[JOINT COMMITTEE PRINT]

 

 

DESCRIPTION OF REVENUE PROVISIONS

CONTAINED IN THE PRESIDENT'S

FISCAL YEAR 2007 BUDGET PROPOSAL

 

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

 

 

 

 

 

 

 

March 2006

 

 

U.S. Government Printing Office

Washington: 2006

JCS-1-06

 

 

 

 

[JOINT COMMITTEE PRINT]

 

 

DESCRIPTION OF REVENUE PROVISIONS

CONTAINED IN THE PRESIDENT'S

FISCAL YEAR 2007 BUDGET PROPOSAL

 

Prepared by the Staff

of the

JOINT COMMITTEE ON TAXATION

 

 

 

 

 

March 2006

 

 

U.S. Government Printing Office

Washington: 2006

JCS-1-06

 

 

 

 

CONTENTS

                                                        Page

INTRODUCTION.............................................................1

I. MAKING PERMANENT TAX CUTS ENACTED IN 2001 AND 2003....................2

A. Permanently Extend Certain Provisions Expiring  Under EGTRRA and JGTRRA

   ......................................................................2

II TAX INCENTIVES

Provisions Related to Savings............................................6

1. Expansion of tax free savings opportunities...........................6

2. Consolidation of employer-based savings accounts.....................18

3. Individual development accounts......................................30

B. Increase Section 179 Expensing.......................................34

C. Health Care Provisions...............................................37

1. Facilitate the growth of HSA-eligible health coverage................37

2. Modify the refundable credit for health insurance costs of eligible

individuals.............................................................51

3. Expand human clinical trial expenses qualifying for the orphan drug tax

credit..................................................................58

D. Provisions Relating to Charitable Giving.............................61

1. Permit tax-free withdrawals from individual retirement arrangements for

charitable contributions................................................61

2. Expand and increase the enhanced charitable deduction for

contributions of

food inventory..........................................................65

3. Reform excise tax based on investment income of private foundations      71

4. Modify tax on unrelated business taxable income of charitable remainder

trusts..................................................................75

5. Modify the basis adjustment to stock of S corporations contributing

appreciated ............................................................78

6. Repeal the $150 million limit for qualified 501(c)(3) bonds..........79

7. Repeal the restrictions on the use of qualified 501(c)(3) bonds

for residential rental property.........................................81

E  Extend the Above-the-Line Deduction for Qualified Out-of-Pocket

Classroom Expenses......................................................85

F. Establish Opportunity Zones..........................................89

G. Permanently Extend Expensing of Brownfields Remediation Costs........96

H. Restructure Assistance to New York...................................99

III.SIMPLY THE TAX LAWS FOR FAMILIES...................................105

A. Clarify Uniform Definition of Child.................................105

B. Simplify EIC Eligibility Requirements Regarding Filing Status

Presence of Children, and Work and Immigrant Status....................111

C. Reduce Computational Complexity of Refundable

 Child Tax Credit......................................................117

 

 

 

 

IV. PROVISIONS RELATED TO THE EMPLOYER-BASED PENSION SYSTEM............120

A. Provisions Relating to Cash Balance Plans...........................120

B. Strengthen Funding for Single-Employer Pension Plans................138

1. Background and summary..............................................138

2. Funding and deduction rules.........................................139

3. Form 5500, Schedule B actuarial statement and summary annual

report      158

4. Treatment of grandfathered floor-offset plans.......................163

5. Limitations on plans funded below target levels.....................165

6. Eliminate plant shutdown benefits      171

7. Proposals relating to the Pension Benefit Guaranty Corporation

("PBGC")...............................................................174

C. Reflect Market Interest Rates in Lump-Sum Payments..................186

V. TAX SHELTERS, ABUSIVE TRANSACTIONS, AND TAX COMPLIANCE..............190

A. Combat Abusive Foreign Tax Credit Transactions......................190

B. Modify the Active Trade or Business Test for Certain Corporate

Divisions..............................................................192

C. Impose Penalties on Charities that Fail to Enforce

Conservation Easements.................................................198

D. Eliminate the Special Exclusion from Unrelated Business Taxable

Income ("UBIT") for Gain or Loss on Sale or Exchange of Certain

Brownfield Properties..................................................201

E. Limit Related-Party Interest Deductions.............................211

F. Modify Certain Tax Rules for Qualified Tuition Programs.............214

VI.TAX ADMINISTRATION PROVISIONS AND UNEMPLOYMENT INSURANCE............223

A. IRS Restructuring and Reform Act of 1998............................223

1. Modify section 1203 of the IRS Restructuring and

Reform Act of 1998.....................................................223

2. Modifications with respect to frivolous returns and

submissions............................................................226

3. Termination of installment agreements...............................228

4. Consolidate review of collection due process cases in the United

States Tax Court.......................................................230

5. Office of Chief Counsel review of offers in compromise..............231

B. Initiate Internal Revenue Service ("IRS") Cost Saving Measures......233

1. Allow the Financial Management Service to retain transaction

fees from levied amounts...............................................233

2. Expand the authority to require electronic filing by large

businesses and exempt organizations....................................233

C. Other Provisions....................................................235

1. Allow Internal Revenue Service ("IRS") to access information

in the National

Directory of New Hires ("NDNH")........................................235

2. Extension of IRS authority to fund undercover operations............236

D. Reduce the Tax Gap..................................................238

1. Implement standards clarifying when employee leasing companies can be held

liable for their clients' Federal employment taxes.....................238

2. Increased information reporting on payment card transactions........242

3. Increased information reporting for certain government payments for goods

and services...........................................................243

4. Amend collection due process procedures for employment tax

liabilities............................................................245

5. Expand the signature requirement and penalty provisions applicable to paid

preparers..............................................................247

E  Strengthen the Financial Integrity of Unemployment Insurance........249

1. Reduce improper benefit payments and tax avoidance..................249

2. Extension of Federal Unemployment Surtax............................251

VII. MODIFY ENERGY POLICY ACT OF 2005..................................253

A. Repeal Temporary 15-Year Recovery Period for Natural Gas

Distribution Lines.....................................................253

B. Modify Amortization for Certain Geological and Geophysical

Expenditures...........................................................256

VIII.EXPIRING PROVISIONS...............................................258

A. Extend Alternative Minimum Tax Relief for Individuals...............258

B. Permanently Extend the Research and Experimentation

("R&E") Tax Credit.....................................................261

C. Extend and Modify the Work Opportunity Tax Credit and

Welfare-to-Work Tax Credit.............................................278

D. Extend District of Columbia Homebuyer Tax Credit....................286

E. Extend Authority to Issue Qualified Zone Academy Bonds..............289

F. Extend Provisions Permitting Disclosure of Tax Return

Information Relating to Terrorist Activity.............................294

G. Permanently Extend and Expand Disclosure of Tax Return

Information for Administration of Student Loans........................300

H. Extend Excise Tax on Coal at Current Rates..........................304

I. Election to Treat Combat Pay as Earned Income for

Purposes of the Earned Income Credit...................................306

IX.OTHER PROVISIONS MODIFYING THE INTERNAL REVENUE CODE................308

A. Extension of the Rate of Rum Excise Tax Cover Over to Puerto

Rico and Virgin Islands................................................308

B. Establish Program of User Fees for Certain Services Provided to

the Alcohol Industry by the Alcohol and Tobacco Tax and Trade

Bureau.................................................................310

ESTIMATED BUDGET EFFECTS OF THE REVENUE PROVISIONS CONTAINED

IN THE PRESIDENT'S FISCAL YEAR 2007 BUDGET PROPOSAL....................314

 

 

 

 

 

INTRODUCTION

This document,  prepared by the staff of the Joint Committee on Taxation,

provides a description and analysis of the revenue provisions modifying

the Internal Revenue Code of 1986 (the "Code") that are contained in the

President's fiscal year 2007 budget proposal, as submitted to the Congress

on February 6, 2006.   The document generally follows the order of the

proposals as included in the Department of the Treasury's explanation of

the President's budget proposal.   For each provision, there is a

description of present law and the proposal (including effective date), a

reference to relevant prior budget proposals or recent legislative action,

and an analysis of policy issues related to the proposal.

 

 

I.    MAKING PERMANENT TAX CUTS ENACTED IN 2001 AND 2003

A.      Permanently Extend Certain Provisions Expiring 

Under EGTRRA and JGTRRA

Present Law

The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA")

The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA")

made a number of changes to the Federal tax laws, including reducing

individual tax rates, repealing the estate tax, increasing and expanding

various child-related credits, providing tax relief to married couples,

providing additional education-related tax incentives, increasing and

expanding various pension and retirement-saving incentives, and providing

individuals relief relating to the alternative minimum tax.  However, in

order to comply with reconciliation procedures under the Congressional

Budget Act of 1974, EGTRRA included a "sunset" provision, pursuant to which

the provisions of the Act expire at the end of 2010.  Specifically, EGTRRA's

provisions do not apply for taxable, plan, or limitation years beginning

after December 31, 2010, or to estates of decedents dying after, or gifts

or generation-skipping transfers made after, December 31, 2010. EGTRRA

provides that, as of the effective date of the sunset, both the Code and

the Employee Retirement Income Security Act of 1974 ("ERISA") will be

applied as though EGTRRA had never been enacted.  For example, the estate

tax, which EGTRRA repeals for decedents dying in 2010, will return as to

decedents dying after 2010, in pre-EGTRRA form, without the various interim

changes made by the Act (e.g., the rate reductions and exemption

equivalent amount increases applicable to decedents dying before 2010).

