qualified expenditures

No provision (i.e., rental or other payments for research use of laboratory equipment, computers, or other personal property remain eligible for the incremental credit).

e. University basic research credit

The Senate amendment is the same as the House bill.

f. Credit use limitation

The Senate amendment is the same as the House bill.

g. Effective date

The provision extending the credit applies to taxable years ending after December 31, 1985. The provisions relating to the research definition, university basic research credit, and the credit use limitation apply for taxable years beginning after December 31, 1985.

 

Conference Agreement

 

 

a. Expiration date

The conference agreement follows the House bill; i.e., the research credit is extended for an additional three years, with modifications.

b. Rate

The conference agreement follows the House bill; i.e., the rate of the research credit is reduced to 20 percent.

c. Research definition

The conference agreement generally follows the approach of the House bill and the Senate amendment, with statutory provisions as to the definition of qualified research for purposes of the credit, as follows.

 

In general

 

As under present law, the conference agreement 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)).2 The term research includes basic research.

Under the conference agreement, research satisfying the section 174 expensing definition is eligible for the credit only if the re. search 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 conference agreement 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 science3--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 outset. 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 characteristics) 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 conference agreement, research is treated as conducted for a functional purpose only if it relates to a new or improved function, performance, reliability, or quality. (Activities undertaken to assure achievement of the intended function, performance, etc. of the business component after the beginning of commercial production of the component do not constitute qualified experimentation.) The conference agreement also provides that research relating to style, taste, cosmetic, or seasonal design factors is not 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 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 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 conference agreement, 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 robotics and software for the robotics for use in operating 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 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 conferees intend 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 conferees intend that these regulations are to apply as of the effective date of the new specific 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 conference agreement 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 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 conferees expect and have been assured by the Treasury Department that guidance to this effect is to be promulgated on an expedited basis.

 

Excluded activities

 

The conference agreement 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-research activities

 

The conference agreement provides that activities with respect to a business component after the beginning of commercial production of the component cannot qualify as qualified research. 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.4 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, would be eligible for the credit.

 

Adaptation

 

The conference agreement provides that adaptation of an existing business component to a particular requirement or customer's 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 an item 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, etc.

 

The conference agreement 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 and development (including advertising or promotions), routine data collections, or routine or ordinary testing or inspection of materials or business items 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 conference agreement 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 a different 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 present law, the conference agreement 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 conference agreement 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.

d. Qualified expenditures

The conference agreement follows the House bill.

e. University basic research credit

The conference agreement is the same as the House bill and the Senate amendment, except that the university basic research credit provisions are effective for taxable years beginning after December 31, 1986.

f. Credit use limitation

The conference agreement follows the House bill and the Senate amendment.

g. Effective date

The extension of the credit is effective for taxable years ending after December 31, 1985. The credit will not apply to amounts paid or incurred after December 31, 1988. The modifications to the credit made by the conference agreement are effective for taxable years beginning after December 31, 1985,5 except that the modifications relating to the university basic research credit are effective for taxable years beginning after December 31, 1986.

2. Augmented charitable deduction for certain donations of scientific equipment

 

Present Law

 

 

Under a special rule, corporations are allowed an augmented charitable deduction for donations of newly manufactured scientific equipment to a college or university for research use in the physical or biological sciences (sec. 170(e)(4)).

 

House Bill

 

 

The House bill expands the category of eligible donees under the special rule in section 170(e)(4) to include certain tax-exempt scientific research organizations, effective for taxable years beginning after December 31, 1985.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the House bill.

3. Tax credit for orphan drug clinical testing

 

Present Law

 

 

A 50-percent tax credit is allowed for expenditures incurred in clinical testing of certain drugs for rare diseases or conditions (sec. 28). Under present law, the credit will not apply to amounts paid or incurred after December 31, 1987.

 

House Bill

 

 

The House bill extends the tax credit for clinical testing of orphan drugs for one additional year (i.e., through December 31, 1988).

 

Senate Amendment

 

 

The Senate amendment makes permanent the orphan drug credit.

 

Conference Agreement

 

 

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

 

D. Rapid Amortization Provisions

 

 

1. Trademark and trade name expenditures

 

Present Law

 

 

Taxpayers may 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 is part of the consideration for an existing trademark or trade name.

 

House Bill

 

 

The House bill repeals the election. Trademark and trade name expenditures are therefore generally capitalized and recovered on a disposition of the asset.

The provision is generally effective for expenditures paid or incurred on or after January 1, 1986.

However, present law applies to expenditures incurred: (1) pursuant to a written contract that was binding as of September 25, 1985; or (2) with respect to development, protection, expansion, registration or defense commenced as of September 25, 1985, 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.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill. The Senate provision is generally effective for expenditures paid or incurred after December 31, 1986. However, present 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 commenced as of March 1, 1986, if the lesser of $1 million or 5 percent of cost has been incurred or committed by the date, provided in each case the trademark or trade name is placed in service before January 1, 1988.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

2. Pollution control facilities

 

Present Law

 

 

Taxpayers may elect to amortize over a 60-month period the cost of a qualifying certified pollution control facility used in connection with a plant that was in operation before 1976. To the extent that a pollution control facility has a useful life in excess of 15 years, a portion of the facility's cost is not eligible for 60-month amortization, but must be recovered through depreciation.

 

House Bill

 

 

The House bill repeals the election. Expenditures for pollution control facilities would therefore be recovered in accordance with the applicable depreciation schedules. The repeal is generally effective for expenditures paid or incurred on or after January 1, 1986.

However, present law applies to expenditures incurred: (1) pursuant to a written contract that was binding as of September 25, 1985; or (2) with respect to facilities, construction of which is commenced as of September 25, 1985, if the lesser of $1 million or 5 percent of cost has been incurred or committed by that date; provided in each case the facility is placed in service before January 1, 1988.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

3. Qualified railroad grading and tunnel bores

 

Present Law

 

 

Domestic railroad common carriers may elect to amortize the cost of qualified railroad grading and tunnel bores over a 50 year period. "Qualified railroad grading and tunnel bores" include 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.

 

House Bill

 

 

Under the House bill, the election is repealed. Expenditures for railroad grading and tunnel bores would therefore be capitalized and recovered on disposition of the asset.

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, 1986. However, present law continues to apply to expenditures incurred: (1) pursuant to a written contract that was binding as of September 25, 1985; or (2) with respect to construction, reconstruction, alteration, improvement, replacement or restoration commenced as of September 25, 1985, 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.

 

Senate Amendment

 

 

The Senate amendment retains the present law election. However, the treatment provided for a particular railroad disaster is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill with respect to the election. No amortization or depreciation deduction for railroad grading and tunnel bores will be allowed.

The repeal of the election generally applies to expenses paid or incurred on or after January 1, 1987. However, present 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.

The conference agreement follows the House bill and the Senate amendment with respect to the particular railroad disaster.

4. Bus operating authorities; freight forwarders

 

Present Law

 

 

Generally, no deduction is allowed for a decline in value of property absent a sale or other disposition. The courts have denied a loss deduction where the value of an operating permit or license decreased as the result of legislation that expanded the number of permits or licenses issued, on the grounds that the permit or license continued to have value as a right to carry on a business.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The Senate amendment allows taxpayers an ordinary deduction ratably over a 60-month period for the adjusted bases of bus-operating authorities held on November 19, 1982, (the date of enactment of the Bus Regulatory Reform Act) or acquired after that date under a written contract that was binding on that date.

The provision is effective retroactively for taxable years ending after November 18, 1982.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment. In addition, it provides a similar rule for freight forwarders, contingent on deregulation.

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

 

Present Law

 

 

Taxpayers may elect to deduct up to $35,000 of qualifying expenses for the removal of architectural and transportation barriers to the handicapped and elderly in the year paid or incurred, instead of capitalizing them. The election is not available in taxable years beginning after December 31, 1985.

 

House Bill

 

 

The election to deduct qualifying expenditures is extended for two years to taxable years beginning before January 1, 1988.

 

Senate Amendment

 

 

The election to deduct qualifying expenditures is extended permanently, effective for taxable years beginning after December 31, 1985.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

E. Real Estate Provisions

 

 

1. Tax credit for rehabilitation expenditures

 

Present Law

 

 

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

Qualified rehabilitation expenditures are eligible for the credit only if incurred in connection with a substantial rehabilitation that satisfies an external-walls requirement. The test of substantial rehabilitation generally is met if the qualified expenditures during a 24-month measuring period exceed 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 is extended to 60 months).

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

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

 

House Bill

 

 

The House bill replaces the existing three-tier 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. Expenditures incurred by a lessee do not qualify for the credit unless the remaining lease term on the date the rehabilitation is completed is at least as long as the applicable recovery period under the general depreciation rules (generally, 30 years; 20 years for low-income housing).

The external-walls requirement will be applied by reference to a single test: whether at least 75 percent of existing external walls (including 50 percent as external walls), as well as 75 percent of a building's internal structural framework, remain in place. Further, this test does not apply to certified historic structures.

The provisions are effective for property placed in service after December 31, 1985.

 

Senate Amendment

 

 

The Senate amendment follows the House bill, except the applicable recovery periods used for purposes of the rule for lessees are 27.5 years for residential property and 31.5 years for nonresidential property.

The provisions are effective for property placed in service after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

2. Five-year amortization of expenditures to rehabilitate low-income housing

 

Present Law

 

 

Taxpayers generally may elect to amortize over a 60-month period certain qualifying expenditures for improvements to low-income rental housing with a useful life of at least five years. In general, expenditures for any dwelling unit are not eligible to the extent that they aggregate more than $20,000 (in certain cases, $40,000). This election generally is scheduled to expire for expenditures incurred after 1986.

 

House Bill

 

 

The House bill extends the election and generally replaces the $20,000 and $40,000 aggregate expenditure limits with a single $30,000 limit. This provision is effective for expenditures paid or incurred after 19S5, except that the $40,000 limit continues for certain expenses under a transitional rule.

 

Senate Amendment

 

 

No provision. (However, see tax credit for low-income rental housing, II.E.3., below.)

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment. (However, see tax credit for low-income rental housing, II.E.3., below.)

3. Tax credit for low-income rental housing

 

Present Law

 

 

No low-income rental housing tax credit is provided under present law, but other tax incentives for low-income housing are available.

 

House Bill

 

 

No provision, but certain other tax incentives are retained for low-income housing.

 

Senate Amendment

 

 

In general

The Senate amendment provides a new tax credit that may be claimed by owners of residential rental projects providing low-income housing, in lieu of certain other tax incentives.

The credit may be claimed annually for a period of 10 years. The credit rate is set so that the annualized credit amounts have a present value of 60 percent or 30 percent of the basis attributable to qualifying low-income units, depending on the income of the tenants qualifying the unit for the credit.

For projects on which construction commences prior to 1988, the annual credit rate is 8 percent (80 percent over 10 years) for units occupied by individuals with incomes of 50 percent or less of area median (as adjusted for family size) and 4 percent (40 percent over 10 years) for a maximum of 30 percent of the units occupied by individuals with incomes of between 50 percent and 70 percent of area median. For projects on which construction begins after 1987, Treasury is directed to adjust the credit rates to maintain the present values of the annualized credit amounts of 60 percent and 30 percent.

Newly constructed buildings and newly acquired existing structures that are substantially rehabilitated are eligible for the credit. Substantial rehabilitation is defined as rehabilitation expenditures made over a two-year period (or five-year period in the case of rehabilitation conducted subject to a comprehensive plan) of at least 22.5 percent of the acquisition cost of the project (other than the cost of land). The cost of rehabilitation and acquisition allocable to low-income units is eligible for the credit.

Comparable to the treatment of multifamily rental housing bonds in the Senate amendment, there is no volume limitation or "trade-in" requirement for low-income housing credits.

Definition of low-income housing

Low-income housing eligible for the credit is defined as follows:

 

(1) At least 20 percent of the housing units in each project is occupied by individuals having incomes of less than 50 percent of the area median income;

(2) Income determinations are made with adjustments for family size;

(3) Qualification as a low-income tenant is determined on a continuing basis; and

(4) The gross rent paid by families in units qualifying for the credit may not exceed 30 percent of the applicable qualifying income for a family of its size.

 

Restriction on tax-exempt financing

A project is not eligible for the credit if any part of the project is financed with obligations on which the interest is exempt from tax under Code section 103. This restriction applies as long as any of those obligations remain outstanding.

A limited exception is made for certain existing federally assisted projects on which tax-exempt bonds remain outstanding.

Federally assisted housing

Unless otherwise specifically provided, projects receiving Federal grants, loans, or rental assistance are not eligible for the credit. (A Federal guarantee does not constitute Federal assistance that would preclude a project from credit eligibility.) Three exceptions are provided:

 

(1) An exception to the Federal assistance restriction is provided for new construction or substantial rehabilitation or properties receiving assistance under the Urban Development Block Grant program, the Community Development Block Grant program, and Housing Development or Rental Rehabilitation programs. Projects receiving assistance under these programs must exclude such assistance from the basis on which the low-income credit is allowable.

(2) A second exception is provided for new construction or substantial rehabilitation of properties receiving assistance under the HUD section 8 moderate rehabilitation program or the FMHA section 515 program. Projects receiving assistance under these programs, however, only are eligible for credits on units occupied by tenants with incomes of 50 percent or less of area median. Section 8 payments may not exceed certain specified amounts on all property eligible for the credit.

(3) A third exception to the Federal assistance restriction is provided for newly acquired existing property receiving assistance under HUD's section 8, section 221(d)(3) or, section 236 programs, or FMHA's section 515 program. Such property must have 50 percent or more of the units occupied by tenants with incomes of 50 percent or less of area median income.

 

All residential rental units in such projects are eligible to be included in the basis on which the credit is allowed. The credit rate is one-half the rate otherwise applicable to units occupied by tenants with incomes of 50 percent or less of area median income.

Generally, a project eligible for this exception may not be placed in service within 15 years of its having last been placed in service, and section 8 payments may not exceed certain specified amounts on property eligible for the credit.

Existing property receiving assistance under HUD section 8, section 221(d)(3), section 236, or FMHA section 515 and described in this exception is also excepted from the substantial rehabilitation requirement. (Generally, existing property (and the acquisition cost of existing property) only is eligible for the credit if substantial rehabilitation is performed after acquisition.)

At-risk limitation

The amount of the credit is subject to an at-risk limitation similar to the investment tax credit at-risk rules in the case of nonrecourse refinancing.

An exception is provided for certain lenders related to the buyer of the low income housing property. Another exception is provided for financing (including seller financing) not in excess of 60 percent of the basis of the property that is lent by charitable and social welfare organizations whose exempt purpose includes fostering low income housing. 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 (described below).

Compliance requirements

Projects are required to comply continuously with the low-income occupancy requirement for at least 15 years.

Failure to meet the minimum low-income occupancy requirement during the 15-year period triggers a recapture of the credit. The credit is recaptured fully for violations during the first ten years, and recaptured partially for violations in years 11-15.

Failure to meet the low-income occupancy requirement upon which the maximum credit is based (while still satisfying the minimum low-income occupancy requirement) results in a reduction of the credit for the year of the violation.

Transferability

Credits may be transferred to new purchasers of a project during the period for which the property is eligible to receive the credit, with the new purchaser "stepping into the shoes" of the seller, both as to credit percentage, basis, and liability for compliance and recapture.

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 general business tax credits in any year. Unused credits for any taxable year may be carried back to each of the three preceding taxable years and then carried forward to each of the 15 following taxable years.

For purposes of the rules in the amendment limiting passive loss deductions, the credit (but not losses from the project) is treated as arising from rental real estate activities in which the taxpayer actively participates, and is subject to the limitations imposed on tax credits from such activities.

The basis with respect to which credits are allowed is reduced to reflect any rehabilitation credit for which the project is eligible.

The basis of a project for purposes of depreciation is not reduced by the amount of low-income housing credits claimed.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment, with certain substantive modifications, including (1) changes in the credit amounts, (2) redefinition of qualifying expenditures with respect to which the credit may be claimed (including the allowance of tax-exempt bond financed expenditures and the elimination of the substantial rehabilitation requirement), (3) the provision of an alternative set-aside requirement (the percentage of low-income units and the qualifying income levels of low-income tenants), (4) the addition of a State volume limitation on the number of new credits issued annually, and (5) modifications to the recapture rules.

Credit amount

The conference agreement provides two separate credit amounts: (1) a 70-percent present value credit for qualified new construction and rehabilitation expenditures 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, certain rehabilitation expenditures incurred in connection with the acquisition of an existing building, 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.

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 to reflect the present values of 70 percent and 30 percent at the time the building is placed in service. The 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 statutory 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 to be computed as of the last day of the first year. In a project consisting of two or more buildings placed in service in different months, a separate credit percentage may apply to each building.

The credit percentage for rehabilitation expenditures not claimed in connection with the acquisition of an existing building is determined when rehabilitation is completed and the property is placed in service, but no later than the end of the 24-month period for which such expenditures are aggregated. These rehabilitation expenditures are treated as a separate new building for purposes of the credit. The determination of whether the 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 (also, see the discussion of qualified basis, below, for a description of federally subsidized expenditures).

Qualified basis

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 units, whether or not presently occupied.

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 through a purchase and the cost of rehabilitation, if any, to such buildings incurred before the close of the first taxable year of the credit period. Only the adjusted basis of the building may be included in eligible basis. The adjusted basis is determined by taking into account the adjustments described in section 1016 (other than paragraphs (2) and (3) of sec. 1016(a), relating to depreciation deductions), including, for example, the basis adjustment provided in section 48(g) for any rehabilitation credits allowed under section 38. 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 are treated as placed in service at the close of the 24-month aggregation period. In the case of rehabilitation expenditures claimed in connection with the acquisition of a building, the capital expenditures incurred through the end of the first year of the credit period may be included in eligible basis.

Residential rental property for purposes of the low-income housing credit has the same meaning as residential rental property within Code section 103. Thus, residential rental property includes residential rental units, facilities for use by the tenants, and other facilities reasonably required by the project.

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. 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. 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. Eligible basis may include the cost of amenities, including personal property, 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).)

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 may be included in eligible basis. The conferees intend that the costs of such a mixed-use facility may 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).)

The qualified basis attributable to rehabilitation expenditures not claimed in connection with the acquisition of an existing building must equal at least $2,000 per low-income unit in order for rehabilitation expenditures to qualify for the credit. 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 rehabilitation expenditures incurred before the close of the two-year period beginning on the date rehabilitation is commenced by the taxpayer. Where rehabilitation is limited to a group of units, Treasury may provide regulations treating a group of units as a separate new building.

The cost of acquisition of an existing building may be included in eligible basis and any rehabilitation expenditures to such buildings incurred before the close of the first year of the credit period may also be included in eligible basis, without a minimum rehabilitation requirement. These costs may be included in eligible basis 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. The Treasury Department may waive this 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 in order to avert an assignment of the mortgage secured by property in the project to HUD or the Farmers Home Administration, to avert a claim against a Federal mortgage insurance fund, or other similar circumstances relating to financial distress of these properties as prescribed by the Treasury Department. A transfer of ownership of a building where the basis of the property in the hands of the new owner is determined in whole or in part by the adjusted basis of the previous owner, is considered not to have been newly placed in service for purposes of the 10-year requirement (also, see the discussion of transferability, below). Any other transfer will begin a new 10-year period.

Eligible basis may not include in any taxable year the amount of any Federal grant, regardless of whether such grants are 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 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 the eligible basis attributable 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 a Federal grant. 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.

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

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. 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 and must receive an allocation of credit authority as described below (see the discussion on the State low-income housing credit authority limitation). Unlike credits claimed on the initial qualified basis, credits claimed on additions to qualified basis are allowable annually for the remainder of the required 15-year compliance period, regardless of the year such additional qualified basis is determined. The additional 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.)

Minimum set-aside requirement for low-income individuals

Residential rental projects providing low-income housing qualify for the credit only if (1) 20 percent or more of the aggregate residential rental units in a 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 a project are occupied by individuals with incomes of 60 percent or less of area median income, as adjusted for family size.6

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

The owner must irrevocably elect the minimum set-aside requirement at the time the project is placed in service. The set-aside requirement must be met within 12 months of the date a building (or rehabilitated property) is placed in service, and complied with continuously throughout each year after first meeting the requirement for a period of 15 years beginning on 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 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 and comply with this expanded requirement continuously after first meeting the requirements for a period of 15 years beginning on 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.7 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.

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, therefore, result 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), however, that tenant may no longer be counted in determining whether the project satisfies the set-aside requirement. (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.)

A special rule is provided for projects that elect to satisfy a stricter set-aside requirement and that significantly restrict the rents on the low-income units relative to the other residential units in the building. 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) 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, and (b) if the project ceases to comply with the set-aside 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.

As stated above, the conference agreement 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. The conferees are 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 Secretary 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.

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.

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 for a family of its size. Gross rent is to include 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 Secretary, after taking into consideration the procedures 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, are not included in gross rent.

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 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, lifecare facility, retirement home, or trailer park may be a qualified low-income project.

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. The residential units in such a building may share bathrooms and have a common dining area.

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 requirements.

Units in addition to those meeting the minimum set-aside requirement on which a credit is allowable also must continuously comply with the income requirement.

The conference agreement 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 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.

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 for all prior years.

Generally, any change in ownership of a building subject to the compliance period is also a recapture event. An exception is provided if the seller posts a bond to the Secretary in an amount satisfactory to the 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.

In the year of a recapture event, no credit is allowable for the building. 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 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. 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. 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.

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. The conferees do not intend, however, that tenants be evicted to return a project to compliance. Rather, the conferees intend 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.

A reduction in qualified basis by reason of a casualty loss shall not be 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 not financed with the proceeds of tax-exempt bonds, which received an allocation pursuant to the new private activity bond volume limitation, 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. The aggregate amount of such credits allocated within the State is limited by the State annual low-income credit authority limitation. Credit allocations are counted against a State's annual credit authority limitation for the calendar year in which the credits are allocated. Credits may not be allocated before the calendar year in which the building is placed in service. The credit amount allocated to a building applies for the year the allocation is made and 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 a State.

 

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 organizations 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, 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 shall be 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.

The conferees intend that any allocation procedure established by the governor or State legislature give balanced consideration to the low-income housing needs of the entire State.

The conferees wish to clarify that gubernatorial proclamations issued before the date of enactment of the conference agreement 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.

The conferees intend 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 conference agreement 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 conference agreement 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 cities 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), but they may not so allocate any amounts specially allocated to the 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 city is treated as a governor, and a city council is treated as a State legislature.

Constitutional home rule cities 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 cities 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 nonprofit 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 authorize 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 allocated to it for the calendar year which includes the last day of the first year of the credit period. Authority must be received 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. The conferees intend 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 limitation 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). (Also, see 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 granted 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 the allocation.

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.

Credit agencies are permitted to assign future credit authority for years before the sunset date to buildings not yet placed in service by inducement resolutions 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 conference agreement 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.

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

The amount of the credit is subject to an at-risk limitation similar to the investment tax credit at-risk rules in the case of nonrecourse financing. An exception is provided for lenders related to the buyer of the low-income housing property.

Another exception is provided for financing (including seller financing) not in excess of 60 percent of the basis of the property that is lent by charitable and social welfare 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.

For purposes of the rules in the conference agreement 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, other than property grandfathered under the depreciation rules, and before January 1, 1990. A building placed in service after 1989 is eligible for the credit if expenditures of 10 percent or more of the reasonably expected cost of the building is incurred before January 1, 1989, and the building is placed in service before January 1, 1991, Credit authority for such property placed in service in 1990 may be carried over from the 1989 volume allocation for the credit agency.

 

F. Merchant Marine Capital Construction Fund

 

 

Present Law

 

 

Under the Merchant Marine Act of 1936, as amended, taxpayers are entitled to deduct certain amounts deposited in a capital construction fund. Earnings from the investment or reinvestment of amounts in a capital construction fund are excluded from income. A qualified withdrawal, one which is made for the acquisition, construction or repair of a qualified vessel, does not generate income to the taxpayer.

A nonqualified withdrawal generates income to the taxpayer, subject to interest payable from the time the amount withdrawn was reported.

 

House Bill

 

 

The rules providing special tax treatment for capital construction funds are retained, but modified to coordinate the application of the Internal Revenue Code with the Merchant Marine Act: (1) the maximum rate of tax is imposed on nonqualified withdrawals; (2) the Secretaries of Transportation and Commerce are required to make reports to the Secretary of Treasury regarding monies in funds; (3) a taxpayer whose fund balance exceeds the amount appropriate for the vessel construction program that was determined when the fund was established must develop appropriate program objectives within three years or treat the excess as a nonqualified withdrawal; (4) a 10-year limit is imposed on the amount of time monies can remain in a fund; monies not withdrawn after a ten-year period are treated as nonqualified withdrawals according to a schedule, beginning with 20 percent in the 11th year and ending with 100 percent in the 15th year.

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

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the House bill, except that a 25-year time limit is imposed on the amount of time monies can remain in a fund without being withdrawn for a qualified purpose. The amendments are effective for taxable years beginning after December 31, 1986.

 

TITLE III. CAPITAL GAINS AND LOSSES

 

 

A. Individual Capital Gains

 

 

Present Law

 

 

An individual may deduct from gross income 60 percent of net capital gain (the excess of net long-term capital gain over any net short-term capital loss). Since the maximum regular individual tax rate is 50 percent, the deduction means that net capital gain is taxed at a maximum rate of 20 percent.

Capital losses are allowed in full against capital gain. Capital losses are also allowed against up to $3,000 of ordinary income; however, only one half of the excess of net long-term capital loss over net short-term capital gain is allowed for this purpose. Unused capital losses may be carried forward.

 

House Bill

 

 

The House bill provides that 42 percent (50 percent in 1986) of an individual's net capital gain is deductible. Since the highest regular rate for the individuals under the House bill is 38 percent, the highest rate applicable to such net capital gain is 22.04 percent.

The provision applies to taxable years beginning after December 31, 1985.

 

Senate Amendment

 

 

The Senate amendment repeals the capital gains deduction.1 The maximum rate on long-term capital gains of individuals (including all long-term capital gains recognized at any time during calendar year 1987) will not exceed the maximum individual rates that become fully effective on January 1, 1988.

These provisions do not change the character of gain as ordinary or capital, or as long- or short-term capital gain.

Capital losses are allowed in full against capital gain as under present 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 present law, capital losses may be carried forward.

The provision applies to taxable years beginning after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment with a conforming change reflecting the change in the maximum individual rates under the conference agreement. The maximum rate on long-term capital gain in 1987 is 28 percent.

The current statutory structure for capital gains is retained in the Code to facilitate reinstatement of a capital gains rate differential if there is a future tax rate increase.

 

B. Corporate Capital Gains

 

 

Present Law

 

 

An alternative tax rate of 28 percent applies to a corporation's net capital gain if the tax would be lower than the tax using the regular graduated rates.

Capital losses are allowed in full against capital gains but are not allowed against ordinary income. Capital losses may generally be carried back three years and forward five years.

 

House Bill

 

 

The House bill makes the alternative tax inapplicable to taxable years for which the new corporate tax rates are fully effective (i.e., taxable years beginning on or after July 1, 1986). Thus, corporate net capital gain for such years is taxed at regular corporate rates (i.e., generally a maximum of 36 percent under the House bill). For taxable years before the new rates are fully effective, the tax rate on gain property taken into account under the taxpayer's method of accounting after December 31, 1985 is 36 percent.

There is no change in the capital loss provisions.

The change in the alternative tax for corporate capital gain applies to gain properly taken into account under the taxpayer's method of accounting on or after January 1, 1986, unless pursuant to a sale that was made on or before September 25, 1985, or that was pursuant to a written binding contract in effect on that date.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement generally follows the House bill with conforming changes reflecting the change in the new top corporate rate under the conference agreement (34 percent rather than 36 percent). The provisions are effective for gain properly taken into account under the taxpayer's method of accounting on or after January 1, 1987, without regard to whether the gain is pursuant to a written binding contract in effect at any earlier time.

The current statutory structure for capital gains is retained in the Code to facilitate reinstatement of a capital gains rate differential if there is a future tax rate increase.

 

C. Incentive Stock Options

 

 

Present Law

 

 

An employee is not taxed on the exercise of an incentive stock option and is entitled to capital gains treatment when the stock is sold. No deduction is taken by the employee when the option is granted or exercised.

In order for options to qualify as incentive stock options, among other requirements, the options must be exercisable in the order they are granted. Also, the employer may not in any one year grant the employee such options to acquire stock with a value (at the time the option is granted) of more than $100,000 (increased by certain carryover amounts).

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The Senate amendment repeals the requirement that the incentive stock options be exercisable in the order granted.

The amendment also modifies the $100,000 limitation so that an employer may not, in the aggregate, grant an employee incentive stock options that are first exercisable during any one calendar year to the extent the aggregate fair market value of the stock (determined at the time the options are granted) exceeds $100,000.

The provisions applies to options issued after 1986.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

D. Straddles

 

 

1. Mark-to-market system

 

Present Law

 

 

Section 1256 contracts (regulated futures contracts, certain listed options, and forward contracts traded in the interbank market) are marked to market at the close of the taxable year, with gain taxed as 60 percent long-term and 40 percent short-term for a maximum tax rate of 32 percent. The mark-to-market rules do not generally apply to hedging transactions, except in the case of certain syndicates.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The Senate amendment provides that gains under the mark-to-market regime are taxed as 100 percent short-term capital gains, for a maximum tax rate equal to the top individual rate.

The provision applies to positions established after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement does not include the Senate amendment. Thus, the 60/40 tax regime for section 1256 contracts is retained.

2. Year-end rule for qualified covered calls

 

Present Law

 

 

A loss-deferral rule applies to a straddle consisting of stock offset by an option, subject to an exception for qualified covered call options. However, the qualified covered call exception is denied to a taxpayer who fails to hold stock for 30 days after the related call option is disposed of at a loss, where gain on sale of the stock is included in the subsequent year.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The Senate amendment denies the qualified covered all exception, and the loss-deferral rule is thus applied, to cases in which it is the stock that is sold at a loss, and the related option that is not held for 30 days thereafter and the gain on which is included in the subsequent year.

The provision applies to positions established after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

3. Hedging exception

 

Present Law

 

 

Except in the case of certain syndicates, hedging transactions are not subject to either the mark-to-market rules or the year-end loss deferral rules.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The Senate amendment repeals the exceptions from the mark-to-market and loss-deferral rules for certain hedging transactions for dealers, except for dealers in agricultural or horticultural commodities (other than trees which bear fruit or nuts).

The provision applies to positions established after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement does not include the Senate amendment.

 

TITLE IV. AGRICULTURE, TIMBER, ENERGY, AND NATURAL RESOURCES

 

 

A. Agricultural Provisions

 

 

1. Special expensing provisions

 

a. Soil and water conservation expenditures
Present Law

 

 

Under present law, a taxpayer may elect to deduct certain expenditures made for the purpose of soil or water conservation that otherwise would be required to be capitalized (Code sec. 175). Among the expenditures eligible for the election are those for grading, terracing, contour furrowing, construction of drainage ditches, irrigation ditches, dams and ponds, and planting of windbreaks.

The annual deduction under this provision is limited to 25 percent of the taxpayer's gross income from farming.

 

House Bill

 

 

Soil and water conservation expenditures eligible for the expensing election are limited to those consistent with a conservation plan approved by the Soil Conservation Service of the Department of Agriculture or, in the absence of such a plan, a plan of a comparable State conservation agency. Expenditures in connection with draining or filling of wetlands or preparing land for installation or operation of a center pivot irrigation system are not eligible for deduction under this provision.

The provision applies to expenditures incurred after December 31, 1985.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except it is effective for expenditures after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement follows the House bill and Senate amendment, effective for expenditures after December 31, 1986. In addition, the conferees wish to clarify that while prior approval of the taxpayer's particular project by the Soil Conservation Service or comparable State agency is not necessary to qualify the expenditure under this provision, there must be an overall plan for the taxpayer's area that has been approved by such an agency in effect at any time during the taxable year.

 

b. Fertilizer and soil conditioning expenditures
Present Law

 

 

A taxpayer engaged in the trade or business of farming may elect to expense amounts otherwise subject to the capitalization rules of the Code that are paid or incurred during the taxable year for materials to enrich, neutralize, or condition land used in farming, or for the application of such materials to the land (sec. 180).

 

House Bill

 

 

The House bill repeals the provision allowing a current deduction for fertilizer and soil conditioning expenditures, effective for expenditures incurred after December 31, 1985.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement does not include the House bill provision. Thus, the special election to deduct fertilizer and soil conditioning expenditures is retained.

 

c. Land clearing expenditures
Present Law

 

 

A taxpayer engaged in the business of farming may elect to deduct currently land clearing expenditures incurred for the purpose of making such land suitable for farming (sec. 182). For any taxable year, the deduction may not exceed the lesser of $5,000 or 25 percent of the taxable income derived by the taxpayer from farming.

 

House Bill

 

 

The House bill repeals the election to expense land clearing expenditures, effective for expenditures after December 31, 1985.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment, effective for expenditures after December 31, 1985.

2. Disposition of converted wetlands and highly erodible croplands

 

Present Law

 

 

Gain realized on the sale or other disposition of a capital asset is subject to tax at preferential rates. The term capital asset does not include depreciable or real property used in a taxpayer's trade or business (sec. 1221(2)). However, gain from the sale of such property ("section 1231 assets") may be taxed on the same basis as gain on the sale of a capital asset if gains on all sales of section 1231 assets during a taxable year exceed losses on sales of such assets.

If losses on the sale or exchange of section 1231 assets exceed the gains from such sales or exchanges, the net loss is ordinary.

 

House Bill

 

 

The House bill provides that gain on the disposition of wetland or highly erodible cropland (as defined in the Food Security Act of 1985) converted to farming use, or used for farming purposes following conversion, is treated as ordinary income. Any loss on the disposition of such property is treated as a long-term capital loss. The provision is effective for dispositions after December 31, 1985.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, effective for dispositions of land converted to farming use after March 1, 1986.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment, effective for dispositions of land converted to farming use after March 1, 1986.

3. Preproductive period expenses of farmers

 

Present Law

 

 

In general

The Code and regulations provide exceptions from the otherwise applicable tax accounting rules for certain farmers. For example, certain farmers may elect to use the cash method of accounting when the accrual method otherwise would be required, and may use simplified inventory methods if an accrual method is adopted. Most farmers use the cash method of accounting, and therefore do not maintain inventories or capitalize preproductive period costs (i.e., costs incurred prior to the time a plant or animal becomes productive).

Expenses relating to grove, orchard and vineyard crops

Costs incurred in planting, cultivating, maintaining, or developing citrus or almond groves before the fourth taxable year after planting must be capitalized. Farming syndicates must capitalize planting and maintenance costs incurred with respect to other orchard, grove, or vineyard crops until production in commercial quantities begins. However, if an orchard, grove, or vineyard is lost or damaged by reason of freezing temperatures, drought, disease, pests, or casualty, otherwise deductible replanting and maintenance costs are currently deductible if the taxpayer replants on the same property.

 

House Bill

 

 

In general

The House bill provides that farmers are subject to the uniform capitalization rules generally applicable to producers of property (see VIII.D., below) if the plant or animal produced has a preproductive period of more than two years. However, certain farmers (in general, those not required to use the accrual method of accounting under present law and those not part of a farming syndicate) may elect to deduct currently preproductive period costs. Taxpayers making this election must recapture these costs as ordinary income on disposition of the product, and must use the nonincentive depreciation system provided under the House bill for all farm assets placed in service in any year the election is in effect.

The provision applies to costs incurred after December 31, 1985.

Expenses relating to grove, orchard, and vineyard crops

Replanting and maintenance costs incurred following loss of or damage to an orchard, grove, or vineyard used in the production of crops for human consumption by reason of freezing temperatures, etc. are currently deductible even though replanting does not take place on the same property. Thus, costs incurred at a different location (within the United States) but by the same taxpayer may qualify, provided they do not relate to acreage in excess of that on which the loss or damage occurred.

The provision applies to costs incurred after December 31, 1985.

 

Senate Amendment

 

 

In general

No provision.

Expenses relating to grove, orchard, and vineyard crops

The provision allowing a deduction for costs incurred following loss or damage due to freezing temperatures, etc. is extended to persons other than the person who owned the grove, orchard, or vineyard at the time of the loss or damage, provided (1) the taxpayer who owned the property at such time retains an equity interest of more than 50 percent in the property, and (2) the person claiming the deduction owns part of the remaining equity interest and materially participates in the replanting, cultivating, maintenance, or development of the property.

The provision is effective for costs incurred after date of enactment.

 

Conference Agreement

 

 

In general

The conference agreement follows the House bill as to the treatment of preproductive period costs incurred in the business of farming, effective for costs incurred after December 31, 1986. Farming for this purpose includes the trade or business of operating a nursery or sod farm or the raising or harvesting of trees bearing fruits, nuts, or other crops; it does not include the raising, harvesting, or growing of timber or ornamental evergreen trees that are more than six years old at the time they are severed from the roots.

Expenses relating to grove, orchard, and vineyard crops

The conference agreement adopts both the House bill and the Senate amendment provisions, effective for costs incurred after date of enactment. The conferees wish to clarify that the special rule for preproductive period expenses following loss or damage due to freezing temperatures, etc., is intended to apply only in the case of crops that are normally eaten or drunk by humans. Thus, for example, jojoba bean production does not qualify under this special exception.

4. Prepayments of farming expenses

 

Present Law

 

 

Persons engaged in the trade or business of farming generally are permitted to use the cash method of accounting. However, a farming syndicate may not deduct any amount paid for feed, seed, or other similar supplies prior to the year in which such supplies are used or consumed.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

In general, farmers using the cash method of accounting may not deduct amounts paid for unconsumed feed, seed, fertilizer, or other supplies to the extent they exceed 50 percent of the expenses incurred in the farming business (including prepaid expenses) during the taxable year. A similar rule applies in the case of costs incurred for the purchase of poultry. The provision is effective for prepayments made on or after March 1, 1986, in taxable years beginning after that date.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment, except that the limitation applies to prepayments for supplies to the extent such prepayments exceed 50 percent of total deductible farming expenses excluding prepaid supplies. The provision is effective for prepayments paid after March 1, 1986, in taxable years beginning after that date.

5. Treatment of plant variety protection certificates as patents

 

Present Law

 

 

A sale or exchange of all substantial rights to a patent by the individual whose efforts created the patent generally produces long-term capital gain (sec. 1235). Treasury Department regulations define the term "patent" for this purpose as any patent granted under title 35 of the United States Code.

The Department of Agriculture administers a program pursuant to the Plant Variety Protection Act of 1970 that extends protections to developers of sexually propagated plant varieties similar to those provided to patent holders.

 

House Bill

 

 

Under the House bill, the term patent for purposes of section 1235 includes a certificate of plant variety protection issued under the Plant Variety Protection Act of 1970.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement does not include the House bill provision.

6. Recapture income on installment sales of farm irrigation equipment

 

Present Law

 

 

In an installment sale of depreciable real or personal property all depreciation recapture income under sections 1245 and 1250 recognized in the taxable year of the disposition, whether or not principal payments are received in that year. Any gain in excess of the depreciation recapture income is taken into account under the installment method (sec. 453).

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

Under the Senate amendment, depreciation recapture income resulting from an installment sale of equipment used to irrigate farmland is recognized under the rules in effect prior to the Deficit Reduction Act of 1984. Accordingly, any depreciation recapture with respect to such equipment is recognized when gain is recognized under the installment method.

 

Conference Agreement

 

 

The conference agreement does not include the Senate amendment. Thus, depreciation is recaptured on farm irrigation equipment in the year of the installment sale.

7. Discharge of indebtedness income of certain farmers

 

Present Law

 

 

If a solvent taxpayer receives income from discharge of trade or business indebtedness, the taxpayer may exclude the income if an election to reduce basis in depreciable property is made. If the amount of the indebtedness forgiven exceeds the taxpayer's available basis, income must be recognized to the extent of the excess.

If an insolvent taxpayer has discharge of indebtedness income, the taxpayer may exclude the income to the extent of insolvency. The taxpayer's tax attributes (e.g., net operating loss carryovers and investment credit carryovers) and basis in property are reduced by the amount of the excluded income. However, the taxpayer's aggregate basis in assets may not be reduced below the amount of the taxpayer's remaining undischarged liabilities. If the discharge of indebtedness income exceeds the taxpayer's available tax attributes and basis, tax on the excess is forgiven.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

Income arising from discharge of indebtedness owed by a qualifying farmer to an unrelated lender is treated as income realized by an insolvent taxpayer, if the debt was incurred in the trade or business of farming or is farm business debt secured by farmland or farm equipment used in such trade or business. A taxpayer is eligible for this relief only if 50 percent or more of his average annual gross receipts for the preceding three taxable years was derived from farming. Thus, discharge of indebtedness income is forgiven after reduction of tax attributes and basis (including basis in farmland). The provision is effective for discharges of indebtedness after April 9, 1986.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

B. Timber Provisions

 

 

1. Preproductive period expenses of timber growers

 

Present Law

 

 

Under present law, the direct costs of acquiring or creating standing timber must be capitalized and recovered through depletion allowances or as a cost of timber sold. The cost of creating timber includes amounts paid for seed or seedlings, for site preparation, for planting (including the cost of tools, labor, and depreciation on machinery and equipment), and for early stand establishment.1 Costs incurred for management and protection after stand establishment (generally one or two years after planting) generally are deductible currently. Expenses in this category include labor and materials for fire, disease, and insect control and for the removal of unwanted trees and brush.