Similarly, the top individual marginal income tax rate, which EGTRRA

reduced to 35 percent will return to its pre-EGTRRA level of 39.6 percent

in 2011 under present law.  Likewise beginning in 2011, all other

provisions of the Code and ERISA will be applied as though the relevant

provisions of EGTRRA had never been enacted.

The Jobs and Growth Tax Relief Reconciliation Act of 2003 ("JGTRRA")

In general

The Jobs and Growth Tax Relief Reconciliation Act of 2003 ("JGTRRA")

changed the expensing of certain depreciable business assets, individual

capital gains tax rates and the tax rates on dividends received by

individuals.  The modifications to the expensing provision sunset

for taxable years beginning after December 31, 2007.  The capital gains

and dividend rate provisions sunset for taxable years beginning after

December 31, 2008.

Expensing provisions

Section 179 provides that the maximum amount a taxpayer may expense, for

taxable years beginning in 2003 through 2007, is $100,000 of the cost of

qualifying property placed in service for the taxable year. In general,

qualifying property is defined as depreciable tangible personal property

that is purchased for use in the active conduct of a trade or business. 

Off-the-shelf computer software placed in service in taxable years

beginning before 2008 is treated as qualifying property.  The $100,000

amount is reduced (but not below zero) by the amount by which the cost of

qualifying property placed in service during the taxable year exceeds

$400,000.The $100,000 and $400,000 amounts are indexed for inflation for

taxable years beginning after 2003 and before 2008.  

An expensing election is made under rules prescribed by the Secretary

(sec. 179(c)(1)).  Under Treas. Reg. sec. 1.179-5, applicable to property

placed in service in taxable years beginning after 2002 and before 2008,

a taxpayer is permitted to make or revoke an election under section 179

without the consent of the Commissioner on an amended Federal tax return

for that taxable year. This amended return must be filed within the time

prescribed by law for filing an amended return for the taxable year. 

For taxable years beginning in 2008 and thereafter, an expensing election

may be revoked only with consent of the Commissioner (sec. 179(c)(2)).

Individual capital gains rates Under JGTRRA, for taxable years beginning

before January 1, 2009,generally the maximum rate of tax on net capital

gain of a non-corporate taxpayer is 15 percent.  In addition,

any net capital gain which otherwise would have been taxed at a 10- or

15-percent rate generally is taxed at a five-percent rate (zero for taxable

years beginning after 2007). For taxable years beginning after

December 31, 2008, generally the rates on net capital gain are 20 percent

and 10 percent, respectively.  Any gain from the sale or exchange of

property held more than five years that would otherwise be taxed at the 10

percent rate is taxed at an eight percent rate.  Any gain from the sale or

exchange of property held more than five years and the holding period for

which began after December 31, 2000, which would otherwise be taxed at a 20

percent rate is taxed at an 18-percent rate.

Taxation of dividends received by individuals

Under rules enacted in JGTRRA, dividends received by a non-corporate

shareholder from domestic corporations and qualified foreign corporations

generally are taxed at the same rates that apply to net capital gain. 

Thus, dividends received by an individual, estate, or trust are taxed

at rates of five (zero for taxable years beginning after 2007) and 15

percent.  This treatment applies to taxable years beginning before

January 1, 2009. For taxable years beginning after December 31, 2008,

dividends received by a non-corporate shareholder are taxed at the same

rates as ordinary income.

Description of Proposal

The proposal repeals the sunset provisions of EGTRRA and JGTRRA.

Specifically, the proposal permanently extends all provisions of EGTRRA

that expire at the end of 2010.  Thus, the estate tax remains repealed

after 2010, and the individual rate reductions and other provisions of

the Act that are in effect in 2010 will remain in place after 2010. 

Also, the proposal permanently extends the provisions of JGTRRA relating

to expensing,  capital gains, and dividends.

Effective date.The proposal is effective on the date of enactment.

Analysis

In general

The policy merits of permanently extending the provisions of EGTRRA and

JGTRRA that sunset depend on considerations specific to each provision.

In general, however, advocates of eliminating the sunset provisions may

argue that it was never anticipated that the sunset actually would be

allowed to take effect, and that eliminating them promptly would promote

stability and rationality in the tax law.  In this view, if the sunsets

were eliminated, other rules of EGTRRA and JGTRRA that phase in or phase

out provisions over the immediately preceding years would be made more

rational.  On the other hand, others may argue that certain provisions

of EGTRRA and JGTRRA would not have been enacted at all, or would not have

been phased in or phased out in the same manner, if the sunset provisions

had not been included in EGTRRA and JGTRRA, respectively.

 

COMPLEXITY ISSUES

 

The present-law sunset provisions of EGTRRA and JGTRRA arguably contribute

to complexity by requiring taxpayers to contend with (at least) two

different possible states of the law in planning their affairs.  For

example, under the sunset provision of EGTRRA, an individual

planning his or her estate will face very different tax regimes depending

on whether the individual dies in 2010 (estate tax repealed) or 2011

(estate tax not repealed).  This "cliff effect" requires taxpayers to plan

an estate in such a way as to be prepared for both contingencies,

thereby creating a great deal of complexity.  On the other hand, some may

argue that this kind of uncertainty is always present to some degree-with

or without a sunset provision, taxpayers always face some risk that the

Congress will change a provision of law relevant to the planning

of their affairs.  Others may acknowledge this fact, but nevertheless

argue that the sunset provision creates an unusual degree of uncertainty

and complexity as to the areas covered by the Act, because they consider

it unlikely that the sunset will actually go into effect.  In this view,

the sunset provision of EGTRRA leaves taxpayers with less guidance as to

the future state of the law than is usually available, making it difficult

to arrange their affairs.  In addition to the complexity created by the

need to plan for the sunset, uncertainty about the timing and details of

how the sunset might be eliminated arguably creates further complexity. 

 

Even if it is assumed that the sunset provisions will take effect, it is

not clear how the sunsets would apply to certain provisions.  It would be

relatively simple to apply the EGTRRA sunset to some provisions, such as

the individual rate reductions.  With respect to other provisions,

however, further guidance would be needed as to the effect of the sunset.

For example, if the Code will be applied after 2010 as if the Act had never

been enacted, then one possible interpretation of the pension provisions

is that contributions made while EGTRRA was in effect will no longer be

valid, possibly resulting in the disqualification of plans.  While this

result was likely not intended, without further guidance taxpayers may be

unsure as to the effect of the sunset.

 

More broadly, in weighing the overall complexity effects of the present-law

sunsets and the proposed sunset repeal, some would point out that the

sunset provisions are not the only feature of EGTRRA and JGTRRA that

generates "cliff effects" and similar sources of uncertainty and complexity

for taxpayers.  For example, under EGTRRA's estate tax provisions, a

decedent dying in 2008 has an exemption equivalent amount of $2 million,

one dying in 2009 has an exemption equivalent amount of $3.5 million, and

one dying in 2010 effectively has an infinite exemption but not a complete

"step-up" in the basis of assets. Thus, the estates of individuals at

certain wealth levels will incur significant estate tax if they die in

2008, but none at all if they die in 2009; the estates of individuals at

other wealth levels will incur significant estate tax if they die in 2009,

but none at all if they die in 2010.  These discontinuities are not caused

by the sunset provisions, but they generate a similar sort of uncertainty and

complexity for many taxpayers.  Similar phase-ins and phase-outs are found

in other provisions of EGTRRA and generate complexity and uncertainty,

irrespective of whether EGTRRA as a whole sunsets or not. In light of

these issues, some may argue that a more detailed reconsideration of EGTRRA

or certain of its provisions would better serve the goal of tax simplification.

 

Beyond phase-ins and phase-outs, some may argue that EGTRRA included other

provisions that increased the complexity of the Code, and that allowing

those provisions to expire at the end of 2010 (or effectively requiring that

they be reconsidered before then) may reduce complexity, albeit

potentially years in the future.  Others would argue that some of

EGTRRA's provisions reduced complexity, such as the repeal of the overall

limitation on itemized deductions and changes relating to the earned income

tax credit, and that permanently extending these provisions would

contribute to simplification of the tax laws.

 

Prior Action

 

A similar proposal was included in the President's fiscal year 2003, 2004,

2005, and 2006 budget proposals.

 

 

 

 

II.   TAX INCENTIVES

A.      Provisions Related to Savings

1.      Expansion of tax free savings opportunities

Present Law

 

In general

 

Present law provides for a number of vehicles that permit individuals to

save on a tax-favored basis.  These savings vehicles have a variety of

purposes, including encouraging saving for retirement, encouraging saving

for particular purposes such as education or health care, and encouraging

saving generally.

 

The present-law provisions include individual retirement

arrangements, qualified retirement plans and similar employer-sponsored

arrangements, Coverdell education savings accounts, qualified tuition

programs, health savings accounts, Archer medical savings accounts,annuity

contracts, and life insurance.  Certain of these arrangements are discussed

in more detail below.

 

Individual retirement arrangements ("IRAs")

 

In general

 

There are two general types of individual retirement arrangements ("IRAs")

under present law: traditional IRAs,  to which both deductible and

nondeductible contributions may be made,  and Roth IRAs.   The Federal

income tax rules regarding each type of IRA (and IRA contributions) differ.

 

The maximum annual deductible and nondeductible contributions that can be

made to a traditional IRA and the maximum contribution that can be made to

a Roth IRA by or on behalf of an individual varies depending on the

particular circumstances, including the individual's income.  However,

the contribution limits for IRAs are coordinated so that the maximum annual

contribution that can be made to all of an individual's IRAs is the lesser

of a certain dollar amount ($4,000 for 2006) or the individual's

compensation.  In the case of a married couple,contributions can be made up

to the dollar limit for each spouse if the combined compensation of

the spouses is at least equal to the contributed amount. An individual who

has attained age 50 before the end of the taxable year may also make

catch-up contributions to an IRA.  For this purpose, the dollar limit is

increased by a certain dollar amount ($1,000 for 2006).   IRA

contributions generally must be made in cash.

 

Traditional IRAs

 

An individual may make deductible contributions to a traditional IRA up to

the IRA contribution limit if neither the individual nor the individual's

spouse is an active participant in an employer-sponsored retirement plan.

If an individual (or the individual's spouse) is an active participant in

an employer-sponsored retirement plan, the deduction is phased out for

taxpayers with adjusted gross income over certain levels for the taxable

year.  The adjusted gross income phase-out ranges are:  (1) for single

taxpayers, $50,000 to $60,000; (2) for married taxpayers filing joint

returns, $75,000 to $85,000 for 2006 and $80,000 to $100,000 for years

after 2006 and (3) for married taxpayers filing separate returns, $0 to

$10,000.  If an individual is not an active participant in an

employer-sponsored retirement plan, but the individual's spouse is, the

deduction is phased out for taxpayers with adjusted gross income between

$150,000 and $160,000.

 

To the extent an individual cannot or does not make deductible contributions

to an IRA or contributions to a Roth IRA, the individual may make

nondeductible contributions to a traditional IRA, subject to the same

limits as deductible contributions.  An individual who has attained age 50

before the end of the taxable year may also make nondeductible catch-up

contributions to an IRA.

 

An individual who has attained age 70-½ prior to the close of a year is

not permitted to make contributions to a traditional IRA.

 

Amounts held in a traditional IRA are includible in income when withdrawn,

except to the extent the withdrawal is a return of nondeductible

contributions.  Early withdrawals from an IRA generally are subject to an

additional 10-percent tax.   That is, includible amounts withdrawn prior

to attainment of age 59-½ are subject to an additional 10-percent tax,

unless the withdrawal is due to death or disability, is made in the form

of certain periodic payments, is used to pay medical expenses in excess of

7.5 percent of adjusted gross income, is used to purchase health insurance

of certain unemployed individuals, is used for higher education expenses,

or is used for first-time homebuyer expenses of up to $10,000.

 

Distributions from traditional IRAs generally are required to begin by the

April 1 of the year following the year in which the IRA owner attains age

70-½.  If an IRA owner dies after minimum required distributions have

begun, the remaining interest must be distributed at least as rapidly as

under the minimum distribution method being used as of the date of death.

If the IRA owner dies before minimum distributions have begun, then the

entire remaining interest must generally be distributed within five years

of the IRA owner's death.  The five-year rule does not apply if

distributions begin within one year of the IRA owner's death and are

payable over the life or life expectancy of a designated beneficiary.

Special rules apply if the beneficiary of the IRA is the surviving spouse.

 

Roth IRAs

 

Individuals with adjusted gross income below certain levels may make

nondeductible contributions to a Roth IRA. The maximum annual contribution

that may be made to a Roth IRA is the lesser of a certain dollar amount

($4,000 for 2006) or the individual's compensation for the year.  An

individual who has attained age 50 before the end of the taxable year may

also make catch-up contributions to a Roth IRA up to a certain dollar

amount ($1,000 for 2006).

 

The contribution limit is reduced to the extent an individual makes

contributions to any other IRA for the same taxable year.  As under the

rules relating to traditional IRAs, a contribution of up to the dollar

limit for each spouse may be made to a Roth IRA provided the combined

compensation of the spouses is at least equal to the contributed amount.

The maximum annual contribution that can be made to a Roth IRA is phased

out for taxpayers with adjusted gross income over certain levels for the

taxable year.  The adjusted gross income phase-out ranges are:  (1) for

single taxpayers, $95,000 to $110,000; (2) for married taxpayers filing

joint returns, $150,000 to $160,000; and (3) for married taxpayers filing

separate returns, $0 to $10,000.  Contributions to a Roth IRA may be made

even after the account owner has attained age 70-½.

 

Taxpayers with modified adjusted gross income of $100,000 or less generally

may convert a traditional IRA into a Roth IRA, except for married

taxpayers filing separate returns The amount converted is includible in

income as if a withdrawal had been made, except that the 10-percent early

withdrawal tax does not apply.

 

Amounts held in a Roth IRA that are withdrawn as a qualified distribution

are not includible in income, or subject to the additional 10-percent tax

on early withdrawals. A qualified distribution is a distribution that (1)

is made after the five-taxable year period beginning with the first taxable

year for which the individual made a contribution to a Roth IRA, and (2) is

made after attainment of age 59-½, on account of death or disability, or is

made for first-time homebuyer expenses of up to $10,000.

 

Distributions from a Roth IRA that are not qualified distributions are

includible in income to the extent attributable to earnings.  To determine

the amount includible in income, a distribution that is not a qualified

distribution is treated as made in the following order: 

(1) regular Roth IRA contributions; (2) conversion contributions (on a

first in, first out basis); and (3) earnings.  To the extent a

distribution is treated as made from a conversion contribution, it is

treated as made first from the portion, if any, of the conversion

contribution that was required to be included in income as a result of the

conversion.  The amount includible in income is also subject to the

10-percent early withdrawal tax unless an exception applies.  The same

exceptions to the early withdrawal tax that apply to traditional IRAs

apply to Roth IRAs.

 

Roth IRAs are not subject to the minimum distribution rules during the IRA

owner's lifetime.  Roth IRAs are subject to the post-death minimum

distribution rules that apply to traditional IRAs.

 

Saver's credit

 

Present law provides a temporary nonrefundable tax credit for eligible

taxpayers for qualified retirement savings contributions.   The maximum

annual contribution eligible for the credit is $2,000.  The credit rate

depends on the adjusted gross income ("AGI") of the taxpayer. 

Taxpayers filing joint returns with AGI of $50,000 or less, head of

household returns of $37,500 or less, and single returns of $25,000 or less

are eligible for the credit.  The AGI limits applicable to single taxpayers

apply to married taxpayers filing separate returns.  The credit is in

addition to any deduction or exclusion that would otherwise apply with

respect to the contribution.  The credit offsets minimum tax liability as

well as regular tax liability.  The credit is available to individuals who

are 18 or over, other than individuals who are full-time students or

claimed as a dependent on another taxpayer's return.  The credit is

available with respect to contributions to various types of retirement

savings arrangements, including contributions to a traditional or Roth

IRA.

 

Coverdell education savings accounts

 

Present law provides tax-exempt status to Coverdell education savings

accounts, meaning certain trusts or custodial accounts that are created or

organized in the United States exclusively for the purpose of paying the

qualified higher education expenses of a designated beneficiary.  

The aggregate annual contributions that can be made by all contributors to

Coverdell education savings accounts for the same beneficiary is $2,000 per

year.  In the case of contributors who are individuals, the maximum

contribution limit is reduced for individuals with adjusted gross

income between $95,000 and $110,000 ($190,000 to $220,000 in the case of

married taxpayers filing a joint return). Contributions to a Coverdell

education savings account are not deductible.

 

Distributions from a Coverdell education savings account are not includible

in the distributee's income to the extent that the total distribution does

not exceed the qualified education expenses incurred by the beneficiary

during the year the distribution is made.  If a distribution from a

Coverdell education savings account exceeds the qualified education

expenses incurred by the beneficiary during the year of the distribution,

the portion of the excess that is treated as earnings generally is subject

to income tax and an additional 10-percent tax Amounts in a Coverdell

education savings account may be rolled over on a tax-free basis to

another Coverdell education savings account of the same beneficiary or of

a member of the family of that beneficiary.

 

Qualified tuition programs

 

Present law provides tax-exempt status to a qualified tuition program,

defined as a program established and maintained by a State or agency or

instrumentality thereof, or by one or more eligible educational institutions.