Under present law, carrying charges such as property taxes, interest, costs of administration, and costs of protecting timber either may be deducted currently or added to the taxpayer's basis in the timber, whether the property is productive or unproductive.2

 

House Bill

 

 

The House bill requires that the costs of producing timber, including interest costs, be capitalized in accordance with the uniform capitalization rules (see VIII.D., below). Generally, costs that are required to be capitalized by the House bill are to be added to the basis of the timber and recovered either through depletion deductions as the timber is cut or as cost of timber sold, as is the case under present law for the direct costs of acquiring or creating standing timber. The House bill provides special transition rules for preproductive period expenses attributable to timber planted before 1986.

The House bill also provides an election for "qualified small timber producers" (those with 75,000 acres of timberland or less) to amortize, over a period of five years, amounts otherwise required to be capitalized as a result of this provision.

The provisions of the House bill are applicable to costs and interest paid or incurred after December 31, 1985, subject to a five-year phase-in for costs attributable to timber planted before 1986.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement does not include the provision in the House bill. Thus, current law is retained with regard to the treatment of the preproductive expenses of growing timber (see VIII.D.).

2. Reforestation expenses

 

Present Law

 

 

Present law allows taxpayers to elect to amortize, over an 84-month period, up to $10,000 of reforestation expenditures incurred in each taxable year. A 10-percent tax credit is available for those expenditures qualifying for 84-month amortization.

 

House Bill

 

 

The House bill repeals the provisions allowing reforestation expenditures to be amortized and to qualify for a tax credit, effective for expenditures incurred after December 31, 1985.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement does not include the provision in the House bill. Thus, current law is retained with regard to the treatment of reforestation expenses.

3. Capital gains for timber

 

Present Law

 

 

Income received on account of a retained economic interest in timber qualifies for capital gains treatment, if the timber has been held for more than six months before disposition. The owner of timber (or a contract right to cut timber) may elect to treat the cutting of the timber as a sale or exchange qualifying for long-term capital gains treatment, even though the timber is sold or used in the taxpayer's trade or business. Once such an election is made, it may be revoked only with the permission of the Secretary of the Treasury. If permission to revoke the election is obtained, a new election may not be made without the Secretary of the Treasury's consent. For this purpose, timber includes evergreen trees that are more than six years old at the time severed from the roots that are sold for ornamental purposes.

 

House Bill

 

 

The House bill generally limits the availability of capital gains for timber disposed of after December 31, 1988, to natural persons, estates, and trusts where all of the beneficiaries are natural persons and estates. A modified corporate capital gains rate is provided for dispositions by corporate taxpayers after December 31, 1985, and before January 1, 1989. Dispositions of timber grown on Federal lands do not qualify for capital gains treatment after December 31, 1985. The House bill treats ornamental trees as agricultural products and not as timber in determining whether a disposition qualifies for capital gains treatment.

 

Senate Amendment

 

 

The Senate amendment contains no specific provision relating to capital gains treatment of timber. However, the Senate amendment generally conforms the capital gains rate for noncorporate taxpayers to the ordinary tax rate, effective for taxable years beginning after December 31, 1986. (See III.A., above.)

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment. Pursuant to the provisions of the conference agreement repealing preferential rates for capital gains (see III.A. and B., above), income from the sale of timber is subject to tax at ordinary income rates.

The conference agreement also 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.

 

C. Oil, Gas and Geothermal Properties

 

 

1. Intangible drilling costs

 

a. General rule
Present Law

 

 

Intangible drilling and development costs (IDCs) generally may be expensed or capitalized at the election of the operator of an oil, gas, or geothermal property.

In the case of integrated producers, 80 percent of IDCs may be expensed and the remaining 20 percent must be amortized over a 36-month period beginning with the month the costs are paid or incurred (sec. 291).

Costs with respect to a nonproductive well ("dry hole") may be deducted currently by any taxpayer in the year the dry hole is completed.

 

House Bill

 

 

The House bill retains present law, including the special rules for integrated producers, with respect to domestic IDCs incurred prior to commencement of the installation of the production string of casing ("casing point").

IDCs incurred at, or subsequent to, the casing point are amortized over a 26-month period, beginning in the month paid or incurred. (These costs are not subject to the 20-percent reduction for integrated producers.)

As under present law, unrecovered IDCs with respect to a dry hole can be deducted in the year the dry hole is completed.

This provision applies to costs paid or incurred after December 31, 1985.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

Under the conference agreement, 70 percent of IDCs of integrated producers may be expensed and the remaining 30 percent are to be amortized ratably over a 60 month (5-year) period, beginning in the month the costs are paid or incurred. This provision does not affect the option to expense dry hole costs in the year the dry hole is completed.

The provision applies to costs paid or incurred after December 31, 1986.

 

b. Treatment of foreign IDCs
Present Law

 

 

IDCs may qualify for expensing whether incurred in the United States or in a foreign country.

 

House Bill

 

 

The House bill provides that IDCs incurred outside of the United States are recovered: (1) over a 10-year, straight-line amortization schedule, or (2) at the election of the operator, as part of the basis for cost depletion. The 20-percent reduction in integrated producer IDCs (under sec. 291) does not apply to these costs.

This provision applies to costs paid or incurred after December 31, 1985.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that the provision applies to costs paid or incurred after December 31, 1986. A transitional exception is provided with respect to certain licenses for North Sea development acquired on or before December 31, 1985.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment. This provision does not affect the option to deduct dry hole costs in the year the dry hole is completed.

2. Depletion for oil, gas, and geothermal properties

 

a. General rule
Present Law

 

 

Under present law, depletable costs with respect to oil and gas properties must be recovered using whichever of two methods provides the higher deduction: cost depletion or percentage depletion.

Under cost depletion, the fraction of depletable costs recovered is equal to the ratio of hydrocarbons produced during the taxable year to total remaining reserves.

Under percentage depletion, 15 percent of the taxpayer's gross income is allowed as a deduction in any taxable year, not to exceed (1) 50 percent of net income for the property, or (2) 65 percent of overall taxable income.

Percentage depletion for oil and gas properties is limited to independent producers and royalty owners, for daily production of up to 1,000 barrels of crude oil or an equivalent amount of natural gas.

Geothermal properties are treated similarly to oil and gas wells, but are not subject to the 65 percent or 1,000 barrels per day limitations.

 

House Bill

 

 

The House bill phases out percentage depletion for oil, gas, and geothermal properties over a 3-year period, by reducing depletion rates 5 percentage points in each year. Percentage depletion is retained for oil and gas stripper wells owned by independent producers and royalty owners.

This provision applies to production after December 31, 1985.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

b. Advance royalty payments
Present Law

 

 

Percentage depletion is available with respect to oil and gas lease bonuses or advance royalty payments (Commissioner v. Engle, 464 U.S. 206 (1984)).

 

House Bill

 

 

The House bill denies percentage depletion for lease bonuses, advance royalties, or other payments made without regard to actual production from an oil, gas, or geothermal property, effective January 1, 1986.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the House bill, effective for amounts received or accrued after August 16, 1986.

3. Gain on disposition of interest in oil, gas or geothermal property

 

Present Law

 

 

Expensed intangible drilling costs incurred after 1975 are recaptured as ordinary income upon disposition of an oil, gas or geothermal property, to the extent of the excess of such costs over the amount that would have been deducted if the costs had been capitalized and recovered through depletion deductions.

 

House Bill

 

 

The House bill provides that expensed intangible drilling costs and depletion which reduced basis are recaptured as ordinary income.

The provision applies to dispositions of property placed in service after December 31, 1985, unless acquired pursuant to a written contract binding on September 25, 1985.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the House bill, except that the provisions apply to dispositions of property placed in service date is after December 31, 1986. (The September 25, 1985, binding contract date is retained.)

4. Windfall profit tax exemption for certain exchanges of crude oil

 

Present Law

 

 

An excise tax (the crude oil windfall profit tax) is imposed on domestic crude oil when it is removed from the production premises. The tax does not apply if crude oil is used to power production equipment on the same property.

 

House Bill

 

 

The House bill provides an exemption for certain otherwise taxable crude oil which is exchanged for an equal amount of residual fuel oil, to be used in enhanced recovery processes on the producing property. Only crude oil attributable to an operating mineral interest qualifies for the exception.

No depletion deduction (including cost or percentage depletion) is allowed with respect to crude oil qualifying for the exception.

The provision applies to residual fuel oil used, and crude oil removed, after the date of enactment.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

D. Hard Minerals

 

 

1. Exploration and development costs

 

a. General rule
Present Law

 

 

Exploration and development costs associated with mines and other hard mineral deposits may be deducted currently at the election of the taxpayer. Exploration (but not development) costs which have been deducted currently either (1) are applied to reduce depletion deductions, or (2) at the taxpayer's election, are recaptured in income once the mine begins production, and then recovered as a depletable expense.

In the case of corporations, only 80 percent of hard mineral exploration and development costs may be expensed. The remaining 20 percent must be recovered over the 5-year ACRS depreciation schedule (beginning in the year that exploration and development costs are paid or incurred), with an investment tax credit for domestic costs (sec. 291).

 

House Bill

 

 

The House bill requires recapture of both expensed development and exploration costs at the time the mine begins production. Recaptured amounts, and development costs incurred after the mine begins production, are recovered in the same manner as depreciable property in Class 1 (3-year recovery period).

The 20 percent of corporate exploration and development costs that is expensed is recovered in the same manner as depreciable property in Class 2 (5-year recovery period), beginning in the year that costs are paid or incurred.

This provision applies to costs paid or incurred after December 31, 1985.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

Under the conference agreement, 30 percent of the mining development and exploration costs of corporations are to be amortized ratably over a 60-month (5-year) period, rather than being expensed.

The provision applies to costs paid or incurred after December 31, 1986.

 

b. Foreign exploration costs
Present Law

 

 

Foreign exploration costs must be capitalized to the extent the taxpayer's foreign and domestic exploration costs (including certain prior years' costs) exceed $400,000.

 

House Bill

 

 

The House bill provides that foreign exploration and development costs are recovered: (1) over a 10-year, straight-line amortization schedule, or (2) at the election of the taxpayers, as part of the basis for cost depletion.

This provision applies to costs paid or incurred after December 31, 1985.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, but effective for costs paid or incurred after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

2. Percentage depletion of hard minerals

 

Present Law

 

 

Depletable costs with respect to hard mineral deposits must be recovered using the greater of: (1) cost depletion, or (2) percentage depletion at the applicable statutory rate for the mineral.

Percentage depletion may not exceed 50 percent of net income from the property in any taxable year.

For corporations only, percentage depletion of coal or iron ore, in excess of adjusted basis (determined without regard to the depletion deduction for that year), is reduced by 15 percent (sec. 291).

 

House Bill

 

 

With the exceptions below, the House bill phases down mineral depletion rates ratably to 5 percent in 1988. Minerals having a 5-percent present law rate (e.g., sand, gravel, and certain clay) are phased down ratably to 0 in 1988. In conjunction with these changes, the 50 percent of net income limitation is phased down ratably to 25 percent.

Present law depletion (rate and net income limitation) is retained for (1) minerals used to produce fertilizer or animal feed ("agricultural minerals"), and (2) dimension stone.

This provision applies to production after December 31, 1985.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement increases the reduction in coal and iron ore percentage depletion (under section 291) from 15 percent to 20 percent.

The provision applies to taxable years beginning after December 31, 1986.

3. Gain on disposition of interest in mining property

 

Present Law

 

 

Adjusted exploration expenditures (generally, amounts expensed in excess of amounts that would have been deducted if the costs had been capitalized) are recaptured as ordinary income upon disposition of a mining property.

 

House Bill

 

 

The House bill provides that expensed exploration and development expenses and depletion that reduced basis are recaptured as ordinary income.

The provision applies to dispositions of property placed in service after December 31, 1985, unless acquired pursuant to a written contract binding on September 25, 1985.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the House bill, except that the provision applies to property placed in service after December 31, 1986. (The September 25, 1985 binding contract date is retained.)

4. Royalty income from coal and domestic iron ore

 

Present Law

 

 

Royalties on dispositions of coal and domestic iron ore qualify for capital gain treatment, provided the coal or iron ore is held for more than six months before mining.

Capital gain treatment does not apply to (1) income realized as a co-adventurer, partner, or principal in the mining of coal or iron ore, or (2) certain related party transactions.

If capital gain treatment applies, the royalty owner is not entitled to percentage depletion with respect to the same coal or iron ore.

 

House Bill

 

 

The House bill phases out the special capital gain treatment for coal and domestic iron ore royalties over a 3-year period, beginning January 1, 1986.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment by retaining the existing Code provision regarding coal and domestic iron ore royalties (sec. 631(c)). Income from such royalties will be taxed as ordinary income pursuant to the general repeal of capital gains for individuals and corporations (see Title III, above). In addition, the conference agreement provides that coal and iron ore royalties are eligible for percentage depletion for any taxable year in which long-term capital gains are subject to tax at the same rate as ordinary income.

 

E. Energy-Related Tax Credits and Other Provisions

 

 

1. Residential solar energy tax credit

 

Present Law

 

 

Individuals are allowed a 40-percent tax credit on expenditures made before December 31, 1985, for up to $10,000 of solar energy source property. Unused credits at the end of 1985 may be carried forward through 1987.

 

House Bill

 

 

The residential solar energy tax credit is extended for three years, through December 31, 1988, and the tax credit rate during that period is 30 percent in 1986 and 20 percent in 1987 and 1988. The $10,000 general limit on qualified expenditures is reduced to $5,000 for solar energy hot water systems. Present-law provisions and the applicable regulations continue in effect, except that the credit is not allowed for a greenhouse, sun room or similar structure. Credits unused at the end of 1988 may be carried forward to 1990.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

2. Business energy tax credits

 

a. Extension of credits
Present Law

 

 

The business energy investment tax credits were enacted as additions to the regular investment tax credit to provide an additional tax credit as an incentive for the purchase of specified property or equipment. 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.

 

House Bill

 

 

The House bill extends the energy tax credit for solar energy property at 15 percent in 1986, 12 percent in 1987, and 8 percent in 1988. The geothermal tax credit is extended at 15 percent in 1986 and 10 percent in 1987 and 1988.

 

Senate Amendment

 

 

The Senate amendment on the solar energy tax credit is the same as the House bill, except that the tax credit rate in 1988 is 12 percent.

The Senate amendment is the same as the House bill for the geothermal energy tax credit.

The Senate amendment extends the tax credit for ocean thermal property at 15 percent through 1988.

The Senate amendment extends the tax credit for wind energy property at 15 percent in 1986 and 10 percent in 1987.

The Senate amendment extends the tax credit for biomass energy property at 15 percent in 1986 and 10 percent in 1987.

 

Conference Agreement

 

 

The conference agreement extends the energy tax credit for solar energy property at 15 percent in 1986, 12 percent in 1987, and 10 percent in 1988.

The conference agreement follows the House bill and the Senate amendment with respect to the energy tax credit for geothermal energy property.

The conference agreement does not change present law with respect to dual purpose solar or geothermal energy property. The conference committee, however, notes with respect to this matter that these are administrative issues which the Secretary of the Treasury should resolve under the regulatory authority provided in the Energy Tax Act of 1978 and subsequent Acts with provisions relating to energy tax credits.

The conference agreement follows the Senate amendment with respect to the energy tax credit for biomass property.

The conference agreement follows the Senate amendment with respect to the energy tax credit for ocean thermal property.

The conference agreement follows the House bill with respect to the wind energy tax credit.

 

b. Modifications to chlor-alkali electrolytic cells
Present Law

 

 

Modifications to chlor-alkali electrolytic cells, a category of specially defined energy property, was eligible for a 10-percent energy tax credit through December 31, 1982.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The Senate amendment extends the expiration date for modifications to chlor-alkali electrolytic cells to December 31, 1983.

 

Conference Agreement

 

 

The conference agreement follows the House bill.

 

c. Affirmative commitment rules
Present Law

 

 

The expired 10-percent credit for certain alternative energy 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.

 

House Bill

 

 

Consistent with the general transitional rules applicable to repeal of the regular investment tax credit, the House bill requires that allowable energy credits are spread ratably over 5 years (i.e., 20 percent of the credit in each of 5 years), and requires a full basis adjustment for the full energy tax credit in the first taxable year.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement 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. (See II.A.2., above, repeal of the regular investment tax credit.)

3. Credit for fuels from nonconventional sources

 

Present Law

 

 

A tax credit equal to $3 per 5.8 million Btus of energy is provided for the domestic production and sale of specified, qualified fuels to unrelated persons. The credit applies to such fuels (1) produced from facilities placed in service after December 31, 1979, and before January 1, 1990, on properties which first begin production after December 31, 1979, and (2) sold after December 31, 1979, and before January 1, 2001.

 

House Bill

 

 

The credit is terminated after December 31, 1985, except for methane gas produced from wood in facilities placed in service before January 1, 1989, and sold before January 1, 2001.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

4. Alcohol fuels tax credit and import duty

 

a. Alcohol fuels income tax credit
Present Law

 

 

A 60-cents-per-gallon income tax credit is allowed through 1992 for alcohol mixed with gasoline, diesel fuel, or any special motor fuel, if the mixture is sold or used as fuel. The credit also is provided for alcohol used in a trade or business or sold at retail and placed in a vehicle fuel tank. Eligible alcohol includes ethanol and methanol but not if made from petroleum, natural, gas, or coal (including peat), or alcohol less than 150 proof.

 

House Bill

 

 

This credit is repealed after December 31, 1985.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

b. Duty on imported alcohol fuels
Present 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).

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The Senate amendment retains present law, but it allows duty-free entry into the United States only for ethyl alcohol produced in a Caribbean Basin Initiative (CBI) country or U.S. insular possession from source material which is the product of a CBI country, an insular possession, or the United States. The change in the source material requirement does not apply, as of January 1, 1986, to certain facilities which were established and operating (up to a maximum of 20 million gallons per year) or ready for shipment to an installation in a CBI country (up to a maximum of 50 million gallons per year).

 

Conference Agreement

 

 

The conference agreement adopts in most respects section 864 of H.R. 4800. In so doing, the conferees disapprove U.S. Customs Service rulings 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.

Under the conference agreement, 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.

5. Neat alcohol fuels

 

Present 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.

 

House Bill

 

 

The 9-cents-per-gallon exemption is reduced to 6 cents per gallon, effective for sales or use after December 31, 1985.

 

Senate Amendment

 

 

The Senate amendment follows the House bill, except the provision is effective for sales or use after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

6. Taxicab fuels tax exemption

 

Present 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).

 

House Bill

 

 

The 4-cents-per-gallon partial exemption from motor fuels excise taxes for qualified taxicabs is extended through September 30, 1988.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the House bill.

 

TITLE V. TAX SHELTERS; INTEREST EXPENSE

 

 

A. At-Risk Rules

 

 

Present Law

 

 

Present law provides 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. The 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 property not used in the activity. The amount at risk is generally increased (or decreased) each year by the taxpayer's share of income (or losses and withdrawals) from the activity.

The investment tax credit at-risk rules limit the credit base of property used in an activity that is subject to the loss limitation at-risk rules, and generally provide that nonrecourse debt is treated as an amount at risk for investment credit purposes where (1) it is borrowed from an unrelated commercial lender, or represents a loan from or is guaranteed by certain governmental entities, (2) the property is acquired from an unrelated person, (3) the lender is unrelated to the seller, (4) the lender or a related person does not receive a fee with respect to the taxpayer's investment in the property, (5) debt is not convertible debt, and (6) the nonrecourse debt does not exceed 80 percent of the credit base of the property.

 

House Bill

 

 

The House bill applies the at-risk rules to the activity of holding real property, with an exception for real estate losses providing that third party nonrecourse debt borrowed from an unrelated commercial lender is treated as an amount at risk under rules similar to the present-law credit at-risk rules (without the requirement limiting the nonrecourse debt to 80 percent).

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except the third party nonrecourse debt exception for real estate losses applies notwithstanding that (1) the lender is related to the taxpayer, and (2) the taxpayer acquired the property from a related party.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment, with modifications.

The conference agreement provides that in the case of the activity of holding real property, certain qualified nonrecourse financing is treated as an amount at risk, provided that, in the case of nonrecourse financing from related persons, the terms of the loan are commercially reasonable and on substantially the same terms as loans involving unrelated persons.

These requirements are imposed in addition to those imposed under the Senate amendment because the conferees believe that the opportunities for overvaluation of property and for the transfer of tax benefits attributable to amounts that resemble equity are insufficiently limited under the Senate amendment in the case of nonrecourse financing from a related person.

The conferees intend 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. Generally, an interest rate would 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 sec. 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. Thus, generally, an interest rate would not be considered commercially reasonable if it significantly exceeds the market rate on comparable loans by unrelated qualified persons. Nor would an interest rate be considered commercially reasonable if it were contingent. The conferees do 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 would not generally be considered contingent.

The terms of the financing would 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, the conferees intend 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.

The conference agreement also provides 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 House bill, the Senate amendment, and the conference agreement, convertible debt is not treated as qualified nonrecourse financing. The conferees believe 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.

Clarification is also provided with respect to the definition of the activity of holding real property. Generally, to the extent an activity is not subject to the at-risk rules by virtue of sec. 465(c)(3)(D) of present law, it will be treated under the conference agreement 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.

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.

 

B. Limitations on Losses and Credits From Passive Activities

 

 

Present Law

 

 

Generally, present law does not limit the use of deductions or credits from a particular business activity to offset income from other activities, except in certain specific instances (e.g., the limitation on the deduction of net capital losses, and the rule that research and development credits cannot offset tax on unrelated income in the case of an individual).

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

General rule

Deductions in excess of income (i.e., losses) from passive activities generally may not offset other income such as salary, interest, dividends, and active business income. Deductions from passive activities may offset income from passive activities. Credits from passive activities generally are limited to the tax attributable to income from passive activities.

Disallowed losses and credits are carried forward and treated as deductions and credits from passive activities in the next taxable year.

Disallowed losses from an activity are allowed in full when the taxpayer disposes of his entire interest in the activity in a taxable transaction. Credits are not so allowed upon disposition.

The provision applies to individuals, estates, trusts, and personal service corporations.

Closely held corporations may not offset portfolio income with passive losses and credits but may use passive losses and credits to offset active business income.

Definition of passive activities

Passive activities include (1) trade or business activities in which the taxpayer (or spouse) does not materially participate (i.e., is not involved on a regular, continuous, and substantial basis), and (2) rental activities where payments are primarily for the use of tangible property.

Passive activities do not include working interests in oil and gas properties in which the taxpayer's form of ownership does not limit liability.

Rental real estate

In the case of rental real estate activities in which an individual actively participates, up to $25,000 of losses (and credits, in a deduction-equivalent sense) from all such activities are allowed each year against nonpassive income of the taxpayer. The $25,000 amount is phased out ratably between $100,000 and $150,000 of adjusted gross income (determined without regard to passive losses). Low income housing credits may be taken under the $25,000 allowance (in a deduction-equivalent sense) against nonpassive income without regard to whether the individual actively participates.

 

Effective Date

 

 

The provision is effective for taxable years beginning after December 31, 1986, with a phase-in rule for investments made before the date of enactment.

Under the phase-in rule, the amount disallowed under the passive loss rule during any year in the phase-in period equals 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 taxable years beginning in 1987, 60 percent in taxable years beginning in 1988, 80 percent in taxable years beginning in 1989, 90 percent in taxable years beginning in 1990, and 100 percent in taxable years beginning after 1990.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment, but with certain modifications and clarifications.

1. Overview

 

Passive activity

 

The definition of a passive activity generally is the same as under the Senate amendment. However, the definition is clarified to accord with the original intent of the provision that 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.

It is also clarified that a net lease of property is a rental activity that is treated as a passive activity under the rule.

Passive activities that are not a trade or business.--The conference agreement 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. The conferees anticipate that the exercise of this authority may 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 passive losses intended to be limited under the provision, but that may not rise to the level of a trade or business.

Interest on taxpayer's residence.--Qualified residence interest is not subject to the passive loss rule (see V.C., below).

Interaction with interest deduction limitation.--The conference agreement provides that interest deductions attributable to passive activities are treated as passive activity deductions, but are not treated as investment interest (see V.C., below). Thus, such interest deductions 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.1

Interaction with other Code sections.--It is clarified that 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 services income not treated as from passive activity.--The conference agreement clarifies that 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.

 

Taxpayers subject to the passive loss rule

 

Under the conference agreement, the passive loss provision generally applies to the same taxpayers as under the Senate amendment, and with the same more limited version of the rule for closely held corporations. However, the applicability of the rule is modified and clarified as described below.

In the case of closely held corporations, the passive loss rule permits passive losses (and credits, in a deduction equivalent sense) to offset net active income, but not portfolio income. Thus, for example, if a closely held 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.

Personal service corporations.--The definition of a personal service corporation applying for purposes of the provision is modified to provide that the passive loss rule does not apply to a corporation where the employee-owners together own less than 10 percent, by value, of the corporation's stock.

The conference agreement provides that the rule applicable to a change in status of a closely held 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 corporation are not subject to limitation under the passive loss rule).

Affiliated groups.--A limited version of the passive loss rule applies to closely held corporations, providing that passive losses of the corporation may not offset portfolio income. In the case of affiliated groups of corporations filing consolidated returns, it is intended that this rule apply on a consolidated group basis. Thus, it is intended that losses from any passive activity within the consolidated group may offset net active income, but not portfolio income, of any member of the group. An activity may be conducted by several corporations, and conversely, 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 is 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 a member'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 are 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. Under the conference agreement, the definition of a personal service corporation is applied taking into account attribution of ownership of stock as provided in section 269A(b).

2. Treatment of losses and credits

 

In general

 

Losses.--The conference agreement provides that interest deductions attributable 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 section V.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.

Rental real estate in which taxpayer actively participates.--Clarification is provided with respect to the rule allowing up to $25,000 of losses and credits (in a deduction equivalent sense) from rental real estate activities in which the taxpayer actively participates to offset non-passive income of the taxpayer. The $25,000 allowance is applied by first netting income and 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 then 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 a 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.

 

The Senate amendment provided that a taxpayer is not treated as actively participating with respect to an interest in a rental real estate activity if such interest is less than 10 percent of all interests in the activity. The conference agreement clarifies that a taxpayer is treated as not actively participating if at any time during the taxable year (or shorter relevant period for which the taxpayer held an interest in the activity) the taxpayer's interest in the activity is less than 10 percent.

It is clarified that, 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.2 The same rule applies to credits, to the extent that active participation is relevant to their allowability.

The conference agreement provides that, 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.

The conference agreement provides that 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 years 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 during the two taxable years of the estate following 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.

It is clarified that a trust is not intended to qualify for the allowance of up to $25,000 in losses and (deduction equivalent) credits from a rental real estate activity in which there is active participation, so that individuals cannot circumvent the $25,000 ceiling, or multiply the number of $25,000 allowances, simply by transferring various rental real properties to one or more trusts.

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) is halved in the case of married individuals filing separate returns, under the Senate amendment. This rule is retained, with modification, in the conference agreement. The conference agreement provides that, 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; the conferees believe that rules that encourage filing separate returns give rise to unnecessary complexity and place an unwarranted burden on the administration of the tax system.

Credits.--The conference agreement 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 to property placed in service before 1990, and only with respect to the original credit compliance period for the property, 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 interaction of the passive loss rules with other rules limiting the use of credits is clarified. 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 conference agreement (providing that credits generally cannot offset more than 75 percent of the taxpayer's tax liability for the year) 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.--The conference agreement generally follows the Senate amendment with respect to dispositions of interests in passive activities which trigger the allowance of suspended losses. The conference agreement clarifies, however, that a transaction constituting a sale (or other taxable disposition) in form, 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 conference agreement 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 section 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 section 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.--Clarification is provided with respect to 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) of present law, 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 conference agreement, 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. Under the Senate amendment, a special rule would apply to dispositions with respect to limited partnership interests. The special rule requires the taxpayer to dispose of his entire interest in the limited partnership (along with all other interests that are part of the passive activity) in order to trigger suspended deductions with respect to any activities conducted by the limited partnership.

The conferees believe that it is not appropriate to disallow a true economic loss realized upon the disposition of the taxpayer's entire interest in an activity by reason of the taxpayer's form of ownership. Therefore, the conference agreement eliminates this special rule for dispositions of limited partnership activities, and provides instead that 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.

The conferees do not, however, intend to change the rule 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.

3. Treatment of portfolio income

 

In general

 

The conference agreement generally follows the Senate amendment with respect to the definition and treatment of portfolio income, with several modifications and clarifications.

Generally, portfolio income of an activity (for example, interest, dividend, royalty or annuity income earned on funds set aside for future use in the activity) is not treated as passive income from the activity, but must be accounted for separately.3 Similarly, portfolio income of an entity which is not attributable to, or part of, an activity of the entity that constitutes a passive activity is also accounted for separately from any passive income or loss. Gain or loss from sales or exchanges of portfolio assets (including property held for investment) is treated as portfolio gain or loss. The conference agreement adds a provision clarifying that income from annuities is treated as not passive income.

 

Expenses allocable to portfolio income

 

The conference agreement 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 conferees anticipate that the Treasury will issue regulations setting forth standards for appropriate allocation of expenses and interest under the passive loss rule. The conferees anticipate that regulations providing guidance to taxpayers with respect to interest allocation will be issued by December 31, 1986. 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.4

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.

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.

The conferees anticipate that Treasury regulations will be issued 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. Such netting 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. Such regulations may, if appropriate, provide that taxpayer's allocable share of the payment for this purpose will be determined without regard to special allocations.

Regulatory authority of Treasury in defining non-passive income.--The conferees believe that clarification is desirable regarding the regulatory authority provided to the Treasury with regard to the definition of income that is treated as portfolio income or as otherwise not arising from a passive activity. The conferees intend that this authority be exercised to protect the underlying purpose of the passive loss provision, i.e., preventing the sheltering of positive income sources through the use of tax losses derived from passive business activities.

Examples where the exercise of such authority may (if the Secretary so determines) be appropriate include the following: (1) ground rents that produce income without significant expenses, (2) related party leases or subleases, with respect to property used in a business activity, that have the effect of reducing active business income and creating passive income; and (3) activities previously generating active business losses that the taxpayer intentionally seeks to treat as passive at a time when they generate net income, with the purpose of circumventing the rule.

4. Material participation

Under the conference agreement, material participation has the same meaning as that set forth in the Senate Report. It is clarified that an individual who works full-time in a line of business consisting of one or more business activities generally is likely to be materially participating in those activities (except to the extent provided otherwise in the case of rental activities), even if the individual's role is in management rather than operations.

This clarification is not intended to alter the description of material participation in the Senate Report in any respect. Rather, it recognizes the substantial likelihood 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.

It is also clarified that 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.

With respect to material participation in an agricultural activity, clarification is provided regarding the decision-making that, 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.

5. Definition of activity

It is clarified that 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).

6. Working interest

The conference agreement follows the Senate amendment with respect to the working interest provision under the passive loss rules.

7. Effective date and phase-in rules

Under the conference agreement, interests in passive activities acquired by the taxpayer on or before the date of enactment of the bill are eligible for the phase-in under the passive loss rule. Interests in activities acquired after the date of enactment, however, are not eligible for the phase-in, but rather are fully subject to the passive loss rule.

The conferees intend that a contractual obligation to purchase an interest in a passive activity that is binding on the date of enactment 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 the date of enactment, 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 the date of enactment, 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 the date of enactment, then (except to the extent the increase in the taxpayer's interest arises pursuant to a pre-enactment date 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 the date of enactment, 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 enactment will qualify for transitional relief.6

In general, in order to qualify for transition relief, the interest acquired by a taxpayer must be in an activity which has commenced by the date of enactment. 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 the date of enactment, the new activity does not qualify for transition 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 the date of enactment. In the case of a residence converted to rental use, for example, the residence must be held out for rental by the date of enactment.

However, in the case of an activity that has not commenced by the date of enactment, 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 the date of conference action (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 the date of conference action (August 16, 1986).

In the case of a taxpayer owning both pre-enactment and post-enactment interests in passive activities, clarification is provided regarding the calculation of 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-enactment interests, that would be disallowed in the absence of the phase-in, and has $60 of net passive income from post-enactment 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-enactment and post-enactment losses are calculated by including credits, in a deduction-equivalent sense.

Under the conference agreement, 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-enactment 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.

 

It is clarified that 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 seven years from the taxpayer's original investment.

 

C. Nonbusiness Interest Limits

 

 

Present Law

 

 

In the case of a noncorporate taxpayer, deductions for interest on debt incurred or continued to purchase or carry property held for investment are generally limited to $10,000 per year, plus the taxpayer's net investment income, plus certain deductible expenditures in excess of rental income from net lease property. Investment interest paid or accrued during the year which exceeds this limitation is not permanently disallowed, but is subject to an unlimited carryover and may be deducted in future years (subject to the applicable limitation).

Net investment income means investment income net of investment expenses. Investment income is income from interest, dividends, rents, royalties, short-term capital gains arising from the disposition of investment assets, and certain recapture amounts, but only if the income is not derived from the conduct of a trade or business. Investment expenses are 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 are directly connected with the production of investment income. For this purpose, straight-line (not accelerated) depreciation over useful life, and cost (not percentage) depletion are used in calculating investment expenses.

 

House Bill

 

 

Under the House bill, the deduction for nonbusiness interest of noncorporate taxpayers is limited to $10,000 ($20,000 for joint returns), plus net investment income, plus certain deductible expenditures in excess of rental income from net lease property. Interest on debt secured by the taxpayer's principal residence or by a second residence of the taxpayer (to the extent of their fair market values) is not subject to limitation. A residential lot is treated as a residence and up to 6 weeks of time-sharing of residential properties is treated as one residence. Interest expense attributable to low income housing which is (1) very low income housing, (2) certain bond-financed low-income housing, or (3) housing eligible for 5-year amortization of rehabilitation expenses under present law, is not subject to the limitation.

Nonbusiness interest means all interest not incurred in the taxpayer's trade or business, including the taxpayer's share of interest of S corporations in whose management he does not actively participate, the taxpayer's share of interest expense of limited partnerships in which he is a limited partner, and the taxpayer's share of interest expense of certain trusts and other entities in which he is a limited entrepreneur.

Net investment income means investment income net of investment expense. investment income is expanded to include the same items as under present law plus the taxable portion of net gain from the disposition of investment property, plus income or loss from investments, interest from which would be nonbusiness interest under the provision. investment expense includes the same items as under present law, except that it includes the depreciation and depletion actually utilized by the taxpayer.

Generally, as under present law, property subject to a net lease is treated as investment property. The bill modifies the 15-percent test of present law, which determines whether leased property is subject to a net lease. Under the bill, in determining whether certain expenses constituting trade or business deductions are less than 15 percent of the rental income from the leased property, the value of the personal management and repair services performed with respect to the leased property by an individual taxpayer if he is a direct owner may be counted. Management and repair services of the taxpayer if he is a general partner in a general partnership that directly owns the leased property may also be counted.

The provision is phased in over a 10-year period, effective for taxable years beginning after December 31, 1985. Interest not disallowed under present law, but which is disallowed under the new provision, becomes subject to disallowance ratably (10 percent per year) over 10 years commencing with taxable years beginning in 1986.

 

Senate Amendment

 

 

The Senate amendment provides that the deduction for investment interest of noncorporate taxpayers is limited to net investment income, plus certain deductible expenditures in excess of rental income from net lease property. Consumer interest is not deductible. Interest on debt secured by the taxpayer's principal residence and a second residence of the taxpayer (to the extent of their fair market values) is not subject to limitation.

Investment interest (in conformity with the passive loss rule) includes all interest subject to limitation in the House bill as well as other interest attributable to an activity in which the taxpayer does not materially participate (or in the case of rental real estate activities, does not actively participate). Material participation and active participation have the same meanings as under the passive loss rule. Consumer interest means interest not attributable to a trade or business (other than the trade or business of performing services as an employee) or to an activity engaged in for profit.

Net investment income means investment income net of investment expense. Investment income is expanded to include the same items as under present law plus the taxable portion of net gain from the disposition of investment property, plus income from investments, interest from which would be investment interest under the provision.

The Senate amendment is the same as the House bill with respect to net lease property.

The provision is phased in, effective for taxable years beginning after December 31, 1986. Interest not disallowed under present law, but which is disallowed under the new provision, becomes subject to disallowance 35 percent in taxable years beginning in 1987, 60 percent in taxable years beginning in 1988, 80 percent in taxable years beginning in 1989, 90 percent in taxable years beginning in 1990, and 100 percent in taxable years beginning after 1990.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment, with modifications and clarifications.

Investment interest

The conference agreement 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.

Definition of investment interest

The definition of investment interest is modified to include interest paid or accrued on indebtedness incurred or continued to purchase or carry property held for investment. Investment interest includes interest expense properly allocable to portfolio income under the passive loss rule (see B., above). Investment interest also includes interest expense properly allocable to an activity, 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.

Investment interest also includes the portion of interest expense 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. 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 attributable to the disposition of property held for investment, and amounts treated as gross portfolio income under the passive loss rule. 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. In determining 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 2 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, because it 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 under sec. 265 (relating to tax-exempt interest).

Personal interest

The conference agreement follows the Senate amendment provision with respect to consumer interest (denominated personal interest under the conference agreement), with modifications and clarifications.

Under the conference agreement, 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 of performing services as a employee), investment interest, or interest taken into account in computing the taxpayer's income or loss from passive activities for the year. Personal interest also generally includes interest on tax deficiencies.

Personal interest does not include qualified residence interest of the taxpayer, nor does it include interest payable on estate tax deferred under sec. 6163 or 6166.

Qualified residence interest

Under the conference agreement, 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 perfected under local law on the taxpayer's principal residence or a second residence of the taxpayer, not in excess of the amount of the taxpayer's cost 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.

Qualified residence interest is calculated as interest on debt secured by the residence, up to the amount of the cost 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 cost basis for the residence, then such amount shall be substituted for the taxpayer's cost 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 the purpose for which the borrowed funds are used. Interest on debt secured by the taxpayer's principal or second residence, incurred after August 16, 1986, which debt exceeds the taxpayer's cost 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 cost basis is determined without taking into account adjustments to basis under sec. 1034(e) (relating to rollover of gain upon the sale of the taxpayer's principal residence), or 1033(b) (relating to involuntary conversions). The cost basis for the residence includes the cost of improvements to the residence that are added to the basis of the residence. The taxpayer's cost 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 cost basis for the residence is not reduced by such deductions for purposes of this provision. Where the basis of a residence is determined under sec. 1014 (relating to the basis of property acquired from a decedent), the cost basis under this provision is the basis determined under sec. 1014. 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 cost basis) is treated as a qualified residence interest. Thus, for example, if the taxpayer's cost 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 purpose for which the borrowed funds are used 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 scholarships (under sec. 117(b) as amended by the conference agreement), for the taxpayer, his spouse or dependent, while a student at an educational organization described in sec. 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.

A principal residence of the taxpayer, and a second residence of the taxpayer, have the meanings set forth in the Senate amendment, except that if a second residence is not used by the taxpayer or 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 (non-rental) purposes for the greater of 14 days or 10 percent of the number of days it is rented.

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. 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 addition, it is intended that the fact that State homestead laws may restrict the rights of secured parties with respect to certain types of residential mortgages will not cause interest on the debt to be treated as nondeductible personal interest, provided the lender's security interest is perfected and provided the interest on the debt is otherwise qualified residence interest.

 

Effective Date

 

 

The conference agreement follows the effective date and phase-in rule of the Senate amendment, with modification.

Under the conference agreement, the amount of investment interest disallowed during the phase-in period under the provision is the excess over the amount of the present law $10,000 allowance ($5,000 in the case of a married individual filing a separate return, and zero in the case of a trust), plus the applicable portion of investment interest expense which would be disallowed without taking into account the present law allowance. Thus, for example, if an individual taxpayer has $20,000 of investment interest expense in excess of investment income 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. 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.7

 

TITLE VI. CORPORATE TAX PROVISIONS

 

 

A. Corporate Tax Rates

 

 

Present Law

 

 

Corporate income is subject to tax under a five-bracket graduated rate structure as follows:

                       Tax Rate

 

 Taxable Income:       (percent)

 

 

 $25,000 or less         15

 

 $25,000-$50,000         18

 

 $50,000-$75,000         30

 

 $75,000-$100,000        40

 

 Over $100,000           46

 

 

An additional five-percent tax is imposed on a corporation's taxable income in excess of $1 million, up to a total additional tax of $20,250. This results in elimination of the benefit of the graduated rate structure (in effect, payment of tax at a flat 46 percent rate) for corporations having taxable income of $1,405,000 or more.

 

House Bill

 

 

Under the House bill, corporate income is subject to tax under a three-bracket graduated rate structure as follows:

                      Tax Rate

 

 Taxable Income:      (percent)

 

 

 $50,000 or less        15

 

 $50,000-$75,000        25

 

 Over $75,000           36

 

 

An additional five-percent tax is imposed on income between $100,000 and $365,000. Thus, corporations having taxable income of $365,000 or more in effect pay tax at a flat 36 percent rate. The provision is effective July 1, 1986; income in taxable years that include July 1, 1986, is subject to blended rates.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except the maximum corporate rate is 33 percent and the phase-out of the benefit of graduated rates occurs between $100,000 and $320,000. The provision is effective July 1, 1987.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment, except the maximum corporate rate is 34 percent. The phase-out of the benefit of graduated rates occurs through the imposition of an additional five-percent tax between $100,000 and $335,000 of taxable income. The new rate structure is 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 blended rates under the rules specified in section 15 of present law.

 

B. Corporate Dividends Paid Deduction

 

 

Present Law

 

 

In general, corporations compute taxable income and are subject to a separate corporate-level tax without any deduction for dividends paid to shareholders.

Foreign shareholders of U.S. corporations generally are subject to a 30-percent withholding tax on dividends (secs. 861, 871, 881, 1441, 1442); a lower rate may be provided by treaty. Tax-exempt entities generally are not taxable on dividends received except in certain cases where the tax-exempt entity owns debt-financed property (sec. 514).

 

House Bill

 

 

Under the House bill, a domestic corporation receives a deduction for 10 percent of dividends paid by the corporation out of corporate earnings that have been subject to tax after the general effective date. A foreign corporation, at least half of whose income is from a U.S. business (and thus generally subject to U.S. tax), also receives a deduction.

The House bill imposes a compensatory withholding tax on foreign shareholders, including those otherwise protected by treaty, except where the foreign recipient's country grants relief from a two-tier tax to U.S. shareholders. In addition, under the House bill, the deductible portion of dividends paid to tax-exempt shareholders owning five percent or more of the distributing corporation's stock is treated as taxable unrelated business income of the shareholder.

The provisions of the House bill are phased in over 10 years. The deduction is one percent for taxable years beginning after January 1, 1987, increasing one percentage point annually until taxable years beginning after January 1, 1996 when the full 10 percent deduction is in effect. The compensatory withholding tax on foreign shareholders otherwise protected by treaty is effective for dividends paid after 1988.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

C. Corporate Dividends Received Deduction

 

 

Present Law

 

 

Corporations that receive dividends generally are entitled to a deduction equal to 85 percent of the dividends received (sec. 243(a)(1)). 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, 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 currently to the recipient (Treas. Reg. sec. 1.1502-14).

The dividends received deduction is limited in the case of certain dividends received by a U.S. corporation from a foreign corporation and from certain other entities. The deduction also is limited in certain other circumstances.

 

House Bill

 

 

Under the House bill, the 85-percent dividends received deduction is reduced to 80 percent.

In addition, the House bill modifies the dividends received deduction for corporations in connection with the dividends paid deduction. Thus, under the House bill, the 80-percent dividends received deduction for distributions from non-affiliates is reduced to 70 percent. For distributions from affiliates, the 100-percent dividends received deduction otherwise available is reduced to 90 percent if the payor was entitled to a dividends paid deduction.

The House bill generally is effective with respect to dividends received after December 31, 1985. The 10-percent reductions in the dividends received deduction are phased in over 10 years corresponding to the phase-in of the dividends paid deduction.

 

Senate Amendment

 

 

The Senate amendment reduces the 85-percent dividends received deduction to 80 percent, effective for dividends received after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

D. Dividend Exclusion for Individuals

 

 

Present Law

 

 

The first $100 of qualified dividends received by an individual shareholder ($200 by a married couple filing jointly) from domestic corporations is excluded from income (sec. 116(a)).

The dividend exclusion for individuals does 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. 116(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 is limited with respect to dividends received from a regulated investment company (sec. 116(c)(2)).

 

House Bill

 

 

Under the House bill, the dividend exclusion for individuals is repealed, effective for taxable years beginning after December 31, 1985.

 

Senate Amendment

 

 

The Senate amendment follows the House bill, effective for taxable years beginning after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment, effective for taxable years beginning after December 31, 1986.

 

E. Extraordinary Dividends

 

 

Present Law

 

 

If a corporate shareholder receives an "extraordinary dividend" on stock and disposes of the stock without having held it for more than one year, the basis of the stock must be reduced by the amount of the untaxed portion of the dividend (sec. 1059). An extraordinary dividend is defined in terms of the size of the dividend in relation to the shareholder's adjusted basis in its stock. The untaxed portion of the dividend is the excess of the value of the distribution over the taxable portion of the distribution (i.e., net of the dividends received deduction).

In general, 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. Apart from certain cases in which a shareholder's interest is completely terminated or is reduced by more than 20 percent, present law is unclear regarding what constitutes a meaningful reduction in interest. The conferees understand that in some cases individual distributees take the position that a redemption is a sale or exchange, while corporate distributees take the position it is a dividend. Distributions in partial liquidation of the distributing corporation are not treated as dividends if the recipient is a noncorporate shareholder.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The basis of stock held by a corporation is reduced on disposition of the stock by the untaxed portion of extraordinary dividends received, regardless of the taxpayer's holding period for the stock. A taxpayer may elect to determine whether the dividend is extraordinary by reference to the fair market value of the stock, rather than adjusted basis, if fair market value is established to the satisfaction of the Commissioner.

The provision is effective for dividends declared after March 18, 1986.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment, with certain modifications and clarifications.

The determination of whether a dividend is extraordinary will be made under the present law percentage-of-adjusted-basis test, subject to the alternative fair market value test provided in the Senate amendment.1 In lieu of the one-year post-acquisition holding period requirement of present law, the conference agreement provides a test based on the holding period of the distributee as of the date the distribution is declared or publicly announced by the distributing corporation's board of directors. Under this test, a distribution with respect to stock will constitute an extraordinary dividend if the taxpayer has not held the stock for more than two years on that date. 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 for purposes of applying the two-year holding period requirement. 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 would 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 an interest in the venture by a new party.

A distribution that would otherwise constitute an extraordinary dividend under the two-year rule described above will not be considered extraordinary if the distributee has held the stock for the entire period the distributing corporation (and any predecessor corporation) has been in existence.

The conference agreement provides for a different treatment of dividends on certain qualifying preferred stock. Absent the special rule under the basic definition of extraordinary dividend, a preferred stock that pays a greater than 5-percent dividend within any period of 85 days or less is paying an extraordinary dividend. Thus, for example, a 6-percent preferred stock dividend that is paid once annually would be extraordinary. On the other hand, if the stock paid four quarterly 5-percent dividends, none of the dividends would be considered extraordinary. The special rule is not intended to apply if no basis adjustment would be required under the general rule.

The exception for qualifying preferred stock 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"). Preferred stock is treated as qualifying for this purpose if: (1) it provides for fixed (i.e. not varying) preferred dividends payable not less often than annually; (2) dividends were not in arrears when the taxpayer acquired the stock, and (3) the dividends received by the taxpayer during the period it owned the stock do not 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.la

Dividends on qualifying preferred stock will be treated as extraordinary dividends only to the extent the dividends received by the taxpayer during the period it owned the stock exceed the dividends it "earned."

To determine whether the taxpayer's dividends exceed the dividends it earned, the taxpayer's "actual dividend rate" is first computed. The actual dividend rate 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. This is then compared to the taxpayer's "stated dividend rate," which is the return represented by the annual fixed preferred dividends payable on the stock. If the actual dividend rate exceeds the stated dividend rate, a portion of each dividend received or deemed received will be an extraordinary dividend, and basis will be reduced by the untaxed portion of such dividend.

 

For example, 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 fixed preferred dividends of $6 per share to shareholders of record on March 31 and September 30 of each year. If the taxpayer does not elect to have the special rule apply, the basic rule would generally require the taxpayer to reduce the basis in the stock by the untaxed portion of each dividend received prior the expiration of the two holding period. This is because a dividend exceeding 5 percent of adjusted basis (or fair market value, if shown to the satisfaction of the Secretary) paid semiannually is an extraordinary dividend under the general rule.2 However, special rule will apply to the preferred stock. Under this provision, the taxpayer's stated dividend rate is 12 percent ($12/$100). If the taxpayer sells the stock on October 1, 1988, (after holding the stock for 1.75 years) and no dividends in excess of the fixed preferred dividends have been paid, its "actual dividend rate" will be 13.7 percent ($240/$1,000 dividend by 1.75). This 13.7 percent exceeds the 12 percent stated dividend rate by 1.7. This excess, as a fraction of the actual dividend rate, is 12.4 percent (1.7 divided by 13.7). Accordingly, each of the dividends will be treated as an extraordinary dividend described in section 1059(a) to the extent of 0.74 per share ($6 x 12.4 percent). However, if the corporation does not sell the stock until January 1, 1989, and no dividends in excess of the fixed preferred dividends have been paid, its "actual dividend rate" will be 12 percent ($240/$1000 divided by 2.0). This does not exceed the stated dividend rate; accordingly, no portion of any dividend will be treated as an extraordinary dividend.

 

In addition, under the conference agreement the term "extraordinary dividend" is expanded to include any distribution (without regard to the holding period for the stock or the relative magnitude of the distribution) to a corporate shareholder in partial liquidation of the distributing corporation. 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, the conferees intend 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.3 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 conference agreement the term extraordinary dividend includes any redemption of stock that is non-pro rata (again, irrespective of the holding period of the stock or the relative size of the distribution).

Except as provided in regulations, the provisions do not apply to distributions between members of an affiliated group filing consolidated returns. In addition, they do not apply to distributions that constitute qualifying dividends within the meaning of section 243(b)(1). Accordingly, the provision generally will not apply to dividend distributions (or deemed dividend distributions) during a consolidated return year by a subsidiary out of earnings and profits accumulated during separate return affiliation years.

In order to prevent double inclusions in earnings and profits, the conferees expect 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.

The provision is generally effective for dividends declared after 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 date of enactment.

 

F. Corporate Shareholder Redemptions

 

 

Present Law

 

 

If a shareholder surrenders stock of the issuing corporation and receives a distribution out of earnings and profits, the transaction is treated as a dividend, rather than a sale of the surrendered stock, unless specified circumstances exist.

If the transaction is treated as a sale, capital gain or loss treatment may apply to the difference between the amount of the distribution and the basis of the stock surrendered. The shareholder's basis in the remaining shares is equal to the basis of all of the taxpayer's shares prior to the surrender, reduced by the basis of the shares surrendered.

If the transaction is treated as a dividend, the gross amount of the distribution is taxed as a dividend and the basis of the shareholder's remaining stock is not reduced. In the case of a corporate shareholder, the dividends received deduction generally is available.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

Under the Senate amendment, if a corporate shareholder surrenders stock of the issuing corporation and receives a distribution for which the dividends received deduction would be available if the distribution were treated as a dividend, the transaction is generally treated as a sale of the surrendered stock. However, no loss is created if no loss would have been allowed under present law.

 

Conference Agreement

 

 

The conference agreement does not include the Senate amendment.

 

G. Stock Redemption Payments

 

 

Present Law

 

 

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. The Supreme Court has held that the capitalization requirement extends to expenses such as legal, brokerage, and accounting fees incident to an acquisition of stock.

Some authority exists 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.

 

House Bill

 

 

The House bill provides that no portion of payments by a corporation in connection with a redemption of its stock is deductible. No effective date is expressly provided.

 

Senate Amendment

 

 

The Senate amendment is generally the same as the House bill, except the provision does not apply to (1) interest deductible under section 163, (2) amounts constituting dividends 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, or (3) 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 demand of a shareholder. The provision is effective for payments on or after March 1, 1986.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment, with certain modifications and clarifications.

The conferees intend that the denial of deductibility will apply to amounts paid in connection with a purchase of stock in a corporation, whether paid by the corporation directly or indirectly, e.g., by a controlling shareholder, commonly controlled subsidiary or other related party.

The conferees wish to clarify that, while the phrase "in connection with [a] redemption" is intended to be construed broadly, the provision is not intended 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.4 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.

The conferees anticipate 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.5

However, the conferees intend 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. The conferees intend 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, the conferees intend no inference regarding the deductibility of such payments under present law. Moreover, no inference is intended as to the character of such payments in the hands of the payee.

The provision is effective for payments on or after March 1, 1986.

 

H. Special Limitations on Net Operating Loss and Other Carryforwards

 

 

Present Law

 

 

Under present law, net operating loss ("NOL") carryforwards are eliminated in different degrees and subject to different requirements, depending on whether the transaction takes the form of a taxable purchase or a tax reorganization. Under the 1954 Code version of section 382, in the case of a taxable purchase, NOL carryforwards are eliminated if one or more of the loss corporation's ten largest shareholders increase their common stock ownership by more than 50 percentage points through taxable purchases within a two-year period, unless the loss corporation continues to conduct the trade or business that was conducted before the ownership change. In the case of a tax-free reorganization, if the loss corporation's shareholders' continuing interest is less than 20 percent, the NOL carryforwards are reduced by five percent for each percentage point less than 20 percent received by such shareholders. The business-continuation requirement applicable to taxable purchases under section 382 is inapplicable to tax reorganizations, although continuity of business enterprise generally is required to qualify a transaction as a tax-free reorganization.

Amendments were made to section 382 by the Tax Reform Act of 1976 that would substantially change these 1954 Code provisions. The effective date of these amendments was repeatedly postponed until January 1, 1986.

 

House Bill

 

 

Under the House bill, if there is a more than 50 percent change in the ownership of a loss corporation over a three-year period, however effected, the loss corporation's NOL carryforwards are not reduced, but there is an annual limitation on their use after the change of ownership. In general, the annual amount of earnings against which the NOL carryforwards may be used after the ownership change cannot exceed the value of the loss corporation at the time of the change multiplied by the long-term tax-exempt rate. Under the bill, however, NOL carryforwards are eliminated entirely following both taxable purchases and tax-free reorganizations, unless the loss corporation satisfies the continuity of business enterprise requirements that apply to tax-free reorganizations under present law, for the two-year period following the ownership change. The acquisition of stock by reason of death does not result in the application of the special limitations, if the decedent was a member of the holder's family.

The limitations imposed by the bill on NOL carryforwards also apply to built-in losses (including built-in depreciation deductions), and take into account built-in gains. The special rules apply to built-in losses and gains recognized during the ten-year recognition period following the change of ownership. The built-in loss and gain rules do not apply, however, unless such net gains or net losses exceed 15 percent of the value of the loss corporation.

The value of the loss corporation for purposes of determining the applicable limitation on the use of NOL carryforwards following an ownership change is reduced under the bill by the value of any capital contributions made to the loss corporation within the three-year period prior to the acquisition date. In addition, if at least one-third of the loss corporation's assets consists of nonbusiness assets, the value of the loss corporation is reduced by the value of such assets (less an allocable portion of the corporation's indebtedness).

Creditors who receive stock in exchange for their claims in a bankruptcy proceeding are treated as new shareholders, not continuing shareholders, for purposes of determining whether a change of ownership has occurred. Accordingly, after a bankruptcy reorganization or a stock-for-debt exchange that occurs as part of a bankruptcy proceeding, the limitations will apply if creditors receive stock worth more than 50 percent of the bankrupt corporation's value. In applying the limitations, however, a loss corporation's value is measured immediately after the change, thus taking account of additional positive value, if any, resulting from the surrender of the creditor's claims.

The bill would be effective for taxable acquisitions on or after January 1, 1986, and for tax-free reorganizations pursuant to plans adopted on or after January 1, 1986.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except as generally described below.

First, transfers by reason of death, gift, divorce, or separation are disregarded for purposes of determining whether an ownership change has occurred. In addition, acquisition of stock by an employee stock ownership plan (ESOP) or ESOP participants are disregarded in making such determinations.

Second, the rate that is applied to the loss corporation's value to determine the annual limitation on the use of NOL carryforwards is the Federal mid-term rate, without any adjustment to take into account tax exemption.

Third, the Senate amendment does not apply the continuity of business enterprise requirements for purposes of the special limitations.

Fourth, although the Senate amendment provides generally similar rules regarding built-in gains and losses, the recognition period is five years (instead of ten years), and the de minimis threshold is 25 percent (instead of 15 percent). Moreover, built-in depreciation deductions are not treated as built-in losses subject to the limitations.

Fifth, NOL carryforwards are totally eliminated if two-thirds or more of the loss corporation's asset value is attributable to assets held for investment. This rule does not apply to regulated investment companies or real estate investment trusts.

Sixth, the value of the loss corporation for purposes of determining the amount of the applicable limitation is reduced by capital contributions made with a tax-avoidance motive. Capital contributions made within two years prior to an ownership change, however, are presumed to have a tax-avoidance motive, except to the extent provided in regulations.

Seventh, if the creditors and former shareholders of the loss corporation retain at least a 50-percent interest in the corporation, creditors who receive stock in exchange for their claims as part of a bankruptcy proceeding are treated as continuing shareholders, provided their debt was held for at least one year prior to the filing of the bankruptcy petition or arose in the ordinary course of the loss corporation's business. Interest deductions on debt converted during the proceeding, however, reduce the amount of NOL carryforwards to the extent such interest was deducted by the loss corporation during the three-year period preceding the bankruptcy proceeding. In addition, all NOL carryforwards are eliminated if a loss corporation experiences a second ownership change within two years.

The Senate amendment is effective for purchases after December 31, 1986, and for tax-free reorganizations pursuant to plans adopted after December 31, 1986.

 

Conference Agreement

 

 

Overview

The conference agreement alters the character of the special limitations on the use of NOL carryforwards in a manner generally similar to the House bill and the Senate amendment. After an ownership change, as described below, the taxable income of a loss corporation available for offset by pre-acquisition NOL carryforwards is annually limited to a prescribed rate times the value of the loss corporation's stock on the date of 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 conference agreement 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 conference agreement also includes numerous technical changes and several anti-avoidance rules. Finally, the conference agreement applies similar rules to carryforwards other than NOLS, such as net capital losses and excess foreign tax credits.

Ownership change

Under the conference agreement, 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).6 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 loss corporation's stock is generally treated as stock owned by a single 5-percent shareholder. 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 or amounts of stock are not taken into account.

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. 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 in the conference agreement, the conferees expect the Treasury Department 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. 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, the conferees are concerned 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 conferees expect that 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 under the conference agreement 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. 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 acquires 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 are 5-percent shareholders, 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 under the conference agreement as any tax-free reorganization within the meaning of section 368, other than a divisive reorganization or an "F" reorganization. In addition, to the extent provided in regulations, the term equity structure shift will 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). A 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 such 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. The conferees believe, however, that 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 conferees intend that the Treasury Department will treat such transactions under the rules applicable to equity structure shifts.

Under the conference agreement, 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. Moreover, the conference agreement provides regulatory authority to apply similar segregation rules in cases, such as a public offering or recapitalization, that involve only a single corporation.

 

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.

 

It is anticipated that the same results would apply in a taxable merger in which the loss corporation survives, under facts as described above, pursuant to regulations treating taxable reorganization-type transactions as equity structure shifts.

 

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 non-voting 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, however, 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. Under the statutory definitions contained in the conference agreement, 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.7 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).

 

Under the conference agreement, however, to the extent provided in regulations that will apply prospectively from the date the regulations are issued, a public offering can be treated as an equity structure shift. 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 public offering could be treated as an equity structure shift, and 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 percent age 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 conference agreement anticipates that the regulations treating public offerings as equity structure shifts also 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 preceding either the owner shift involving a 5-percent shareholder or the equity structure shift. 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. In determining whether an ownership change has occurred as a result of a transaction or transactions following an equity structure shift or owner shift involving a 5-percent shareholder that did not result in an ownership change, the conference agreement provides that, unless a different proportion is established, the acquisition of stock after such a shift shall be treated as being made proportionately from all the shareholders immediately before the acquisition.

 

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 exceptions, are applied. The rules for attributing ownership from corporations to their shareholders are applied without regard to the extent of the shareholders' ownership in the corporation. Thus, any stock owned by a corporation is treated as being owned proportionately by its shareholders. Moreover, except as provided in regulations, any such 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. 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. 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 otherwise established, 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 merges into P, with P surviving, and B is completely cashed out. The attribution rules and special aggregation rules apply to treat Shareholder Group A as a single, separate 5-percent shareholder owning 80 percent of both L and P prior to the merger. Following the merger, Shareholder Group A still owns 80 percent of the stock of P, a new loss corporation, and Y owns 20 percent. No ownership change occurs as a result of the merger, because the stock of P, the new loss corporation, owned by Y (20 percent) has not increased by more than 50 percentage points over the lowest percentage of stock of L, the old loss corporation, owned by Y at any time during the testing period (0 percent prior to January 1, 1988).

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 conference agreement provides that, unless a different proportion is established, acquisitions of stock following an equity structure shift shall be treated as being made proportionately from all shareholders immediately before such acquisition. 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).

 

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.

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. (The subsequent exercise of such an option is, of course, disregarded if the owner of the option has been treated as owning the underlying stock.) 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, or put, if such a presumption results in an ownership change. 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.

 

Under the conference agreement, A, except as provided in regulations, is treated as owning all the L stock that he might receive under the contingency (and such stock is thus treated as additional outstanding stock). Accordingly, an ownership change of L has Code occurred, 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)) has 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).

 

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. 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. The acquisition of employer securities from any such plan by a participant of any such plan pursuant to the requirements of section 409(h) will also 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. 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 20.--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 21.--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 the conference agreement, Public/L and Public/P are each treated as a separate 5-percent shareholder of Newco, the new loss corporation.8 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. 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.

In addition, the testing period does not begin before the first day of the first taxable year from which there is a loss carryforward or excess credit. 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 conferees expect, 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 taxable income that can be offset by a pre-change loss (described below) cannot exceed the section 382 limitation for such year. 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).

The conference agreement requires the Treasury Department to prescribe regulations regarding the application of the section 382 limitation in the case of a short taxable year. The conferees expect that 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.

The section 382 limitation for any taxable year is increased by the amount of any recognized built-in gains (determined under the rules described below) and any gain recognized by virtue of a section 338 election (to the extent such gain is not 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 22.--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 conference agreement 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) 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 foregoing 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. 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. Under the conference agreement, 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 conference agreement also requires the Treasury Department 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.

In determining value, the conferees intend that 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 simply to gross-up the amount paid for the 20-percent interest to determine the value of the corporation's stock. The conferees anticipate that, under regulations, 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 23.--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 under the bill 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. The conferees intend that 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 for acquiring 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 of 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 corporate tax rate of 34 percent) and 100 percent of the long-term Federal rate.

 

Example 24.--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 a 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 irrefutably 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 conferees intend that the regulations will generally 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 nonbusiness 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 under the conference agreement.

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. This rule minimizes the NOLs that are subject to the special limitations.

Built-in gains and 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.

 

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 25.--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.

Under the conference agreement, 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. Under the conference agreement, depreciation deductions cannot be treated as accrued deductions or built-in losses. The conference agreement, however, requires the Secretary of the Treasury 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.

 

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 (1) the asset was held by the loss corporation immediately before the change date, and (2) 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 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. 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 this rule, 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.

If the exception for bankruptcy proceedings applies, several special rules are applicable. First, the pre-change masses 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 conference agreement directs the Secretary of the Treasury to study informal bankruptcy workouts under sections 108 and 382, and report to the tax-writing committees of the Congress before January 1, 1988.

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 present law.8a 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 deposits of the troubled thrift that become deposits in the acquiring corporation are treated as stock, as under present law. 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 under the conference agreement. 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 existing 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 under the conference agreement, 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 conference agreement 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 conference agreement also expands the scope of section 383 to include passive activity losses and credits and minimum tax credits.

Anti-abuse rules

The conference agreement does not alter the continuing application of section 269, relating to acquisitions made to evade or avoid taxes, as under present law. Similarly, the SRLY and CRCO principles under the regulations governing the filing of consolidated returns will continue to apply. The conferees intend, however, that the Libson Shops doctrine will have no application to transactions subject to the provisions of the conference agreement.

The conference agreement 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 conferees expect the regulations 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, the conferees believe 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.

The conferees do not intend any inference to be drawn 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 conferees expect the Treasury Department to review this situation.

The conferees expect that regulations issued under this grant of authority with respect to partnerships should be effective for transactions after the date of enactment. The conferees expect that 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 conference agreement 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 conference agreement, 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 conference agreement generally apply to ownership changes that occur on or after January 1, 1987. In the case of equity structure shifts, the new rules apply to reorganizations pursuant to plans adopted on or after January 1, 1987. For purposes of these 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 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 that occurs as part of a Title 11 or other court-supervised proceeding, 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 conference agreement begins on May 6, 1986 (the date of Senate Finance Committee action). If an ownership change occurs after May 5, 1986, but before January 1, 1987, and section 382 and 383 (as amended by the conference agreement) do not apply, then the earliest testing date will not begin before the first day immediately after 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 conference agreement, 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.

Special transitional rules are provided under which present law continues to apply to certain ownership changes after January 1, 1987.

 

I. Net Operating Loss (NOL) Carrybacks--Tax Rate Limitation

 

 

Present Law

 

 

A net operating loss may be carried back (generally, to each of the three years preceding the taxable year of the loss) without regard to any differences between the tax rates in effect in the year in which the loss arose and the rates in effect in the year to which the loss is carried back.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

Under the Senate amendment, a net operating loss of a corporation may reduce such corporation's income tax liability for a carryback year only up to an amount equal to the product of (1) the amount of the carryback and (2) the highest regular corporate tax rate in effect in the taxable year in which the loss arose. However, the number used as such highest rate of tax is to be adjusted under regulations to result in aggregate revenues during fiscal years 1987 through 1991 not exceeding $200 million. The provision is effective for net operating losses for taxable years beginning after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement does not adopt the Senate amendment.

 

J. Recognition of Gain or Loss on Liquidating Sales and Distributions of Property

 

(General Utilities)

 

 

Present Law

 

 

In general, a corporation recognizes no gain or loss on a distribution of its assets to shareholders in liquidation or, if certain conditions are met, on a liquidating sale of its assets (secs. 336 and 337). Partial recognition of gain may be required, however, under statutory or judicial rules such as the depreciation recapture provisions and the tax benefit doctrine. The statutory provision providing for nonrecognition in these circumstances is sometimes referred to as the General Utilities rule, after a Supreme Court case8b said to be codified in the provision.

Nonrecognition is also available in certain "deemed" liquidating sale transactions following a purchase of a controlling interest in one corporation by another corporation (sec. 338).

Gain (but not loss) is generally recognized by a corporation on a nonliquidating distribution of property with respect to its stock (e.g., a dividend or a redemption). The gain recognized is generally the excess of the fair market value of the property over its basis in the hands of the distributing corporation. A corporation may be entitled to nonrecognition on a nonliquidating distribution if it relates to "qualified stock." In general, qualified stock is stock held by a long-term noncorporate shareholder owning ten percent or more of the corporation's outstanding stock.

 

House Bill

 

 

In general

Under the House bill, gain or loss is recognized by a corporation on a liquidating distribution of its assets, as if the corporation had sold the assets to the distributee at fair market value, and on liquidating sales. In addition, the treatment of nonliquidating distribution is generally conformed to the treatment of liquidating distributions.

Exceptions to requirement of recognition

The House bill provides exceptions from the general rule for the following distributions and sales in liquidation:

 

(1) distributions to a controlling corporate shareholder in a liquidation qualifying under section 332 in which the basis of the property in the hands of the shareholder is determined under section 334(b)(1) (but only to the extent of the controlling corporation's pro rata share of gain or loss on each asset);

(2) certain distributions in connection with tax-free reorganizations;

(3) certain distributions with respect to stock held by noncorporate, long-term shareholders holding ten percent or more of the distributing corporation's stock (under rules similar to the qualified stock exception applicable to nonliquidating distributions under present law); and

(4) certain liquidating sales of property, and sales of stock treated as asset sales under section 338, to the extent nonrecognition would be available if the property had been distributed in liquidation.

 

The recapture provisions and other statutory and judicial exceptions to nonrecognition continue to apply to these excepted transactions to the same extent as under present law. In addition, gain on ordinary income property and short-term capital gain property is subject to tax under the third and fourth exceptions.

S corporations

The House bill provides a special rule for S corporations designed to prevent avoidance of the provisions through a conversion of a C corporation to S corporation status. If an S corporation that was formerly a C corporation is liquidated before the close of the second taxable year following the year in which the election took effect, the S election is terminated retroactively.

Nonliquidating distributions

In general, present law rules continue to apply to nonliquidating distributions, except that the rules relating to the definition of qualified stock for purposes of the exception under present law are conformed to the rules for the definition qualified stock for liquidating distributions provided by the bill.

 

Effective Date

 

 

The provisions apply to distributions and sales and exchanges occurring on or after November 20, 1985. Under transitional rules, distributions and sales made pursuant to a plan of liquidation adopted before that date are not affected. Special rules apply in determining whether a plan was adopted before November 20, 1985, including rules for certain stock sales underway before that date.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement generally follows the House bill, with certain modifications and clarifications, thus repealing the General Utilities doctrine.

Thus, gain or loss is generally recognized by a corporation on a liquidating sale of its assets. Gain or loss is also generally recognized on a liquidating distribution of assets as if the corporation had sold the assets to the distributee at fair market value. Neither gain nor loss is recognized, however, with respect to any distribution of property by a corporation to the extent there is nonrecognition of gain or loss to the recipient under the tax-free reorganization provisions of the Code (part III of subchapter C).

Limitations on the recognition of losses

The conferees are concerned that taxpayers may utilize various means to avoid the repeal of the General Utilities doctrine, or otherwise take advantage of the new provisions, to recognize losses in inappropriate situations or inflate the amount of losses actually sustained. For example, under the general rule permitting recognition of losses on liquidating distributions, taxpayers may be able to create artificial losses at the corporate level or to duplicate shareholder losses in corporate solution through contribution of built-in loss property. Consequently, the conference agreement includes two provisions intended to prevent the recognition of such corporate level losses.

First, the conference agreement provides generally that no loss is recognized by a liquidating corporation with respect to any distribution of property to a related person (within the meaning of section 267), unless the property is distributed to all shareholders on a pro rata basis and 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 would not be permitted to 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 would not be permitted to 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.

Second, the conference agreement generally provides that if a principal purpose of the contribution of property to a corporation in advance of its liquidation is to recognize a loss upon the sale or distribution of the property and thus eliminate or otherwise limit corporate level gain, then the basis (for purposes of determining loss) of any property acquired by such corporation in a section 351 transaction or as a contribution to capital will be reduced, but not below zero, by the excess of the basis of the property on the date of contribution over its fair market value on such date. For purposes of this rule, it is presumed, except to the extent provided in regulations, that any section 351 transaction or contribution to capital within the two-year period prior to the adoption of a plan to complete liquidation (or thereafter) has such a principal purpose. Although a contribution more than two years before the adoption of a plan of liquidation might be made with a prohibited purpose, the conferees expect that those rules will apply only in the most rare and unusual cases under such circumstances.

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, the conferees intend that, in appropriate cases, the liquidating corporation may recapture the disallowed loss on the tax return for the taxable year in which such plan of liquidation is adopted. In the alternative, the corporation could file an amended return for the taxable year in which the loss was reported.

The conferees intend that the Treasury Department will issue regulations generally providing that the presumed prohibited purpose for contributions of property two years in advance 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. For 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, the conferees do not expect that any loss arising from the disposition of the New Mexico real estate would be allowed under the Treasury regulations.

As another example, the conferees expect that such regulations would 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. In such circumstance, application of the loss disallowance rule is inappropriate assuming there is a meaningful relationship between the contribution and the utilization of the corporate form to conduct a business enterprise, i.e., the contributed business, as distinguished from a portion of its assets, is not disposed of immediately after the contribution. The conferees also anticipate that the basis adjustment rules will generally not apply to a corporation's acquisition of property during its first two years of existence.

To illustrate the mechanical aspects of the basis adjustment rules, assume that on June 1, 1987, a shareholder who owns a 10-percent interest in X corporation ("X") contributes nondepreciable property with a basis of $1,000 and a value of $100 to X in exchange for additional stock; X is a calendar year taxpayer. Assume further that on September 30, 1987, X sells the property to an unrelated third party for $200, and includes the resulting $800 loss on its 1987 tax return. Finally, assume that X adopts a plan of liquidation on December 31, 1988. Thereafter, X could file an amended return reflecting the fact that the $800 loss was disallowed, because the property's basis would be reduced to $200. Alternatively, the conferees intend that X, under regulations, may be permitted to recapture the loss on its 1988 tax return. The amount of loss recapture in such circumstances would be limited to the lesser of the built-in loss ($900, or $1,000, the transferred basis under section 362, less $100, the value of the property on that date it was contributed to X) or the loss actually recognized on the disposition of such property ($800, or the $1,000 transferred basis less the $200 amount realized). Thus, unless X files an amended return, X must recapture $800 on its return for its taxable year ending December 31, 1988.

Section 332 liquidations9

The conference agreement provides an exception for liquidating transfers within an affiliated group because 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.

The conference agreement modifies the exception for section 332 liquidations in which an 80-percent corporate shareholder receives property with a carryover basis, to provide for nonrecognition of gain or loss with respect to any property actually distributed to the controlling corporate shareholder (rather than a pro rata share of each gain or loss). If a minority shareholder receives property in such a liquidation, the distribution is treated in the same manner as a distribution in a nonliquidating redemption. Accordingly, gain (but not loss) is recognized to the distributing corporation.

The conference agreement denies nonrecognition under the exception for 80-percent corporate shareholders where the shareholder is a tax-exempt organization, unless the property, received in the distribution is used by the organization in an unrelated trade or business immediately after the distribution. If such property later ceases to be used in an unrelated trade or business of the organization acquiring the property, 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 conference agreement, in an amendment to section 367 of the Code, also denies nonrecognition under the section 332 carryover basis exception where the controlling corporate shareholder is a foreign corporation, except as provided in regulations. The conferees expect that regulations may permit nonrecognition if the appreciation on the distributed property is not being removed from the U.S. taxing jurisdiction prior to recognition.

Nonliquidating distributions of appreciated property

In general, the tax treatment of corporations with respect to nonliquidating distributions of appreciated property has historically been the same as liquidating distributions. In recent years, however, nonliquidating distributions have been made subject 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 conference agreement generally conforms the treatment of nonliquidating distributions with liquidating distributions. Accordingly, the conference agreement provides that gain must generally be recognized to a distributing corporation if appreciated property (other than an obligation of the corporation) is distributed to shareholders outside of complete liquidation.

The present law exceptions to recognition that are provided for nonliquidating distributions to ten percent, long-term noncorporate shareholders, and for certain distributions of property in connection with the payment of estate taxes or in connection with certain redemptions of private foundation stock, are repealed. As under current law, no loss is recognized to a distributing corporation on a nonliquidating distribution of property to its shareholders.

Conversion from C corporation to S corporation status

The conference agreement 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 or distribution, 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, will be limited to the aggregate net built-in gain of the corporation at the time of conversion to S corporation status. Gains on sales or distributions of assets by the S corporation will be presumed to be built-in gains, except to the extent the taxpayer can establish 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 will be 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 will be allowed to continue to take into account all of its subchapter C tax attributes in computing the amount of the tax on recognized built-in gains, permitting it, for example, to use unexpired net operating losses, capital loss carryovers and minimum tax carryover credits to offset such tax. These provisions will generally be effective with respect to S elections made after December 31, 1986. For S elections made before January 1, 1987, the amendments made by the conference agreement do not apply. Thus, for example, the prior version of section 1374 will apply to such corporations.

Election to treat sales or distributions of certain subsidiary stock as asset transfers

The conference agreement generally conforms the treatment of liquidating sales and distributions of subsidiary stock to the present law treatment of nonliquidating sales or distributions of such stock; thus, such liquidating sales or distributions are generally taxable at the corporate level. The conferees believe it is 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 an individual recipient outside the economic unit of the selling or distributing affiliated group.

Section 338(h)(10) of present law, in certain circumstances, permits a corporate purchaser and a seller of an 80-percent-controlled subsidiary to 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) are that the selling corporation and its target subsidiary are members of an affiliated group filing a consolidated return for the taxable year that includes the acquisition date. If an election is made, the underlying assets of the company that was sold receive a stepped-up, fair market value basis; the selling consolidated group recognizes the gain or loss attributable to the assets; and there is no separate tax on the seller's gain attributable to the stock. This provision offers taxpayers relief from 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 assets of the corporation. The conference agreement, following the House bill, retains this provision.

In addition, the conference agreement permits the expansion of the section 338(h)(10) concept, to the extent provided in regulations, to situations in which the selling corporation owns 80 percent of the value and voting power of the subsidiary, but does not file a consolidated return. Moreover, the conference agreement provides that, under regulations, principles similar to those of section 338(h)(10) may be applied to taxable sales or distributions of controlled corporation stock. The conferees intend that the regulations under this elective procedure will account for appropriate principles that underlie the liquidation-reincorporation doctrine. For example, to the extent that regulations make available an election to treat a stock transfer of controlled corporation stock to persons related to such corporation within the meaning of section 368(c)(2), it may be appropriate to provide special rules for such corporation's section 381(c) tax attributes so that net operating losses may not be used to offset liquidation gains, earnings and profits may not be manipulated, or accounting methods may not be changed.

The conferees do not intend this election to affect the manner in which a corporation's distribution to its shareholders will be characterized for purposes of determining the shareholder level income tax consequences.

Regulatory authority to prevent the circumvention of General Utilities repeal

The repeal of the General Utilities doctrine is designed to require the corporate level recognition of gain on a corporation's sale or distribution of appreciated property, irrespective of whether it occurs in a liquidating or nonliquidating context. The conferees expect the Secretary to issue, or to amend, regulations to ensure that the purpose of the new provisions is not circumvented through the use of any other provision, including the consolidated return regulations or the tax-free reorganization provisions of the Code (part III of Subchapter C).

 

Effective Dates

 

 

The repeal of the General Utilities doctrine is generally effective for liquidating sales and distributions after July 31, 1986. The conference agreement generally preserves all transitional rules provided in the House bill. Thus, transactions for which the requisite action had occurred prior to November 20, 1985, under the special rules and definitions provided in the House bill and the Report of the Committee on Ways and Means will generally continue to be grandfathered. However, in order to qualify under those transitional rules, all the liquidating sales or distributions, (instead of at least one such sale or distribution) must be completed before January 1, 1988. The agreement provides two additional transitional rules, one of general application and one applicable only to certain closely held corporations.

General transitional rules

In addition to the rule discussed above, the new provisions do not apply to the following transactions:

 

(1) a liquidation completed before January 1, 1987;

(2) a deemed liquidation pursuant to a section 338 election where the acquisition date (the first date on which there is a qualified stock purchase under section 338) occurs before January 1, 1987;

(3) a liquidation pursuant to a plan of liquidation adopted before August 1, 1986, that is completed before January 1, 1988;

(4) a liquidation of a corporation if a majority of the voting stock of the corporation is acquired on or after August 1, 1986, pursuant to a written binding contract in effect before August 1, 1986, and if the liquidation is completed before January 1, 1988;

(5) a liquidation of a corporation if there was a binding written contract or contracts to acquire substantially all the assets of the corporation in effect before August 1, 1986, and the liquidation is completed before January 1, 1988; and

(6) a deemed liquidation, under section 338, of a corporation for which a qualified stock purchase under section 338 first occurs on or after August 1, 1986, pursuant to a written binding contract in effect before August 1, 1986, provided the section 338 acquisition date occurs before January 1, 1988.

 

A plan of liquidation is adopted if the plan has been approved by the shareholders. (See Treas. Reg. sec. 1.337-2(b)). If a plan of liquidation would have been considered adopted for purposes of commencing the present-law 12-month period under section 337, it will be deemed adopted for this purpose.

Although the special additional definitions of the term "adoption of a plan" provided in the House bill and Report of the Committee on Ways and Means continue to apply for purposes of determining whether the requisite action was taken prior to November 20, 1985, such special rules do not apply for purposes of determining whether a plan of liquidation is adopted before August 1, 1986.

For purposes of determining whether there was a binding written contract or contracts to sell substantially all the assets of a corporation before August 1, 1986, the term "substantially all the assets" shall generally mean 70 percent of the gross fair market value and 90 percent of the net fair market value of the assets. In addition, even though the contract or contracts cover a lesser amount of assets, if such contract or contracts would require shareholder approval under the applicable state law that may require such approval for a sale of substantially all of such corporation's assets, then they shall qualify as contracts to sell substantially all the assets and shall be considered binding even though shareholder approval has not yet been obtained.

An acquisition of stock or assets will be considered made pursuant to a binding written contract even though the contract is subject to normal commercial due diligence or similar provisions and the final terms of the actual acquisition may vary pursuant to such provisions.

For purposes of these rules, a liquidation is completed by a required date if it would be considered completed for purposes of section 337 of present law by that date. For example, there may be a distribution of assets to a qualified liquidating trust (See, e.g., Rev. Rul. 80-150, 1980-1 C.B. 316).

Certain closely held corporations

The conference agreement deletes the House bill exception for distributions to certain long-term noncorporate shareholders. The conference agreement provides an additional transitional rule for certain closely held corporations. Corporations eligible for this rule are generally entitled to present law treatment with respect to liquidating sales and distributions occurring before January 1, 1989, provided the liquidation is completed before that date. A liquidation will be treated as completed under the same standard that is applied under the general transitional rules. However, this special transitional rule requires the recognition of income on distributions of ordinary income property (appreciated property that would not produce capital gain if disposed of in a taxable transaction) and short-term capital gain property. Thus, the failure of an eligible closely held corporation to complete its liquidation by December 31, 1986, or otherwise to satisfy the general transitional rules, will result in the loss of nonrecognition treatment for the distribution of appreciated ordinary income and short-term capital gain property. Corporations eligible for this rule may also make an S election prior to January 1, 1989, without becoming subject to the special S corporation rules of the conference agreement. Such eligible, electing corporations, however, will be subject to the 1954 Code version of section 1374.

A corporation is eligible for this rule if its value does not exceed $10 million and more than 50 percent of its stock is owned by 10 or fewer individuals who have held their stock for five years or longer. Full relief is available under this rule only if the corporation's value does not exceed $5 million; relief is phased out for corporations with values between $5 million and $10 million. For purposes of this rule, a corporation's value will be the higher of the value on August 1, 1986, and its value as of the date of adoption of a plan of liquidation (or, in the case of a nonliquidating distribution, the date of such distribution), and aggregation rules similar to those in section 1563 apply, except that control is defined as 50 percent rather than 80 percent.