Under a qualified tuition program, a person may purchase tuition credits or

certificates on behalf of a designated beneficiary, or in the case of a

State program, may make contributions to an account that is established for

the purpose of meeting qualified higher education expenses of the

designated beneficiary of the account.  Contributions to a qualified

tuition program must be made in cash, and the program must have

adequate safeguards to prevent contributions in excess of amounts

necessary to provide for the beneficiary's qualified higher education

expenses.  Contributions to a qualified tuition program

are not deductible.  Contributions to a qualified tuition program

generally are treated as a completed gift eligible for the gift tax annual

exclusion.

 

Distributions from a qualified tuition program are not includible in the

distributee's gross income to the extent that the total distribution does

not exceed the qualified education expenses incurred by the beneficiary

during the year the distribution is made.  If a distribution from a

qualified tuition program exceeds the qualified education expenses incurred

by the beneficiary during the year of the distribution, the portion of the

excess that is treated as earnings generally is subject to income tax and

an additional 10-percent tax.  Amounts in a qualified tuition program

may be rolled over on a tax-free basis to another qualified tuition

program for the same beneficiary or for a member of the family of that

beneficiary.

 

Health savings accounts

 

A health savings account ("HSA") is a trust or custodial account used to

accumulate funds on a tax-preferred basis to pay for qualified medical

expenses.   Within limits,contributions to an HSA made by or on behalf of

an eligible individual are deductible by the individual. Contributions to

an HSA are excludable from income and employment taxes if made by the

individual's employer. Earnings on amounts in HSAs are not taxable.

Distributions from an HSA for qualified medical expenses are not includible

in gross income.  Distributions from an HSA that are not used for qualified

medical expenses are includible in gross income and are

subject to an additional 10 percent-tax unless the distribution is made

after death, disability, or the individual attains the age of Medicare

eligibility (i.e., age 65).

 

Eligible individuals for HSAs are individuals who are covered by a high

deductible health plan and no other health plan that is not a high

deductible health plan.  A high deductible health plan is a health plan

that has a deductible that is at least $1,050 for self-only coverage or

$2,100 for family coverage (for 2006) and that has an out-of-pocket expense

limit that is no more than $5,250 in the case of self-only coverage and

$10,500 in the case of family coverage (for 2006).

 

The maximum aggregate annual contribution that can be made to an HSA is

the lesser of (1) 100 percent of the annual deductible under the high

deductible health plan, or (2) the maximum deductible permitted under an

Archer MSA high deductible health plan under present law, as adjusted for

inflation.  For 2006, the amount of the maximum deductible under an Archer

MSA high deductible health plan is $2,700 in the case of self-only coverage

and $5,450 in the case of family coverage.  The annual contribution limits

are increased for individuals who have attained age 55 by the end of the

taxable year.  In the case of policyholders and covered spouses

who are age 55 or older, the HSA annual contribution limit is greater than

the otherwise applicable limit by $700 in 2006, $800 in 2007, $900 in 2008,

and $1,000 in 2009 and thereafter.Archer medical savings accounts ("MSAs")

Like HSAs, an Archer MSA is a tax-exempt trust or custodial account to which

tax-deductible contributions may be made by individuals with a high

deductible health plan

 

Archer MSAs provide ta x benefits similar to, but generally not as

favorable as, those provided by HSAs for certain individuals covered by

high deductible health plans. The rules relating to Archer MSAs and HSAs

are similar.  The main differences include:(1) only self-employed

individuals and employees of small employers are eligible to have an

Archer MSA; (2) for MSA purposes, a high deductible plan is a health plan

with (a) an annual deductible of at least $1,800 and no more than $2,700 in

the case of individual coverage and at least $3,650 and no more than $5,450

in the case of family coverage (for 2006), and (b) maximum out-of-pocket

expenses of no more than $3,650 in the case of individual coverage

and no more than $6,650 in the case of family coverage (for 2006); and (3)

the additional tax on distributions not used for medical expenses is 15

percent rather than 10 percent After 2005, no new contributions can be made

to Archer MSAs except by or on behalf of individuals who previously had

Archer MSA contributions and employees who are employed by a participating

employer.

 

                        Description of Proposal

 

In general

 

The proposal consolidates traditional and Roth IRAs into a single type of

account, a Retirement Savings Account ("RSA").  The proposal also creates

a new type of account that can be used to save for any purpose, a Lifetime

Savings Account ("LSA").

 

The tax treatment of both RSAs and LSAs is generally

similar to that of present-law Roth IRAs; that is, contributions are not

deductible and earnings on contributions generally are not taxable when

distributed.  The major difference between the tax treatment of LSAs and

RSAs is that all distributions from LSAs are tax free, whereas tax-free

treatment of earnings on amounts in RSAs applies only to distributions

made after age 58 or in the event of death or disability.

 

Retirement Savings Accounts

 

Under the proposal, an individual may make annual nondeductible

contributions to an RSA of up to the lesser of $5,000 or the individual's

compensation for the year.  As under present-law rules for IRAs, in the

case of a married couple, contributions of up to the dollar limit may be

made for each spouse if the combined compensation of both spouses is at

least equal to the total amount contributed for both spouses. Contributions

to an RSA may be made regardless of the individual's age or adjusted gross

income.  Contributions to an RSA may be made only in cash.  Contributions

to an RSA are taken into account for purposes of the Saver's credit. 

Earnings on contributions accumulate on a tax-free basis.

 

Qualified distributions from RSAs are excluded from gross income.  Under

the proposal, qualified distributions are distributions made after age 58

or in the event of death or disability. Distributions from an RSA that are

not qualified distributions are includible in income (to the extent that

the distribution exceeds basis) and subject to a 10-percent additional tax.

As under the present-law rules for Roth IRAs, distributions are deemed to

come from basis first.

 

As under the present-law rules for Roth IRAs, no minimum distribution rules

apply to an RSA during the RSA owner's lifetime.  In addition, married

individuals may roll amounts over from an RSA to a spouse's RSA.

 

Under the proposal, existing Roth IRAs are renamed RSAs and are subject to

the rules for RSAs. In addition, existing traditional IRAs may be converted

into RSAs .  The amount converted is includible in income (except to the

extent it represents a return of nondeductible contributions).  No income

limits apply to such conversions.  For conversions of traditional IRAs

made before January 1, 2008, the income inclusion may be spread ratably

over four years.  For conversions of traditional IRAs made on or after

January 1, 2008, the income that results from the conversion is included

for the year of the conversion.

 

Under the proposal, existing traditional IRAs that are not converted to

RSAs may not accept new contributions, other than rollovers from other

traditional IRAs or employer-sponsored retirement plans.  New traditional

IRAs may be created to accept rollovers from employer-sponsored retirement

plans or other traditional IRAs, but they cannot accept any other

contributions.  An individual may roll an amount over directly from an

employer-sponsored retirement plan to an RSA by including the rollover

amount (excluding basis) in income, similar to a conversion to a Roth IRA

under present law. 

 

Amounts converted to an RSA from a traditional IRA or an Employer Retirement

Savings Account ("ERSA")  are subject to a five-year holding period.  If an

amount attributable to such a conversion (other than an amount attributable

to a Roth-type account in an ERSA) is distributed from the RSA before the

end of the five-year period starting with the year of the conversion or, if

earlier, the date on which the individual attains age 58, becomes disabled,

or dies, an additional 10-percent tax applies to the entire amount.  The

five-year period is determined separately for each conversion distribution.

To determine the amount attributable to a conversion, a distribution is

treated as made in the following order: (1) regular RSA contributions; (2)

conversion contributions (on a first in, first out basis); and

(3) earnings.  To the extent a distribution is treated as made from a

conversion contribution, it is treated as made first from the portion, if

any, of the conversion contribution that was required to be included in

income as a result of the conversion.

 

Lifetime Savings Accounts

 

Under the proposal, an individual may make nondeductible contributions to

an LSA of up to $5,000 annually, regardless of the individual's age,

compensation, or adjusted gross income. Additionally, individuals other

than the LSA owner may make contributions to an LSA.  The contribution

limit applies to all LSAs in an individual's name, rather than to the

individuals making the contributions.  Thus, contributors may make annual

contributions of up to $5,000 each to the LSAs of other individuals but

total contributions to the LSAs of any one individual may not exceed

$5,000 per year.  Contributions to LSAs may be made only in cash. 

Contributions to an LSA are not taken into account for purposes of the

Saver's credit.  Earnings on contributions accumulate on a tax-free basis.

 

All distributions from an individual's LSA are excludable from income,

regardless of the individual's age or the use of the distribution.  As

under the present-law rules for Roth IRAs, no minimum distribution rules

apply to an LSA during the LSA owner's lifetime.  In addition,

married individuals may roll amounts over from an LSA to a spouse's LSA.

 

Control over an LSA in a minor's name is to be exercised exclusively for

the benefit of the minor by the minor's parent or legal guardian acting in

that capacity until the minor reaches the age of majority (determined under

applicable state law).

 

Taxpayers may convert balances in Coverdell education savings accounts and

qualified tuition programs to LSA balances on a tax-free basis before

January 1, 2008, subject to certain limitations.  An amount may be rolled

over to an individual's LSA only if the individual was the beneficiary of

the Coverdell education savings account or qualified tuition program as of

December 31, 2005.  The amount that can be rolled over to an LSA from a

Coverdell education savings account is limited to the sum of:  (1) the

amount in the Coverdell education savings account as of December 31, 2005;

and (2) any contributions to and earnings on the account for

2006.  The amount that can be rolled over to an LSA from a qualified

tuition program is limited to the sum of:  (1) the lesser of $50,000 or

amount in the qualified tuition program as of December 31, 2005; and

(2) any contributions to and earnings on the qualified tuition program

for 2006.  The total amount rolled over to an individual's LSA that is

attributable to 2006 contributions for the individual to Coverdell

education savings accounts and qualified tuition programs cannot exceed

$5,000 (plus any earnings on such contributions).

Under the proposal, qualified tuition programs continue to exist as

separate arrangements, but may be offered in the form of an LSA.

For example, State agencies that administer qualified tuition programs may

offer LSAs with the same investment options that are available under the

qualified tuition program.  The annual limit on LSA contributions apply to

such an LSA, but the additional reporting requirements applicable to

qualified tuition programs under present law do not apply and distributions

for purposes other than education are not subject to Federal tax

. 

Effective date.-The proposal is effective on January 1, 2007.

 

                                 Analysis

In general

 

The proposal is intended to accommodate taxpayers' changing circumstances

over time by providing a new account that taxpayers may use for tax-favored

saving over their entire lifetimes, with no restrictions on withdrawals.

The proposal also provides a new account for individual retirement savings

with fewer restrictions on eligibility than present-law IRAs.  The

proposal is intended to simplify saving by permitting the consolidation of

existing savings accounts into these accounts and allowing individuals to

make contributions to the new accounts with no limitations based on age or

income level.

 

By providing additional tax incentives for saving, the proposal intends to

encourage additional saving generally.  By providing a tax-favored savings

account with no restrictions on withdrawals, the proposal intends to

encourage additional saving in particular by those who are reluctant to

take advantage of existing tax-preferred savings accounts because of

withdrawal restrictions. Some argue that the national saving rate is too

low, and that this is due in part to the bias of the present-law income

tax structure against saving and in favor of current consumption. 

By providing tax incentives for saving - specifically, removing the tax on

the return to savings - the present-law income tax structure can be

modified to function more like a consumption tax. Proponents of such tax

incentives argue that saving will increase if the return to savings is not

reduced by taxes.  Others have argued that saving has not necessarily

increased as a result of existing tax incentives for savings.  Some have

argued that much existing savings have merely been shifted into

tax-favored accounts, and thus do not represent new saving.  Also, it may

be advantageous to borrow in order to fund tax-favored saving vehicles.

To the extent that

borrowing occurs to fund these accounts, no net saving occurs.  Ideally,

saving incentives should apply only to net new saving, in order to avoid

windfall gains to existing savings.  However,measuring net new saving would

be difficult in practice.

 

Others have argued that increasing the return to savings (by not taxing

earnings) might cause some taxpayers actually to save less, as a higher

return to savings means that less saving is necessary to achieve a "target"

level of savings at some point in the future.

 

From an economic perspective, both LSAs and RSAs receive tax treatment

generally equivalent to Roth IRAs.  While the taxpayer does not deduct

contributions to LSAs, tax is never paid on the income earned on the

investment. The same is generally true for RSAs as long as

amounts are withdrawn in qualified distributions.  However, while LSAs and

RSAs receive tax treatment similar to Roth IRAs, the maximum allowable

annual contribution is greater than the

amount of contributions currently permitted to Roth IRAs.  The increase in

the amounts that may be contributed to tax-preferred savings accounts

provides a tax incentive for further saving for those who have already

contributed the maximum to existing tax-favored savings accounts. 

However, for taxpayers not already contributing the maximum amounts,

the new accounts provide no additional economic inducement to save, except

to the extent that LSAs provide withdrawal flexibility relative to existing

retirement savings vehicles' age restrictions.Opponents of proposals to

increase tax-favored saving thus argue that the only beneficiaries are

likely to be wealthy taxpayers with existing savings that will be shifted

to the tax-favored accounts, since most taxpayers have not taken full

advantage of existing saving incentives.

 

RSAs also replace traditional IRAs and thereby eliminate taxpayers' ability

to make deductible contributions.  From an economic perspective, RSAs

receive tax treatment generally equivalent to traditional IRAs to which

deductible contributions are made.   However, some argue that the upfront

deduction provides a greater psychological inducement to save, and that

the elimination of traditional IRAs may reduce saving by those who would

have been able to make deductible contributions.

 

Taxpayers may convert balances under Coverdell education savings accounts

and qualified tuition programs into LSAs on a tax-free basis before

January 1, 2008.  Under the proposal, existing balances in Coverdell

education savings accounts and existing balances in qualified tuition

programs (up to $50,000) may be converted to LSA balances with no income

tax consequences.  This means that pretax earnings accumulated on Coverdell

education savings accounts and qualified tuition program balances that are

converted to LSAs may be withdrawn and spent for purposes other than

education without the income tax consequences applicable to Coverdell

education savings account and qualified tuition program distributions that

are used for nonqualifying expenses.  Conversion allows the consolidation

of saving into a single vehicle for simplification purposes.  However,

there is some scope for abuse of this conversion option.  A taxpayer with

sufficient resources may effect such a conversion simply to shift more

saving into tax-favored accounts.  For example, a taxpayer could transfer

$50,000 from an existing qualified tuition program into an LSA, thus

insulating already accumulated earnings from tax, regardless

of whether they are used for education expenses, and then reinvest a

different $50,000 into the qualified tuition program.

 

The tax treatment of contributions under qualified retirement plans is

essentially the same as that of traditional IRAs to which deductible

contributions are made.  However, the limits on contributions to qualified

plans are much higher than the IRA contribution limits, so that qualified

plans provide for a greater accumulation of funds on a tax-favored basis.

A policy rationale for permitting greater accumulation under qualified

plans than IRAs is that the tax benefits for qualified plans encourage

employers to provide benefits for a broad group of their employees.  This

reduces the need for public assistance and reduces pressure on the social

security system.

 

Some argue that offering LSAs and RSAs will reduce the incentive for small

business owners to maintain qualified retirement plans for themselves and

their employees.  A business owner can generally contribute more to a

qualified plan than the contributions that may be made to LSAs and RSAs,

but only if comparable contributions are made by or on behalf of rank-and-

file employees.  The business owner must therefore successfully encourage

rank-and-file employees to contribute to the plan or, in many cases, make

matching or nonelective contributions for rank-and-file employees.  The

opportunity to contribute $5,000 annually to both an LSA and an RSA for

both the business owner and his or her spouse, without regard to

adjusted gross income or contributions for rank-and-file employees, may be

a more attractive alternative to maintaining a qualified retirement plan.

Others argue that many employers (including small employers) offer

qualified retirement plans to attract and retain high-quality employees

and will continue to do so.  In addition, the ability to make pretax

contributions to an employer-sponsored plan is attractive to many

individuals.  Some raise concerns that, as a substitute for a qualified

retirement plan, an employer could selectively choose to pay additional

compensation only to highly compensated employees in the form of

contributions to LSAs and RSAs.  This may undermine the principle of

promoting savings for rank-and-file employees.

 

Thus, some argue that the proposal may reduce qualified retirement plan

coverage,particularly in the case of small businesses. Whether any reduced

coverage would result in an overall reduction of retirement security would

depend, in part, on the extent to which individuals who are not covered by

a qualified retirement plan instead contribute to the new saving vehicles. 

 

Complexity

 

The proposal has elements that may both increase and decrease tax law

complexity. On one hand, the proposal provides new saving options to

individuals, which may increase complexity to the extent that taxpayers

open new LSAs and RSAs without consolidating existing tax-preferred savings

into such accounts. In addition, although the proposal relating to RSAs

generally precludes future contributions to traditional IRAs, the proposal

relating to LSAs does not preclude future contributions to present-law

tax-favored arrangements for certain purposes, such as Coverdell education

savings accounts, qualified tuition programs, and health savings

accounts.  On the other hand, the proposal may decrease complexity by

permitting consolidation of tax-favored savings accounts. 

 

Additionally, with respect to future saving, in one respect choices are

made easier by the elimination of the need to decide whether to make

deductible or nondeductible IRA contributions for those taxpayers eligible

to contribute to both.  However, employer-sponsored qualified retirement

plans generally receive the same tax treatment as traditional IRAs to which

deductible contributions are made (i.e., contributions are not taxable, but

distributions are).  Therefore, the increased availability of Roth-type

savings vehicles, in terms of eligibility to make contributions and higher

contribution limits, is likely to mean that many more taxpayers will face

a choice of how to balance their savings between deductible and

nondeductible savings vehicles.  Nonetheless, the ability to make

contributions to LSAs and RSAs without limitations based on

age or income level, the uniform tax treatment of all contributions to LSAs

and RSAs, and the lack of restrictions on LSA withdrawals, are likely to

decrease complexity.