In the case of nonliquidating distributions, apart from changes in the case of ordinary income property and short-term capital gain property, present law is otherwise retained for distributions to qualified, long-term individual shareholders (but only during the transitional period) for corporations qualifying under the closely held corporation transitional rule.

Treasury study of subchapter C

The conference agreement directs the Treasury Department to consider whether changes to the provisions of subchapter C (relating to the income taxation of corporations and their shareholders) and related sections of the Code are desirable, and to report to the taxwriting committees no later than January 1, 1988.

 

K. Allocation of Purchase Price in Certain Sales of Assets

 

 

Present Law

 

 

When a going business is sold for a lump-sum amount, the buyer and seller must each allocate the purchase price among the assets for tax purposes.

Under one method of allocating purchase price to nondepreciable goodwill and going concern value, the value of such assets is determined as the excess of the purchase price over the aggregate fair market value of the tangible assets and the identifiable other intangible assets. This is the so-called "residual" method of allocation. Another method attempts to determine the value of goodwill and going concern value under a formula approach that capitalizes the apparent "excess" earning capacity of the business.

In some cases a taxpayer who has purchased a going business at a premium (that is, a price that it has determined exceeds the apparent aggregate fair market values of the tangible and intangible assets, including goodwill and going concern value) might take the position that it is entitled to allocate an amount in excess of fair market value to the basis of each of the individual assets. Relying on one interpretation of the judicial and administrative authorities, the taxpayer would separately value each of the acquired assets (including goodwill and going concern value) and allocate the premium among all the assets (other than cash and cash equivalents) in proportion to their relative fair market values in a so-called "second-tier allocation."

Proposed and temporary regulations recently issued by the Treasury Department under section 338 mandate a residual method of allocation (and prohibit a second-tier allocation) in determining the basis of assets acquired in a qualified stock purchase for which a section 338 election is made or is deemed to have been made, i.e., a stock purchase which is treated as a purchase of assets for tax purposes. These rules do not by their terms apply to actual asset acquisitions.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The Senate amendment requires both the buyer and seller to use the residual method in actual asset acquisitions, and thus conforms the rules for such acquisitions with the rules for deemed asset acquisitions as provided in the Treasury regulations.

The amendment also authorizes the Treasury Department to require information reporting regarding allocations by the parties to such asset acquisitions.

The provision is effective for transactions completed after May 6, 1986, unless pursuant to a binding contract in effect on that date and at all times thereafter.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

L. Related Party Sales

 

 

Present Law

 

 

Installment sale treatment is not available for gain on a sale of property to a related party if the property is depreciable in the hands of the transferee, unless it is established to the satisfaction of the Internal Revenue Service that tax avoidance was not a principal purpose of the sale. Gain on sales of depreciable property between related parties is treated as ordinary income. In the case of certain related party partnership transactions, ordinary income treatment is also required if the property is not a capital asset in the hands of the transferee.

Related parties for these purposes include a person and all entities which are 80 percent owned, directly or indirectly, with respect to that person. Specified attribution rules apply.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The Senate amendment modifies the definition of the related parties to which the present law rules apply. Under the amendment, related parties include a person and all entities more than 50 percent owned, directly or indirectly, by that person. Related parties also include entities more than 50 percent owned, directly or indirectly, by the same persons. The attribution and relationship rules are generally based on present law rules that apply to limit losses on sales between related parties. For example, there is attribution between parents and children.

The provision applies to sales after June 20, 1986, unless made pursuant to a binding contract in effect on that date.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment, with certain modifications. The definition of related parties is further expanded to cover other relationships that are covered under present law for purposes of disallowing losses on related party sales. In addition, in some types of sales, the conference agreement requires ratable basis recovery by the seller and conformity between buyer and seller regarding recognition of income and basis.

 

M. Amortizable Bond Premium

 

 

Present Law

 

 

An amortizable bond premium exists where a taxpayer buys B bond for more than face value. The amount of that excess is allowed as a deduction over the remaining term of the bond, generally offsetting interest income on the bond.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The amortizable bond premium deduction is treated as interest, except as otherwise provided by regulations. Thus, for example, bond premium is treated as interest for purposes of applying the investment interest limitations.

The provision is effective for obligations acquired after date of enactment.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

N. Cooperative Housing Corporations

 

 

Present Law

 

 

A tenant-stockholder in a cooperative housing corporation generally is entitled to deduct his or her "proportionate share" of the cooperative's expenses for interest and taxes (sec. 216(a)). Tenant-stockholders generally are limited to individuals (sec. 216(b)).

The tenant-stockholder's proportionate share of the cooperative's interest and taxes is that portion of such items that bears the same ratio to the cooperative's total interest and taxes that the portion of the cooperative's stock held by the tenant-stockholder bears to the total outstanding stock of the cooperative (sec. 216(b)(3)).

 

House Bill

 

 

The House bill provides that cooperative housing corporations that charge tenant-stockholders with a portion of the cooperative's interest and taxes in a manner that reasonably reflects the cost to the cooperative of the interest and taxes allocable to each tenant stockholder's dwelling unit, may elect to have such tenant-stockholders deduct the separately allocated amounts.

The provisions of the House bill are effective for taxable years beginning after December 31, 1985.

 

Senate Amendment

 

 

The Senate amendment provides that corporations, trusts and other taxpayers besides individuals may be treated as tenant-stockholders in cooperative housing corporations. In addition, maintenance and lease expenses are disallowed where payments by tenant-stockholders are allocable to amounts properly chargeable to the capital account of the cooperative.

The provisions of the Senate amendment are effective for taxable years beginning after December 31, 1986. Special rules are provided for two limited profit cooperatives.

 

Conference Agreement

 

 

The conference agreement includes the provisions of both the House bill and the Senate amendment. The conference agreement makes certain technical amendments to the provisions contained in the House bill, however, whereby separately allocated amounts of interest or taxes are deductible by a tenant-stockholder if the amount of such interest or taxes so allocated reasonably reflects the cost to the cooperative of the interest or taxes, as the case may be, allocable to the tenant-stockholder's dwelling unit, whether or not this condition is met with respect to both interest and taxes of the cooperative.

The conference agreement is effective for taxable years beginning after December 31, 1986. The conference agreement includes the special provisions contained in the Senate amendment for two limited profit cooperatives.

 

O. Real Estate Investment Trusts

 

 

Present Law

 

 

General requirements

An entity that qualifies as a real estate investment trust ("REIT") is subject to a corporate tax but is allowed a deduction for dividends paid to shareholders. In general, to qualify as a REIT, an entity (1) must be taxable as a domestic corporation, (2) must have at least 100 shareholders, (3) must not have 50 percent or more of its stock held by five or fewer individuals, (4) must distribute most of its income currently, (5) must hold a minimum percentage of its assets in real estate related and other passive assets, and (6) must derive minimum percentages of its income from such assets (secs. 856, 857). A REIT is required to be a calendar year taxpayer unless it was in existence as a REIT for any taxable year beginning prior to October 4, 1976 (sec. 859).

Asset and income requirements

In general, in order to meet the asset requirements, at least 75 percent of the value of the REIT's assets at the close of each quarter of the taxable year, must be represented by real estate assets, cash and cash items, and Government securities (sec. 856(c)).

In general, in order to meet the income requirements, at least 75 percent of the REIT's gross income for the taxable year must be derived from rents on real property, interest on obligations secured by real property, gain from the sale of interests in real property (other than property held for sale in the ordinary course of a trade or business), dividends from a REIT, refunds of property taxes, and certain other limited sources. In addition, at least 95 percent of the REIT's gross income must be derived from these sources and interest, dividends, or gains from the sale of securities (sec. 856(c)).

In addition, less than 30 percent of the gross income of the REIT must be derived from the sale or other disposition of property held for less than certain specified periods.

Definition of rents

Rents from real property include rents from interests in real property and charges for services customarily furnished in connection with the rental of real property whether or not such charges are separately stated (sec. 856(d)(1)). Income is not considered to qualify as rents from real property if services are provided other than through an independent contractor (sec. 856(d)(2)(C)). In addition, rents are not considered to qualify if they are based on the net profits of the tenant (sec. 856(d)(2)(A)).

Distribution requirement

In general, the distribution requirement is satisfied if, for the taxable year, the REIT distributes at least 95 percent of its taxable income determined without regard to any net capital gain (sec. 857(a)). For this purpose, a REIT may treat certain dividends paid after the close of the taxable year as having been paid during the taxable year (sec. 858(a)). Shareholders receiving such "spillover dividends" recognize income attributable to such dividends in the year of payment (sec. 858(b)).

Capital gains

If the REIT has recognized any net capital gain during a taxable year, the REIT is taxable on the amount of such gain unless it elects to pay a capital gain dividend.

The REIT may elect to pay a capital gain dividend by designating in a notice mailed to shareholders within 30 days of the end of the REIT's taxable year, that a dividend or portion thereof paid during the taxable year is a capital gain dividend. The dividend or portion so designated may not exceed the REIT's net capital gain reduced by any net operating losses. Any dividend so designated is treated as a long-term capital gain by the recipient shareholder (sec. 857(b)(3)).

Prohibited transactions

A 100-percent tax is imposed on a REIT's net income from prohibited transactions (sec. 857(b)(6)). Any net loss from prohibited transactions is not deductible in computing taxable income.

In general, a prohibited transaction is the sale of property held primarily for sale in the ordinary course of business. A safe harbor is provided whereby a sale of property is not treated as a prohibited transaction if such property has been held by the REIT for at least four years (for the production of rental income if land and improvements), the aggregate expenditures during the four year period preceding the date of sale that are includible in the basis of the property do not exceed 20 percent of the selling price of the property, and the sale is one of not more than five sales of property by the REIT during the taxable year, excluding sales of foreclosure property (sec. 857(b)(6)(C)). In general, the disposition of property acquired pursuant to a foreclosure is not treated as a prohibited transaction.

Deficiency dividends

If it is determined that the taxable income of a REIT for a prior year is understated, then the REIT may avoid the imposition of tax at the REIT level and possible disqualification, by the prompt distribution of a "deficiency dividend" (sec. 860). A REIT for which such a deficiency is determined must pay interest on an amount equal to the deficiency dividend, as well as a penalty equal to the amount of interest not in excess of half of the amount of the deficiency dividend (sec. 6697).

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

General requirements

Under the Senate amendment, a taxpayer without prior operating history is permitted to change its accounting year without consent in connection with its initial election of REIT status. The Senate amendment also provides that an entity is not disqualified from electing REIT status in the first taxable year of its existence because it was closely held. Partner to partner attribution is ignored in determining if the REIT is closely held. In order to elect REIT status under the Senate amendment, the electing entity must either have been treated as a REIT for all taxable years beginning after February 28, 1986, or must have no earnings and profits accumulated as a regular corporation.

Asset and income requirements

The Senate amendment provides that REITs are permitted to hold assets in wholly owned subsidiaries. The REIT and its REIT subsidiaries are treated as a single taxpayer under the Senate amendment (i.e., the separate corporate status of the REIT subsidiaries is ignored).

Under the Senate amendment, for a one-year period after the receipt of new equity capital, income from the temporary investment of the new capital that is derived from stock or debt instruments is treated as qualifying "75-percent income." Such stock or debt instruments are treated as qualifying assets for the same period under the Senate amendment.

Definition of rents

The Senate amendment permits REITs to provide, without being required to use independent contractors, those services that may be furnished in connection with the rental of real property by a tax-exempt organization without giving rise to unrelated business income.

The Senate amendment also permits REITs to receive rents based on the net income of the tenant, provided that the tenant's profits are derived only from sources that would be qualified rent if earned directly by the REIT.

Distribution requirement

Under the Senate amendment, any income that is accrued but not received with respect to original issue discount on a loan issued in exchange for nonpublicly traded property, or with respect to a deferred rental agreement, or any income that is recognized as the result of the failure of an exchange that the REIT intended in good faith to qualify, but that was ultimately determined not to qualify for treatment as a tax-free like kind exchange, is not subject to the distribution requirement to the extent that such amounts exceed five percent of the REIT's taxable income. The REIT is required to pay income tax on the undistributed amount.

The Senate amendment provides that the amount of a REIT's current earnings and profits will not be less than the REIT's taxable income for the purpose of determining whether a distribution was made out of earnings and profits.

Capital gains

The Senate amendment permits REITs to compute their capital gain dividends without offset for net operating losses (NOLs). NOLs not used to offset capital gain income are carried over according to the ordinary rules. REITs are permitted to send capital gain notices to shareholders with the mailing of their annual report, rather than 30 days after year end.

Prohibited transactions

Under the Senate amendment, the number of sales that a REIT is able to make within the prohibited transaction safe harbor is expanded from five to seven. The Senate amendment provides an alternative safe harbor whereby a REIT may make any number of sales during a taxable year provided that the gross income from such sales does not exceed 15 percent of the REIT's taxable income for such year (computed with certain adjustments). Any marketing or development activities with respect to properties that are sold is required to be performed by independent contractors where the REIT is taking advantage of the alternative safe harbor. The Senate amendment also increases the extent of improvements that a REIT is permitted to make from 20 percent to 30 percent of the property's adjusted basis. In addition, under the Senate amendment, losses from prohibited transactions are permitted to offset taxable income but are not permitted to offset gains from prohibited transactions.

Deficiency dividends

The Senate amendment eliminates the penalty tax under section 6697 on deficiency dividends paid by REITs.

 

Effective Date

 

 

The provisions of the Senate amendment generally are effective for taxable years beginning after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment with the following modifications.

Imposition of excise tax

 

In general

 

The conference agreement imposes a nondeductible excise tax on any REIT for each calendar year equal to four percent of the excess, if any, of the "required distribution" for the calendar year, over the "distributed amount" for such calendar year. The excise tax must be paid on or before March 15 of the following calendar year.

For these purposes, the term required distribution means, with respect to any calendar year, the sum of (1) 85 percent of the REIT's "ordinary income" for the calendar year, (determined as if the calendar year were the REIT's taxable year), (2) 95 percent of the REIT's capital gain net income (within the meaning of sec. 1222(9)) for such calendar year, (determined as if the calendar year were the REIT's taxable year), and (3) the excess, if any, of the "grossed up required distribution" for the preceding calendar year over the distributed amount for such preceding calendar year. For this purpose, the term grossed up required distribution for any calendar year is the sum of the taxable income of the REIT for the calendar year (without regard to the deduction for dividends paid) and all amounts from earlier years that are not treated as having been distributed under the provision.

The REIT's ordinary income for this purpose means its real estate investment trust taxable income (as defined in sec. 857(b)(2)) determined (1) without taking into account the dividends paid deduction, (2) by not taking into account any gain or loss from the sale of any capital asset, and (3) by treating the calendar year as the REIT's taxable year.

In addition, for these purposes, the term distributed amount means, with respect to any calendar year, the sum of (1) the deduction for dividends paid (within the meaning of sec. 561) during such calendar year, (2) amounts on which the REIT is required to pay corporate tax, and (3) the excess (if any) of the distributed amount for the preceding taxable year over the grossed up required distribution for such preceding taxable year. The amount of dividends paid for these purposes is determined without regard to the provisions of section 858.

Under the conference agreement, for purposes of applying these provisions, any deficiency dividend, (as defined in sec. 860(f)), is taken into account at the time it is paid, and any income giving rise to the adjustment is treated as arising at the time the dividend is paid.

 

Timing of inclusion of certain dividends

 

Under the conference agreement, any dividend declared by a REIT in December of any calendar year and payable to shareholders of record as of a specified date in such month, shall be deemed to have been paid by the REIT, (including for purposes of section 561), and to have been received by each shareholder, on such record date, but only if such dividend is actually paid by the REIT before February 1 of the following calendar year. This provision does not apply for purposes of section 858(a), however.

 

Earnings and profits

 

Under the conference agreement, a REIT is treated as having sufficient earnings and profits to treat as a dividend any distribution during any calendar year (other than a redemption to which section 302(a) applies), which distribution is treated as a dividend by such REIT, but only to the extent that the amount distributed during such calendar year does not exceed the required distribution for such calendar year. The purpose of this provision is to prevent the REIT from failing to meet the requirements for avoiding the imposition of the excise tax where losses incurred by the REIT after December 31, but before the close of its taxable year, otherwise would prevent the REIT from having sufficient earnings and profits for its distributions to be treated as dividends.

The conference agreement does not contain the provision from the Senate amendment under which a REIT's earnings and profits for a taxable year would not be less than its real estate trust taxable income for the taxable year (without regard to the dividends paid deduction), since the conferees believe that this provision is a restatement of present law.

 

Treatment of certain capital losses

 

The conference agreement provides that, in the case of a REIT that has a taxable year other than the calendar year, for purposes of determining the amount of capital gain dividends, such REIT may distribute for a taxable year, the REIT's net capital gain for the taxable year is determined without regard to any net capital loss attributable to transactions after December 31 of such year. For these purposes, any such net capital loss is treated as arising on the first day of the next taxable year. To the extent provided in regulations, the same rule will apply for purposes of determining the REIT's net income.1

Distribution requirement

The conference agreement clarifies that the amount on which relief is provided from the 95 percent distribution requirement in the case of income derived from certain transactions to which section 467 or section 1274 applies, is based on the excess of those amounts that the REIT is required to recognize on account of either section 467 or section 1274 over the amounts that the REIT otherwise would recognize under its regular method of accounting. Thus, for example, in the case of a REIT using the accrual method of accounting, the provision would apply in the case of a section 467 rental agreement only to the extent that the income required to be recognized under section 467 exceeded the amount of income that the taxpayer would include under the accrual method if section 467 did not apply.

Definition of rents and interest

The conference agreement provides that for purposes of the income requirements for qualification as a REIT, and for purposes of the prohibited transactions provisions, any income derived from a "shared appreciation provision" is treated as gain recognized on the sale of the "secured property." For these purposes, a shared appreciation provision is any provision that is in connection with an obligation that is held by the REIT and secured by an interest in real property, which provision entitles the REIT to receive a specified portion of any gain realized on the sale or exchange of such real property (or of any gain that would be realized if the property were sold on a specified date). Secured property for these purposes means the real property that secures the obligation that has the shared appreciation provision.

In addition, the conference agreement provides that for purposes of the income requirements for qualification as a REIT, and for purposes of the prohibited transactions provisions, the REIT is treated as holding the secured property for the period during which it held the shared appreciation provision (or, if shorter, the period during which the secured property was held by the person holding such property),2 and the secured property is treated as property described in section 1221(1) if it is such property in the hands of the obligor on the obligation to which the shared appreciation provision relates (or if it would be such property if held by the REIT). For purposes of the prohibited transaction safe harbor, the REIT is treated as having sold the secured property at the time that it recognizes income on account of the shared appreciation provision, and any expenditures made by the holder of the secured property are treated as made by the REIT.3

For example, under the conference agreement, if a REIT is the holder of an obligation under which it is paid a fixed percentage of interest on a fixed principal amount, and also is entitled to a payment equal to a portion of the appreciation in the property as of the time the property is sold (or at an earlier specified time), then the additional payment would be treated as gain on the sale of the property secured by the obligation for purposes of section 856(c), with the holding period of the property considered to be the shorter of the REIT's holding period of the obligation or the obligor's holding period for the secured property. This gain would be eligible for the prohibited transaction safe harbor if the applicable requirements are met.

The conferees intend no inference regarding the treatment of any shared appreciation provision for any other purposes of Federal income taxation.

The conferees wish to make certain clarifications regarding those services that a REIT may provide under the conference agreement without using an independent contractor, which services would not cause the rents derived from the property in connection with which the services were rendered to fail to qualify as rents from real property (within the meaning of section 856(d)). The conferees intend, for example, that a REIT may provide customary services in connection with the operation of parking facilities for the convenience of tenants of an office or apartment building, or shopping center, provided that the parking facilities are made available on an unreserved basis without charge to the tenants and their guests or customers. On the other hand, the conferees intend that income derived from the rental of parking spaces on a reserved basis to tenants, or income derived from the rental of parking spaces to the general public, would not be considered to be rents from real property unless all services are performed by an independent contractor. Nevertheless, the conferees intend that the income from the rental of parking facilities properly would be considered to be rents from real property (and not merely income from services) in such circumstances if services are performed by an independent contractor.

The conferees also wish to clarify that a REIT may directly select, hire, and compensate those independent contractors who will provide the customary services that may be provided by a REIT in connection with the rental of real property, rather than hiring an independent contractor to hire other independent contractors.

Income and asset requirements

The conference agreement provides that the investment of the proceeds of the public offering of debt securities that have a maturity of at least five years receives the same treatment as the investment of new equity capital. The conferees intend that debt securities for which there is an intention to call before five years would not be treated as having a maturity of at least five years.

The conferees wish to clarify that if a REIT purchases all of the stock of a corporation and makes an election under section 338 with respect to the purchased stock, then the corporation that is deemed to be newly formed pursuant to the section 338 election may qualify as a REIT subsidiary as of the time that the newly formed corporation is deemed to come into existence.

Prohibited transactions

Instead of measuring the alternative safe harbor for prohibited transactions by reference to the income of the REIT, the alternative safe harbor provided by the conference agreement is any number of sales provided that the adjusted basis of the property sold does not exceed 10 percent of the adjusted basis of all of the REIT's assets at the beginning of the REIT's taxable year. For this purpose, the total adjusted basis of all of the REIT's assets (including the property that is sold) is to be computed using depreciation deductions that are used for purposes of computing earnings and profits. The other requirements for use of the alternative safe harbor in the Senate bill continue to apply. The conferees intend no inference regarding whether sales that qualify under this safe harbor for the REIT are or are not properly considered to be sales of property held for sale to customers.

 

Effective Date

 

 

The provisions of the conference agreement generally are effective for taxable years beginning after December 31, 1986. The provisions relating to the imposition of the excise tax are effective for calendar years beginning after December 31, 1986.

 

P. Mortgage-Backed Securities

 

 

Present Law

 

 

Imposition of corporate tax

 

In general

 

A corporation generally is treated as an entity separate from its shareholders. The corporation is taxed on its income, and the shareholder is taxed on the subsequent distribution of the corporation's income in the form of dividends. Corporations generally do not receive any deduction for dividends paid to shareholders, but interest on indebtedness incurred by a corporation generally is deductible.4

 

Corporations treated as conduits

 

Certain small business corporations ("S corporations') generally are not subject to a corporate level tax. Rather, the income of the corporation is allocated among, and taxed directly to, the shareholders. To qualify as an S corporation, a corporation must be a domestic corporation that has 35 or fewer shareholders none of whom are corporations, and also must meet certain other requirements (secs. 1361-1379).

Regulated investment companies ("RICs") and real estate investment trusts ("REITs") generally are treated as pass-through entities since they receive deductions for dividends paid to shareholders (secs. 561, 562, 852(b), 857(b)). Capital gains realized by a REIT or a RIC also may be passed through to its shareholders (secs. 852(b)(3), 857(b)(3)).

To qualify as a RIC, a corporation must derive most of its income from investments in securities, must distribute most of its income currently, and must meet certain other requirements (secs. 851, 852).

To qualify as a REIT, a corporation must derive most of its income from real estate related sources, must hold primarily real estate assets, must distribute most of its income currently, and must meet certain other requirements (secs. 856, 857). An interest in a corporate debt obligation that is secured by real property mortgages is not treated as a qualifying real estate asset for a REIT.

Certain requirements are imposed on both REITs and RICs that are intended to prevent these entities from engaging in the active conduct of a trade or business (see e.g., secs. 851(b)(3), 856(c)(4)).

Entity classification

Under Treasury regulations, certain noncorporate entities that have sufficient corporate characteristics are treated as corporations for Federal income tax purposes (Treas. Reg. sec. 301.7701-2).

In May, 1984, the Treasury Department issued proposed regulations addressing the treatment of trusts that have more than one class of ownership interest. Final regulations were issued in March, 1985 (Treas. Reg. sec. 301.7701-4(c)(1)). Under these regulations, a trust is treated as having one class of ownership if all of the beneficiaries of the trust have undivided interests in all of the trust property. More than one class of ownership may exist where, for example, some beneficiaries are entitled to receive more than their pro rata share of trust distributions in early years and other beneficiaries are entitled to more than their pro rata share in later years.

Under the regulations, an arrangement having more than one class of ownership interest generally may not be treated as a trust, but is treated as a corporation for Federal income tax purposes. Thus, if a trust held a portfolio of mortgages, and interests in the trust assets were divided so that one class of beneficiaries were to receive all principal collected by the trust and a specified rate of interest thereon until the trust had collected a specified amount of principal on the mortgages, and another class of beneficiaries were to receive all remaining amounts collected by the trust, then such trust would be treated as an association taxable as a corporation under the regulations. The regulations provide a limited exception for certain trusts with multiple classes, where the existence of multiple classes is incidental to the purpose of facilitating direct investment in the assets of the trust. The regulations apply to interests issued after April 27, 1984.

Original issue discount and market discount

 

Original issue discount

 

Under the original issue discount ("OID") rules, any OID, which is defined as the excess of the stated redemption price of a debt instrument over its issue price, is treated as interest (secs. 1272, 1273). Both borrower and lender generally are required to account for the accrual of original issue discount currently on an economic basis over the term of the debt instrument (sec. 1272(a)). The application of the OID rules is uncertain for debt instruments the maturity of which may be accelerated on account of prepayments on obligations that collateralize the debt instrument.

 

Market discount

 

Market discount generally is that portion of the excess of a debt instrument's stated redemption price at maturity over the holder's basis, which portion exceeds the amount of OID, if any, with respect to the instrument (sec. 1278(a)). The holder of a debt instrument with market discount generally treats gain on the disposition of such debt instrument as interest income to the extent of accrued market discount (sec. 1276). For this purpose, market discount is deemed to accrue ratably over the maturity of the debt instrument, unless the holder elects to treat market discount as accruing on an economic basis (sec. 1276(b)). The application of the market discount rules to debt instruments the principal of which is payable in more than one installment is uncertain.

Other

Certain thrift institutions are permitted to deduct a percentage of their taxable income as a bad debt deduction provided that a specified portion of the institution's assets are "qualifying assets," including "qualifying real property loans" (secs. 593, 7701(a)(19)). Corporate debt obligations secured by real property mortgages are not treated as qualifying real property loans.

Issuers of debt instruments that have original issue discount are required to report to certain holders, the amount of interest payments and the annual accrual of OID (sec. 6049).

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

REMICs

 

In general

 

The Senate amendment creates a new form of entity known as a real estate mortgage investment company ("REMIC"). A REMIC is an entity that is formed for the purpose of holding a fixed pool of mortgages secured by an interest in real property, and issuing multiple classes of interests therein. A REMIC is treated as a corporation for income tax purposes, but is given a deduction for all amounts includible in income of holders of "regular interests" regardless of whether such interests otherwise would be treated as debt for Federal income tax purposes, and also is given a deduction for amounts distributed to holders of "residual interests" up to the amount of a deemed rate of return that is based on the "long-term Federal rate." Rules are provided to prevent active business activities with respect to the REMIC's assets.

 

Regular and residual interests

 

Under the Senate amendment, all interests in a REMIC must be either regular or residual interests. Regular interests are treated as debt instruments for Federal income purposes, regardless of their form. Residual interests generally are treated as stock for Federal income tax purposes (also regardless of form), but special rules are provided for the inclusion in income of distributions with respect to residual interests, the adjustment of the holder's basis in the residual interest, and for dispositions of residual interests.

 

Transfers of property to a REMIC

 

The transfer of property to a REMIC in exchange for either regular or residual interests, or for cash or other property, results in the recognition of gain upon the transfer. Loss is recognized on the transfer of property to a REMIC for cash or other property, but if property is transferred to a REMIC in exchange for regular or residual interests, loss is deferred until the disposition of the interests.

Original issue discount and market discount rules

 

Original issue discount rules

 

The Senate amendment clarifies the application of the OID rules to debt instruments, the maturity of which is accelerated on account of prepayments on obligations that collateralize the instrument. Under the Senate amendment, OID on such an instrument is calculated taking into account prepayments as such prepayments occur and assuming that there will be no further prepayments.

 

Market discount rules

 

The Senate amendment grants regulatory authority to the Treasury Department to provide rules for the treatment of market discount on obligations the principal of which is paid in installments, whether or not such obligations are subject to prepayment.

Other

Under the Senate amendment, an interest in a REMIC is treated as a real estate asset for purposes of the requirements for qualification as a REIT, and is treated as a qualifying real property loan for purposes of the requirements relating to bad debt deductions for certain thrift institutions. Reporting requirements are expanded under the Senate amendment to include reporting of interest and OID to corporate and certain other holders of debt instruments that are subject to the OID rules prescribed by the Senate amendment. In addition, the Senate amendment treats regular, but not residual interests as subject to the provisions of section 582, providing ordinary income or loss treatment upon the sale of such interests by certain financial institutions.

The Senate amendment treats "owners' debt pools" as corporations. In general, the Senate amendment provides that an owners, debt pool is an entity that is treated as a trust or partnership, the principal activity of which is the holding of assets the principal portion of which is real estate mortgages that directly or indirectly act as collateral for debt obligations having varying maturities.

 

Effective Date

 

 

The Senate amendment generally is effective for taxable years beginning after December 31, 1986. The OID and market discount provisions are effective for debt instruments issued after December 31, 1986, The owners' debt pool provisions generally are effective for entities formed after December 31, 1986.

 

Conference Agreement

 

 

Overview

In general, the conference agreement provides rules relating to "real estate mortgage investment conduits" or "REMICs." In general, a REMIC is a fixed pool of mortgages with multiple classes of interests held by investors. The conference agreement provides rules prescribing (1) the Federal income tax treatment of the REMIC, (2) the treatment of taxpayers who exchange mortgages for interests in the REMIC, (3) the treatment of taxpayers holding interests in the REMIC, and (4) the treatment of disposition of interests in the REMIC.

In general, if the specified requirements are met, the REMIC is not treated as a separate taxable entity. Rather, the income of the REMIC is allocated to, and taken into account by, the holders of the interests therein, under specified rules. Holders of "regular interests" generally take into income that portion of the income of the REMIC that would be recognized by an accrual method holder of a debt instrument that had the same terms as the particular regular interest; holders of "residual interests" take into account all of the net income of the REMIC that is not taken into account by the holders of the regular interests. Rules are provided that (1) treat a portion of the income of the residual holder derived from the REMIC as unrelated business income for tax-exempt entities or as subject to withholding at the statutory rate when paid to foreign persons, and (2) prevent such portion from being offset by net operating losses, other than net operating losses of certain thrift institutions.

The conference agreement also contains provisions relating to the application of the OID rules to certain debt instruments the timing of whose maturities is contingent upon the timing of payments on other debt instruments. In addition, the conference agreement imposes certain new information reporting requirements.

Further, the conference agreement treats as a corporation any entity or other arrangement, referred to as a "taxable mortgage pool" that is used primarily to hold mortgages, where maturities of debt instruments that are issued by the entity in multiple classes, are tied to the timing of payment on the mortgages.

Requirements for qualification as a REMIC

Under the conference agreement, any entity, including a corporation, partnership, or trust, that meets specified requirements would be permitted to elect to be treated as a REMIC. In addition, a segregated pool of assets also may qualify as a REMIC as if it were an entity meeting the requirements. To elect REMIC status, requirements relating to the composition of assets and the nature of the investors' interests must be satisfied, and an election to be treated as a REMIC must be in effect for the taxable year, and if applicable, all prior taxable years.

 

The asset test

 

Under the conference agreement, in order to qualify as a REMIC, substantially all of the assets of the entity or segregated pool, as of the close of the third calendar month beginning after the startup day and as of the close of every quarter of each calendar year thereafter, must consist of "qualified mortgages," and "permitted investments." The conferees intend that the term substantially all should be interpreted to allow the REMIC to hold only de minimis amounts of other assets.

A "qualified mortgage" is any obligation (including any participation or certificate of beneficial ownership interest therein) that is principally secured directly or indirectly by an interest in real property, and that either (1) is transferred to the REMIC on or before the "startup day," or (2) is purchased by the REMIC within the three-month period beginning on the startup day.5 A qualified mortgage also includes a "qualified replacement mortgage." A qualified replacement mortgage is any property that would have been treated as a qualified mortgage if it were transferred to the REMIC on or before the startup day, and that is received either (1) in exchange for a defective qualified mortgage6 within a two-year period beginning on the startup day, or (2) in exchange for any other qualified mortgage within a three-month period beginning on the startup day. In addition, a regular interest in another REMIC that is transferred to the REMIC on or before the startup day is treated as a qualified mortgage. The startup day is any day selected by the REMIC that is on or before the first day on which interests in the REMIC are issued.

 

"Permitted investments" are "cash flow investments," "qualified reserve assets," and "foreclosure property."

 

"Cash flow investments" are any investment of amounts received under qualified mortgages for a temporary period before distribution to holders of interests in the REMIC. The conferees intend that these are assets that are received periodically by the REMIC, invested temporarily in passive-type assets, and paid out to the investors at the next succeeding regular payment date. The conferees intend that these temporary investments are to be limited to those types of investments that produce passive income in the nature of interest. For example, the conferees intend that an arrangement commonly known as a "guaranteed investment contract," whereby the REMIC agrees to turn over payments on qualified mortgages to a third party who agrees to return such amounts together with a specified return thereon at times coinciding with the times that payments are to be made to holders of regular or residual interests, may qualify as a permitted investment.

"Qualified reserve assets" are any intangible property held for investment that is part of a "qualified reserve fund." A qualified reserve fund is any reasonably required reserve that is maintained by the REMIC to provide for payments of certain expenses and to provide additional security for the payments due on regular interests in the REMIC that otherwise may be delayed or defaulted upon because of defaults (including late payments) on the qualified mortgages. In determining whether the amount of the reserve is reasonable, the conferees believe that it is appropriate to take into account the creditworthiness of the qualified mortgages and the extent and nature of any guarantees relating to the qualified mortgages. Further, amounts in the reserve fund must be reduced promptly and appropriately as regular interests in the REMIC are retired.

Under the conference agreement, a reserve is not treated as a qualified reserve unless for any taxable year (and all subsequent taxable years) not more than 30 percent of the gross income from the assets in such fund for the taxable year is derived from the sale or other disposition of property held for less than three months. For this purpose, gain on the disposition of a reserve fund asset is not taken into account if the disposition of such asset is required to prevent default on a regular interest where the threatened default resulted from a default on one or more qualified mortgages.

"Foreclosure property" is property that would be foreclosure property under section 856(e) if acquired by a real estate investment trust, and which is acquired by the REMIC in connection with the default or imminent default of a qualified mortgage. Property so acquired ceases to be foreclosure property one year after its acquisition by the REMIC.

 

Investors' interests

 

In order to qualify as a REMIC under the conference agreement, all of the interests in the REMIC must consist of one or more classes of "regular interests" and a single class of "residual interests."

 

Regular interests

 

A regular interest in a REMIC is an interest in a REMIC whose terms are fixed on the startup day, which terms (1) unconditionally entitle the holder to receive a specified principal (or similar) amount, and (2) provide that interest (or similar) payments, if any, at or before maturity are based on a fixed rate (or to the extent provided in regulations, a variable rate). An interest in the REMIC may qualify as a regular interest where the timing (but not the amount) of the principal (or similar) payments are contingent on the extent of prepayments on qualified mortgages and the amount of income from permitted investments.

The conferees intend that regular interests in REMICs may be issued in the form of debt, stock, partnership interests, interests in a trust, or any other form permitted by state law. Thus, if an interest in a REMIC is not in the form of debt, the conferees understand that the interest would not have a specified principal amount, but that the interest would qualify as a regular interest if there is a specified amount that could be identified as the principal amount if the interest were in the form of debt. For example, an interest in a partnership could qualify as a regular interest if the holder of the partnership interest were to receive a specified amount in redemption of the partnership interest, and that the amount of income allocated to such partnership interest were based on a fixed percentage of the specified outstanding redemption amount.

The conferees intend that an interest in a REMIC would not fail to be treated as a regular interest if the payments of principal (or similar) amounts with respect to such interest are subordinated to payments on other regular interests in the REMIC, and are dependent upon the absence of defaults on qualified mortgages. Thus, the conferees intend that regular interests in a REMIC may resemble the types of interests described in Treas. Reg. sec. 301.7701-4(c)(2) (Example 2).7

The conferees intend that an interest in a REMIC may not qualify as a regular interest if the amount of interest (or similar payments) is disproportionate to the specified principal amount. For example, if an interest is issued in the form of debt with a coupon rate of interest that is substantially in excess of prevailing market interest rates (adjusted for risk), the conferees intend that the interest would not qualify as a regular interest. Instead, the conferees intend that such an interest may be treated either as a residual interest, or as a combination of a regular interest and a residual interest.

 

Residual interests

 

In general, a residual interest in a REMIC is any interest in the REMIC other than a regular interest, and which is so designated by the REMIC, provided that there is only one class of such interest, and that all distributions (if any) with respect to such interests are pro rata. For example, the residual interest in a mortgage pool that otherwise qualifies as a REMIC is held by two taxpayers, one of whom has a 25 percent interest in the residual and the other of whom has a 75 percent interest. Except for their relative size, the interests of the two taxpayers are identical. Provided that all distributions to the residual interest holders are pro rata, the mortgage pool would qualify as a REMIC because there is only one class of residual interest. If, however, the holder of the 25 percent interest is entitled to receive all distributions to which residual holders combined are entitled for a specified period (or up to a specified amount) in return for the surrender of his interest, then the mortgage pool would be considered to have two classes of residual interests and would not qualify as a REMIC.

The conferees intend that the right to receive payment from the REMIC for goods or services rendered in the ordinary operation of the REMIC would not be considered to be an interest in the REMIC for these purposes.

Inadvertent terminations

The conference agreement provides regulatory authority to the Treasury Department to issue regulations that address situations where failure to meet one or more of the requirements for REMIC status occurs inadvertently, and disqualification of the REMIC would occur absent regulatory relief. The conferees anticipate that the regulations would provide relief only where the failure to meet any of the requirements occurred inadvertently and in good faith. The conferees also intend that the relief may be accompanied by appropriate sanctions, such as the imposition of a corporate tax on all or a portion of the REMIC's income for the period of time in which the requirements are not met.

Transfers of property to the REMIC

Under the conference agreement, no gain or loss is recognized to the transferor upon the transfer of property to a REMIC in exchange for regular or residual interests in the REMIC. Upon such a transfer, the adjusted bases of the regular or residual interests received in the transaction are to be equal in the aggregate to the aggregate of the adjusted bases of the property transferred. The aggregate basis of the interests received is allocated among the regular or residual interests received in proportion to their fair market values.8 The basis of any property received by a REMIC in exchange for regular or residual interests in the REMIC is equal to the fair market value of the property at the time of transfer (or earlier time provided by regulations).9

In the case of a REMIC that is not formed as a separate entity, but rather as a segregated pool of assets, the conferees intend that the transfer is deemed to occur and the REMIC is deemed to be formed only upon the issuance of regular and residual interests therein.

Federal income tax treatment of the REMIC

 

Pass-through status

 

In general, the conference agreement provides that a REMIC is not a taxable entity for Federal income tax purposes. The income of the REMIC generally is taken into account by holders of regular and residual interests in the REMIC as described below. Nevertheless, the REMIC is subject to tax on prohibited transactions, and may be required to withhold on amounts paid to foreign holders of regular or residual interests.

The pass-through status of the REMIC provided by the conference agreement applies regardless of whether the REMIC otherwise would be treated as a corporation, partnership, trust, or any other entity. The conferees intend that where the requirements for REMIC status are met, that the exclusive set of rules for the treatment of all transactions relating to the REMIC and of holders of interests therein are to be those set forth in the provisions of the conference agreement. Thus, for example, in the case of a REMIC that would be treated as a partnership if it were not otherwise a REMIC, the provisions of subchapter K of the Code would not be applicable to any transactions involving the REMIC or any of the holders of regular or residual interests.10

 

Prohibited transactions

 

Under the conference agreement, a REMIC is required to pay a tax equal to 100 percent of the REMIC's net income from prohibited transactions. For this purpose, net income from prohibited transactions is computed without taking into account any losses from prohibited transactions or any deductions relating to prohibited transactions that result in a loss. Prohibited transactions for the REMIC include the disposition of any qualified mortgage other than pursuant to (1) the substitution of a qualified replacement mortgage for a defective qualified mortgage, (2) the bankruptcy or insolvency of the REMIC, (3) a disposition incident to the foreclosure, default, or imminent default of the mortgage, or (4) a qualified liquidation (described below). In addition, the disposition of a qualified mortgage is not a prohibited transaction if such disposition is required to prevent default on a regular interest where such default on the regular interest is threatened on account of a default on one or more qualified mortgages. Other prohibited transactions include the disposition of any cash flow investment other than pursuant to a qualified liquidation, the receipt of any income from assets other than assets permitted to be held by the REMIC, and the receipt of any compensation for services.11

Taxation of the holders of regular interests

 

In general

 

Under the conference agreement, holders of regular interests generally are taxed as if their regular interest were a debt instrument to which the rules of taxation generally applicable to debt instruments apply, except that the holder of a regular interest is required to account for income relating to such interest on the accrual method of accounting regardless of the method of accounting otherwise used by the holder.12 In the case of regular interests that are not debt instruments, the amount of the fixed unconditional payment is treated as the stated principal amount of the instrument, and the periodic payments (i.e., the amounts that are based on the amount of the fixed unconditional payment), if any, are treated as stated interest payments. In other words, generally consistent with the pass-through nature of the REMIC, the holders of regular interests generally take into account that portion of the REMIC's income that would be taken into account by an accrual method holder of a debt instrument with terms equivalent to the terms of the regular interest.13

The conferees intend that regular interests are to be treated as if they were debt instruments for all other purposes of the Internal Revenue Code, Thus, for example, regular interests would be treated as market discount bonds, where the revised issue price (within the meaning of section 1278) of the regular interest exceeds the holder's basis in the interest. Moreover, the conferees intend that the REMIC is subject to the reporting requirements of section 1275 with respect to the regular interests. In addition, the conferees intend that regular interests are to be treated as evidences of indebtedness under section 582(c)(1), so that gain or loss from the sale or exchange of regular interests by certain financial institutions would not be treated as gain or loss from the sale or exchange of a capital asset. In addition, any market premium on a regular interest could be amortized currently under section 171.

The issue price of regular interests in the REMIC are determined under the rules of section 1273(b). In the case of regular interests issued in exchange for property, however, the issue price of the regular interest is equal to the fair market value of the property,14 regardless of whether the requirements of section 1273(b)(3) are met. A holder's basis in the regular interest generally is equal to the holder's cost therefor, but in the case of holders who received their interests in exchange for property, then as discussed above, the holder's basis is equal to the basis of the property exchanged for the REMIC interest. Where property is transferred in exchange for more than one class of regular or residual interest, the basis of the property transferred is allocated in proportion to the fair market value of the interests received.

 

Regular interests received in exchange for property

 

Under the conference agreement, where an exchange of property for regular interests in a REMIC has taken place, any excess of the issue price of the regular interest over the basis of the interest in the hands of the transferor immediately after the transfer is, for periods during which such interest is held by the transferor (or any other person whose basis is determined in whole or in part by reference to the basis of such interest in the hands of the transferor), includible currently in the gross income of the holder under rules similar to the rules of section 1276(b) (i.e., the holder of such an interest is treated like the holder of a market discount bond for which an election under section 1278(b) is in effect). Conversely, the excess of the basis of the regular interest in the hands of the transferor immediately after the transfer over the issue price of the interest is treated for such holders as market premium that is allowable as a deduction under rules similar to the rules of section 171.

 

Disposition of regular interests

 

The conference agreement treats gain on the disposition of a regular interest as ordinary income to the extent of a portion of unaccrued OID with respect to the interest. Such portion generally is the amount of unaccrued OID equal to the excess, if any, of the amount that would have been includible in the gross income of the taxpayer with respect to such interest if the yield on such interest were 110 percent of the applicable Federal rate (as defined in sec. 1274(d) without regard to paragraph (2) thereof) determined as of the time that the interest is acquired by the taxpayer, over the total amount of ordinary income includible by the taxpayer with respect to such regular interest prior to disposition. In selecting the applicable Federal rate, the conferees intend that the same prepayment assumptions that are used in calculating OID are to be used in determining the maturity of the regular interest.

Taxation of the holders of residual interests

 

In general

 

In general, the conference agreement provides that at the end of each calendar quarter, the holder of a residual interest in a REMIC takes into account his daily portion of the taxable income or net loss of the REMIC for each day during the holder's taxable year in which such holder held such interest. The amount so taken into account is treated as ordinary income or loss. The daily portion for this purpose is determined by allocating to each day in any calendar quarter a ratable portion of the taxable income or net loss of the REMIC for such quarter, and by allocating the amounts so allocated to any day among the holders (on such day) of residual interests in proportion to their respective holdings on such day.

For example, a REMIC's taxable income for a calendar quarter (determined as described below) is $1,000. There are two holders of residual interests in the REMIC. One holder of 60 percent of the residual holds such interest for the entire calendar quarter. Another holder has a 40 percent interest, and transfers the interest after exactly one half of the calendar quarter to another taxpayer. As of the end of the calendar quarter, the holder of the sixty percent interest would be treated as receiving $600 ratably over the quarter. Each holder of the 40 percent interest would be treated as receiving $200 ratably over the portion of the quarter in which the interest was held.

Distributions from the REMIC are not included in the gross income of the residual holder to the extent that such distributions do not exceed the adjusted basis of the interest. To the extent that distributions exceed the adjusted basis of the interest, the excess is treated as gain from the sale of the residual interest. Residual interests are treated as evidences of indebtedness for purposes of section 582(c).

The amount of any net loss of the REMIC that may be taken into account by the holder of a residual interest is limited to the adjusted basis of the interest as of the close of the quarter (or time of disposition of the interest if earlier), determined without taking into account the net loss for the quarter. Any loss that is disallowed on account of this limitation may be carried over indefinitely by the holder of the interest for whom such loss was disallowed and may be used by such holder only to offset any income generated by the same REMIC.

Except for adjustments arising from the nonrecognition of gain or loss on the transfer of mortgages to the REMIC (discussed below), the holders of residual interests take no amounts into account other than those allocated from the REMIC.15

 

Determination of REMIC taxable income or net loss

 

In general, under the conference agreement, the taxable income or net loss of the REMIC for purposes of determining the amounts taken into account by holders of residual interests, is determined in the same manner as for an individual having the calendar year as his taxable year and using the accrual method of accounting, with certain modifications. The first modification is that a deduction is allowed with respect to those amounts that would be deductible as interest if the regular interests in the REMIC were treated as indebtedness of the REMIC. Second, in computing the gross income of the REMIC, market discount with respect to any market discount bond (within the meaning of sec. 1278) held by the REMIC is includible for the year in which such discount accrues, as determined under the rules of section 1276(b)(2), and sections 1276(a) and 1277 do not apply. Third, no item of income, gain, loss, or deduction allocable to a prohibited transaction is taken into account. Fourth, deductions under section 703(a)(2) (other than deductions allowable under section 212) are not allowed.16

If a REMIC distributes property with respect to any regular or residual interest, the REMIC recognizes gain in the same manner as if the REMIC had sold the property to such distributee at its fair market value. The conferees intend that the distribution is to be treated as an actual sale by the REMIC for purposes of applying the prohibited transaction rules and the rules relating to qualified reserve funds. The basis of the distributed property in the hands of the distributee is then the fair market value of the property.

 

Adjusted basis of residual interests

 

Under the conference agreement, a holder's basis in a residual interest in a REMIC is increased by the amount of the taxable income of the REMIC that is taken into account by the holder. The basis of such an interest is decreased (but not below zero) by the amount of any distributions received from the REMIC and by the amount of any net loss of the REMIC that is taken into account by the holder. In the case of a holder who disposes of a residual interest, the basis adjustment on account of the holder's daily portions of the REMIC's taxable income or net loss is deemed to occur immediately before the disposition.

 

Special treatment of a portion of residual income

 

Under the conference agreement, a portion of the net income of the REMIC taken into account by the holders of the residual interests may not be offset by any net operating losses of the holder. The conference agreement provides a special exception from this rule in the case of certain thrift institutions, on account of the difficulties currently being experienced by such industry.

In addition, the conference agreement provides that the same portion of the net income of the REMIC that may not be offset by net operating losses, is treated as unrelated business income for any organization subject to the unrelated business income tax under section 511, and is not eligible for any reduction in the rate of withholding tax (by treaty or otherwise) in the case of a nonresident alien holder.

The portion of the income of the residual holder that is subject to these rules is the excess, if any, of the amount of the net income of the REMIC that the holder takes into account for any calendar quarter, over the sum of the daily accruals with respect to such interest while held by such holder. The daily accrual for any residual interest for any day in any calendar quarter is determined by allocating to each day in such calendar quarter a ratable portion of the product of the adjusted issue price of the residual interest at the beginning of such accrual period, and 120 percent of the long-term Federal rate. The long-term Federal rate used for this purpose is the Federal long-term rate that would have applied to the residual interest under section 1274(d) (without regard to section 1274(d)(2)) if it were a debt instrument, determined at the time that the residual interest is issued. The rate is adjusted appropriately in order to be applied on the basis of compounding at the end of each quarter.

For this purpose, (and for purposes of the treatment of gain or loss that is not recognized upon the transfer of property to a REMIC in exchange for a residual interest, as discussed below), the residual interest is treated as having an issue price that is equal to the amount of money paid for the interest at the time it is issued, or in the case of a residual interest that is issued in exchange for property, the fair market value of the interest at the time it is issued. The adjusted issue price of the residual interest is equal to the issue price of the interest increased by the amount of daily accruals for prior calendar quarters, and decreased (but not below zero) by the amount of any distributions with respect to the residual interest prior to the end of the calendar quarter.

In addition, the conference agreement provides that under regulations, if a REIT owns a residual interest in a REMIC, a portion of dividends paid by the REIT would be treated as excess inclusions for REIT shareholders. Thus, such income could not be offset by net operating losses, would constitute unrelated business taxable income for tax-exempt holders, and would not be eligible for and reduction in the rate of withholding tax in the case of a nonresident alien holder.

The conference agreement provides that to the extent provided in regulations, in the case of a residual interest that has does not have significant value, the entire amount of income that is taken into account by the holder of the residual interest is treated as unrelated business income and is subject to withholding at the statutory rate. In addition, in the case of such a residual, income allocated to the holder thereof may not be offset by any net operating losses, regardless of who holds the interest. The conferees intend that the regulations would take into account the value of the residual interest in relation to the regular interests, and that the regulations would not apply in cases where the value of the residual interest is at least two percent of the combined value of the regular and residual interests.17

The conference agreement provides that the partnership information return filed by the REMIC is to supply information relating to the daily accruals of the REMIC.

 

Treatment of foreign residual holders

 

The conference agreement provides that in the case of a holder of a residual interest of a REMIC who is a nonresident alien individual or foreign corporation, then for purposes of sections 871(a), 881, 1441, and 1442, amounts includible in the gross income of such holder with respect to the residual interest are taken into account only when paid or otherwise distributed (or when the interest is disposed of).18 The conference agreement also provides that under regulations, the amounts includible may be taken into account earlier than otherwise provided where necessary to prevent avoidance of tax. The conferees intend that this regulatory authority may be exercised where the residual interest in the REMIC does not have significant value (as described above).

 

Residual interests received in exchange for property

 

In the case of a residual interest that is received in exchange for property, any excess of the issue price of the residual interest over the basis of the interest in the hands of the transferor of the property immediately after the transfer, is amortized and is included in the residual holder's income on a straight line basis over the expected life of the REMIC. Similarly, any excess of the transferor's basis in the residual interest over the issue price of the interest is deductible by the holder of the interest on a straight line basis over the expected life of the REMIC. In determining the expected life of the REMIC for this purpose, the conferees intend that the assumptions used in calculating original issue discount and any binding agreement regarding liquidation of the REMIC are to be taken into account.

 

Dispositions of residual interests

 

The conference agreement provides that, except as provided in regulations, the wash sale rules of section 1091 apply to dispositions of residual interests in a REMIC where the seller of the interest, during the period beginning six months before the sale or disposition of the residual interest and ending six months after such sale or disposition, acquires (or enters into any other transaction that results in the application of section 1091) any residual interest in any REMIC or any interest in a "taxable mortgage pool" (discussed below) that is comparable to a residual interest.

Liquidation of the REMIC

Under the conference agreement, if a REMIC adopts a plan of complete liquidation, and sells all of its assets (other than cash) within the 90-day period beginning on the date of the adoption of the plan of liquidation, then the REMIC recognizes no gain or loss on the sale of its assets, provided that the REMIC distributes in liquidation all of the sale proceeds plus its cash (other than amounts retained to meet claims) to holders of regular and residual interests within the 90-day period.

Other provisions

 

Compliance provisions

 

The application of the OID rules contemplated by the conference agreement requires calculations that are based on information that would not necessarily be known by any holder, and is more readily available to the issuer than any other person. Accordingly, the conference agreement requires broader reporting of interest payments and OID accrual by the REMIC, or any issuer of debt that is subject to the OID rules of the conference agreement. The conference agreement specifies that the amounts includible in gross income of the holder of a regular interest in a REMIC are treated as interest for purposes of the reporting requirements of the Code (sec. 6049), and that the REMIC or similar issuer is required to report interest and OID to a broader group of holders than is required under present law. The holders to whom such broader reporting is required include corporations, certain dealers in commodities or securities, real estate investment trusts, common trust funds, and certain other trusts. In addition to reporting interest and OID, the REMIC or similar issuer is required to report sufficient information to allow holders to compute the accrual of any market discount or amortization of any premium in accordance with provisions of the conference agreement.19

 

Treatment of REMIC interests for certain financial institutions and real estate investment trusts

 

Under the conference agreement, regular and residual interests are treated as qualifying real property loans for purposes of section 593(d)(1) and section 7701(a)(19), in the same proportion that the assets of the REMIC would be treated as qualifying real property loans.20 In the case of residual interests, the conferees intend that the amount treated as a qualifying real property loan not exceed the adjusted basis of the residual interest in the hands of the holder. Both regular and residual interests are treated as real estate assets under section 856(c)(6) in the same proportion that the assets of the REMIC would be treated as real estate assets for purposes of determining eligibility for real estate investment trust status.21 In the case of a residual interest, the fair market value of the residual interest, and not the fair market value of all of the REMIC's assets, is used in applying the asset test of section 856(c)(5). In addition, income derived from the holding of a regular or residual interest in a REMIC is treated as interest for a real estate investment trust.

 

Foreign withholding

 

The conferees intend that for purposes of withholding on interest paid to foreign persons, regular interests in REMICs should be considered to be debt instruments that are issued after July 18, 1984, regardless of the time that any debt instruments held by the REMIC were issued. The conferees intend that amounts paid to foreign persons with respect to residual interests should be considered to be interest for purposes of applying the withholding rules.

 

OID rules

 

The conference agreement provides rules relating to the application of the OID rules to debt instruments that, as is generally the case with regular interests in a REMIC, have a maturity that is initially fixed, but that is accelerated based on prepayments on other debt obligations securing the debt instrument (or, to the extent provided in regulations, by reason of other events). The OID rules provided by the conference agreement also apply to OID on qualified mortgages held by a REMIC.

In general, the OID rules provided by the conference agreement require OID for an accrual period to be calculated and included in the holder's income based on the increase in the present value of remaining payments on the debt instrument, taking into account payments includible in the instrument's stated redemption price at maturity received on the regular interest during the period. For this purpose, the present value calculation is made at the beginning of each accrual period (1) using the yield to maturity determined for the instrument at the time of its issuance (determined on the basis of compounding at the close of each accrual period and properly adjusted for the length of the accrual period), calculated on the assumption that, as prescribed by regulations, certain prepayments will occur, and (2) taking into account any prepayments that have occurred before the close of the accrual period.

The conferees intend that the regulations will provide that the prepayment assumption to be used in calculating present values as of the close of each accrual period, and in computing the yield to maturity used in the calculation of such present values, will be that used by the parties in pricing the particular transaction. The conferees intend that such prepayment assumption will be determined by the assumed rate of prepayments on qualified mortgages held by the REMIC and also the assumed rate of earnings on the temporary investment of payments on such mortgages insofar as such rate of earnings would affect the timing of payments on regular interests.22

The conferees intend that the regulations will require these pricing assumptions to be specified in the first partnership return filed by the REMIC. In addition, the conferees intend that appropriate supporting documentation relating to the selection of the prepayment assumption must be supplied to the Internal Revenue Service with such return. Further, the conferees intend that the prepayment assumptions used must not be unreasonable based on comparable transactions, if comparable transactions exist.23

The conferees intend that unless otherwise provided by regulations, the use of a prepayment assumption based on a recognized industry standard would be permitted. For example, the conferees understand that prepayment assumptions based on a Public Securities Association standard currently is such an industry recognized standard.

The conferees intend that in no circumstances, would the method of accruing OID prescribed by the conference agreement allow for negative amounts of OID to be attributed to any accrual period. If the use of the present value computations prescribed by the conference agreement produce such a result for an accrual period, the conferees intend that the amount of OID attributable to such accrual period would be treated as zero, and the computation of OID for the following accrual period would be made as if such following accrual period and the preceding accrual period were a single accrual period.

Regulatory authority

The conference agreement grants the Treasury Department authority to prescribe such regulations as are necessary or appropriate to implement the provisions relating to REMICs. The conferees expect that, among other things, regulations will be issued to prevent unreasonable accumulations of assets in the REMIC, to require the REMIC to report information adequate to allow residual holders to compute taxable income accurately (including reporting more frequently than annually). Further, such regulations may require reporting of OID accrual more frequently than otherwise required by the conference agreement.

Treasury study

The conferees are concerned about the impact of the REMIC provisions upon the thrift industry. Accordingly, the conferees request that the Treasury Department conduct a study of the effectiveness of the REMIC provisions in enhancing the efficiency of the secondary market in mortgages, and the impact of these provisions upon thrift institutions.

Taxable mortgage pools

The conferees intend that REMICs are to be the exclusive means of issuing multiple class real estate mortgage-backed securities without the imposition of two levels of taxation. Thus, the conference agreement provides that a "taxable mortgage pool" ("TMP") is treated as a taxable corporation that is not an includible corporation for purposes of filing consolidated returns.

Under the conference agreement, a TMP is any entity other than a REMIC if (1) substantially all of the assets of the entity consist of debt obligations (or interests in debt obligations) and more than 50 percent of such obligations (or interests) consist of real estate mortgages, (2) such entity is the obligor under debt obligations with two or more maturities,24 and (3) under the terms of such debt obligations on which the entity is the obligor, payment on such debt obligations bear a relationship to payments on the debt obligations (or interests therein) held by the entity.25 Typically, the relationship between the assets of the entity and its debt obligations would be such that payments on the debt obligations must be made within a period of time from when payments on the assets are received.

Under the conference agreement, any portion of an entity that meets the definition of a TMP is treated as a TMP. For example, if an entity segregates mortgages in some fashion and issues debt obligations in two or more maturities, which maturities depend upon the timing of payments on the mortgages, then the mortgages and the debt would be treated as a TMP, and hence as a separate corporation. The TMP provisions are intended to apply to any arrangement under which mortgages are segregated from a debtor's business activities (if any) for the benefit of creditors whose loans are of varying maturities.

The conference agreement provides that no domestic building and loan association (or portion thereof) is to be treated as a TMP.

Special rule for REITs

The conferees intend that an entity that otherwise would be treated as a TMP may, if it otherwise meets applicable requirements, elect to be treated as a REIT. If so, the conference agreement provides that under regulations, a portion of the REIT's income would be treated in the same manner as income subject to the special rules provided for a portion of the income of the income interest in a REMIC. The conferees intend that this calculation is to be made as if the equity interests in the REIT were the residual interest in a REMIC and such interests were issued (i.e., the issue price of interests is determined) as of the time that the REIT becomes a TMP.26

The conferees intend that the regulations would provide that dividends paid to the shareholders of a REIT would be subject to the same rules provided for a portion of the income of holders of residual interests in a REMIC. Thus, for example, the conferees intend that the regulations would provide that to the extent that dividends from the REIT exceed the daily accruals for the REIT (determined in the same manner as if the REIT were a REMIC) such dividends (1) may not be offset by net operating losses (except those of certain thrift institutions), (2) are treated as unrelated business income for certain tax-exempt institutions, and (3) are not eligible for any reduction in the rate of withholding when paid to foreign persons. The conferees also intend that the regulations would require a REIT to report such amounts to its shareholders.27

 

Effective Date

 

 

The provisions of the conference agreement are effective with respect to taxable years beginning after December 31, 1986. The amendments made by the conference agreement to the OID rules apply to debt instruments issued after December 31, 1986. The provisions relating to taxable mortgage pools do not apply to any entity in existence on December 31, 1991, unless there is a substantial transfer of cash or property to such entity (other than in payment of obligations held by the entity) after such date. For purposes of applying the wash sale rules provided by the conference agreement, however, the definition of a TMP is applicable to any interest in any entity in existence on or after January 1, 1986.

 

Q. Regulated Investment Companies

 

 

Present Law

 

 

A regulated investment company ("RIC") receives a deduction for dividends paid to shareholders during a taxable year if, for the taxable year, at least 90 percent of its ordinary income is derived from specified sources commonly considered passive investment income, if it distributes at least 90 percent of its ordinary income to shareholders, if less than 30 percent of its gross income is derived from sales of stock or securities held for less than three months, and if it also meets certain other requirements (secs. 851, 852(a)).

A RIC may adopt any fiscal year as its taxable year. RICs are permitted to treat certain dividends paid after the close of a taxable year as paid during the preceding taxable year (sec. 855(a)). Shareholders receiving such "spillover dividends" recognize income attributable to such dividends in the year of payment (sec. 855(b)).

A RIC that has long-term capital gain income may designate a dividend as a capital gain dividend in a notice sent to shareholders within 45 days after the end of its taxable year (sec. 852(b)(3)). Shareholders treat such capital gain dividends as long-term capital gain regardless of their holding period for the RIC stock, and the RIC is not required to pay any capital gains tax on the amount so designated.

If a RIC, organized as a corporation, has several "series" of stock, with each series of stock representing an interest in the income and assets of a particular fund, the RIC generally is treated as a single corporation.28 If the RIC is organized as a business trust, it is unclear whether the RIC properly is treated as a single corporation or whether each fund properly is treated as a separate corporation.

In the case of certain summonses served upon "third party recordkeepers," certain notice requirements are imposed on the Internal Revenue Service (sec. 7609). Third party recordkeepers generally include various types of financial institutions, and others such as attorneys, accountants, and brokers, but do not include RICs.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

Under the Senate amendment, RICs are required to adopt a calendar year as their taxable year. In addition, a RIC is required to pay a nondeductible excise tax equal to five percent of the amount of any dividends paid after the close of its taxable year that are treated as having been paid in the preceding taxable year.

The Senate amendment clarifies the definition of "securities" by reference to the definition of securities in the Investment Company Act of 1940. In addition, permitted income for RICs is defined to include income from foreign currencies, and options and futures contracts, derived with respect to the RIC's business of investing. The Senate amendment provides regulatory authority, however, to exclude certain gains from investment in foreign currency.

The Senate amendment also provides that, in the case of RICs that have so-called series funds, each fund is treated as a separate corporation. Tax-free treatment is provided for the deemed formation of the separate corporations that are deemed to be formed under the provision.

The Senate amendment extends the time for filing notices for capital gain dividends and certain other purposes from 45 to 60 days. RICs are treated as third party recordkeepers under the Senate amendment.

The provisions of the Senate amendment relating to the adoption of a calendar year generally are effective for taxable years beginning after December 31, 1986. The provision of the Senate amendment relating to treatment of a RIC as a third party recordkeeper is effective for summonses served after the date of enactment. The other provisions of the Senate amendment are effective for taxable years of RICs beginning after the date of enactment.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment with the following modifications.

Imposition of excise tax

 

In general

 

The conference agreement does not require all RICs to adopt a calendar year as their taxable year and does not impose an excise tax on all "spillover" dividends. Instead, the conference agreement imposes for any calendar year, a nondeductible excise tax on any RIC equal to four percent of the excess, if any, of the "required distribution" for the calendar year ending within the taxable year of the RIC, over the "distributed amount" for such calendar year. The excise tax imposed for any calendar year is to be paid not later than March 15 of the succeeding calendar year.

For these purposes, the term required distribution means, with respect to any calendar year, the sum of (1) 97 percent of the RIC's "ordinary income" for such taxable year, (2) 90 percent of the RIC's capital gain net income (within the meaning of sec. 1222(9)) for the one year period ending on October 31 of such taxable year (as if the one year period ending on October 31 were the RIC's taxable year), 29 and (3) the excess, if any, of the "grossed up required distribution" for the preceding calendar year over the distributed amount for such preceding calendar year. For this purpose, the term grossed up required distribution for any calendar year is the sum of the taxable income of the RIC for the calendar year (determined without regard to the deduction for dividends paid) and all amounts from earlier years that are not treated as having been distributed under the provision.

The RIC's ordinary income for this purpose means its investment company taxable income (as defined in sec. 852(b)(2)) determined (1) taking into account the net capital gain of the RIC and without taking into account the dividends paid deduction, (2) by not taking into account any gain or loss from the sale of any capital asset, and (3) by treating the calendar year as the RIC's taxable year.

In addition, for these purposes, the term distributed amount means, with respect to any calendar year, the sum of (1) the deduction for dividends paid (within the meaning of sec. 561) during such calendar year, (2) amounts on which the RIC is required to pay corporate tax, and (3) the excess (if any) of the distributed amount for the preceding taxable year over the required distribution for such preceding taxable year. The amount of dividends paid for these purposes is determined without regard to the provisions of section 855 and without regard to any exempt-interest dividend (as defined in sec. 852(b)(5)).

Under the conference agreement, for purposes of applying these provisions, any deficiency dividend (as defined in sec. 860(f)) is taken into account at the time it is paid, and any income giving rise to the adjustment is treated as arising at the time the dividend is paid.

 

Special rule for certain regulated investment companies

 

The conference agreement provides that RICs that have a taxable year ending on either November 30, or December 31, may make an irrevocable election to use their actual taxable year, rather than a year ending on October 31, for purposes of applying the distribution requirement rules relating to capital gains.

 

Timing of inclusion of certain dividends

 

The conference agreement provides that any dividend declared by a RIC in December of any calendar year and payable to shareholders of record as of a specified date in such month, shall be deemed to have been paid by the RIC, (including for purposes of section 561), and to have been received by each shareholder, on such record date, but only if such dividend is actually paid by the RIC before February 1 of the following calendar year. This provision does not apply for purposes of section 855(a), however.30

 

Earnings and profits

 

Under the conference agreement, a RIC is treated as having sufficient earnings and profits to treat as a dividend any distribution during any calendar year which distribution is treated as a dividend by such RIC, (other than a redemption to which section 302(a) applies), but only to the extent that the amount distributed during such calendar year does not exceed the required distribution for such calendar year. The purpose of this provision is to prevent a RIC from failing to meet the requirements for avoiding the imposition of the excise tax where losses incurred by the RIC after October 31, but before the close of its taxable year, otherwise would prevent the RIC from having sufficient earnings and profits for its distributions to be treated as dividends.

 

Treatment of certain capital losses

 

For purposes of determining the amount of capital gain dividends that a RIC may distribute for a taxable year, the RIC's net capital gain for the taxable year is determined without regard to any net capital loss attributable to transactions after October 31 of such year. For these purposes, any such net capital loss is treated as arising on the first day of the next taxable year. To the extent provided in regulations, the same rule will apply for purposes of determining the RIC's taxable income.31

Hedging exception

The conferees believe that the requirement that a RIC derive less than 30 percent of its gross income from the sale or other disposition of stock or securities held for less than three months is an appropriate requirement to ensure that a RIC is a passive entity that is appropriately granted pass-through status. Nevertheless, the conferees recognize that this requirement may not necessarily reflect accurately the extent of the active business activities of a RIC where the RIC engages in certain hedging transactions that are otherwise consistent with the passive nature of the RIC. The conferees believe that in general, in the case of such hedging transactions, both the hedged and the hedging positions properly are considered to be single investment.

Accordingly, the conference agreement modifies the computation of gross income of a RIC for purposes of the requirement of section 851(b)(3) that less than 30 percent of the gross income of the RIC is derived from the sale or exchange of stock or securities held for less than three months. Under the conference agreement, for purposes of applying this test, any increase in value on a position that is part of a designated hedge is offset by any decrease in value (whether or not realized) on any other position that is part of such hedge. For this purpose, increases and decreases in value are taken into account only to the extent attributable to increases or decreases in value (as the case may be) during the period of the hedge. This rule applies for purposes of calculating both gains from the sale or other disposition of stock or securities held for less than three months and also the gross income of the RIC for purposes of section 851(b)(3).

For these purposes, there is a designated hedge where the taxpayer's risk of loss with respect to any position in property is reduced by reason of (1) the taxpayer having an option to sell, being under a contractual obligation to sell, or having made (and not closed) a short sale of substantially identical property, (2) the taxpayer being the grantor of an option to buy substantially identical property, or (3) under regulations prescribed by the Secretary, the taxpayer holding one or more other positions. The conferees intend that a qualified covered call (within the meaning of sec. 1092(c)) may be treated as part of a designated hedge. In addition, the positions that are part of the hedge must be clearly identified by the taxpayer in the manner prescribed by regulations.

Prior to the issuance of such regulations, the conferees intend that the identification requirement would be treated as having been satisfied with identification by the close of the day on which the hedge is established, either (a) by the placing of the positions that are part of hedge in a separate account that is maintained by a broker, futures commission merchant, custodian or similar person, and that is designated as a hedging account, provided that such person maintaining such account makes notations identifying the hedged and hedging positions and the date on which the hedge is established, or (b) by the designation by such a broker, merchant, custodian or similar person, of such positions as a hedge for purposes of these provisions, provided that the RIC is provided with a written confirmation stating the date the hedge is established and identifying the hedged and hedging positions.

Business development companies

The conference agreement provides that a business development company registered under the Investment Company Act of 1940, as amended (15 U.S.C. 80a-1 to 80b-2) may qualify as a RIC.

Preference dividends

The conference agreement provides that differences in the rate of dividends paid to shareholders are not treated as preferential dividends (within the meaning of section 562(c)), where the differences reflect savings in administrative costs (but not differences in management fees), provided that such dividends are paid by a RIC to shareholders who have made initial investments of at least $10 million.

 

Effective Date

 

 

The provisions of the conference agreement relating to the imposition of the excise tax on RICs are applicable for calendar years beginning after December 31, 1986. Other provisions of the conference agreement have the same effective date as the Senate amendment.

 

R. Definition of Personal Holding Company Income

 

 

Present Law

 

 

Personal holding companies are subject to a 50 percent tax, in addition to the corporate income tax, on personal holding company income that is not distributed to shareholders (sec. 541). In general, a personal holding company is a corporation more than 50 percent of whose stock is owned by not more than five individuals, and at least 60 percent of whose adjusted ordinary gross income is personal holding company income (sec. 542).

Personal holding company income includes dividends, interest, royalties, and certain other types of income (sec. 543). No exceptions are provided for royalties or interest received in connection with the development of computer software, the development of biomedical products, or the brokering or dealing in securities.

In general, certain U.S. shareholders of a foreign personal holding company are treated as having received the amount of the foreign personal holding company's undistributed foreign personal holding company income as a dividend on the last day of the corporation's taxable year (sec. 551). A foreign personal holding company generally is a foreign corporation more than 50 percent of whose stock is owned by not more than five individuals who are U.S. citizens or residents, and at least 60 percent of the gross income of which is foreign personal holding company income (sec. 552). Foreign personal holding company income includes royalties (sec. 553).

 

House Bill

 

 

The House bill provides an exception from the definition of personal holding company income for computer software royalties received by corporations that are engaged in the active conduct of the trade or business of developing or manufacturing computer software, provided that four conditions are met. First, the software from which the royalties are derived must be developed or manufactured by the corporation (or predecessor) in connection with such trade or business. Second, the software royalties meeting the first requirement must make up at least 50 percent of the corporation's ordinary gross income for the taxable year. Third, certain expenses incurred by the corporation must equal or exceed 25 percent of the corporation's ordinary gross income for the taxable year (or other periods in certain cases). And fourth, the corporation must distribute most of its personal holding company income (excluding computer software royalties and certain interest income).

The House bill also provides an exception from the definition of personal holding company income for interest on securities held in the inventory of a dealer in securities. In addition, under the House bill, a dealer in securities may deduct interest on certain "offsetting loans" in computing its gross interest income.

The provisions of the House bill are effective for royalties and interest received after December 31, 1985.

 

Senate Amendment

 

 

The Senate amendment generally is the same as the House bill with respect to computer software royalties with two modifications. First, to qualify for the exception, a corporation is not required to derive at least 50 percent of its ordinary gross income from computer software royalties. Second, under the Senate amendment, computer software royalties that qualify for the exception from the definition of personal holding company income also qualify for an exception from the definition of foreign personal holding company income.

The Senate amendment also provides an exception from the definition of personal holding company income for royalties received on account of biomedical research products of a specified biomedical research company under rules similar to those applicable to computer software royalties. In addition, the Senate amendment excludes from the definition of personal holding company income certain interest received by a specified broker-dealer in securities.

The provisions of the Senate amendment are effective for royalties received on, before, or after December 31, 1986, and for interest received after the date of enactment.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment with certain modifications. First, to qualify for the exception for certain computer software royalties under the conference agreement, the corporation receiving such royalties must meet the "fifty percent test" contained in the House bill. Second, the conference agreement does not contain the provision in the Senate amendment relating to biomedical research royalties.

The exception in the conference agreement for computer software royalties is effective for royalties received on, before, or after December 31, 1986. The exception for interest received by a specified broker-dealer in securities is effective for interest received on or after the date of enactment. In addition, the conference agreement excludes from the definition of passive investment income for purposes of subchapter S of the Code, computer software royalties derived by a specified taxpayer, which royalties would not be treated as personal holding company income under the conference agreement, effective for taxable years beginning after December 31, 1984. The conference agreement also contains an exception from the definition of personal holding company income for certain royalties derived by a specified toy manufacturer from the licensing of toys, under rules similar to those provided for computer software royalties, effective for royalties received or accrued in taxable years beginning after December 31, 1981.

 

S. Certain Entity Not Taxed as a Corporation

 

 

Present Law

 

 

Entities that are organized as trusts under local law may be subject to Federal income tax as corporations, rather than trusts, if they possess certain corporate characteristics. Such entities must pay corporate level tax in addition to the tax at the beneficiary level.

A certain trust (Great Northern Iron Ore Trust) has been held to be taxable as a corporation due to the existence of certain business powers.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

Under the Senate amendment, a certain trust (Great Northern Iron Ore Trust) will not be taxed as a corporation if, among other things, it makes an election and agrees not to exercise business powers contained in its trust instrument.

The provision is effective for taxable years beginning after the taxable year in which the election is made, provided that all conditions of the Senate amendment continue to be satisfied.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

TITLE VII. MINIMUM TAX PROVISIONS

 

 

A. Individual Minimum Tax

 

 

1. Structure

 

Present Law

 

 

Individuals are subject to an alternative minimum tax, applying to a broader income base (regular taxable income plus tax preferences) and at a lower rate than the regular tax, and payable to the extent in excess of regular tax liabilities.

 

House Bill

 

 

The House bill is the same as present law.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

2. Tax rate

 

Present Law

 

 

The alternative minimum tax is imposed at a rate of 20 percent.

 

House Bill

 

 

The House bill provides for a minimum tax rate of 25 percent.

 

Senate Amendment

 

 

The Senate amendment provides for a minimum tax rate of 20 percent.

 

Conference Agreement

 

 

The conference agreement provides for a minimum tax rate of 21 percent.

3. Exemption amount

 

Present Law

 

 

Alternative minimum taxable income is reduced by an exemption amount of $40,000 for joint returns, $30,000 for singles, and $20,000 for married filing separately.

 

House Bill

 

 

The House bill is the same as present law.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that the exemption amount is reduced by 25 cents for each $1 by which alternative minimum taxable income exceeds $150,000 ($112,500 for singles and $75,000 for married filing separately).

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

4. Tax preferences

 

a. Dividends excluded from gross income
Present Law

 

 

Dividends that are excludable from gross income (up to $100 per person, $200 for joint returns) are treated as a minimum tax preference.

 

House Bill

 

 

Under the House bill, the exclusion is repealed for regular tax purposes.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

 

b. Accelerated depreciation on real property
Present Law

 

 

The excess of accelerated over straight-line depreciation on real property, using the same useful lives, is treated as a preference.

 

House Bill

 

 

The House bill is the same as present law for real property placed in service before 1986. For real property placed in service after 1985, the preference is the excess of regular tax depreciation over the alternative depreciation described in the depreciation section of the conference report (15 years for certain low-income housing rehabilitation).

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except (1) present law treatment applies to property placed in service in 1986, and to property grandfathered under the depreciation rules, and (2) no special rule applies to low-income housing.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment, as conformed to the alternative depreciation provision described in the depreciation section of this report. However, for property other than (1) section 1250 property and (2) property with respect to which the taxpayer elects or is required to use a straight-line method for regular tax purposes, minimum tax depreciation uses the 150 percent declining balance method (switching to straight-line in the year necessary to maximize the allowance) over the alternative depreciation life.

 

c. Accelerated depreciation on personal property
Present Law

 

 

Solely for leased personal property, the excess of accelerated over straight-line depreciation, using the same useful lives, is a preference.

 

House Bill

 

 

The House bill is the same as present law for personal property placed in service before 1986. For personal property placed in service after 1985, the preference is the excess of regular tax depreciation over the alternative depreciation described in the depreciation section of the conference report.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that present law treatment applies to property placed in service in 1986 and to property grandfathered under the depreciation rules.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment, as conformed to the alternative depreciation provision described in the depreciation section of this report. However, for property other than that with respect to which the taxpayer elects or is required to use a straight-line method for regular tax purposes, minimum tax depreciation uses the 150 percent declining balance method (switching to straight-line in the year necessary to maximize the allowance) over the alternative depreciation life. The preference, computed using the useful life under the alternative depreciation system, applies to property placed in service in 1986 with respect to which the taxpayer elects the application of section 201 of the Act.

 

d. Expensing of intangible drilling costs
Present Law

 

 

The excess of expensing over 10-year amortization or cost depletion, to the extent in excess of 100 percent of net oil and gas income, is a preference.

 

House Bill

 

 

Under the House bill, the excess of expensing over 10-year amortization or cost depletion, to the extent in excess of 65 percent of net oil and gas income, is a preference.

 

Senate Amendment

 

 

The Senate amendment is the same as present law.

 

Conference Agreement

 

 

The conference agreement follows the House bill.

 

e. 60-month amortization on certified pollution control facilities
Present Law

 

 

The excess over depreciation otherwise allowable is a preference.

 

House Bill

 

 

The House bill is the same as present law for property placed in service before 1986. The provision is repealed for regular tax purposes, effective in 1986.

 

Senate Amendment

 

 

The Senate amendment treats the excess over alternative depreciation as a preference.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

f. Expensing of mining exploration and development costs
Present Law

 

 

The excess of expensing over 10-year amortization is a preference.

 

House Bill

 

 

The House bill is the same as present law.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

 

g. Expensing of circulation expenditures (for newspapers, magazines, etc.)
Present Law

 

 

The excess of expensing over 3-year amortization is a preference.

 

House Bill

 

 

The House bill is the same as present law.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

 

h. Expensing of research and experimentation expenditures
Present Law

 

 

The excess of expensing over 10-year amortization is a preference.

 

House Bill

 

 

The House bill is the same as present law.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

 

i. Percentage depletion
Present Law

 

 

The excess over the adjusted basis of the depletable property is a preference.

 

House Bill

 

 

The House bill is the same as present law.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

 

j. Net capital gain deduction
Present Law

 

 

The net capital gain deduction is treated as a preference.

 

House Bill

 

 

Under the House bill, a portion of the net capital gain deduction is treated as a preference, so that the minimum tax rate on capital gains, like the regular tax rate, will be 22 percent.

 

Senate Amendment

 

 

Under the Senate amendment, the net capital gain deduction is repealed for regular tax purposes, and net capital gains accordingly are fully included in minimum taxable income.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

k. Incentive stock options
Present Law

 

 

The excess of the fair market value of stock over the exercise price is treated as a preference.

 

House Bill

 

 

The House bill is the same as present law.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement generally follows the House bill and the Senate amendment. However, for minimum tax purposes, the basis of stock acquired through the exercise of an incentive stock option after 1986 equals the fair market value taken into account in determining the amount of the preference.

 

Assume, for example, that an individual pays an exercise price of $10 to purchase stock having a fair market value of $15. The preference in the year of exercise is equal to $5, and the stock has a basis of $10 for regular tax purposes and $15 for minimum tax purposes. If, in a subsequent year, the taxpayer sells the stock for $20, the gain recognized is $10 for regular tax purposes and $5 for minimum tax purposes.

l. Tax-exempt interest

Present Law

 

 

Tax-exempt interest is not treated as a preference.

 

House Bill

 

 

Under the House bill, tax-exempt interest on newly issued private activity (i.e., nonessential function) bonds that continue to be exempt for regular tax purposes is treated as a preference. Certain refundings of pre-1986 bonds are not treated as a preference.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the House bill with certain modifications and clarifications. First, the preference applies only to interest on private activity bonds other than qualified 501(c)(3) bonds. Second, the preference applies only to bonds issued on or after August 8, 1986 (on or after September 1, 1986, in the case of bonds covered under the Joint Statement on Effective Dates of March 14, 1986).1

The conference agreement further clarifies that the House bill's exception for certain current refundings of bonds issued before August 8, 1986 (or September 1, 1986) also applies in the case of a series of current refundings of an issue originally issued before those dates. This exception does not apply to refundings of pre-August 8, 1986 (or September 1, 1986), bonds.

 

m. Excludable income earned abroad by U.S. citizens
Present Law

 

 

The exclusion for income earned abroad by U.S. citizens is not treated as a preference.

 

House Bill

 

 

Under the House bill, the exclusion for income earned abroad by U.S. citizens is treated as a preference.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

n. Completed contract and other methods of accounting for long-term contracts
Present Law

 

 

The use of a method of accounting for long-term contracts, such as the completed contract method, that permits deferral of income during the contract period, is not treated as a preference.