 

                                 Prior Action

                                

A similar proposal was included in the President's fiscal year 2005 and

2006 budget proposals.  The President's fiscal year 2004 budget proposal

included a similar proposal; among the differences is that, in the fiscal

year 2004 proposal, the annual dollar limit on contributions to RSAs or

to LSAs was $7,500.

 

 

2.      Consolidation of employer-based savings accounts

 

                               Present Law

                               

In general

 

A plan of deferred compensation that meets the qualification standards of

the Code (a qualified retirement plan) is accorded special tax treatment

under present law.  Employees do not include contributions in gross income

until amounts are distributed, even though the arrangement is funded and

benefits are nonforfeitable.  In the case of a taxable employer, the

employer is entitled to a current deduction (within limits) for

contributions even though the contributions are not currently included in

an employee's income.  Contributions to a qualified plan, and earnings

thereon, are held in a tax-exempt trust.

 

Qualified retirement plans may permit both employees and employers to make

contributions to the plan.  Under a qualified cash or deferred arrangement

(i.e., a "section 401(k)" plan), employees may elect to make pretax

contributions to a plan.  Such contributions are referred to as elective

deferrals.  Employees may also make after-tax contributions to a qualified

retirement plan.  Employer contributions consist of two types:  nonelective

contributions and matching contributions.  Nonelective contributions are

employer contributions that are made without regard to whether

the employee makes pretax or after-tax contributions. 

Matching contributions are employer contributions that are made only if

the employee makes contributions.

 

Present law imposes a number of requirements on qualified retirement plans

that must be satisfied in order for the plan to be qualified and for

favorable tax treatment to apply.  These requirements include

nondiscrimination rules that are intended to ensure that a qualified

retirement plan covers a broad group of employees. Certain of these rules

are discussed in more detail below.

 

Qualified retirement plans are broadly classified into two categories,

defined benefit pension plans and defined contribution plans, based on the

nature of the benefits provided. Under a defined benefit pension plan,

benefits are determined under a plan formula, generally

based on compensation and years of service.  Benefits under defined

contribution plans are based solely on the contributions, and earnings

thereon, allocated to separate accounts maintained for plan participants.

 

In addition to qualified section 401(k) plans, present law provides for

other types of employer-sponsored plans to which pretax employee elective

contributions can be made.  Many of these arrangements are not qualified

retirement plans, but receive the same tax-favored treatment as qualified

retirement plans.  The rules applicable to each type of arrangement vary.

These arrangements include SIMPLE section 401(k) plans, tax sheltered

annuity plans ("section 403(b)" plans),  governmental eligible deferred

compensation plans ("section 457" plans), SIMPLE IRAs,  and

salary-reduction simplified employee pensions ("SARSEPs").

 

Limits on contributions to qualified defined contribution plans

 

The annual additions under a defined contribution plan with respect to

each plan participant cannot exceed the lesser of (1) 100 percent of the

participant's compensation or (2) a dollar amount, indexed for inflation

($44,000 for 2006).  Annual additions are the sum of employer contributions,

employee contributions, and forfeitures with respect to an individual

under all defined contribution plans of the same employer.

 

Nondiscrimination requirements applicable to qualified retirement plans

 

The nondiscrimination requirements are designed to ensure that qualified

retirement plans benefit an employer's rank-and-file employees as well as

highly compensated employees. Under a general nondiscrimination

requirement, the contributions or benefits provided under a qualified

retirement plan must not discriminate in favor of highly compensated

employees. Treasury regulations provide detailed and exclusive rules for

determining whether a plan satisfies the general nondiscrimination rules.

Under the regulations, the amount of contributions or benefits provided

under the plan and the benefits, rights and features offered under the

plan must be tested.

 

Treasury regulations provide three general approaches to testing the

amount of nonelective contributions provided under a defined contribution

plan:  (1) design-based safe harbors; (2) a general test; and

(3) cross-testing.  Elective deferrals, matching contributions, and

after-tax employee contributions are subject to separate testing as

described below.

 

Qualified cash or deferred arrangements (section 401(k)plans)

 

In general

 

Section 401(k) plans are subject to the rules generally applicable to

qualified defined contribution plans.  In addition, special rules apply.

As described above, an employee may make elective deferrals to a section

401(k) plan. The maximum annual amount of elective deferrals that can be

made by an individual is $15,000 (for 2006).  An individual who has

attained age 50 before the end of the taxable year may also make catch-up

contributions to a section 401(k) plan.  As a result, the dollar limit on

elective deferrals is increased for an individual who has attained age 50

by $5,000 (for 2006).  An employee's elective deferrals must be fully

vested.

 

Special nondiscrimination tests

 

A special nondiscrimination test applies to elective deferrals under a

section 401(k) plan, called the actual deferral percentage test

(the "ADP" test).   The ADP test compares the actual deferral percentages

("ADPs") of the highly compensated employee group and the nonhighly

compensated employee group.  The ADP for each group generally is the

average of the deferral percentages separately calculated for the

employees in the group who are eligible to make elective deferrals for

all or a portion of the relevant plan year.  Each eligible employee's

deferral percentage generally is the employee's elective deferrals for

the year divided by the employee's compensation for the year.

 

The plan generally satisfies the ADP test if the ADP of the highly

compensated employee group for the current plan year is either (1) not

more than 125 percent of the ADP of the nonhighly compensated employee

group for the prior plan year, or (2) not more than 200 percent

of the ADP of the nonhighly compensated employee group for the prior plan

year and not more than two percentage points greater than the ADP of the

nonhighly compensated employee group for the prior plan year.

 

Under a safe harbor, a section 401(k) plan is deemed to satisfy the

special nondiscrimination test if the plan satisfies one of two

contribution requirements and satisfies a notice requirement (a "safe

harbor" section 401(k) plan).   A plan satisfies the contribution

requirement under the safe harbor rule if the employer either

(1) satisfies a matching contribution

requirement or (2) makes a nonelective contribution to a defined

contribution plan of at least three percent of an employee's compensation

on behalf of each nonhighly compensated employee who is eligible to

participate in the arrangement.

 

A plan satisfies the matching contribution requirement if, under the

arrangement:  (1) the employer makes a matching contribution on behalf of

each nonhighly compensated employee that is equal to (a) 100 percent of

the employee's elective deferrals up to three percent of compensation and

(b) 50 percent of the employee's elective deferrals from three to five

percent of compensation; and (2) the rate of match with respect to any

elective deferrals for highly compensated employees is not greater than

the rate of match for nonhighly compensated employees.  Alternatively, the

matching contribution requirement is met if (1) the rate of matching

contribution does not increase as the rate of an employee's elective

deferrals increases,and (2) the aggregate amount of matching contributions

at such rate of employee elective deferral is at least equal to the

aggregate amount of matching contributions that would be made if matching

contributions were made on the basis of the percentages described in the

preceding formula. A plan does not meet the contributions requirement if

the rate of matching contribution with respect to any rate of elective

deferral of a highly compensated employee is greater than the

rate of matching contribution with respect to the same rate of elective

deferral of a nonhighly compensated employee.

 

Nondiscrimination tests for matching contributions and after-tax employee

contributions

 

Employer matching contributions and after-tax employee contributions are

also subject to a special annual nondiscrimination test (the "ACP test").

The ACP test compares the actual contribution percentages ("ACPs") of the

highly compensated employee group and the nonhighly compensated employee

group.  The ACP for each group generally is the average of the

contribution percentages separately calculated for the employees in the

group who are eligible to make after-tax employee contributions or who

are eligible for an allocation of matching contributions for all or a

portion of the relevant plan year.  Each eligible employee's contribution

percentage generally is the employee's aggregate after-tax employee

contributions and matching contributions for the year divided by the

employee's compensation for the year.

 

The plan generally satisfies the ACP test if the ACP of the highly

compensated employee group for the current plan year is either (1) not

more than 125 percent of the ACP of the nonhighly compensated employee

group for the prior plan year, or (2) not more than 200 percent of the

ACP of the nonhighly compensated employee group for the prior plan year

and not more than two percentage points greater than the ACP of the

nonhighly compensated employee group for the prior plan year.

 

A safe harbor section 401(k) plan is deemed to satisfy the ACP test with

respect to matching contributions, provided that (1) matching

contributions are not provided with respect to elective deferrals or

after-tax employee contributions in excess of six percent of compensation,

(2) the rate of matching contribution does not increase as the rate of an

employee's elective deferrals or after-tax contributions increases, and (3)

the rate of matching contribution with respect to any rate of elective

deferral or after-tax employee contribution of a highly compensated

employee is no greater than the rate of matching contribution with respect

to the same rate of deferral or contribution of a nonhighly compensated

employee.

 

Tax-sheltered annuities (section 403(b) plans)

 

Section 403(b) plans are another form of employer-based retirement plan

that provide the same tax benefits as qualified retirement plans. 