 

House Bill

 

 

Under the House bill, use of the completed Contract or another method of accounting for long-term contracts that permits deferral of income during the contract period is treated as a preference, by requiring use of the percentage of completion method for minimum tax purposes on post-September 25, 1985 long-term contracts.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that the preference applies only to post-March 1, 1986 long-term contracts.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

o. Installment method of accounting
Present Law

 

 

Use of the installment method of accounting is not treated as a minimum tax preference.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

Under the Senate amendment, use of the installment method of accounting by dealers is treated as a preference, by not permitting use of the installment method for minimum tax purposes on sales after March 1, 1986. The provision does not apply (1) to certain sales by a manufacturer where special relief is provided under the regular tax rules, and (2) in the case of certain elections to pay interest on the deferral of income with respect to sales of timeshares and residential lots.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment, except that the preference applies to all transactions subject to proportionate disallowance of the installment method (i.e., dealer sales, and sales of trade or business or rental property where the purchase price exceeds $150,000).

 

p. Net loss from passive trade or business activities
Present Law

 

 

Net losses from trade or business activities in which the taxpayer does not materially participate are not treated as a minimum tax preference.

 

House Bill

 

 

Under the House bill, to the extent otherwise deductible for minimum tax purposes, the excess net loss with respect to trade or business activities (including the production of rental or royalty income) in which the taxpayer did not materially participate in management or provide substantial personal services is treated as a preference. The excess net loss is defined as net losses in excess of cash basis, which includes no more than $50,000 attributable to the taxpayer's tax shelter investments.

 

Senate Amendment

 

 

The Senate amendment provides that the passive loss rules of the regular tax apply to the minimum tax (using minimum tax measurements of items of income and deduction), except that the preference is reduced by the amount, if any, of the taxpayer's insolvency, and the provision is not phased in.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment. Changes made by the conference agreement to the regular tax passive loss provision apply for minimum tax purposes as well.

 

q. Losses from passive farming activities
Present Law

 

 

Net losses from farming activities in which the taxpayer does not materially participate are not treated as a minimum tax preference.

 

House Bill

 

 

Under the House bill, excess passive farm losses are treated as a preference. The rule is the same as the passive loss rule set forth above, except that it applies only to farming, applies separately to each farming activity, and treat as a preference only losses in excess of twice cash basis (without limiting cash basis from tax shelters).

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that (1) the preference applies to the entire net loss without regard to cash basis, (2) the preference applies to personal service corporations, (3) the preference is reduced by the amount, if any, of the taxpayer's insolvency, and (4) the definition of a passive farm activity is conformed to the passive loss rules.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

r. Charitable contributions of appreciated property
Present Law

 

 

Deductions for charitable contributions of appreciated property do not give rise to a minimum tax preference.

 

House Bill

 

 

Under the House bill, in the case of a charitable contribution of appreciated property, the lesser of the amount of untaxed appreciation allowed as a regular tax deduction and the amount of the taxpayer's other preferences is treated as a preference.

 

Senate Amendment

 

 

The Senate amendment is the same as present law.

 

Conference Agreement

 

 

The conference agreement follows the House bill, except that the amount of untaxed appreciation treated as a preference is not limited to the amount of the taxpayer's other preferences. The preference does not apply to carryovers of the deduction with respect to charitable contributions made before August 16, 1986,

5. Itemized deductions

 

Present Law

 

 

The only itemized deductions allowed for minimum tax purposes are those for casualty and theft losses, gambling losses to the extent of gambling gains, charitable deductions, medical deductions (to the extent in excess of 10 percent of adjusted gross income), interest expenses (restricted to housing interest plus net investment income), and certain estate taxes.

 

House Bill

 

 

The House bill is the same as present law.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that the definition of net investment income is conformed to the definition for regular tax purposes.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment in conforming the definition of net investment income to the definition adopted for regular tax purposes (although determined with regard to minimum tax items of income and deduction), with an amendment providing for a carryover of investment interest deductions that are disallowed. Other regular tax itemized deductions generally are allowed for minimum tax purposes.

For minimum tax purposes, medical deductions are allowed only to the extent in excess of 10 percent of adjusted gross income, miscellaneous itemized deductions and itemized deductions for State and local taxes are not allowed, and the investment interest rule is not phased in. It is clarified that, for minimum tax purposes, upon a refinancing of a loan that gives rise to qualified housing interest, interest paid on the new loan is treated as qualified housing interest to the extent that (1) it so qualified under the prior loan, and (2) the amount of the loan was not increased. Moreover, a residence does not constitute a qualified residence for minimum tax purposes unless it meets the requirements for a qualified residence applying for regular tax purposes. Further, the conference agreement provides that a refund of State and local taxes paid, for which no minimum tax deduction was allowed, is not included in alternative minimum taxable income.

6. Regular tax elections

 

Present Law

 

 

Taxpayers generally can elect to have minimum tax rules for measuring a particular item apply for regular tax purposes.

 

House Bill

 

 

The House bill is the same as present law.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

7. Adjustments in other years when taxpayer pays minimum tax

 

Present Law

 

 

Minimum tax liability incurred by a taxpayer in one year has no effect on regular tax liability in other years.

 

House Bill

 

 

Under the House bill, the amount of minimum tax liability relating to deferral preferences is allowed as a carryforward credit against regular tax liability.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill,

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

8. Incentive tax credits

 

Present Law

 

 

Incentive tax credits are not allowed against the minimum tax. Credits that do not benefit the taxpayer due to the minimum tax can be used as credit carryovers against the regular tax.

 

House Bill

 

 

Under the House bill, incentive tax credits are not allowed against the minimum tax. Credits that cannot be used for regular tax purposes due to the minimum tax can be used as credit carryovers against the regular tax.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

9. Foreign tax credit

 

Present Law

 

 

Foreign tax credits are allowed against the minimum tax, under limits similar to those applying under the regular tax. Credits that cannot be used in the current taxable year because of these limits are carried over under a system separate from but parallel to that applying for regular tax purposes.

 

House Bill

 

 

The House bill is the same as present law.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that foreign tax credits cannot offset more than 90 percent of tentative minimum tax liability (as determined without regard to foreign tax credits).

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment. It is clarified that the taxpayer's regular tax election regarding whether to treat foreign taxes as giving rise to a deduction or a credit is controlling for minimum tax purposes as well. Moreover, in light of the limitation on the use of net operating losses, described below, it is provided that foreign tax credits cannot offset more than 90 percent of minimum tax liability as determined without regard to foreign tax credits and net operating losses.

 

For example, assume that in 1987 a taxpayer has $10 million of alternative minimum taxable income for the year. In the absence of net operating losses or foreign tax credits, the taxpayer's tentative minimum tax liability (i.e., liability as determined without regard to the amount of regular tax liability) would equal $2.1 million. Accordingly, foreign tax credits cannot be used to reduce liability to less than $210,000, whether or not the taxpayer has any minimum tax net operating losses.

 

10. Net operating losses (NOLs)

 

Present Law

 

 

NOLs are allowed against alternative minimum taxable income. For years after 1982, minimum tax NOLs are reduced by the items of tax preference. Minimum tax NOLs are carried over under a system separate from but parallel to that applying for regular tax purposes.

 

House Bill

 

 

The House bill is the same as present law.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment, except that NOLs cannot offset more than 90 percent of alternative minimum taxable income. As with the 90 percent limitation on the use of the foreign tax credit, amounts disallowed by reason of this limitation may be carried over to other taxable years.

 

Thus, for example, assume that in 1987 a taxpayer has $10 million of alternative minimum taxable income for the year, and minimum tax NOLs in the amount of $11 million. The NOLs reduce alternative minimum taxable income to $1 million. This gives rise to tentative minimum tax liability of $210,000. The taxpayer carries forward $2 million of minimum tax NOLs to 1988. Since the allowability of net operating losses is determined prior to the allowability of foreign tax credits, this taxpayer would not be permitted to use any minimum tax foreign tax credits in 1987.

 

It is clarified that an election under section 172(b)(3)(C) to relinquish the carryback period applies both for regular tax and for minimum tax purposes.

11. Miscellaneous changes and clarifications

 

Conference Agreement

 

 

Under the conference agreement, it is clarified that Code sections suspending losses, such as sections 465, 704(d), 1366(d), and other sections specified in regulations, are recomputed for minimum tax purposes, to apply with respect to amounts otherwise deductible for purposes of the minimum tax. Thus, the amount of the deductions suspended or recaptured may differ for regular and minimum tax purposes, respectively. This clarification applies with respect to all taxpayers subject to the at-risk rules.

It is clarified that the application of the tax benefit rule to the minimum tax is within the discretion of the Secretary of the Treasury. Since the regular and minimum taxes generally are computed separately, relief from the minimum tax under the tax benefit rule is not appropriate solely by reason of the fact that a taxpayer has received no benefit under the regular tax with respect to a particular item. This clarification applies with respect to corporations as well as individuals.

In the case of an estate or trust, instead of allocating items of tax preference between the estate or trust and its beneficiaries (as under present law), it is provided that the minimum tax will apply by determining distributable net income on a minimum tax basis (except to the extent inconsistent with the modifications under section 643(a), with the minimum tax exemption amount being treated the same way as the deduction for personal exemptions under section 643(a)(2)).

12. Effective date

 

House Bill

 

 

The House bill applies for taxable years beginning after December 31, 1985.

 

Senate Amendment

 

 

The Senate amendment applies for taxable years beginning after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

B. Corporate Minimum Tax

 

 

1. Structure

 

Present Law

 

 

Corporations are subject to an add-on tax, equaling a percentage of certain preferences minus regular tax paid.

 

House Bill

 

 

The House bill provides for an alternative minimum tax, applying to a broader income base (regular taxable income plus preferences) and at a lower rate than the regular tax, and payable to the extent in excess of regular tax liabilities.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

2. Tax rate

 

Present Law

 

 

The add-on tax is imposed at a rate of 15 percent.

 

House Bill

 

 

The House bill provides for a minimum tax rate of 25 percent.

 

Senate Amendment

 

 

The Senate amendment provides for a minimum tax rate of 20 percent.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

3. Exemption amount

 

Present Law

 

 

The amount of preferences that are subject to the add-on tax is reduced by an exemption amount equal to the greater of $10,000 or the taxpayer's regular tax liability.

 

House Bill

 

 

Alternative minimum taxable income is reduced by an exemption amount of $40,000.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that the exemption amount is reduced by 25 cents for each $1 by which alternative minimum taxable income exceeds $150,000.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

4. Tax preferences

 

a. Accelerated depreciation on real property
Present Law

 

 

The excess of accelerated over straight-line depreciation on real property, using the same useful lives, is treated as a preference.

 

House Bill

 

 

The House bill is the same as present law for real property placed in service before 1986. For real property placed in service after 1985, the preference is the excess of regular tax depreciation over the alternative depreciation described in the depreciation section of the conference report (15 years for certain low-income housing rehabilitation).

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except (1) present law treatment applies to property placed in service in 1986 and to property grandfathered under the depreciation rules, and (2) no special rule applies to low-income housing.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment, as conformed to the alternative depreciation provision described in the depreciation section of this report. However, for property other than (1) section 1250 property and (2) property with respect to which the taxpayer elects or is required to use a straight-line method for regular tax purposes, minimum tax depreciation uses the 150 percent declining balance method (switching to straight-line in the year necessary to maximize the allowance) over the alternative depreciation life.

 

b. Accelerated depreciation on personal property
Present Law

 

 

Solely for leased personal property in the hands of a personal holding company (PHC), the excess of accelerated over straight-line depreciation, using the same useful lives, is a preference.

 

House Bill

 

 

The House bill is the same as present law for personal property placed in service before 1986. For personal property placed in service after 1985, the preference applies to all corporations and is the excess of regular tax depreciation over the alternative depreciation described in the depreciation section of the conference report.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that present law treatment applies to property placed in service in 1986 and to property grandfathered under the depreciation rules.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment, as conformed to the alternative depreciation provision described in the depreciation section of this report. However, for property other than that with respect to which the taxpayer elects or is required to use a straight-line method for regular tax purposes, minimum tax depreciation uses the 150 percent declining balance method (switching to straight-line in the year necessary to maximize the allowance) over the alternative depreciation life. The preference, computed using the useful life under the alternative depreciation system, applies to property placed in service in 1986 with respect to which the taxpayer elects the application of section 201 of the Act.

 

c. Expensing of intangible drilling costs
Present Law

 

 

Solely for PHCs, the excess of expensing over 10-year amortization or cost depletion, to the extent in excess of 100 percent of net oil and gas income, is a preference.

 

House Bill

 

 

Under the House bill, the excess of expensing over 10-year amortization or cost depletion, to the extent in excess of 65 percent of net oil and gas income, is a preference for all corporations.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that the preference is reduced by 100 percent of net oil and gas income.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

 

d. 60-month amortization on certified pollution control facilities
Present Law

 

 

The excess over depreciation otherwise allowable is a preference.

 

House Bill

 

 

The House bill is the same as present law for property placed in service before 1986. The provision is repealed for regular tax purposes, effective in 1986.

 

Senate Amendment

 

 

The Senate amendment treats the excess over alternative depreciation as a preference.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment. It is clarified that the preference applies without regard to the applicability of section 291 for regular tax purposes.

 

e. Expensing of mining exploration and development costs
Present Law

 

 

Solely for PHCs, the excess of expensing over 10-year amortization is a preference.

 

House Bill

 

 

Under the House bill, the excess of expensing over 10-year amortization is a preference for all corporations.

 

Senate Amendment

 

 

The Senate amendment is the same as present law.

 

Conference Agreement

 

 

The conference agreement follows the House bill. It is clarified that 10-year amortization applies for minimum tax purposes without regard to the applicability of section 291 for regular tax purposes.

 

f. Expensing of circulation expenditures (for newspapers, magazines, etc.)
Present Law

 

 

Solely for PHCs, the excess of expensing over 3-year amortization is a preference.

 

House Bill

 

 

Under the House bill, the excess of expensing over 3-year amortization is a preference, solely for PHCs.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

 

g. Expensing of research and experimentation expenditures
Present Law

 

 

Solely for PHCs, the excess of expensing over 10-year amortization is a preference.

 

House Bill

 

 

The House bill provides that the excess of expensing over 10-year amortization is not a preference for any corporation.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

 

h. Percentage depletion
Present Law

 

 

The excess over the adjusted basis of the depletable property is a preference,

 

House Bill

 

 

The House bill is the same as present law.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

 

i. Capital gain preference
Present Law

 

 

The benefit of the lower corporate rate applying to capital gains is treated as a preference.

 

House Bill

 

 

Under the House bill, net corporate capital gains are fully included in minimum taxable income,

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

 

j. Tax-exempt interest
Present Law

 

 

Tax-exempt interest is not treated as a preference.

 

House Bill

 

 

Under the House bill, tax-exempt interest on newly issued private activity (i.e., nonessential function) bonds that continue to be exempt for regular tax purposes is treated as a preference. Certain refundings of pre-1986 bonds are not treated as a preference.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the House bill with certain modifications and clarifications. First, the preference applies only to interest on private activity bonds other than qualified 501(c)(3) bonds. Second, the preference applies only to bonds issued on or after August 8, 1986 (on or after September 1, 1986, in the case of bonds covered under the Joint Statement on Effective Dates of March 14, 1986).2

The conference agreement further clarifies that the House bill's exception for certain current refundings of bonds issued before August 8, 1986 (or September 1, 1986) also applies in the case of a series of current refundings of an issue originally issued before those dates. This exception does not apply to current refundings of pre-August 8, 1986 (or September 1, 1986) bonds.

 

k. Completed contract and other methods of accounting for long-term contracts
Present Law

 

 

The use of a method of accounting for long-term contracts, such as the completed contract method, that permits deferral of income during the contract period, is not treated as a preference.

 

House Bill

 

 

Under the House bill, use of the completed contract or another method of accounting for long-term contracts that permits deferral of income during the contract period is treated as a preference, by requiring use of the percentage of completion method for minimum tax purposes on post-September 25, 1985 long-term contracts.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that the preference applies only to post-March 1, 1986 long-term contracts.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

l. Installment method of accounting
Present Law

 

 

Use of the installment method of accounting is not treated as a minimum tax preference.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

Under the Senate amendment, use of the installment method of accounting by dealers is treated as a preference, by not permitting use of the installment method for minimum tax purposes on sales after March 1, 1986. The provision does not apply (1) to certain sales by a manufacturer where special relief is provided under the regular tax rules, and (2) in the case of certain elections to pay interest on the deferral of income with respect to sales of timeshares and residential lots.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment, except that the preference applies to all transactions subject to proportionate disallowance of the installment method (i.e., dealer sales, and sales of trade or business or rental property where the purchase price exceeds $150,000).

 

m. Bad debt reserve deductions for financial institutions
Present Law

 

 

The excess of the deduction by a financial institution for bad debts over the amount allowable under the experience method is a preference.

 

House Bill

 

 

The House bill is the same as present law.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

 

n. Charitable contributions of appreciated property
Present Law

 

 

A deduction for a charitable contribution of appreciated property does not give rise to a minimum tax preference.

 

House Bill

 

 

Under the House bill, the lesser of untaxed appreciation for which the taxpayer claimed a charitable deduction, or the amount of the taxpayer's other preferences, is treated as a preference.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the House bill, except that the amount of untaxed appreciation treated as a preference is not limited to the amount of the taxpayer's other preferences. The preference does not apply to carryovers of the deduction with respect to charitable contributions made before August 16, 1986.

 

o. Excludable foreign sales corporation (FSC) income
Present Law

 

 

The exclusion by a shareholder for certain income of a FSC is not treated as a minimum tax preference.

 

House Bill

 

 

Under the House bill, the exclusion for FSC income is treated as a preference.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

p. Capital construction funds for shipping companies
Present Law

 

 

Reductions for contributions and tax-free inside buildup with regard to capital construction funds of shipping companies do not give rise to a minimum tax preference.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

Under the Senate amendment, the use of a capital construction fund gives rise to a minimum tax preference.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

q. Special deduction for certain tax-exempt insurance providers
Present Law

 

 

No provision.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

Under the conference agreement, the special deduction allowed for certain existing Blue Cross/Blue Shield organizations and for new organizations meeting certain requirements with respect to high risk coverage is a minimum tax preference.

 

r. Business untaxed reported profits
Present Law

 

 

Differences between book and tax treatment of particular items do not give rise to a minimum tax preference.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The Senate amendment treats as a preference 50 percent of the excess of the taxpayer's pre-tax book income over alternative minimum taxable income (determined without regard to this preference and prior to reduction by net operating losses). Book income is the income of the taxpayer as shown in financial reports or statements filed with the Securities and Exchange Commission or other Federal, State, or local regulators, or provided to shareholders, owners, or creditors. Under certain circumstances, earnings and profits may be substituted for book income.

The preference is computed by consolidating the book income of those corporations which are consolidated for tax purposes. Earnings of a corporation that does not file a consolidated tax return with the taxpayer are taken into account only to the extent of dividends received from the other corporation.

Certain Alaska native corporations may calculate book income using the asset bases determined under the Alaska Native Claims Settlement Act. Certain amounts paid to other Alaska native corporations may be treated as expenses for book purposes in the same year as the amounts are deductible for tax purposes.

 

Conference Agreement

 

 

Taxable years beginning in 1987, 1988, and 1989

For taxable years beginning in 1987, 1988, and 1989, the conference agreement is generally the same as the Senate amendment. It is clarified that dividends paid by cooperatives, to the extent deductible for regular tax and general minimum tax purposes under section 1382, are also deductible for book income purposes.

Further, the conference agreement provides that dividends received from a section 936 corporation and included in the recipient's book income are to be adjusted; i.e., grossed up, for purposes of measuring book income, by the amount of withholding taxes paid with respect to such dividends by such section 936 corporation. To the extent that the alternative minimum taxable income of the recipient is increased by reason of the inclusion of such dividends (including the gross-up) in book income, the related withholding taxes are treated, for minimum tax purposes, as creditable foreign taxes paid by the recipient.

 

Assume, for example, that a corporation receives a dividend in the amount of $90 from a section 936 corporation that has paid $10 of withholding taxes with respect to such dividend. The recipient's adjusted pre-tax book income includes dividends of $100. If such book income equals or exceeds other alternative minimum taxable income of the recipient, disregarding this inclusion, then the result of the inclusion is to increase alternative minimum taxable income by $50 (50 percent of $100). Accordingly, the amount of foreign taxes creditable for minimum tax purposes by the recipient is increased by $5 (50 percent of $10).

Assume that, in the above example, the recipient's adjusted pre-tax book income, disregarding the receipt of the above dividend, is $20 less than other alternative minimum taxable income. Accordingly, after inclusion of the grossed-up dividend, book income exceeds other alternative minimum taxable income by $80, and the book preference results in a $40 increase in the amount of alternative minimum taxable income. Since this increase is 40 percent of the full amount of the grossed-up dividend, the amount of foreign taxes creditable for minimum tax purposes is increased by $4 (40 percent of $10).

 

In the case of an insurance company whose applicable financial statement is the financial statement prepared for regulatory purposes, the conferees intend that the measure of pre-tax book income is the amount of net gain from operations after dividends to policyholders and before Federal income taxes.

It is clarified that no item of Federal or foreign income tax expenses or benefit (other than foreign taxes deducted in lieu of claiming a foreign tax credit), including any adjustment of deferred taxes resulting from the corporate tax rate changes of this Act or any subsequent legislation, is included in the computation of adjusted pre-tax book income for minimum tax purposes.

The conference agreement provides that, under regulations prescribed by the Secretary of the Treasury, adjusted book income shall be properly adjusted to prevent the omission or duplication of any item. The conferees intend that adjustments made under this provision may include adjustments made under the principles of section 482. The Secretary may require that adjustments be made to book income where the principles of this provision otherwise would be avoided through the disclosure of financial information through footnotes and other supplementary statements.

The conference agreement also provides that a taxpayer's current earnings and profits for the taxable year may be used in certain cases for purposes of the book income preference. The conferees clarify that earnings and profits for this purpose shall be determined without diminution by reason of distributions or federal income taxes during the taxable year. Moreover, for purposes of this provision, earnings and profits shall not be determined with regard to the adjusted current earnings calculation applicable for years beginning after 1989. In calculating earnings and profits for an affiliated group of corporations filing a consolidated return, appropriate adjustments will be made, as prescribed by the Secretary of the Treasury, to prevent the double inclusion of earnings and profits through the operation of the consolidated return regulations or otherwise.

Taxable years beginning after December 31, 1989

 

Application of the preference in general

 

For taxable years in which the preference applies, alternative minimum taxable income is increased by 75 percent of the amount by which adjusted current earnings exceeds alternative minimum taxable income (before this adjustment), whether alternative minimum taxable income and adjusted current earnings are positive or negative amounts. If alternative minimum taxable income (before this adjustment) exceeds the amount of adjusted current earnings, then alternative minimum taxable income is reduced by 75 percent of such difference. However, such reduction cannot exceed the excess of the aggregate amount by which alternative minimum taxable income has been increased as a result of this provision in prior taxable years, less the aggregate amount of reductions taken in prior years.

 

For example, a calendar year taxpayer has adjusted current earnings of $400 in 1990, $300 in 1991, and $200 in 1992. Alternative minimum taxable income is $300 for each of those years. In 1990, adjusted current earnings exceeds alternative minimum taxable income by $100, 75 percent of which ($75) must be included as an additional item of alternative minimum taxable income. In 1992, alternative minimum taxable income exceeds adjusted current earnings by $100, creating a potential negative adjustment to alternative minimum taxable income of $75. As the aggregate increases to alternative minimum taxable income for prior years equals $75 (the amount added to alternative minimum tax in 1990) and there are no aggregate reductions, the full amount of the potential negative adjustment will reduce alternative minimum taxable income for 1992.

A positive amount is always considered to be in excess of a negative amount and a smaller negative amount in excess of a larger negative amount. Thus, adjusted current earnings of $20 exceeds alternative minimum taxable income of negative $20 by $40, and $30 (equal to 75% of the excess) would be includible in alternative minimum taxable income. Likewise, alternative minimum taxable income of negative $20 exceeds adjusted current earnings of negative $40 by $20, and $15 (equal to 75% of the excess) could be used to reduce alternative minimum taxable income if not subject to limitation.

Adjusted current earnings

 

In general, adjusted current earnings requires the same treatment of an item as used for purposes of computing alternative minimum taxable income (before this adjustment). In the case of exclusion items, however, adjusted current earnings requires the same treatment of an item as used for the computation of regular earnings and profits as computed for purposes of Subchapter C. An exclusion item is an item of income or expense that is included in regular earnings and profits but is never included in the computation of either regular or alternative minimum taxable income (e.g. interest on tax-exempt bonds and the portion of dividends excluded under the dividends received deduction). For this purpose, the fact that an item could eventually be included in alternative minimum taxable income on the liquidation or disposal of a business (or similar circumstances) will not prevent exclusion item treatment. Additionally, adjusted current earnings requires different treatment of certain specifically listed items.

An exclusion item that is income for regular earnings and profits purposes is included in adjusted current earnings. Generally, any item of expense that is not allowable for any year for alternative minimum tax purposes solely because it relates to an exclusion item of income will be allowed in computing adjusted current earnings. Thus, interest on all tax-exempt bonds is included in adjusted current earnings, as well as the costs incurred to carry such tax-exempt bonds. However, if such carrying costs would be limited in the computation of taxable income, even if the income to which they relate is fully taxable, then the costs will be similarly limited for adjusted current earnings. Also, the original issue discount and market discount rules will apply to tax-exempt bonds for purposes of computing adjusted current earnings in the same manner as for taxable bonds.

In determining the amount of an item of deduction or loss allowable for adjusted current earnings, no deduction is allowed for an exclusion item of expense or deduction. Thus, the dividends received deduction generally is not allowed for adjusted current earnings. However, an exception is made for deductions allowed under section 243 or 245 for a dividend qualifying for a 100-percent dividends received deduction if the payor and recipient corporation could not be members of the same affiliated group under section 1504 by reason of section 1504(b), to the extent the payor corporation is subject to Federal income tax.

For example, a foreign sales corporation (FSC) is prohibited from inclusion in its parent's affiliated group, but is subject to Federal income tax on only a percentage of its income. The portion of any dividend paid from current earnings and profits to the parent equal to the percentage of the FSC's income that is subject to tax would be eligible for exclusion from adjusted current earnings. In the case of dividends received from section 936 corporations, a dividends received deduction rule is used for adjusted current earnings that generally follows the same rule that applies with regard to the book income preference (the full amount of the dividend is included in income and a credit allowed for a percentage of the withholding tax.)

Adjusted current earnings measures pre-tax income without diminution by reason of any distribution made during the taxable year. Thus, the deduction for Federal and foreign income tax expense allowed for regular earnings and profits purposes is not allowed in the computation of adjusted current earnings (except for foreign taxes where the taxpayer elects to deduct such taxes rather than claim a credit). Moreover, no deduction is allowed with respect to a dividend paid.

Depreciation is computed for the adjusted current earnings using the slower of the method used in connection with the preparation of the taxpayer's applicable financial statement or the applicable earnings and profits method. For property placed in service in taxable years beginning after 1989, the applicable earnings and profits method is straight-line over the ADR midpoint life. For property placed in service after 1986 but before the first taxable year beginning after 1989 and to which the amendments made by section 301 of this agreement apply, the applicable earnings and profits method generally provides for depreciation using (1) the adjusted minimum tax basis of property as of the close of the last taxable year beginning before January 1, 1990, (2) the remaining ADR midpoint life of the property at the beginning of the first taxable year beginning after 1989, and (3) the straight line method. For property to which the section 168 (as in effect on the day before the date of the enactment of this Act) applies, the applicable earnings and profits method provides for depreciation using (1) the adjusted regular tax basis of property as of the close of the last taxable year beginning before January 1, 1990, (2) the remaining ADR life as of the beginning of the first taxable year beginning after 1989, and (3) the straight-line method. For property placed in service before 1981, the applicable earnings and profits method is the same method as is used for regular tax purposes.

The determination of whether the method used in connection with the preparation of the taxpayer's applicable financial statement or the applicable earnings and profits method is slower is calculated by comparing the net present values of the deductions provided by each method. In the case of property placed in service in taxable years beginning before 1990, the net present value of deductions is to be determined only with regard to the remaining deductions allowable in taxable years beginning after 1989. In making this determination, the net value of deductions is computed using the same adjusted basis for both methods. It is anticipated that the Secretary of the Treasury will publish interest rates for use in computing the net present value of deductions. In the absence of such published rates, the applicable federal rate (c.f. section 1274(d)) for the period equal to the ADR life of the property may be used.

Intangible drilling and development costs allowable under section 263(c) are capitalized for adjusted current earnings and amortized over the slower of the method used in the preparation of the taxpayer's applicable financial accounting statement or the 60-month period beginning with the month in which production from the well begins. In the case of a taxpayer recovering intangible drilling and development costs through unit of production cost depletion for financial statement purposes, the determination of which method is slower will be done under regulations to be provided by the Secretary of the Treasury, taking into account reasonable estimates of the rate at which the intangible drilling and development costs are expected to be recovered for financial accounting purposes. Similar rules apply with respect to mining exploration and development costs in comparing the 120-month period with the method used in the preparation of the taxpayer's applicable financial statement.

No loss is allowed in the determination of adjusted current earnings on the exchange of any pool of debt obligations for another pool of debt obligations having substantially the same effective interest rates and maturities for the purpose of the adjusted earnings and profits method.

Special rules apply to insurers computing adjusted current earnings. In the case of a life insurance company, the acquisition expenses of any policy, for adjusted current earnings purposes, must be capitalized and amortized in accordance with the method generally required at the time such costs are insured by the Financial Accounting Standards Board (FASB), or, if the FASB has not published such a method, under guidelines issued by the American Institute of Certified Public Accountants that relate to generally accepted accounting principles. Acquisition expenses of life insurance companies are subject to this treatment on a fresh start basis, i.e., in calculating adjusted current earnings, it is assumed that life insurance acquisition expenses have been treated in the same manner as required under this provision for prior years. Acquisition expenses of property and casualty insurance companies are not subject to this treatment, because the unearned premium reserve deduction of property and casualty insurance companies is reduced by 20 percent (10 percent in the case of certain bond insurance) under the regular tax, as a method of addressing mismatching of deductible acquisition expenses and deferred premium income. In computing adjusted current earnings, the small life insurance company deduction under section 806 and the election for small property and casualty insurance companies to be taxed only on investment income under section 831(b) do not apply.

The conference agreement clarifies that inside buildup on a life insurance contract (as determined under section 7702g)) or on an annuity policy (as determined under section 72(u)(2)) is includible in adjusted current earnings, and a deduction is allowed for that portion of any premium that is attributable to insurance coverage.

In the case of a corporation that has experienced a change of ownership after the date of the enactment of this Act, the basis of the property of the corporation many not, for adjusted current earnings, exceed the allocable portion of the purchase price paid for the corporation.

Certain other adjustments required by section 312(n) (i.e., under paragraphs 1 through 6) generally are required in determining adjusted current earnings, subject to the rules regarding dates that apply for such purposes. For example, in the case of a disposition of property occurring in 1990 or thereafter, use of the installment method is not allowable in determining adjusted current earnings even if the use of such method is otherwise allowable for minimum tax purposes.

For the purposes of section 312(n)(1), which requires the capitalization of construction period carrying charges, the conferees intend that the "avoided cost method" under section 263A shall apply to determine the amount of interest allocable to production. Under section 312(n)(1), the avoided cost method is intended to apply irrespective of whether application of such method (or a similar method) is required, authorized, or considered appropriate under financial or regulatory accounting principles applicable to the taxpayer. Thus, for example, a utility company must apply the avoided cost method of determining capitalized interest under section 312(n)(1) even though a different method is authorized or required by Financial Accounting Standards Board Statement 34 or the regulatory authority having jurisdiction over the utility. The growing of timber or other crops is not considered construction under section 312(n)(1).

The conferees intend that no inference is to be drawn from the classification of an item as a specifically listed item as to current treatment for regular earnings and profits purposes or as to whether such a specifically listed item is an exclusion item.

In calculating adjusted current earnings for an affiliated group of corporations filing a consolidated return, appropriate adjustments will be made, as prescribed by the Secretary of the Treasury, to prevent the double inclusion of any item of adjusted current earnings through the operation of the consolidated return regulations or otherwise. The determination of whether a consolidated group is eligible to decrease alternative minimum taxable income as a result of alternative minimum taxable income exceeding adjusted current earnings is expected to be made at the consolidated level.

 

Separate item allocation

 

The conferees understand that reliance on adjusted earnings and profits has consequences regarding compliance by taxpayers who already must keep records based on the regular tax and general minimum tax systems. It is intended that the adjusted earnings and profits and general minimum tax systems be integrated regarding recordkeeping to the maximum extent feasible. The conferees anticipate that before the end of 1989, the Secretary of the Treasury will provide guidance through regulations or rulings regarding such integration. The furtherance of such integration should also be considered in the Treasury study regarding book income and earnings and profits that is mandated under the Act.

Study

The conferees direct the Secretary of the Treasury to study and to report regarding the book income and earnings and profits provisions, including refinements that may be appropriate (e.g., with regard to the application of the separate item allocation election).

The final report is to be submitted, by January 1, 1989, to the House Committee on Ways and Means and the Senate Committee on Finance.

5. Regular tax elections

 

Present Law

 

 

Taxpayers generally can elect to have minimum tax rules for measuring a particular item apply for regular tax purposes.

 

House Bill

 

 

Under the House bill, taxpayers generally can elect to have minimum tax rules for measuring a particular item apply for regular tax purposes.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

6. Adjustments in other years when taxpayer pays minimum tax

 

Present Law

 

 

Minimum tax liability incurred by a taxpayer in one year has no effect on regular tax liability in other years.

 

House Bill

 

 

Under the House bill, the amount of minimum tax liability is allowed as a carryforward credit against regular tax liability.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that the credit is allowed only with respect to minimum tax liability relating to deferral preferences.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment. The minimum tax preference, described in section X of this report, regarding deductions determined under section 833(b), is treated as an exclusion preference. Moreover, for taxable years beginning in 1990 or thereafter, the items included by reason of the preference for earnings and profits that otherwise would be permanently excluded from alternative minimum taxable income (e.g., dividends received and tax-exempt interest) are treated as exclusion items.

7. Incentive tax credits

 

Present Law

 

 

Incentive tax credits are not allowed against the minimum tax. Credits that do not benefit the taxpayer due to the minimum tax can be used as credit carryovers against the regular tax.

 

House Bill

 

 

Under the House bill, incentive tax credits generally are not allowed against the minimum tax. Credits that do not benefit the taxpayer due to the minimum tax can be used as credit carryovers against the regular tax. Corporations with net operating losses in two of the last three years before 1986 can use pre-1986 credits to offset 75 percent of minimum tax liability. The Puerto Rico and possessions tax credit (sec. 936) does not give rise to minimum tax liability.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that no credits can be used by any corporation to offset minimum tax liability.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment, except that, as a transition rule, regular investment tax credits are permitted, in effect, to reduce minimum tax liability by 25 percent. Under this modification, such credits can be used to reduce regular tax liability to 75 percent of tentative minimum tax liability, rather than only to the full amount of such liability. Moreover, such credits can instead be used to offset 25 percent of the taxpayer's tentative minimum tax for the year, where this results in permitting a greater amount of such credits to be used. The amount of minimum tax that is treated as paid, for purposes of the minimum tax credit, is determined without regard to the use of investment tax credits.

 

For example, assume that, disregarding investment tax credits, Corporation A would have a regular tax liability of $10 million and a tentative minimum tax liability of $4 million. A can use up to $7 million of investment tax credits, reducing A's tax liability to $3 million (treated as a payment of regular rather than of minimum tax).

Moreover, assume that, disregarding investment tax credits, Corporation B would have a regular tax liability of zero and a tentative minimum tax liability of $4 million. B can use up to $1 million of investment tax credits, reducing B's tax liability to $3 million. This gives rise to a minimum tax credit of $4 million in the event that all of B's preferences are deferral preferences, since the minimum tax credit is measured without regard to the use of the investment tax credit.

Further, assume that, disregarding investment tax credits, Corporation C would have a regular tax liability of $3.5 million and a tentative minimum tax liability of $4 million. C can use up to $1 million of investment tax credits, reducing C's tax liability to $3 million. This gives rise to a minimum tax credit of $500,000, if all of C's preferences are deferral preferences.

 

The rule for investment tax credits is applied consistently with the amount of tentative minimum tax liability in light of the limitations, described below, on the use of foreign tax credits and net operating losses. Thus, for example, assume that a taxpayer would have no regular tax liability, and a minimum tax liability of $10 million in the absence of foreign tax credits, net operating losses, and investment tax credits. As described below, foreign tax credits and net operating losses could not be used to reduce minimum tax liability to less than $1 million. To the extent that such losses and credits did not so reduce minimum tax liability, investment tax credits could then be used to reduce such liability to $1 million.

The conference agreement provides a technical correction regarding the treatment of income eligible for the section 936 credit. Under this correction, it is clarified that income of a section 936 corporation eligible for the credit generally is excluded from alternative minimum taxable income (including the preference for book income or earnings and profits).3 However, a taxpayer that qualifies for the section 936 credit may be subject to minimum tax with respect to income not qualifying for the credit.

It is clarified that, for purposes of the minimum tax, the megawattage of an electric generating unit is to be determined with reference to the Summary Information Report (NUREG-0871, Vol. No. 4, Issue Date: October 1985), published by the U.S. Nuclear Regulatory Commission.

8. Foreign tax credit

 

Present Law

 

 

Foreign preferences are not subject to the add-on tax.

 

House Bill

 

 

Under the House bill, foreign tax credits are allowed against the minimum tax, under limits similar to those applying under the regular tax. Credits that cannot be used in the current taxable year because of these limits are carried over under a system separate from but parallel to that applying for regular tax purposes.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill, except that foreign tax credits cannot offset more than 90 percent of tentative minimum tax liability.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment. For taxable years beginning in 1990 or thereafter, items included in alternative minimum taxable income by reason of the preference for earnings and profits are sourced, for purposes of the section 904 limitation, on an item-by-item basis. It is clarified that the taxpayer's regular tax election regarding whether to treat foreign taxes as giving rise to a deduction or a credit is controlling for minimum tax purposes as well. Moreover, in light of the limitation on the use of net operating losses, described below, it is provided that foreign tax credits cannot offset more than 90 percent of minimum tax liability as determined without regard to foreign tax credits and net operating losses.

 

For example, assume that in 1987 a taxpayer has $10 million of alternative minimum taxable income for the year. In the absence of net operating losses or foreign tax credits, the taxpayer's tentative minimum tax liability (i.e., liability as determined without regard to the amount of regular tax liability) would equal $2 million. Accordingly, foreign tax credits cannot be used to reduce liability to less than $200,000, whether or not the taxpayer has any minimum tax net operating losses.

 

It is clarified that, with regard to years prior to the effective date of the corporate alternative minimum tax, rules apply similar to those applying in 1982 upon the enactment of the individual alternative minimum tax. Thus, pre-effective date regular tax foreign tax credits carried forward to 1987 are treated as minimum tax foreign tax credit carryforwards, and minimum tax foreign tax credits are reduced by the amount of any foreign tax credits carried back, for regular tax purposes, to years prior to 1987.

9. Net operating losses (NOLs)

 

Present Law

 

 

Net operating losses are not directly taken into account in calculating the add-on tax. However, a taxpayer that would have an NOL even in the absence of the enumerated preferences may defer the add-on tax until the NOLs attributable to such preferences are used to offset taxable income.

 

House Bill

 

 

Under the House bill, the net operating loss deduction is allowed against alternative minimum taxable income. For any taxable year beginning after 1985, the minimum tax is reduced by the items of tax preference arising in that year. Minimum tax NOLs are carried over under a system separate from but parallel to that applying for regular tax purposes.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill for taxable years beginning after 1986.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment, except that NOLs cannot offset more than 90 percent of alternative minimum taxable income. As with the 90 percent limitation on the use of the foreign tax credit, amounts disallowed by reason of this limitation may be carried over to other taxable years.

 

Thus, for example, assume that in 1987 a taxpayer has $10 million of alternative minimum taxable income for the year, and minimum tax NOLs in the amount of $11 million. The NOLs reduce alternative minimum taxable income to $1 million. This gives rise to tentative minimum tax liability of $200,000. The taxpayer carries forward $2 million of minimum tax NOLs to 1988. Since the allowability of net operating losses is determined prior to the allowability of foreign tax credits, this taxpayer would not be permitted to use any minimum tax foreign tax credits in 1987.

 

It is clarified that, in light of the parallel nature of the regular tax and minimum tax systems, any limitations applying for regular tax purposes to the use by a consolidated group of NOLs or current year losses (e.g., section 1503) apply for minimum tax purposes as well. Moreover, it is clarified that an election under section 172(b)(3)(C) to relinquish the carryback period applies for both regular tax and minimum tax purposes.

10. Estimated tax payments

 

Present Law

 

 

Corporations are not required to make estimated tax payments with respect to minimum tax liability.

 

House Bill

 

 

The House bill requires that estimated tax payments be made with respect to minimum tax liability.

 

Senate Amendment

 

 

The Senate amendment is the same as the House bill.

 

Conference Agreement

 

 

The conference agreement follows the House bill and the Senate amendment.

11. Effective date

 

House Bill

 

 

The House bill applies for taxable years beginning after December 31, 1985.

 

Senate Amendment

 

 

The Senate amendment applies for taxable years beginning after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

TITLE VIII. ACCOUNTING PROVISIONS

 

 

A. Limitations on the Use of the Cash Method of Accounting

 

 

Present Law

 

 

A taxpayer generally may elect to use any method of accounting that clearly reflects income and is regularly used in keeping its books. Taxpayers using the cash method of accounting generally recognize items of income when actually or constructively received and items of expense when paid. Tax shelters using the cash method of accounting generally may not recognize items of expense prior to economic performance.

Taxpayers using the accrual method of accounting generally accrue items as income when all the events have occurred that establish the right to receive the income and the amount of income can be determined with reasonable accuracy. Taxpayers using the accrual method of accounting generally may not deduct items of expense prior to the time of economic performance. Taxpayers are required to keep inventories and to use the accrual method of accounting with respect to inventory items if the production, purchase, or sale of merchandise is a material income producing factor to the taxpayer (sec. 471). Certain corporations engaged in agricultural activities with gross receipts exceeding $1 million are required to use the accrual method of accounting (sec. 447).

 

House Bill

 

 

The House bill generally provides that the cash method of accounting may not be used by any C corporation, by any partnership that has a C corporation as a partner, or by a tax-exempt trust with unrelated business income. Exceptions are made for farming businesses, qualified personal service corporations, and entities with average annual gross receipts of $5 million or less for all prior taxable years (including the prior taxable years of any predecessor of the entity).

A qualified personal service corporation is a corporation that meets both a function test and an ownership test. The function test is met if substantially all the activities of the corporation are the performance of services in the field of health, law, engineering (including surveying and mapping), architecture, accounting, actuarial science, performing arts or consulting.

The ownership test is met if substantially all of the value of the outstanding stock in the corporation is owned by employees performing services for the corporation in a field satisfying the function test, retired individuals who performed services for the corporation or its predecessor(s) in such a field, the estate of such an individual, or any person who acquired its ownership interest as a result of the death of such an individual within the prior 24 months. For the purpose of applying the ownership test, stock owned by a partnership, an S corporation or a qualified personal service corporation will be considered as owned by its partners or shareholders. The ownership test is applied without regard to any community property law.

A taxpayer, other than a financial institution or a utility, is not required to accrue as income any amount to be received for the performance of services prior to the time the amount is billed. Similarly, the House bill provides that economic performance of services provided to an accrual basis taxpayer will not be considered to have occurred prior to the time the taxpayer is billed for the services, unless the services are performed by an employee of the taxpayer. In addition, a taxpayer, other than a financial institution, is not required to accrue as income any amount to be received for the performance of services that, on the basis of experience, will not be collected, as long as unpaid balances do not bear interest or result in a late payment charge.

The provision of the House bill is effective for taxable years beginning after December 31, 1985. Any change from the cash method of accounting required as a result of this provision is treated as a change in the taxpayer's method of accounting, initiated by the taxpayer with the consent of the Secretary of the Treasury. Any adjustment to income resulting from the change is recognized over a period not to exceed five years (not to exceed 10 years in the case of a hospital). Taxpayers may elect to continue to report income from loans, leases, and transactions with related persons, entered into before September 25, 1985, using the cash method.

 

Senate Amendment

 

 

The Senate amendment provides that the cash method of accounting may not be used by any financial institution, bank for cooperatives, production credit association, or finance company qualifying to use the reserve method of computing losses on bad debts.

A financial institution is any organization described in section 581 (relating to banks, including mutual savings banks, cooperative banks, and building and loan associations) and section 586 (relating to small business investment companies and business development corporations). A bank for cooperatives is an institution chartered pursuant to section 2121 of Title 12 of the United States Code. A production credit association is an institution chartered pursuant to section 2091 of Title 12 of the United States Code.

The finance companies that may not use the cash method of accounting under the amendment are those persons meeting the definition of a lending or finance company contained in section 542(c)(6) that has as a substantial portion of its business the making of loans to members of the general public. Income from a loan that arises from the sale of property or services that were sold or manufactured by the taxpayer (or an affiliate of the taxpayer) is not considered as income derived from the active and regular conduct of a lending or finance business for these purposes.

The provision is effective for taxable years beginning after December 31, 1986. Any change from the cash method of accounting required as a result of this provision is treated as a change in the taxpayer's method of accounting, initiated by the taxpayer with the consent of the Secretary of the Treasury. Any adjustment to income resulting from the change is recognized over a period not to exceed five years.

 

Conference Agreement

 

 

The conference agreement generally follows the House bill with certain modifications.

Tax shelters

The conference agreement provides that the cash method of accounting may not be used by any tax shelter. For this purpose, a tax shelter is defined in the same manner as under section 461(i) of present law. Thus, a tax shelter is (a) any enterprise (other than a C corporation) if at any time interests in such enterprise have been offered for sale in any offering required to be registered with any Federal or State agency having the authority to regulate the offering of securities for sale, (b) any syndicate within the meaning of section 1256(e)(3), or (c) any tax shelter within the meaning of section 6661(b)(2)(C)(ii). In the case of an enterprise engaged in the trade or business of farming, a tax shelter is (a) any tax shelter within the meaning of section 6661(b)(2)(C)(ii) or (b) a farming syndicate within the meaning of section 464(c).

The exceptions to the general rule for farming businesses, qualified personal service corporations, and entities with average annual gross receipts of $5 million or less do not apply in the case of tax shelters.

The conference agreement further provides that a tax shelter may not take advantage of the recurring item exception under section 461(h)(3) to the rule requiring economic performance before an accrual basis taxpayer may deduct an item of expense. However, in the case of a tax-shelter economic performance with respect to the drilling of an oil and gas well will be considered to have occurred if the drilling of the well commences within 90 days of the close of the taxable year.

Qualified personal service corporations

The conference agreement also changes the requirements of the ownership test under the definition of a qualified personal service corporation. In order to meet the ownership test under the conference agreement, substantially all (i.e., at least 95 percent) of the value of the stock of the corporation must be held, directly or indirectly, by employees performing services for such corporation in connection with the qualified services performed by the company, retired employees who had performed such services, the estate of any such current or retired employee, or any other person who acquired stock by reason of the death of such an employee (for the 2-year period beginning with the death of such employee.) In applying the ownership test, the applicable community property laws of any State are to be disregarded, stock held by any plan described in section 401(a) that is exempt from tax under section 501(a) is treated as held by the employees of the entity and, at the election of the common parent of an affiliated group, all members of such affiliated group may be treated as a single entity for the purpose of applying the ownership test if substantially all of the activities of such members involve the performance of services in the same qualified field.

Farming businesses

The conference agreement provides that, for the purpose of determining whether an entity is engaged in a farming business, the definition of farming shall include the raising or harvesting of trees (including evergreen trees that are not subject to the capitalization provisions of section 263A.)

Gross receipts test

The conference agreement provides that the gross receipts test will be considered to have been met if the entity had average annual gross receipts of $5 million or less for all prior taxable years (including the prior taxable years of any predecessor entity) beginning after December 31, 1985.

Billing rule

The conference agreement deletes the provision of the House bill providing that a taxpayer, other than a financial institution or a utility, is not required to accrue as income any amount to be received for the performance of services prior to the time the amount was billed. Similarly, the conference agreement deletes the provision of the House bill providing that economic performance of services provided to an accrual basis taxpayer generally will not be considered to have occurred prior to the time the taxpayer is billed. In not adopting these two provisions of the House bill, the conferees intend that no inference is to be drawn with regard to when economic performance occurs under present law.

 

Effective Date

 

 

The provision of the conference agreement is effective for taxable years beginning after December 31, 1986. The provision of the House bill allowing taxpayers to elect to continue to report income from loans, leases, certain real property contracts, and transactions with related parties entered into before September 25, 1985, using the cash method, applies to tax shelters as well as other entities. Any change from the cash method required by this provision is treated as initiated by the taxpayer with the consent of the Secretary of the Treasury. Any adjustment required by section 481 as a result of such change generally shall be taken into account over a period not to exceed four years. It is the intent of the conferees that this apply to all changes resulting from the provision, including any changes necessitated by the rule that certain accrual taxpayers, including taxpayers presently on the accrual method of accounting, need not recognize income on amounts statistically determined not to be collectible. In the case of a hospital, the adjustment shall be taken into account ratably over a ten-year period. For this purpose, a hospital is not required to be owned by or on behalf of a governmental unit or by a 501(c)(3) organization or operated by a 501(c)(3) organization to meet the definition of a hospital. The conferees intend that the timing of the section 481 adjustment other than for a hospital will be determined under the provisions of Revenue Procedure 84-74, 1984-2 C.B. 736. In addition, the conferees intend that (i) net operating loss and tax credit carryforwards will be allowed to offset any positive section 481 adjustment; (ii) for purposes of determining estimated tax payments, the section 481 adjustment will be recognized in taxable income ratably throughout the year in question; and (iii) the timing of a negative section 481 adjustment shall be determined as if the adjustment were positive.

The conferees are aware that taxpayers may request from the Internal Revenue Service permission to change their taxable years. In addition, the Treasury Department has issued several administrative pronouncements and regulations permitting taxpayers to change their taxable years in certain circumstances without prior permission of the Internal Revenue Service. The effective date of many of the provisions of the conference agreement relate to commencement or end of the taxpayer's taxable year. As a result, the Treasury Department may exercise its administrative authority to modify its rules to prevent the avoidance of these effective dates.

 

B. Simplified Dollar Value LIFO Method for Certain Small Businesses

 

 

Present Law

 

 

Taxpayers using the dollar-value LIFO (last-in, first-out) method of accounting for inventories are allowed, under Treasury regulations, to construct the indexes necessitated by the use of the LIFO method from data published by the Bureau of Labor Statistics. These indexes are constructed for any particular taxpayer by taking a weighted average of price changes for the specific categories of inventory that the taxpayer holds. A taxpayer with average annual gross receipts for its most recent three years of $2 million or less may use 100 percent of the constructed index. Taxpayers with average annual gross receipts in excess of $2 million are limited to an index equal to 80 percent of the constructed index.

Inventory values under the dollar-value LIFO method normally are determined by comparison of current prices or indexes with the prices or indexes for the same items in the first year in which the LIFO method was used (the "double-extension" method). If the permission of the Secretary of the Treasury is obtained, values also may be determined by comparing current prices or indexes with the prior year's prices or indexes to determine an annual price change component, and applying that component to all prior annual price change components (the "link-chain" method).

The LIFO method of accounting normally requires items of inventory to be grouped together in inventory pools. Wholesalers, retailers, jobbers, and distributors generally determine their pools with reference to their major lines, types, or classes of goods. Manufacturers may group all inventory items that represent a natural business unit into a single pool. A taxpayer with average annual gross receipts of $2 million or less for its three most recent taxable years may elect to use a single pool for all inventory items (Code sec. 474).

 

House Bill

 

 

The House bill provides an election to use a simplified dollar-value LIFO method to taxpayers whose average annual gross receipts for the three preceding taxable years (or for such portion of the preceding three taxable years that the taxpayer actively has been engaged in a trade or business) are $5 million or less. All persons who are members of a controlled group, defined as those persons who would be treated as a single employer by the Treasury regulations prescribed under section 52, are treated as a single taxpayer for the purpose of determining average annual gross receipts.

The simplified dollar-value LIFO method uses multiple pools in order to avoid the construction of weighted-average indexes individual to the taxpayer. These pools are based on the 11 general categories of the "Consumer Price Index for all Urban Consumers" in the case of retailers using the retail method, or on the 15 general categories of the "Producers Prices and Price Indexes for Commodity Groupings and Individual Items" in the case of other taxpayers. The change in the published index for the general category to which the pool relates is used as the annual price change component and the indexes necessary to compute the equivalent dollar values of prior years are developed using the link-chain method.

The election to use the simplified dollar-value LIFO method may be made without the consent of the Secretary of the Treasury. If the method is elected, it must be used for all the inventories of the taxpayer accounted for using a LIFO method and may not be revoked unless permission to change to another method is obtained from the Secretary of the Treasury or the $5 million average annual gross receipts amount is exceeded. A taxpayer that previously has used a method of accounting for its inventories that allows the value of inventories to be written down below cost must restore the amount of any such write-down to income in accordance with section 472(d)).

The simplified dollar-value LIFO method in the House bill replaces the current law rule allowing taxpayers with average annual gross receipts of $2 million or less to elect to use a single LIFO pool. Any taxpayer who has in effect a valid election to use the single pool method of present law may continue the use of such method if the taxpayer continues to meet the requirements for that election and does not elect to use the simplified dollar-value LIFO method of the House bill.

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

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the provision of the House bill, effective for taxable years beginning after December 31, 1986

A taxpayer using the simplified dollar-value LIFO method is required to change to a different method in the first year that it fails to meet the $5 million average annual gross receipts test. The conferees intend that any change that would be allowed if made directly from the method used immediately prior to the adoption of the simplified dollar-value LIFO method to the new method be allowed in this case. It is anticipated that a taxpayer always will be allowed to return to the method used prior to the adoption of the simplified dollar-value LIFO method. Thus, if a taxpayer had been using a first-in, first-out (FIFO) method prior to the adoption of the simplified dollar-value method, it is allowed to change to the same FIFO method it had used previously or any FIFO, LIFO, or other method that it would have been allowed to change to from the FIFO method used immediately prior to the adoption of the simplified dollar-value LIFO method.

In changing from the simplified dollar-value LIFO method to another method, it is not intended that the taxpayer be required to obtain permission from the Secretary of the Treasury for the change if it would not be required to obtain permission if changing directly from the method used immediately prior to the adoption of the simplified dollar-value method to the new method. Likewise, the administrative burden of obtaining the change in method should be no greater than it would be if the change were made directly.

 

C. Installment Sales

 

 

Present Law

 

 

In general

Under present law, gain or loss from a sale of property generally is recognized in the taxable year in which the property is sold. Nonetheless, gain from certain sales of property in exchange for which the seller receives deferred payments is reported on the installment method, unless the taxpayer elects otherwise (Code sec. 453). Eligible sales include dispositions of personal property on the installment plan by a person who regularly sells or otherwise disposes of personal property on the installment plan (sec. 453A) and other dispositions of property, including publicly traded property, where at least one payment is to be received after the close of the taxable year in which the disposition occurs (sec. 453(b)(1)). The installment method may not be used where a sale results in a loss.

Under the installment method, in any taxable year, a taxpayer recognizes income resulting from a disposition of property equal to an amount that bears the same ratio to the payments received in that year that the gross profit under the contract bears to the total contract price. Payments taken into account for this purpose generally include cash or other property (including foreign currency and obligations of third parties), marketable securities, certain assumptions of liabilities, and evidences of indebtedness of the purchaser that are payable on demand or are readily tradable (Temp. Treas. Reg. sec. 15A.453-1(b)(3)).

Sales under a revolving credit plan

Taxpayers who sell property under arrangements commonly known as revolving credit plans are permitted to treat a portion of the receivables arising from sales on such a plan as installment receivables, and report any income therefrom on the installment method (Treas. Reg. sec. 1.453-2(d)). In general, these regulations define a revolving credit plan to include a cycle budget account, a flexible budget account, a continuous budget account, and other similar arrangements, under which the customer agrees to pay a part of the outstanding balance of the customer's account during each period of time for which a periodic statement of charges and credits is rendered.

Dispositions of installment obligations

Generally, if an installment obligation is disposed of, gain (or loss) is recognized equal to (a) the difference between the amount realized and the basis of the obligation in the case of satisfaction at other than face value, or sale or exchange of the obligation, or (b) the difference between the fair market value of the obligation at the time of the disposition and the basis of the obligation in the case of any other disposition (sec. 453B). The basis of the obligation is equal to the basis of the property sold plus amounts of gain previously recognized, less the amount of any payments received. In general, the mere pledge of an installment obligation as collateral for a loan is not treated as a disposition.1

 

House Bill

 

 

Under the House bill, if an installment obligation is pledged as collateral for a loan, the proceeds of the loan are treated as a payment on the obligation, and a proportionate amount of the gain that was deferred under the installment method is recognized.

The House bill provides an exception under which no payments would be treated as having been received on a portion of an installment obligation, which portion is due within nine months of the receipt of the obligation, regardless of the maturity of any other payments on the obligation. For a taxpayer who sells property on a revolving credit plan, the amount eligible for the exception is that portion of the receivable balance that is determined (pursuant to a statistical sampling technique) to be paid within nine months of the related sale.

The provisions of the House bill do not apply to pledges of obligations for debt that by its terms is payable within 90 days, provided that the debt is not renewed or continued, and provided that the taxpayer does not issue additional debt within 45 days.

The House bill includes anti-avoidance rules, under which borrowed amounts may be treated as a payment on installment obligations that are not formally pledged, if it is reasonable to expect that the lender took into account payments on the installment obligations as a source for payments on the indebtedness. The House bill provides a safe harbor from this anti-avoidance rule where more than 50 percent of the taxpayer's assets are used in an active trade or business.

The House bill applies to pledges of installment obligations after December 31, 1985, and applies as of January 1, 1986, to pledges before that date of obligations arising after September 25, 1985, unless the debt for which such obligations are pledged is repaid by December 31, 1985. The provisions of the House bill are phased in over three years for installment obligations arising from the sale of property in the ordinary course of business that are pledged in 1986, and phased in over two years for like installment obligations pledged in 1987. One residential condominium project is grandfathered.

 

Senate Amendment

 

 

Proportionate disallowance rule

 

Overview

 

Under the Senate amendment, use of the installment method for certain sales by persons who regularly sell real or personal property described in section 1221(1), and for certain sales of business or rental real property, is limited based on the amount of the outstanding indebtedness of the taxpayer. The limitation generally is applied by determining the amount of the taxpayer's "allocable installment indebtedness" ("AII") for each taxable year and treating such amount as a payment immediately before the close of the taxable year on "applicable installment obligations" of the taxpayer that arose in that taxable year and are outstanding as of the end of the year.

 

Allocable installment indebtedness

 

In general, under the Senate amendment, AII for any taxable year is determined by (1) dividing the face amount of the taxpayer's applicable installment obligations that are outstanding at the end of the year by the sum of (a) the face amount of all installment obligations (i.e., both applicable installment obligations and all other installment obligations) and (b) the adjusted basis of all other assets of the taxpayer,2 (2) multiplying the resulting quotient by the taxpayer's average quarterly indebtedness, and (3) subtracting any AII that is attributable to applicable installment obligations arising in previous years that are outstanding at the end of the taxable year. In the case of an individual, this computation does not take into account certain farm property or personal use property or indebtedness that is secured by only such property.

"Applicable installment obligations" are any installment obligations that arise from the sale after February 28, 1986, of (a) certain property held for sale to customers, or (b) real property used in the taxpayer's trade or business or held for the production of rental income, provided that the selling price of the property exceeds $150,000.3 In applying the "$150,000 exception," the aggregation rule applicable for purposes of section 1274(c)(3)(ii) is applied.

In each subsequent taxable year, the taxpayer is not required to recognize gain attributable to applicable installment obligations arising in any prior year to the extent that any actual payments on the obligations do not exceed the amount of AII attributable to such obligations. On the receipt of such payments, the AII attributable to the obligation on which the payment is received is reduced by the amount of such payments. Payments on an applicable installment obligation in excess of the AII allocable to such obligation are accounted for under the ordinary rules for applying the installment method.

 

Calculation of indebtedness

 

Under the Senate amendment, the taxpayer must compute its average indebtedness for the year in order to calculate the amount of its AII. The calculation is made, for this purpose, on a quarterly basis. In making the calculation, all indebtedness of the taxpayer that is outstanding as of the end of each quarter is taken into account, including (but not limited to) accounts payable and accrued expenses as well as other amounts more commonly considered as indebtedness (such as loans from banks, and indebtedness arising in connection with the purchase of property by the taxpayer).

 

Affiliated groups

 

Where the taxpayer is a member of an affiliated group or a group under common control, then all such members are treated as one taxpayer for purposes of making the calculations required under the Senate amendment.4 Thus, under the Senate amendment, each member is treated for this purpose as having all of the assets and liabilities of every other member. Thus, taxpayers who are members of such groups would compute AII on a group-wide basis for each taxable year. The AII so computed would then be allocated pro rata to the applicable installment obligations of all of the members of the group, and the allocated amount accordingly would be treated as a payment on the obligations.

The Senate amendment also provides that under regulations to be issued by the Secretary of the Treasury, use of the installment method would be disallowed in whole or in part where the provisions of the bill otherwise would be avoided through use of related parties or other intermediaries.

 

Special election for sales of timeshares and residential lots

 

The Senate amendment provides an election under which the proportionate disallowance rule would not apply to installment obligations that arise from the sale of certain types of property by a dealer to an individual, but only if the individual's obligation is not guaranteed or insured by any third person other than an individual. To be eligible for the election, the obligation must arise from the sale of a "timeshare" or of unimproved land, the development of which will not be done by the seller of the land or any affiliate of the seller.

If these conditions are met, then the seller of the property may elect not to have the proportionate disallowance rule apply to the installment obligations arising from such sale and must pay interest on the deferral of its tax liability attributable to the use of the installment method.

 

Exception for certain sales by manufacturers to dealers

 

The Senate amendment provides an exception from the proportionate disallowance rule for installment obligations arising from the sale of tangible personal property by the manufacturer of the property (or an affiliate of the manufacturer) to a dealer, but only if the dealer is obligated to make payments of principal only when the dealer resells (or rents) the property, the manufacturer has the right to repurchase the property at a fixed (or ascertainable) price after no longer than a nine-month period following the sale to the dealer, and certain other conditions regarding the ratio of the taxpayer's installment obligations to its sales to dealers are met.

Revolving credit plans

Under the Senate amendment, taxpayers who sell property on a revolving credit plan are not permitted to account for such sales on the installment method. For this purpose, the term "revolving credit plan" has the same meaning as under present law (see Treas. Reg. sec. 1.453-2(d)).

Publicly traded property

Under the Senate amendment, taxpayers who sell stock or securities that are traded on an established securities market, or to the extent provided in Treasury regulations, property (other than stock or securities) of a kind regularly traded on an established market, are not permitted to use the installment method to account for such sales.

The Senate amendment also provides that, under regulations to be issued by the Secretary of the Treasury, use of the installment method may be disallowed in whole or in part where the provisions of the bill otherwise would be avoided through use of related parties or other intermediaries.

 

Effective Date

 

 

The elimination of the installment method for sales on a revolving credit plan and for sales of publicly traded property is effective for sales of property after December 31, 1986. Taxpayers who sell property under revolving credit plans and who may no longer use the installment method of accounting for such sales may include in income any adjustment resulting from their ceasing to use the installment method over a period not exceeding five years.

The proportionate disallowance rule is effective as of January 1, 1987, for sales made on or after March 1, 1986. In addition, the Senate amendment does not treat certain specified loans as outstanding indebtedness for purposes of the proportionate disallowance rule.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment with certain modifications.

Proportionate disallowance rule

The conference agreement generally adopts the proportionate disallowance rule contained in the Senate amendment. However, the conference agreement specifies that, in applying the proportionate disallowance rule, installment obligations arising from the sale of personal use property by an individual, and either property used or property produced in the trade or business of farming, are not treated as applicable installment obligations. Thus, for example, the proportionate disallowance rule does not apply under the conference agreement, to installment obligations arising from the sale of crops or live stock held for slaughter. In addition, personal use property, installment obligations arising from the sale of personal use property, and indebtedness substantially all the security for which is such property (or such installment obligations) are not taken into account in applying the proportionate disallowance rule under the conference agreement.

The conference agreement provides that, in applying the proportionate disallowance rule, the calculation of indebtedness is made on an annual basis, rather than a quarterly basis, for taxpayers who have no applicable installment obligations that arose from the sale on the installment method of either personal property by a person who regularly sells property of the same type on the installment method, or real property that was held for sale to customers in the ordinary course of a trade or business. The Treasury Department is given authority to issue regulations that would prevent possible avoidance of the provision where the calculation of indebtedness is made on such an annual basis.

The conference agreement modifies the aggregation rule contained in the Senate amendment for applying the proportionate disallowance rule. Under the conference agreement, all persons treated as a single employer under section 52(a) or section 52(b) (the "controlled group") are treated as one taxpayer for these purposes. Hence, in applying the proportionate disallowance rule to the controlled group, the installment percentage is determined by aggregating all of the assets of the members of the controlled group, and such installment percentage is multiplied by the aggregate average quarterly (or if appropriate, annual, indebtedness) of members of the controlled group, to determine the total allocable installment indebtedness for the controlled group. The total allocable installment indebtedness so determined then is allocated pro rata to the applicable installment obligations held by members of the controlled group, (regardless of the amount of any indebtedness that any particular member of the group has outstanding), and the regular provisions of the proportionate disallowance rule are then applied.

The conference agreement provides authority under which the Treasury Department may issue regulations that disallow the use of the installment method in whole or in part for transactions in which the effect of the proportionate disallowance rule would be avoided through the use of related parties, pass-through entities, or intermediaries. The conferees intend that the meaning of related party is to be construed for these purposes in a manner consistent with carrying out the purposes of the proportionate disallowance rule. Thus, the conferees intend that the regulations may treat any corporation, partnership, or trust as related to its shareholders, partners, or beneficiaries, as the case may be, in circumstances where the proportionate disallowance rule otherwise might be avoided.

The conferees intend that these regulations may aggregate the assets of the related parties for purposes of applying the proportionate disallowance rule. For example, the conferees intend that such regulations may aggregate the assets and indebtedness of a partnership and each of its partners in determining the extent to which each such partner may report gain arising from the installment sale of partnership assets on the installment method.

In addition, the conferees intend that the regulations may treat installment obligations arising from the sale of an interest in one related party by another as applicable installment obligations to the extent that installment obligations arising from the sale of the assets of the related party the interest in which is sold would be treated as applicable installment obligations.

The conferees intend that these regulations may in appropriate cases apply to all transactions after the general effective date of the provision, but prior to the issuance of the regulations.

The conference agreement also makes certain technical modifications to the statutory language relating to the proportionate disallowance rule.

Special election for sales of certain property

The conference agreement adopts the special provision contained in the Senate amendment relating to installment obligations arising from the sales of certain "timeshares" and residential lots. In applying the special election, the conference agreement provides that the interest rate charged is 100 percent of the applicable Federal rate that would apply to the installment obligation received in the sale (without regard to the three-month lookback rule of section 1274(d)(2)). In addition, the conference agreement clarifies that in applying the "six-week" limitation on the eligibility of timeshare interests for the special rule, a timeshare right to use (or timeshare ownership in) a specific property, which right (or ownership interest) is held by the spouse, children, grandchildren or parents of an individual, shall be treated as held by such individual.

Publicly traded property and revolving credit

For sales of publicly traded property and for sales of property pursuant to revolving credit plans, the conference agreement generally follows the Senate amendment. Under the conference agreement, such sales are treated as installment sales with respect to which all payments are received in the year of sale. The conference agreement provides that the Treasury Department has regulatory authority to disallow the use of the installment method in whole or in part for transactions in which the rules of the conference agreement relating to sales of publicly traded property or sales pursuant to a revolving credit plan would be avoided through the use of related parties, pass-through entities, or intermediaries. The conferees intend that these regulations are to be similar to those relating to the proportionate disallowance rule.

 

Effective Date

 

 

In general, the proportionate disallowance rule is effective for taxable years ending after December 31, 1986, with respect to sales of property after February 28, 1986. For this purpose, the conferees intend that any sales of property after February 28, 1986, but before the first taxable year of the taxpayer ending after December 31, 1986, (i.e., if the taxpayer has a calendar year as a taxable year, or has a short taxable period ending between February 28, 1986 and December 31, 1986), are to be treated as arising in the taxpayer's first taxable year ending after December 31, 1986.

In the case of installment obligations arising from the sale of real property in the ordinary course of the trade or business of the taxpayer, any gain attributable to allocable installment indebtedness allocated to any such installment obligations that arise or (are deemed to arise) in the first taxable year of the taxpayer ending after December 31, 1986, is taken into account ratably over the three taxable years beginning with such first taxable year; for installment obligations arising in the second taxable year of the taxpayer ending after December 31, 1986, any such gain is taken into account ratably over the two taxable years beginning with such second taxable year. The conferees intend that the rules of the conference agreement relating to the treatment of subsequent payments on applicable installment obligations are to be applied in this situation as if the provisions were fully effective in the first taxable year ending after December 31, 1986.

In the case of installment obligations arising from the sale of personal property in the ordinary course of the trade or business of the taxpayer, any increase in the tax liability of the taxpayer for the first taxable year of the taxpayer ending after December 31, 1986, on account of the application of the proportionate disallowance rule, is treated as being imposed ratably over the three taxable years beginning with such first taxable year; any increase in tax liability for the second taxable year of the taxpayer ending after December 31, 1986, on account of the proportionate disallowance rule, (disregarding the ratable share of the increase in tax liability from the preceding taxable year), is treated as being imposed ratably over the two taxable years beginning with such second taxable year. The conferees intend that the rules of the conference agreement relating to the treatment of subsequent payments on applicable installment obligations are to be applied in this situation as if the provisions were fully effective in the first taxable year ending after December 31, 1986.

In the case of applicable installment obligations other than installment obligations arising from the sale of real or personal property in the ordinary course of a trade or business of the taxpayer, the proportionate disallowance rule is effective for taxable years ending after December 31, 1986, with respect to sales after August 16, 1986. The conferees intend that sales after August 16, 1986, and before the taxpayer's first taxable year ending after December 31, 1986 are to be treated as arising in the first taxable year of the taxpayer ending after December 31, 1986.

The provisions of the conference agreement relating to sales pursuant to a revolving credit plan are effective for taxable years beginning after December 31, 1986. Any adjustment resulting from the change in method of accounting is taken into account over a period not exceeding four years. In cases where the adjustment is taken into account over the four year period, the taxpayer would take into account 15 percent of the adjustment in the first taxable year, 25 percent in the second taxable year, and 30 percent in each of the succeeding two taxable years.

The provisions of the conference agreement relating to sales of publicly traded property are effective for sales of property after December 31, 1986.

The conference agreement excludes from the definition of applicable installment obligation, installment obligations arising from the sale of units of a specified condominium project. The conference agreement also excludes certain indebtedness of a specified taxpayer from the calculation of the taxpayer's average quarterly indebtedness. In addition, the provisions of the conference agreement are effective for taxable years ending after December 31, 1991, with respect to a specified taxpayer that incurred substantial indebtedness in connection with a specified acquisition.

 

D. Capitalization Rules for Inventory, Construction, and Development Costs

 

 

Present Law

 

 

1. Inventory

Manufacturers must accumulate costs of producing inventory goods in an inventory account. Accumulated inventory costs may be deducted as the goods to which they relate are sold. Treasury regulations provide for use of the "full absorption method" in determining which costs must be included in inventory. Under these regulations, all direct production costs, including costs of materials incorporated into the product or consumed during production and labor directly involved in manufacturing, must be inventoried. The treatment of indirect production costs varies according to the nature of the costs: some costs are currently deductible; others are inventoriable; and others ("financial conformity" costs) are deductible only if deducted by the taxpayer for financial reporting purposes.

Purchasers of goods for resale (e.g., wholesalers and retailers) must include in inventory the invoice price of the purchased goods plus transportation and other necessary costs incurred in acquiring possession.

2. Self-constructed property and noninventory property produced for sale

The costs of acquiring, constructing, or improving buildings, machinery, equipment, or other assets having a useful life beyond the end of the taxable year are not currently deductible. These "capital expenditures" become part of the basis of the asset, and may be recoverable over the useful life of the property through depreciation or amortization deductions if the property is held for business or investment purposes. Any unrecovered basis may be offset against the amount realized if the property is sold or otherwise disposed.

Although a taxpayer's direct costs of constructing an asset for its own use or a noninventory asset produced for sale must be capitalized, the proper treatment of many indirect costs is uncertain.

3. Interest

Interest is generally deductible in the year paid or incurred. However, interest incurred by a taxpayer during construction or improvement of real property to be held in a trade or business or activity for profit generally must be capitalized and amortized over ten years (sec. 189). The amount of interest that must be capitalized is determined under the "avoided cost" method. Under this method, the taxpayer must capitalize (in addition to interest directly traceable to construction indebtedness) any interest expense during the construction period that could have been avoided if funds had not been expended for construction.

 

House Bill

 

 

1. Inventory

Under the House bill, comprehensive capitalization rules (the "uniform capitalization rules"') apply to the manufacture of inventory goods. These rules essentially parallel the full absorption rules of present law, but require that most financial conformity costs be inventoried. In addition, all tax depreciation, current pension and fringe benefit costs, and a portion of general and administrative expenses are treated as inventory costs. Research and experimental costs (within the meaning of sec. 174), however, are not subject to capitalization. Special rules apply to farmers (see Title IV.A.3.) and producers of timber (see Title IV.B.1.).

These provisions are effective for taxable years beginning after December 31, 1985. The section 481 adjustment is to be spread ratably over a period of not more than five years under the rules applicable to a change in a method of accounting initiated by the taxpayer

2. Self-constructed property and noninventory property produced for sale

Self-constructed property and noninventory property produced for sale are subject to the uniform capitalization rules, effective for costs incurred after December 31, 1985.

3. Interest

Under the House bill, a taxpayer must capitalize interest on debt incurred to finance the construction or production of real property, long-lived personal property, or other tangible property requiring more than two years (one year in the case of property costing more than $1 million) to produce or construct or to reach a productive stage. The amount of interest subject to capitalization is determined under the avoided cost method. This rule applies to interest paid or incurred after December 31, 1985.

 

Senate Amendment

 

 

1. Inventory

The Senate amendment generally is the same as the House bill, except that the required capitalization of costs under the uniform capitalization rules is extended to apply to purchasers of goods for resale having average annual gross receipts in excess of $5 million. Thus, costs (including general and administrative costs) attributable to purchasing, processing, and storage of goods, and other similar costs, are to be treated as inventory costs. In addition, the uniform capitalization rules apply to intangible as well as tangible property. Farmers and producers of timber are excepted from the rules (see Title IV.A.3. and B.1.).

The rules apply to inventory for taxable years beginning after December 31, 1986. Excess depreciation on property placed in service before March 1, 1986, however, is not subject to the new rules. The section 481 adjustment is to be spread ratably over a period of not more than five years under the rules applicable to a change in a method of accounting initiated by the taxpayer.

2. Self-constructed property and noninventory property produced for sale

The Senate amendment generally is the same as the House bill, except that the uniform capitalization rules apply to intangible as well as tangible property. The rules apply to costs incurred with respect to self-constructed and noninventory property after December 31, 1986, unless incurred in connection with property on which substantial construction occurred before March 1, 1986.

3. Interest

The Senate amendment generally is the same as the House bill, except that long-lived personal property is subject to the interest capitalization rule only if the property is to be used by the taxpayer in a trade or business or activity for profit (i.e., is not to be held for sale). In addition, all taxpayers producing property under a long-term contract must capitalize interest with respect to the contract.

The interest capitalization rule applies to interest paid or incurred after December 31, 1986, unless incurred with respect to property on which substantial construction occurred before March 1, 1986.

 

Conference Agreement

 

 

1. Inventory

 

In general

 

The conference agreement generally follows the Senate amendment, with certain modifications and clarifications. However, the agreement follows the House bill in applying the uniform capitalization rules to taxpayers engaged in the trade or business of farming (other than timber) where the preproductive period exceeds two years (see Title IV.A.3.). In addition, the conference agreement provides that the uniform capitalization rules are to apply to all depreciation deductions for Federal income tax purposes with respect to assets of the taxpayer (i.e., the conference agreement deleted the provisions of the Senate amendment which exempted existing assets from the capitalization of all tax depreciation).

The gross receipts threshold for taxpayers acquiring property for resale is increased from $5 million to $10 million. Accordingly, present law rules continue to apply to resellers whose average annual gross receipts do not exceed $10 million.

The conference agreement provides that the uniform capitalization rules do not apply to the growing of timber and certain ornamental trees (i.e., those evergreen trees which are more than 6 years old when severed from the roots and sold for ornamental purposes). Thus, present law is retained with regard to the treatment of the preproductive expenses of growing timber and such ornamental trees.

The conferees intend that present law be retained with regard to which costs of growing timber are deductible in the year incurred and which costs must be capitalized. Thus, any costs which must be capitalized under present law would continue to be capitalized and costs incurred in growing timber which are not required to be capitalized under present law would remain deductible currently.

The definition of timber used in the conference agreement is intended to be coextensive with the definition of timber (including ornamental trees) under present law. The conferees intend that nothing in the definition of timber shall be construed to narrow the types of activities which constitutes the growing of timber for purpose of the exclusion of timber from the uniform capitalization rules.

The conferees wish to clarify their intent as to the treatment of costs incurred by taxpayers engaged in the resale of natural gas with respect to so-called "cushion gas"--gas necessary to maintain operating pressures in an underground gas storage facility sufficient to meet expected peak customer demand. It is not intended that such taxpayers be required to allocate to such gas any portion of their overhead or other indirect costs under the new uniform capitalization rules. The conferees anticipate that the Treasury Department may issue rules or regulations under which some portion of the so-called "emergency reserve" gas in such facilities also may be exempt from allocations of indirect costs under the capitalization rules of this provision.

The uniform capitalization rules are not intended to affect the valuation of inventories on a basis other than cost. Thus, the rules will not affect the valuation of inventories at market by a taxpayer using the lower of cost or market method, or by a dealer in securities or commodities using the market method. However, the rules will apply to inventories valued at cost by a taxpayer using the lower of cost or market method.

The conferees clarify that, in addition to the costs specifically excepted from capitalization under the conference agreement (e.g., research and experimental costs, selling, marketing, advertising, and distribution expenses) are not subject to capitalization under the uniform capitalization rules.

 

Simplified method for taxpayers acquiring property for resale

 

The conference agreement directs the Treasury Department to provide a simplified method for applying the uniform capitalization rules in the case of taxpayers acquiring property for resale. The conferees expect that the simplified method provided under rules or regulations generally will follow the examples described below and that, until rules or regulations are issued, taxpayers may rely on these examples.

Taxpayers not electing to use the simplified method are required to apply the new uniform capitalization rules to property acquired for resale under the same procedures and methods applicable to manufacturers, The Treasury Department may modify the simplified method or permit the use of other methods by rules or regulations. Once a taxpayer has chosen either the simplified method or the capitalization methods applicable to manufacturers, the taxpayer may not change its method without obtaining the permission of the Secretary.

For purposes of the simplified method, it is anticipated that taxpayers initially will calculate their inventory balances without regard to the new uniform capitalization rules. Taxpayers will then determine the amounts of additional costs that must be capitalized under the new rules (under the procedures described below) and add such amounts, along with amounts of additional costs contained in beginning inventory balances where appropriate, to the preliminary inventory balances to determine their final balances. Thus, for example, with respect to a taxpayer using the last-in, first-out (LIFO) method, the calculation of a particular year's LIFO index will be made without regard to the new capitalization rules. For such a taxpayer, however, costs capitalized under these rules will be added to the LIFO layers applicable to the various years for which the costs were accumulated. Likewise, in the case of a tax-payer on the first-in, first-out (FIFO) method that does not sell its entire beginning inventory during the year, a proportionate part of the additional costs capitalized into the beginning inventory under these rules will be included in ending inventory.

The simplified method will be applied separately to each trade or business of the taxpayer.

In general, four categories of indirect costs will be allocable to inventory under this simplified method:

 

(1) off-site storage and warehousing costs (including, but not limited to, rent or depreciation attributable to a warehouse, property taxes, insurance premiums, security costs, and other costs directly identifiable with the storage facility).4A

(2) purchasing costs such as buyers' wages or salaries;

(3) handling, processing, assembly, repackaging, and similar costs, including labor costs attributable to unloading goods (but not including labor costs attributable to loading of goods for final shipment to customers, or labor at a retail facility);5 and

(4) the portion of general and administrative costs allocable to these functions.

 

Storage costs.--Under the simplified method, a taxpayer includes storage costs in inventory based on the ratio of total storage costs for the year to the sum of (1) the beginning inventory balance and (2) gross purchases during the year. For example, assume that a FIFO taxpayer incurred $1 million of storage costs during the taxable year, had a beginning inventory balance (without regard to any adjustments under the simplified method) of $2 million, made gross purchases of $8 million, and had an ending inventory (without regard to any adjustments under the simplified method) of $3 million. The ratio of storage costs to beginning inventory and purchases is 10 percent ($1,000,000 divided by ($2,000,000 plus $8,000,000)). Thus, for each dollar of ending inventory, the taxpayer must capitalize ten cents of storage costs. Ending inventory for the year would be increased by $300,000. The balance of the storage costs ($700,000) would be included in cost of goods sold.

In the case of a LIFO taxpayer, to the extent that ending inventory exceeds beginning inventory, additional capitalized storage costs would be calculated by multiplying the increase in inventory for the year by the applicable ratio. Accordingly, if the taxpayer in the above example used the LIFO method, an additional $100,000 (i.e., .10 x $1,000,000) of storage costs would be included in ending inventory. Moreover, in contrast to the FIFO taxpayer in the previous example, any storage costs that were included in the taxpayer's beginning inventory balance would remain in the taxpayer's ending inventory balance and would not be included in cost of goods sold for the year.

Purchasing costs.--Purchasing costs are allocated between inventory and cost of goods sold based on the ratio of purchasing costs to gross purchases during the year. For example, assume that the taxpayer in the above example incurred $500,000 in purchasing costs during the year. The ratio of purchasing costs to gross purchases is 6.25 percent ($500,000 divided by $8,000,000). Thus, 6.25 cents of purchasing costs would be capitalized for each dollar's worth of items in ending inventory that were not in beginning inventory (i.e., were purchased during the current year). Assuming the taxpayer uses the first-in, first-out (FIFO) basis for determining inventories, $187,500 (i.e., .0625 x $3,000,000) of purchasing costs would be capitalized.