Employers may contribute to such plans on behalf of their employees, and

employees may make elective deferrals.  Section 403(b) plans may be

maintained only by (1) tax-exempt charitable organizations, and (2)

educational institutions of State or local governments (including public

schools).  Many of the rules that apply to section 403(b) plans are

similar to the rules applicable to qualified retirement plans,

including section 401(k) plans. 

 

Contributions to a section 403(b) plan are generally subject to the same

contribution limits applicable to qualified defined contribution plans,

including the special limits for elective deferrals and catch-up

contributions under a section 401(k) plan. If contributions are made to

both a qualified defined contribution plan and a section 403(b) plan for

the same employee, a single limit applies to the contributions under both

plans.  Special contribution limits apply to certain employees under a

section 403(b) plan maintained by a church.  In addition, additional

elective deferrals are permitted under a plan maintained by an educational

organization, hospital,home health service agency, health and welfare

service agency, church, or convention or association of churches in the

case of employees who have completed 15 years of service.

 

Section 403(b) plans are generally subject to the minimum coverage and

general nondiscrimination rules that apply to qualified defined

contribution plans.  In addition, employer matching contributions and

after-tax employee contributions are subject to the ACP test. 

However, pretax contributions made by an employee under a salary reduction

agreement (i.e., elective deferrals) are not subject to nondiscrimination

rules similar to those applicable to elective deferrals under section

401(k) plans. Instead, all employees generally must be eligible

to make salary reduction contributions.  Certain employees may be

disregarded for purposes of this rule.

 

Eligible deferred compensation plans of State and local governments

(section 457 plans)

 

Compensation deferred under a section 457 plan of a State or local

governmental employer is includible in income when paid.   The maximum

annual deferral under such a plan generally is the lesser of (1) $15,000

(for 2006) or (2) 100 percent of compensation.  A special, higher limit

applies for the last three years before a participant reaches normal

retirement age (the "section 457 catch-up limit").  In the case of a

section 457 plan of a governmental employer, a participant who has attained

age 50 before the end of the taxable year may also make catch-up

contributions up to a limit of $5,000 (for 2006), unless a higher section

457 catch-up limit applies.   Only contributions to section 457 plans are

taken into account in applying these limits; contributions made to a

qualified retirement plan or section 403(b) plan for an employee do not

affect the amount that may be contributed to a section 457 plan for that

employee

.

SIMPLE retirement plans

Under present law, a small business that employs fewer than 100 employees

can establish a simplified retirement plan called the savings incentive

match plan for employees ("SIMPLE") retirement plan.  A SIMPLE plan can be

either an individual retirement arrangement for each employee

(a "SIMPLE IRA") or part of a section 401(k) plan (a "SIMPLE section

401(k)" plan).

 

A SIMPLE retirement plan allows employees to make elective deferrals,

subject to a limit of $10,000 (for 2006).  An individual who has attained

age 50 before the end of the taxable year may also make catch-up

contributions to a SIMPLE plan up to a limit of $2,500 (for 2006).

 

Employer contributions to a SIMPLE plan must satisfy one of two

contribution formulas. Under the matching contribution formula, the

employer generally is required to match employee elective contributions

on a dollar-for-dollar basis up to three percent of the employee's

compensation.  Under a special rule applicable only to SIMPLE IRAs, the

employer can elect a lower percentage matching contribution for all

employees (but not less than one percent of each employee's compensation).

In addition, a lower percentage cannot be elected for more than two

out of any five years.  Alternatively, for any year, an employer is

permitted to elect, in lieu of making matching contributions, to make a

two percent of compensation nonelective contribution on behalf of each

eligible employee with at least $5,000 in compensation for such year,

whether or not the employee makes an elective contribution.

 

No contributions other than employee elective contributions, required

employer matching contributions or employer nonelective contributions can

be made to a SIMPLE plan and the employer may not maintain any other plan.

All contributions to an employee's SIMPLE account must be fully vested.

 

In the case of a SIMPLE IRA, the group of eligible employees generally

must include any employee who has received at least $5,000 in compensation

from the employer in any two preceding years and is reasonably expected to

receive $5,000 in the current year.  A SIMPLE IRA is not subject to the

nondiscrimination rules generally applicable to qualified retirement

plans.  In the case of a SIMPLE section 401(k) plan, the group of

employees eligible to participate must satisfy the minimum coverage

requirements generally applicable to qualified retirement plans.  A SIMPLE

section 401(k) plan does not have to satisfy the ADP or ACP test

and is not subject to the top-heavy rules. The other qualified retirement

plan rules generally apply.

 

Salary reduction simplified employee pensions (SARSEPs)

 

A simplified employee pension ("SEP") is an IRA to which employers may

make contributions up to the limits applicable to defined contribution

plans. All contributions must be fully vested.  Any employee must be

eligible to participate in the SEP if the employee (1) has

attained age 21, (2) has performed services for the employer during

at least three of the immediately preceding five years, and (3) received

at least $450 (for 2006) in compensation from the employer for the year.

Contributions to a SEP generally must bear a uniform relationship to

compensation

 

Effective for taxable years beginning before January 1, 1997, certain

employers with no more than 25 employees could maintain a SARSEP (i.e., a

salary reduction SARSEP) under which employees could make elective

deferrals. The SARSEP rules were generally repealed with the adoption of

SIMPLE plans.  However, contributions may continue to be made to SARSEPs

that were established before 1997.  Salary reduction contributions to a

SARSEP are subject to the same limit that applies to elective deferrals

under a section 401(k) plan ($15,000 for 2006).  An individual who has

attained age 50 before the end of the taxable year may also make catch-up

contributions to a SARSEP up to a limit of $5,000 (for 2006).

 

Designated Roth contributions

 

There are two general types of individual retirement arrangements ("IRAs")

under present and prior law:  traditional IRAs, to which both deductible

and nondeductible contributions may be made, and Roth IRAs.  Individuals

with adjusted gross income below certain levels generally may make

nondeductible contributions to a Roth IRA.  Amounts held in a Roth IRA

that are withdrawn as a qualified distribution are not includible in

income, nor subject to the additional 10-percent tax on early withdrawals.

A qualified distribution is a distribution that (1) is made after the

five-taxable year period beginning with the first taxable

year for which the individual made a contribution to a Roth IRA, and

(2) is made after attainment of age 59-½, is made on account of death or

disability, or is a qualified special purpose distribution (i.e., for

first-time homebuyer expenses of up to $10,000).  A distribution from a

Roth IRA that is not a qualified distribution is includible in income to

the extent attributable to earnings, and is subject to the 10-percent tax

on early withdrawals (unless an exception applies).

 

Beginning in 2006, a section 401(k) plan or a section 403(b) plan is

permitted to include a "qualified Roth contribution program" that permits

a participant to elect to have all or a portion of the participant's

elective deferrals under the plan treated as designated Roth contributions.  

Designated Roth contributions are elective deferrals that the participant

designates (at such time and in such manner as the Secretary may

prescribe) as not excludable from the participant's gross income.  The

annual dollar limit on a participant's designated Roth contributions is

the same as the limit on elective deferrals, reduced by the participant's

elective deferrals that the participant does not designate as designated

Roth contributions. Designated Roth contributions are treated as any

other elective deferral for certain purposes, including the

nondiscrimination requirements applicable to section 401(k) plans

 

A qualified distribution from a participant's designated Roth contributions

account is not includible in the participant's gross income.  A qualified

distribution is a distribution that is made after the end of a specified

nonexclusion period and that is (1) made on or after the date on which

the participant attains age 59-½, (2) made to a beneficiary (or to the

estate of the participant) on or after the death of the participant, or

(3) attributable to the participant's being disabled.

 

 

                            Description of Proposal

 

In general

 

Under the proposal, the various present-law employer-sponsored retirement

arrangements under which individual accounts are maintained for employees

and employees may make contributions are consolidated into a single type

of arrangement called an employer retirement savings account (an "ERSA").

An ERSA is available to all employers and is subject to simplified

qualification requirements.

 

Employer Retirement Savings Accounts

 

In general

 

The rules applicable to ERSAs generally follow the present-law rules for

section 401(k) plans with certain modifications.  Existing section 401(k)

plans and thrift plans are renamed ERSAs and continue to operate under the

new rules.  Existing section 403(b) plans, governmental section 457 plans,

SARSEPs, and SIMPLE IRAs and SIMPLE section 401(k) plans may be renamed

ERSAs and operate under the new rules.  Alternatively, such arrangements

may continue to be maintained in their current form, but may not accept

any new employee deferrals or after-tax contributions after

December 31, 2007.

 

Types of contributions and treatment of distributions

 

An ERSA may provide for an employee to make pretax elective contributions

and catch-up contributions up to the present-law limits applicable to a

section 401(k) plan, that is, a limit of $15,000 for elective deferrals

and $5,000 for catch-up contributions (as indexed for future years). 

An ERSA may also allow an employee to designate his or her elective

contributions as Roth contributions or to make other after-tax employee

contributions.  An ERSA may also provide for matching contributions and

nonelective contributions.  Total annual contributions to an ERSA for an

employee (i.e., employee and employer contributions, including elective

deferrals) may not exceed the present-law limit of the lesser of 100

percent of compensation or $44,000 (as indexed for future years).