In the case of a taxpayer using the last-in, first-out (LIFO) method for valuing inventory, ending inventory consists of newly acquired items only to the extent that ending inventory exceeds beginning inventory. Capitalized purchasing costs would be calculated by multiplying the increase in inventory from the beginning of the year to the end by the applicable ratio. Accordingly, in the above example, the taxpayer would capitalize $62,500 (i.e., .0625 x $1,000,000) of purchasing costs. In contrast to a FIFO taxpayer, the purchasing costs attributable to a LIFO taxpayer's beginning inventory would be retained in the taxpayer's ending inventory balance.

Processing, repackaging, etc. costs.--Processing, repackaging, and other similar costs are allocated based on the ratio of total processing, repackaging, etc. costs to the sum of (1) the beginning inventory balance and (2) gross purchases during the year.

General and administrative expenses allocable to storage, purchasing, and processing.--General and administrative expenses that are allocable in part to storage, purchasing, and processing activities and in part to activities for which no capitalization is required under the simplified method are allocated based on the ratio of direct labor costs incurred in a particular function to gross payroll costs. For example, assume that the total cost of operating the taxpayer's accounting department for the year was $75,000, direct labor purchasing costs were $500,000, and gross payroll was $1,500,000. The portion of the accounting department cost subject to capitalization in connection with the purchasing function would be $25,000 (i.e., $500,000 divided by $1,500,000 x $75,000).

In addition, assume that direct labor warehousing costs were $250,000. The portion of the accounting department cost allocated to the storage and warehousing functions and thus subject to capitalization would be $12,500 (i.e., $250,000 divided by $1,500,000 x $75,000).

 

Section 481 adjustment

 

Under the conference agreement, the section 481 adjustment resulting from the change in accounting method is to be included in income over a period not exceeding four years. The conferees intend that the timing of the section 481 adjustment will be determined under the provisions of Revenue Procedure 84-74, 1984-2 C.B. 736. In addition, the conferees intent that (i) net operating loss and tax credit carryforwards will be allowed to offset any positive section 481 adjustment; and (ii) for purposes of determining estimated tax payments, the section 481 adjustment will be recognized ratably throughout the taxable year of the adjustment.

In computing the section 481 adjustment, taxpayers using the simplified method for property acquired for resale must apply this method in restating beginning inventory. Taxpayers using the LIFO method who lack sufficient data to compute the section 481 adjustment precisely may use the methods of approximation (based on the data for the three prior years for which increments in the inventory occurred) available to manufacturers under the Senate bill.

2. Self-constructed property and noninventory property produced for sale

The conference agreement generally follows the Senate amendment on self-constructed and noninventory property produced for sale. The conference agreement provides that the application of the uniform capitalization rules with respect to production activities is limited to tangible property.6 On the other hand, the conference agreement provides that the extension of the uniform capitalization rules to property acquired for resale includes intangible, as well as tangible, property.

The conference agreement adopts the Senate amendment's effective date for self-constructed property. Thus, the rules apply to costs incurred after December 31, 1986, unless incurred with respect to property on which substantial construction occurred before March 1, 1986.

3. Interest

The conference agreement follows both the House bill and the Senate amendment in certain respects. Long-lived personal property is subject to the interest capitalization rules regardless of whether it is constructed for self-use or for sale, as under the House bill. In addition, taxpayers producing property under a long-term contract must capitalize interest costs to the extent income is not being reported under the percentage of completion method.

The conferees wish to clarify that the avoided cost method of determining the amount of interest allocable to production is intended to apply irrespective of whether application of such method (or a similar method) is required, authorized, or considered appropriate under financial or regulatory accounting principles applicable to the taxpayer. Thus, for example, a regulated utility company must apply the avoided cost method of determining capitalized interest even though a different method is authorized or required by Financial Accounting Standards Board Statement 34 or the regulatory authority having jurisdiction over the utility. No inference is intended that the avoided cost method is not required in such circumstances under section 189 of present law.

 

E. Long-Term Contracts

 

 

Present Law

 

 

The treatment of costs of producing property under a "long-term contract" varies depending on the method of accounting used by the taxpayer. In addition to an inventory method (e.g., accrual shipment or accrual delivery), taxpayers may use one of two special methods of accounting for long-term contracts: the percentage of completion method or the completed contract method. Under the percentage of completion method, gross income is recognized according to the percentage of the contract completed during each taxable year, and costs incurred under the contract are currently deductible. Under the completed contract method, the gross contract price is included in income, and costs associated with the contract are deducted, in the year that the contract is completed and accepted.

The rules relating to which costs are contract costs for purposes of the completed contract method vary depending on whether the contract is an extended period contract (generally one requiring longer than two years to complete) or a non-extended period contract. The rules applicable to extended period contracts essentially parallel the uniform capitalization rules (see D., above). Research and development costs (within the meaning of section 174) that relate to a particular extended period long-term contract must be capitalized.

Non-extended period contracts are subject to similar but somewhat less comprehensive rules. For example, research and development costs related to a particular contract need not be capitalized as part of that contract.

 

House Bill

 

 

Under the House bill, the income and expenses of all long-term contracts must be reported under the percentage of completion method. Revenues from such contracts must be included in gross income based on the ratio of contract costs incurred during the year to total projected contract costs; contract costs are currently deductible. Interest is payable by (or to) the taxpayer if the actual profit on a contract allocable to any year varies from the estimated profit used in reporting income. An exception is provided for contracts for the construction of real property to be completed within two years of the contract date, if performed by a taxpayer whose average annual gross receipts do not exceed $10 million. Present law capitalization rules are retained for contracts not required to be reported under the percentage of completion method. These pro-visions are effective for contracts entered into after September 25, 1985.

 

Senate Amendment

 

 

In general, all long-term contracts are subject to rules similar to the uniform capitalization rules, including the rules relating to the capitalization of interest (see D., above), unless the contract is reported on the percentage of completion method. Moreover, additional general and administrative costs attributable to cost-plus contracts and to Federal government contracts requiring certification of costs are treated as contract costs. An exception from the uniform capitalization rules (except the interest capitalization rule) is provided for real estate construction contracts not requiring more than two years to complete, if performed by a taxpayer with average annual gross receipts of $10 million or less.

The provisions are effective for contracts entered into on or after March 1, 1986.

 

Conference Agreement

 

 

In general

The conference agreement adopts elements of both the House bill and the Senate amendment provisions. Under the conference agreement, taxpayers may elect to compute income from long-term contracts under one of two methods: (1) the "percentage of completion-capitalized cost method" (i.e., 40 percent PCM) described below or (2) the percentage of completion method. In general, percentage of completion is determined as provided in the House bill for purposes of both methods. Except in the case of certain real property construction contracts (i.e., those for which exceptions were provided under the House bill and Senate amendment), these are the exclusive methods under which long-term contracts may be reported. The conference agreement generally adopts the definition of a long-term contract in the Senate amendment. This definition is the same as present law.

The conference agreement also prescribes the treatment of independent research and development costs, effective for all open tax years.

Percentage of completion-capitalized cost method

In the case of any long-term contract not reported under the percentage of completion method, the taxpayer must take into account 40 percent of the items with respect to the contract under the percentage of completion method. Percentage of completion is determined by comparing the total contract costs incurred before the close of the taxable year with the estimated total contract costs. The contract costs taken into account in determining the percentage of completion are those for which capitalization is required under the Senate amendment in the case of long-term contracts ("capitalizable costs").

The remaining 60 percent of the items under the contract are to be taken into account under the taxpayer's normal method of accounting, capitalizing those costs as required under the Senate amendment. Thus, 60 percent of the gross contract income will be recognized, and 60 percent of the contract costs will be deducted, at the time required by the taxpayer's method. For example, if the taxpayer uses the completed contract method of accounting, these items would be taken into account upon completion of the contract. If the taxpayer uses an accrual method (e.g., an accrual shipment method), such contract items would be taken into account at the time of shipment.

Under the conference agreement, the look-back method provided in the House bill is to be applied to the 40 percent portion of the contract reported on the percentage of completion method. Thus, interest is paid to or by the taxpayer on the difference between the amount actually taken into account by the taxpayer for each year of the contract and the amount the taxpayer would have taken into account recomputing the 40-percent portion under the look-back method.

Independent research and development costs

Under the conference agreement, independent research and development costs are expressly excepted from the category of capitalizable costs. Independent research and development costs for this purpose are defined as any expenses incurred in the performance of independent research and development other than (1) expenses directly attributable to a long-term contract in existence when the expenses are incurred, and (2) any expenses under an agreement to perform research and development.1

In particular, the conferees intend that the contractual arrangement regarding I&D and its allocation to the contract shall not be severed, for Federal income tax purposes, from the long-term contract in such a manner as to render I&D ineligible for treatment as a cost of a long-term contract, or to accelerate the recognition of any income pertaining to I&D in comparison to the recognition of income which would otherwise occur under the taxpayer's method of accounting.

The conferees are aware that the treatment of independent research and development (I&D) is presently a subject of controversy between taxpayers and the Internal Revenue Service. Under the conference agreement, the position of the Internal Revenue Service in several recent technical advice memoranda is expressly overruled.

Exception for small construction contracts

Under the conference agreement, the required use of either the percentage of completion-capitalized cost method or the percentage of completion method does not apply to certain small construction contracts. Contracts within this exception are those contracts for the construction or improvement of real property if the contract (1) is expected to be completed within the two-year period beginning on the commencement date of the contract, and (2) is performed by a taxpayer whose average annual gross receipts for the three taxable years preceding the taxable year in which the contract is entered into do not exceed $10 million. Contracts eligible for this exception will remain subject to the rules of present law (i.e., the regulations applicable to non-extended period long-term contracts). Since such contracts involve the construction of real property, they are subject to the interest capitalization rules of the conference agreement without regard to their duration.

 

Effective Date

 

 

The provisions of the conference agreement generally are effective for contracts entered into after February 28, 1986.

For purposes of accounting for long-term contracts, the treatment of independent research and development costs (as includible in contract price but not includible in capitalizable contract costs) applies to all open taxable years of taxpayers.

 

F. Reserve for Bad Debts

 

 

Present Law

 

 

Present law permits taxpayers to take a deduction for losses on business debts using either the specific charge-off method or the reserve method. The specific charge-off method allows a deduction at the time and in the amount that any individual debt is wholly or partially worthless. The reserve method allows the current deduction of the amount that is necessary to bring the balance in the bad debt reserve account as of the beginning of the year, adjusted for actual bad debt losses and recoveries, to the balance allowable under an approved method as of the end of the year. The deduction taken under the reserve method is required to be reasonable in amount, determined in light of the facts existing at the close of the taxable year.

Worthless debts are charged off, resulting in a deduction under the specific charge-off method, or an adjustment to the reserve account under the reserve method, in the year in which they become worthless. In the case of a partially worthless debt, the amount allowed to be charged off for Federal income tax purposes cannot exceed the amount charged-off on the taxpayer's books. No such requirement is applicable to wholly worthless debts.

Present law requires an actual debt be owed to the taxpayer in order to support the creation of a reserve for bad debts. An exception to this rule is provided for dealers who guarantee, endorse, or provide indemnity agreements on debt owed to others if the potential obligation of the dealer arises from its sale of real or tangible personal property.

 

House Bill

 

 

The House bill repeals the availability of the reserve method in computing the deduction for bad debts for all taxpayers, other than commercial banks whose assets do not exceed $500 million, and thrift institutions. Wholly worthless debts are not deductible for Federal income tax purposes until charged off on the taxpayer's books, as is the case under present law for partially worthless debts. The House bill does not address the continued use of the reserve method by dealers who guarantee, endorse, or provide indemnity agreements with regard to debt obligations arising out of the sale by the dealer of real or tangible personal property in the ordinary course of business.

The provision is effective for taxable years beginning after December 31, 1985. The balance in any reserve for bad debts as of the effective date is to be taken into income ratably over a five-year period.

 

Senate Amendment

 

 

The Senate amendment repeals the availability of the reserve method in computing the deduction for bad debts for all taxpayers, other than financial institutions, banks for cooperatives, production credit associations, and certain finance companies. Wholly worthless debts are not deductible for Federal income tax purposes until charged off on the taxpayer's books, as is the case under present law for partially worthless debts.

The Senate amendment also repeals the reserve method for dealers who guarantee, endorse, or provide indemnity agreements with respect to debt obligations arising out of the sale by the dealer of real or tangible personal property in the ordinary course of business (sec. 166(f)).

The Senate amendment is effective for taxable years beginning after December 31, 1986. The balance in any reserve for bad debts as of the effective date is to be included in income ratably over a five-year period. In the case of a bad debt reserve for guarantees, the amount of the reserve is first reduced by the remaining balance in any suspense account established under section 166(f)(4), and the net amount taken into income ratably over a five-year period beginning with the first taxable year beginning after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement generally follows the House bill with regard to the availability of the reserve method for computing losses on business debts. Thus, taxpayers (other than certain financial institutions) will be required to use the specific charge-off method in accounting for losses on bad debts. In determining whether a debt is worthless, the fact that a utility is required to continue to provide services to a customer whose account has otherwise been determined to be uncollectible will not be considered as evidence that the debt is not worthless for Federal income tax purposes.

The conference agreement does not include the provision limiting the deduction of wholly worthless business debts to the amount written off on the taxpayer's books. Thus, a wholly worthless debt will be deductible in full in the year that it becomes worthless, as is the case under present law.

The conference agreement follows the Senate amendment in repealing the reserve method for dealers who guarantee, endorse, or provide indemnity agreements with respect to debt obligations arising out of the sale by the dealer of real or tangible personal property in the ordinary course of business.

The provision of the conference agreement is effective for taxable years beginning after December 31, 1986. Any change from the reserve method of accounting for bad debts is treated as a change in method of accounting initiated by the taxpayer with the consent of the Secretary of the Treasury. The balance in any reserve for bad debts as of the effective date is generally to be included in income ratably over a four-year period. The amount to be included in income is the full balance of the reserve account, without offset for any anticipated amounts that will not be currently accrued as income under the rules allowing accrual basis service providers to exclude from income amounts that are statistically determined not to be collectible until such amounts are actually collected. (see VIII. A., supra). In the case of a bad debt reserve for guarantees, the amount of the reserve subject to inclusion is first reduced by the remaining balance in any suspense account established under section 166(f)(4).

The conferees intend that (1) net operating loss and tax credit carryforwards will be allowed to offset any positive section 481 adjustment; and (2) for purposes of determining estimated tax payments, the section 481 adjustment will be recognized in taxable income ratably throughout the year in question.

The conferees also direct the Secretary of the Treasury to study and to issue a report regarding appropriate criteria to be used to determine if a debt is worthless for Federal income tax purposes. The conferees anticipate that the report will consider under what circumstances a rule providing for a conclusive or rebuttable presumption of the worthlessness of an indebtedness is appropriate.

The final report is to be submitted, by January 1, 1988, to the House Committee on Ways and Means and the Senate Committee on Finance.

 

G. Taxable Years of Partnerships, S Corporations, and Personal Service Corporations

 

 

Present Law

 

 

Partnerships

Present law requires a partnership adopting or changing a taxable year to use the same taxable year as all of its principal partners (or the calendar year, if all of the partnership's principal partners do not have the same taxable year), unless the partnership establishes to the satisfaction of the Secretary of the Treasury a business purpose for selecting a different taxable year (sec. 706). A partnership that adopted its taxable year prior to April 2, 1954, is not required to change its taxable year regardless of whether the taxable year adopted is the same as the taxable year of all of the principal partners (Treas. Reg. sec. 1.706-1(b)(6)).

In 1972, the Internal Revenue Service announced in Revenue Procedure 72-51 (1972-2 C.B. 832) that requests by a partnership to adopt or change to an accounting period differing from that of the principal partners generally will be approved where the adoption of such change would result in the deferral of income to the partners of three months or less.

S corporations

Present law requires a corporation that makes an election to be taxed as an S corporation, or an S corporation that changes its taxable year to adopt a "permitted year" (sec. 1378). A permitted year is a calendar year or any other accounting period for which the S corporation establishes a business purpose to the satisfaction of the Secretary of the Treasury. A corporation that was an S corporation for a taxable year that includes December 31, 1982 (or that was an S corporation for a taxable year beginning in 1983 by reason of an election made on or before October 19, 1982) may retain a taxable year that is not a permitted year. However, if more than 50 percent of the stock of such an S corporation is newly owned stock, the S corporation must change its taxable year to a permitted year. Revenue Procedure 83-25 (1983-1 C.B. 689) provides procedures that the Internal Revenue Service will follow in approving a request by a S corporation desiring to change to, or to adopt, a taxable year other than a calendar year. Revenue Procedure 83-25 provides that requests will be approved where the adoption of the taxable year results in the deferral of income to shareholders of three months or less.

Personal service corporations

A personal service corporation generally may adopt any taxable year on its first Federal income tax return that conforms with its annual accounting period. A personal service corporation desiring to change its taxable year must generally first obtain the consent of the Secretary of the Treasury.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

In general, the Senate amendment requires that all partnerships, S corporations, and personal service corporations conform their taxable years to the taxable years of their owners. An exception to the rule is made in the case where the partnership, S corporation, or personal service corporation establishes to the satisfaction of the Secretary of the Treasury a business purpose for having a different taxable year. The deferral of income to owners for a limited period of time, such as the three months or less rule of present law, is not to be treated as a business purpose.

All partnerships generally are required to adopt the same taxable year as the partners owning a majority interest in partnership profits and capital. If partners owning a majority of partnership profits and capital do not have the same taxable year, the partnership is required to adopt the same taxable year as all of its principal partners. If neither partners owning a majority of partnership profits and capital, or all of the partnership's principal partners have the same taxable year, the partnership is required to adopt the calendar year. S corporations and personal service corporations generally are required to adopt the calendar year.

The amendment is effective for taxable years beginning after December 31, 1986. A partner in a partnership or a shareholder in an S corporation that is required to include the items from more than one taxable year of the partnership or S corporation in any one taxable year as a result of the amendment is allowed to take into account the items from the short taxable year of the partnership or S corporation ratably in each of the partner's or shareholder's four taxable years beginning after December 31, 1986, unless the partner or shareholder elects to include all such amounts in the taxable year to which they would otherwise apply.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment.

The conference agreement extends the provisions of section 267 to provide that a personal service corporation and its employee-owners are treated as related taxpayers regardless of the amount of the corporation's stock owned, directly or indirectly, by the employee-owner. Thus, a personal service corporation may not deduct payments made to employee-owners prior to the time that such employee-owner would include the payment in gross income.

The rule allowing partners or shareholders of a partnership or S corporation to include items of income from the short year of the partnership or S corporation in each of the partner or shareholder's four taxable years beginning after December 31, 1986 is applicable regardless of what type of entity the partner or S corporation shareholder is. Thus, a personal service corporation that is a partner in a partnership required to adopt a new taxable year as a result of this provision is eligible to include the partner's distributive share of partnership income over four taxable years. The rule is applicable to income from an S corporation only if such corporation was an S corporation for a taxable year beginning in 1986.

The conferees intend that any partnership that received permission to use a fiscal year-end (other than a year-end that resulted in a three-month or less deferral of income) under the provisions of Rev. Proc. 74-33, 1974-2 C.B. 489, shall be allowed to continue the use of such taxable year without obtaining the approval of the Secretary. Similarly, any S corporation that received permission to use a fiscal year-end (other than a year-end that resulted in a three-month or less deferral of income), which permission was granted on or after the effective date of Rev. Proc. 74-33, shall be allowed to continue the use of such taxable year without obtaining the approval of the Secretary.

Moreover, any partnership, S corporation, or personal service corporation may adopt, retain, or change to a taxable year, under procedures established by the Secretary, if the use of such year meets the requirements of the "25% test" as described in Rev. Proc. 83-25, 1983-1 C.B. 689 (i.e., 25% or more of the taxpayer's gross receipts for the 12-month period in question are recognized in the last two months of such period and this requirement has been met for the specified three consecutive 12-month periods).

In addition, the Secretary may prescribe other tests to be used to establish the existence of a business purpose, if, in the discretion of the Secretary, such tests are desirable and expedient towards the efficient administration of the tax laws.

The conferees intend that (1) the use of a particular year for regulatory or financial accounting purposes; (2) the hiring patterns of a particular business, e.g., the fact that a firm typically hires staff during certain times of the year; (3) the use of a particular year for administrative purposes, such as the admission or retirement of partners or shareholders, promotion of staff, and compensation or retirement arrangements with staff, partners, or shareholders; and (iv) the fact that a particular business involves the use of price lists, model year, or other items that change on an annual basis ordinarily will not be sufficient to establish that the business purpose requirement for a particular taxable year has been met.]

The conferees anticipate that the Secretary of the Treasury will promulgate regulations regarding the use of the 52-53 week taxable year to prevent the evasion of the principles of this provision. It is anticipated that the regulations will provide that, for the purpose of determining when taxable income is included by a partner or S corporation shareholder, a 52-53 week taxable year of a partner, shareholder, partnership, or S corporation will be treated as ending on the last day of the calendar month ending nearest to the last day of such 52-53 week taxable year. For example, a calendar year partner will include its share of taxable income from a partnership with a 52-53 week taxable year ending on January 3, 1988 in its 1987 calendar year Federal income tax return. The Secretary of the Treasury may also prescribe similar rules to prevent the evasion of the principles of the provision through the use of a 52-53 week taxable year by personal service corporations and the shareholder-employees of such corporations. It is also anticipated that the Secretary of the Treasury will suspend the operation of Treas. Reg. sec. 1.441-2(c) allowing taxpayers in certain cases to adopt, or change to, a 52-53 week taxable year without the approval of the Secretary of the Treasury.

Some partnerships and S corporations that adopted a taxable year providing a deferral of income to owners of three months or less were required to include the amount of deferral obtained in income over a 10-year period. Any portion of such amount not taken into income as of the effective date of the provision may be used to reduce the income attributable to any short taxable year required by the provision.

 

H. Special Treatment of Certain Items

 

 

1. Qualified discount coupons

 

Present Law

 

 

Under present law, issuers of qualified discount coupons using the accrual method of accounting may elect to deduct the cost of redeeming qualified discount coupons outstanding at the close of the taxable year and received for redemption by the taxpayer within a statutory redemption period following the close of the taxable year (sec. 466). The statutory redemption period is the 6-month period immediately following the close of the taxable year, unless the taxpayer elects a shorter period.

A qualified discount coupon is coupon which (1) is issued by the taxpayer, (2) is redeemable by the taxpayer, and (3) allows a discount on the purchase price of merchandise or other tangible personal property. The coupon must not be redeemable directly by the issuer (i.e., a direct consumer rebate) and may not by itself, or in conjunction with any other coupons, bring about a price reduction of more than $5 with respect to any item.

The election must be made with respect to each trade or business of the taxpayer and constitutes a method of accounting. Revocation of an election may be made only with permission of the Secretary of the Treasury. In certain situations, a taxpayer is required to establish a suspense account in the year of election in order to limit the bunching of deductions in that year.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The Senate amendment repeals the provision of present law allowing a deduction for the cost of redeeming qualified discount coupons received during a redemption period after the close of the taxable year. As a result, only those costs of redeeming discount coupons received for redemption during the taxable year will be allowed as a deduction during that taxable year.

The Senate amendment treats any taxpayer currently electing to deduct the cost of redeeming qualified discount coupons as having elected to change its method of accounting. The change will be considered to have been initiated by the taxpayer with the consent of the Secretary of the Treasury. Any adjustment which is required to be made by section 481 will be reduced by any balance in the suspense account of the taxpayer, and the net amount is to be taken into account over a period not to exceed five taxable years, commencing with the first taxable year beginning after December 31, 1986. It is expected that the concepts of Revenue Procedure 84-74, 1984-2 C.B. 736, generally will apply to determine the actual timing of recognition or expense as a result of the adjustments arising from this provision.

The provision of the Senate amendment is effective for taxable years beginning after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement generally follows the Senate amendment. The net adjustment required to be made as a result of the provision, after reduction for any balance in the suspense account, is required to be taken into account over a period not to exceed four taxable years, commencing with the first taxable year ending after December 31, 1986.

The conferees also intend that (i) net operating loss and tax credit carryforwards will be allowed to offset any positive section 481 adjustment; and (ii) for purposes of determining estimated tax payments, the section 481 adjustment will be recognized in taxable income ratably throughout the year in question.

2. Utilities using accrual accounting

 

Present Law

 

 

Present law requires taxpayers using the accrual method of accounting to recognize income at the time all the events have occurred which establish the taxpayer's right to receive the income and the amount of income can be established with reasonable accuracy.

The Internal Revenue Service has allowed utilities using the accrual method of accounting to recognize income in the taxable year in which a customer's utility meter is read, providing a similar technique is used for financial accounting purpose (Rev. Rul. 72-114, 1972-1 C.B. 124). Recent judicial decisions have allowed income to be recognized in the taxable year in which a customer's utility meter is read regardless of the technique used for financial accounting purposes. See, e.g., Orange and Rockland Utilities v. Commissioner, 86 T.C. No. 14 (1986). Some courts also have held that taxpayers are allowed to defer recognition of income until such time as the taxpayer bills (or is entitled to bill) the customer for services.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The Senate amendment requires accrual basis taxpayers to recognize income attributable to the furnishing or sale of utility services to customers not later than the taxable year in which such services are provided to the customer. The year in which utility services are provided may not be determined by reference to the time the customer's meter is read or to the time that the customer is billed (or may be billed) for such services.

The effect of the provision is to require an estimate of the income attributable to utility services provided during the taxable year but after the final meter reading or billing date which falls within the taxable year. It is anticipated that, where it is not practical for the utility to determine the actual amount of services provided through the end of the current year, this estimate may be made by assigning a pro rata portion of the revenues determined as of the first meter reading date or billing date of the following taxable year.

Utility services subject to the Senate amendment are the provision of electrical energy, water or sewage disposal, the furnishing of gas or steam through a local distribution system, telephone and other communications services, and the transportation of gas or steam by pipeline. It is anticipated that similar rules also would be applicable to other utility services which might come into existence at some future date. Whether or not a utility service is regulated by a government or governmental agency does not affect its treatment under this provision. The Senate amendment creates no inference as to the proper Federal income tax treatment of utility services under current law.

The conferees are aware that the proper accounting for utility services is presently a matter of controversy between taxpayers and the Internal Revenue Service. In order to minimize disputes over prior taxable years, the conference agreement provides that, for any taxable year beginning before August 16, 1986, a method of accounting which took into account income from the providing of utility services on the basis of the period in which the customers' meters were read shall be deemed to be proper for Federal income tax purposes. No inference is intended as to methods of accounting for utility services not described in the preceding sentence (e.g., a method of accounting which takes income into account on the basis of the date the customer is billed for utility services).

The provision is effective for taxable years beginning after December 31, 1986. The amount of any adjustment required to be made as a result of this provision is to be included in income ratably over the first four taxable years for which the proposal is effective.

 

Conference Agreement

 

 

The conference agreement follows the provision of the Senate amendment.

The conferees also intend that (i) net operating loss and tax credit carryforwards will be allowed to offset any positive section 481 adjustment; and (ii) for purposes of determining estimated tax payments, the section 481 adjustment will be recognized in taxable income ratably throughout the year in question.

In addition, the conferees intend that taxpayers required to accrue income at the time the utility services are furnished to customers may accrue at such time any deductions for the related costs of providing the utility services if economic performance has occurred with respect to such costs within the taxable year in question. Therefore, the conferees intend that any change in accounting method required under this provision include any related change in accounting method for the related items of expense or deduction. The section 481 adjustment is then to be computed on the net amount of the two changes and taken into income ratably over a 4-year period.

3. Contributions in aid of construction

 

Present Law

 

 

The gross income of a corporation does not include contributions to its capital. A corporate regulated public utility that provides electric energy, gas (through a local distribution system or transportation by pipeline), water, or sewage disposal services may treat contributions received in aid of construction as a contribution to capital not includible in gross income. Such contributions may not be included in the utility's rate base for rate making purposes. Property received (or purchased with the proceeds of) a contribution to capital has no depreciable basis for Federal income tax purposes and is not eligible for the investment tax credit.

 

House Bill

 

 

The House bill repeals the provision of present law allowing contributions in aid of construction received by a corporate regulated public utility to be excluded from gross income. Property, including money, that is received to encourage the provision of services to, or for the benefit of, the person transferring the property must be included as an item of gross income.

The provision is effective for contributions received after December 31, 1985.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

The conference agreement follows the provision of the House bill, effective for contributions received after December 31, 1986.

4. Discharge of indebtedness income of solvent taxpayers

 

Present Law

 

 

Present law generally requires taxpayers to include in gross income the amount of any discharge of indebtedness to the extent the taxpayer is solvent following the discharge. In the case of a discharge of qualified business indebtedness, a taxpayer may elect to reduce the basis of depreciable assets (or, by election, inventory) instead of including the amount of the discharge in gross income. Qualified business indebtedness is indebtedness incurred or assumed by a corporation or by an individual in connection with property used in the individual's trade or business.

 

House Bill

 

 

No provision.

 

Senate Amendment

 

 

The Senate amendment repeals the provision of present law that provides for the election to exclude income from the discharge of qualified business indebtedness from gross income. Thus, any discharge of indebtedness, other than a discharge in title 11 cases or a discharge that occurs when the taxpayer is insolvent, results in the current recognition of income in the amount of the discharge.

The Senate amendment does not change the present-law treatment of a discharge of indebtedness that occurs in a title 11 case or when the taxpayer is insolvent (including a farmer treated as insolvent under section 108(g) as added by the amendment, see IV.A.7.), nor does it change the provision of present law (sec. 108(e)(5)) that treats any reduction of purchase-money debt of a solvent debtor as a purchase price adjustment, rather than a discharge of indebtedness.

The provision of the Senate amendment is applicable to discharges of indebtedness occurring after December 31, 1986.

 

Conference Agreement

 

 

The conference agreement follows the Senate amendment.

 

TITLE IX. FINANCIAL INSTITUTIONS

 

 

A. Reserves for Bad Debts

 

 

1. Commercial banks

 

Present Law

 

 

In general

Under present law, commercial banks1 are allowed to use either the specific charge-off method or the reserve method in computing their deduction for bad debts for Federal income tax purposes. Under the reserve method, a commercial bank is entitled to a deduction equal to that amount necessary to increase the year-end bad debt reserve balance to an amount computed under either the "bank experience method" or the "percentage of eligible loans method."

Experience method

The maximum allowed ending reserve balance for a bank using the bank experience method is the amount of loans outstanding at the close of the taxable year times a fraction, the numerator of which is the sum of actual bad debts for the current and five preceding taxable years, and the denominator of which is the sum of the amount of loans outstanding at the close of the each of those years.

Percentage of eligible loans method

The maximum allowed ending reserve balance for a bank using the percentage of eligible loans method is equal to a specified percentage of the outstanding eligible loans at the close of the taxable year, plus an amount determined under the bank experience method for loans other than eligible loans. The specified percentage for taxable years beginning after 1982 is 0.6 percent.2 Eligible loans for this purpose generally are loans incurred in the course of a bank's normal customer loan activities on which there is more than an insubstantial risk of loss.3

Under both the experience method and the percentage of eligible loans method, the ending reserve balance need not be less than the balance at the end of the "base year," providing that the amount of outstanding loans at the close of the current year is at least as great as the balance at the close of the base year.

A commercial bank may switch between the experience method and the percentage of eligible loans method of determining the addition to its reserve for losses on loans from one year to another. If the bad debt reserve deduction for the taxable year determined under the above rules exceeds the amount which would have been allowed as a deduction on the basis of actual experience, the deduction is reduced by 20 percent of such excess (sec. 291). Also, 59-5/6 percent of the deductible excess (after the 20-percent reduction) is treated as a tax preference for purposes of computing the corporate minimum tax (sec. 57).

The availability of the percentage of eligible loans method is scheduled to expire after 1987. For taxable years beginning after 1987, banks will be limited to the experience method in computing additions to bad debt reserves.

 

House Bill

 

 

Repeal of reserve method for large banks

The House bill retains present law regarding the use of reserves in computing the deduction for losses on bad debts, except in the case of "large banks." A bank is considered a "large bank" if, for the current taxable year or any taxable year beginning after December 31, 1985, the sum of the average adjusted bases of all assets of such bank (or any controlled group of which the bank is a member) exceeds $500 million. The adjusted basis of an asset generally will be considered to be the tax basis of the asset, adjusted by those amounts allowed as adjustments to basis by section 1016. In determining the sum of the average adjusted bases of all assets of a controlled group, interests held by one member of such group in another member of such group are to be disregarded. The average adjusted basis of the assets of a bank or controlled group is the average of the adjusted bases of the assets for each period of time falling within the taxable year the bank is required to report for regulatory purposes.

A controlled group for this purpose is a controlled group of corporations described in section 1563(a)(1). For the purpose of determining the sum of the adjusted bases of the assets of a controlled group, all corporations includible in the group under the ownership tests of section 1563(a) are included, without regard to their status as an "excluded member" of a controlled group as a result of the application of section 1563(b)(2), and whether or not the corporation meets the definition of a commercial bank.

Recapture of bad debt reserves

 

Ratable inclusion method

 

A commercial bank that is determined to be a large bank generally is required to include in income the balance in any reserve for bad debts, ratably over a period of five taxable years, beginning with the disqualification year. Alternatively, the bank may elect to include in income a greater amount in the first year for which recapture is required and include any remaining amount ratably over the next four years.

 

Cut-off method

 

In lieu of recapture, the bank may elect to use a cut-off approach with regard to its outstanding loans at the time it becomes a large bank. Under the cut-off method, all charge-offs and recoveries of such loans generally will be adjustments to the reserve accounts and not separate items of income and expense. However, if the charge-off of any loan would reduce the balance in any reserve account below zero, the charge-off shall be an adjustment to the reserve account only in the amount necessary to reduce the balance in such account to zero. Any charge-offs in excess of such reserve balance, and any recoveries with regard to such loans, will be items of income and expense in the year of charge-off or recovery, as if the taxpayer had always used the specific charge-off method. Under the cut-off method, no additional deductions in the disqualification year or thereafter are allowable for additions to the reserve for bad debts.

Unless the balance of a reserve account has been reduced to zero by the adjustment required for a charged-off item, the allowable ending balance for the reserve account is computed for year end by taking into account only those debts which were outstanding on the last day of the taxable year before the disqualification year. No additional deductions may be taken for an addition to restore the reserve account to its allowable ending balance. However, income must be recognized in the amount by which the balance in any reserve account after adjustments for charge-offs and recoveries exceeds the allowable ending balance for the account.

 

Effective Date

 

 

The provision of the House bill is effective for taxable years beginning after December 31, 1985.

 

Senate Amendment

 

 

No provision.

 

Conference Agreement

 

 

In general

The conference agreement follows the House bill with certain modifications.

Recapture of existing reserves

A large bank not electing to use the cut-off method is required to recapture its bad debt reserve by including 10 percent of the reserve balance in income in the first taxable year for which the provision is effective, 20 percent in the second, 30 percent in the third, and 40 percent in the fourth. A bank may elect to include more than 10 percent of its reserve balance in income in the first taxable year. If such an election is made, 2/9 of the remainder of the reserve balance (after reduction for the amount included in income in the first taxable year) must be included in income in the second taxable year, 1/3 of the remainder in the third taxable year and 4/9 of the remainder in the fourth taxable year.

Suspension of recapture for financially troubled banks

The conference agreement also provides that a bank, other than a bank electing to use the cut-off method, may suspend the inclusion in income of its bad debt reserve for any year in which it is a "financially troubled bank." Nonetheless, a financially troubled bank may elect to include in income currently all or a portion of the amount of its reserves that otherwise would be recaptured that year.

A bank is considered to be a financially troubled bank if the average of its nonperforming loans for the taxable year exceeds 75 percent of the average of its equity capital for the year. Nonperforming loans include (1) loans that are "past due 90 days or more and still accruing," (2) "nonaccrual" loans, and (3) "renegotiated 'troubled' debt" under the existing standards of the Federal Financial Institution Examination Council. Equity capital is assets less liabilities, as those amounts are reported for regulatory purposes. Equity capital does not include the balance in any reserve for bad debts. The average of nonperforming loans and equity capital for the year is to be determined as the average of those amounts at each time during the taxable year that the bank is required to report for regulatory purposes. In the case of a bank that is a member of a controlled group described in section 1563(a)(1), the determination of whether the bank is a financially troubled bank is made with respect to all members of that controlled group.

The inclusion in income of a portion of the bad debt reserve suspends for each year in which the bank is considered to be a financially troubled bank. For example, assume that a large bank is financially troubled in the disqualification year, is not financially troubled in the two following years, and then returns to financially troubled status in the fourth year. No portion of its bad debt reserve need be included in income during the disqualification year, since the bank meets the definition of a financially troubled bank. In the second year, the bank must begin the inclusion of its bad debt reserve in income. As the inclusion in income begins in this year, the bank may include in income either 10% of its reserve balance or a greater amount if it so elects. The bank may not elect at this time to use the cut-off method, since it has already tolled the inclusion of the bad debt reserve in income as a financially troubled bank. In the third year, the bank must include 2/9 of the bad debt reserve not included in income in the prior year. The bank returns to troubled status in the fourth year and no portion of the bad debt reserve must be included in income in that year. The bank will be required to include the amount it would have included in that year in the next year in which it is not a financially troubled bank.

The provision allowing a financially troubled bank to suspend the inclusion of its bad debt reserve in income does not affect the requirement that a large bank account for its bad debts using the specific charge-off method.

 

Effective Date

 

 

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

2. Thrift institutions

 

Present Law

 

 

General rule

Under present law, mutual savings banks, domestic building and loan associations and cooperative banks without capital stock which are organized and operated for mutual purposes and without profit (collectively called "thrift institutions"), are allowed to use either the specific charge-off method or the reserve method in computing their deduction for bad debts for Federal income tax purposes. For thrift institutions using the reserve method, the reasonable addition to the reserve for bad debts is equal to the addition to the reserves for losses computed under the "bank experience" method, the "percentage of eligible loans" method, or, if a sufficient percentage of the thrift's assets constitute "qualified assets," the "percentage of taxable income" method.

Permissible methods

The bank experience and percentage of eligible loans methods for thrift institutions generally are the same as for commercial banks (discussed above).

Under the percentage of taxable income method, an annual deduction is allowed for a statutory percentage of taxable income.4 The statutory percentage for tax years beginning after 1978 is 40 percent.

The full 40-percent of taxable income deduction is available only where 82 percent (72 percent in the case of mutual savings banks without capital stock) of the thrift institution's assets are qualified, Where the 82-percent test is not met, the statutory rate is reduced by three-fourths of one percentage point for each one percentage point of such shortfall. For mutual savings banks without capital stock, the statutory rate is reduced by 1-1/2 percentage points for each percentage point that qualified assets fail to reach the 72-percent requirement. At a minimum, 60 percent of a thrift institution's assets must be qualifying (50 percent for mutual savings banks without stock) in order to be eligible for deductions under the percentage of income method.

A thrift institution may switch between methods of determining the addition to its loan loss reserves from one year to another.

Corporate preferences and minimum tax

Under present law, if the deduction for bad debts for the taxable year determined under the above rules exceeds the amount which would have been allowed as a deduction on the basis of actual experience, the deduction is reduced by 20 percent of such excess (sec. 291). Also, 59-5/6 percent of the deductible excess (after the 20-percent reduction) is treated as a tax preference for purposes of computing the corporate minimum tax (sec. 57).

 

House Bill

 

 

The House bill provides that thrift institutions (mutual savings banks, domestic building and loan associations and cooperative banks) will continue to be able to compute bad debt deductions using the bank experience method and the percentage of taxable income method. The percentage of eligible loans method will no longer be available. In the case of the percentage of taxable income method, the portion of taxable income which may be deducted as an addition to a reserve for bad debts is reduced from 40 percent to 5 percent. The rules reducing the amount of the percentage of taxable income deduction available to a thrift institution which holds 60 percent of its assets in qualifying assets, but fails to hold a sufficient percentage of qualifying assets to use the maximum percentage of taxable income deduction, are eliminated. Any institution meeting the definition of a thrift institution and holding at least 60 percent of its assets as qualifying assets, will be eligible for the full 5 percent of taxable income deduction. The 60-percent test applies to mutual savings banks as well as other types of thrift institutions.

Thrift institutions which claim the 5 percent of taxable income deduction allowed by the bill are not to be considered to have obtained a tax preference for purposes of the 20-percent reduction of section 291. The excess of the percentage of taxable income deduction over the deduction that would have been allowable on the basis of actual experience will be treated as a preference item for the purpose of computing the corporate minimum tax (sec. 57).

The House bill also repeals the provision of current law (sec. 586) that allows small business investment companies operating under the Small Business Investment Act of 1958 and business development companies to use the reserve method of computing losses on bad debts.

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

 

Senate Amendment

 

 

The Senate amendment reduces the percentage of taxable income that a thrift institution using the percentage of taxable income method may exclude from taxable income as an addition to a reserve for bad debts from 40 percent to 25 percent.

The rules reducing the amount of the percentage of taxable income deduction available to a thrift institution that holds 60 percent of its assets in qualifying assets, but fails to hold a sufficient percentage of qualifying assets to use the maximum percentage of taxable income deduction are changed. A thrift institution other than a mutual savings bank will reduce the maximum 25 percent of taxable income deduction by one-half of one percentage point for each full percentage point by which its qualified assets fall below 82 percent of total assets. A mutual savings bank will reduce the maximum 25 percent of taxable income deduction by a full percentage point for ea