 

Distributions from an ERSA of after-tax employee contributions (including

Roth contributions) and qualified distributions of earnings on Roth

contributions are not includible in income.  All other distributions are

includible in income.

 

Nondiscrimination requirements

 

The present-law ADP and ACP tests are replaced with a single

nondiscrimination test.  If the average contribution percentage for

nonhighly compensated employees is six percent or less,the average

contribution percentage for highly compensated employees cannot exceed 200

percent of the nonhighly compensated employees' average contribution

percentage.  If the average contribution percentage for nonhighly

compensated employees exceeds six percent, the nondiscrimination test is

met.  For this purpose, a "contribution percentage" is calculated for

each employee as the sum of employee pretax and after-tax contributions,

employer matching contributions, and qualified nonelective contributions

made for the employee, divided by the employee's compensation.

 

A design-based safe harbor is available for an ERSA to satisfy the

nondiscrimination test. Similar to the section 401(k) safe harbor under

present law, under the ERSA safe harbor, the plan must be designed to

provide all eligible nonhighly compensated employees with either (1) a

fully vested nonelective contribution of at least three percent of

compensation, or (2) fully vested matching contributions of at least

three percent of compensation, determined under one of two

formulas.  The ERSA safe harbor provides new formulas for determining

required matching contributions.  Under the first formula, matching

contributions must be made at a rate of 50 percent of an employee's

elective contributions up to six percent of the employee's

compensation.  Alternatively, matching contributions may be made under

any other formula under which the rate of matching contribution does not

increase as the rate of an employee's elective contributions increases,

and the aggregate amount of matching contributions at such rate

of elective contribution is at least equal to the aggregate amount of

matching contributions that would be made if matching contributions were

made on the basis of the percentages described in the first formula.  In

addition, the rate of matching contribution with respect to any rate of

elective contribution cannot be higher for a highly compensated employee

than for a nonhighly compensated employee.

 

A plan sponsored by a State or local government is not subject to the

nondiscrimination requirements.  In addition, a plan sponsored by an

organization exempt from tax under section 501(c)(3) is not subject to the

ERSA nondiscrimination tests (unless the plan permits after-tax or

matching contributions), but must permit all employees of the organization

to participate.

 

Special rule for small employers

 

Under the proposal, an employer that employed 10 or fewer employees with

compensation of at least $5,000 in the prior year is able to offer an ERSA

in the form of custodial accounts for employees (similar to a present law

IRA), provided the employer's contributions satisfy the ERSA design based

safe harbor described above.  The option of using custodial accounts under

the proposal provides annual reporting relief for small employers as

well as relief from most fiduciary requirements under the Employee

Retirement Income Security Act of 1974 ("ERISA") under circumstances

similar to the relief provided to sponsors of SIMPLE IRAs under present law.

 

Effective date.-The proposal is effective for years beginning after

December 31, 2006.

 

                                  Analysis

 

In general

 

An employer's decision to establish or continue a retirement plan for

employees is voluntary.  The Federal tax laws provide favorable tax

treatment for certain employer-sponsored retirement plans in order to

further retirement income policy by encouraging the establishment

and continuance of plans that provide broad coverage, including

rank-and-file employees.  On the other hand, tax policy is concerned also

with the level of tax subsidy provided to retirement plans.  Thus, the tax

law limits the total amount that may be provided to any one employee under

a tax favored retirement plan and includes strict nondiscrimination rules

to prevent highly compensated employees from receiving a disproportionate

amount of the tax subsidy provided with respect to employer-sponsored

retirement plans.

 

The rules governing employer-sponsored retirement plans, particularly the

nondiscrimination rules, are generally regarded as complex.   Some have

argued that this complexity deters employers from establishing qualified

retirement plans or causes employers to terminate such plans.  Others

assert that the complexity of the rules governing employer-sponsored

retirement plans is a necessary byproduct of attempts to ensure that

retirement benefits are delivered to more than just the most highly

compensated employees of an employer and to provide employers,

particularly large employers, with the flexibility needed to recognize

differences in the way that employers do business and differences in

workforces.

 

Analysis of ERSA proposal

 

General nondiscrimination test.

 

The special nondiscrimination rules for 401(k) plans are designed to

ensure that nonhighly compensated employees, as well as highly compensated

employees, receive benefits under the plan. The nondiscrimination rules

give employers an incentive to make the plan attractive to lower and middle

income employees (e.g., by providing a match or qualified nonelective

contributions) and to undertake efforts to enroll such employees, because

the greater the participation by such employees, the more highly

compensated employees can contribute to the plan. 

 

Some argue that the present-law nondiscrimination rules are unnecessarily

complex and discourage employers from maintaining retirement plans. 

By reducing the complexity associated with ADP and ACP testing and reducing

the related compliance costs associated with a plan, the proposal arguably

makes employers more likely to offer retirement plans, thus increasing

coverage and participation.  Others argue that the present-law section

401(k) safe harbor already provides a simplified method of satisfying the

nondiscrimination requirements without the need to run the ADP and ACP

tests. Some also point out that the proposal allows a greater differential

in the contribution rates for highly and nonhighly compensated employees

under an ERSA than the present law rules for section 401(k) plans. They

argue that this weakens the nondiscrimination rules by enabling employers

to provide greater contributions to highly paid employees than under

present law without a corresponding increase in contributions for rank-

and-file employees. They also argue that the proposal reduces the

incentive for employers to encourage nonhighly compensated employees to

participate in the plan, which could result in lower contributions for

rank-and-file employees.  On the other hand, others believe that allowing

contributions to favor highly paid employees more than under present law

is appropriate in order to encourage employers to maintain plans that

benefit rank-and-file employees.

 

ERSA safe harbor

 

The present law safe harbors for elective deferrals and matching

contributions were designed to achieve the same objectives as the special

nondiscrimination tests for these amounts, but in a simplified manner. 

The alternative of a nonelective contribution of three percent ensures

a minimum benefit for all employees covered by the plan, while the

alternative of matching contributions at a higher rate (up to four percent)

was believed to be sufficient incentive to induce participation by nonhighly

compensated employees.  It was also hoped that the safe harbors would

reduce the complexities associated with qualified plans, and induce more

employers to adopt retirement plans for their employees.

 

To the extent that the ERSA safe harbor requires an employee's elective

deferrals to be matched at only a 50 percent rate and requires a total of

only three percent in matching contributions, some argue that the proposal

not only weakens the matching contribution alternative under the safe

harbor, but also makes that alternative clearly less expensive for the

employer than the nonelective contribution alternative, thereby reducing

the incentive for an employer to provide nonelective contributions.

In addition, because, as under the present-law safe harbor, the matching

contribution alternative is satisfied by offering matching contributions

(without regard to the amount actually provided to nonhighly compensated

employees), some argue that employers may no longer have a financial

incentive to encourage employees to participate.  This may reduce

participation by rank-and-file employees.  The argument may also

be made that the matching contribution requirement under the ERSA safe

harbor is less rigorous than the matching contribution requirement that

applies to a SIMPLE plan under present law,even though an ERSA is not

subject to the limitations on SIMPLE arrangements (i.e.,contributions are

subject to lower limits and SIMPLEs are available only to small employers). 

On the other hand, some believe that the present-law safe harbor for

section 401(k) plans has failed to provide an adequate incentive for

employers to offer retirement plans to their employees

and further incentive is needed.  Some argue that the proposal makes the

safe harbor more attractive for employers, especially small employers, and

will thus increase coverage and participation. 

 

Consolidation of various types of employer-sponsored plans

 

One of the sources of complexity in the present-law rules relating to

employer-sponsored retirement plans is the existence of numerous vehicles

with similar purposes but different rules.  Thus, employers desiring to

adopt a retirement plan must determine which vehicles are available

to that employer and which of the various vehicles available it wishes to

adopt.  This determination may entail a costly and time-consuming analysis

and comparison of a number of different types of plans. By providing only

one type of defined contribution plan to which employee contributions may

be made, i.e., an ERSA, the proposal makes it easier for employers

to determine whether to adopt a plan and what type of plan to provide.

Having a single type of plan may also make it easier for employees to

understand their retirement benefits, particularly when employees change

jobs.

 

On the other hand, many employers already have plans and are

familiar with the present-law rules applicable to their plans.  Converting

a present-law arrangement to an ERSA will involve administrative costs,

which some employers may not view as commensurate with simplification

benefits.

 

Many view the different rules for different types of plans as largely

historical in nature and as adding complexity without serving an overriding

policy objective.  On the other hand, some argue that the differences in

the rules serve different employment objectives and policies of different

types of employers.

 

Some may be concerned that the proposal, in combination with the proposals

for expanded individual savings opportunities (i.e., Lifetime Savings

Accounts and Retirement Savings Accounts), will further reduce the

incentive for small employers to offer retirement plans to their employees.

Although higher contributions may be made to an employer-sponsored

retirement plan than to these other arrangements, comparable contributions

must be made by or on behalf of rank-and-file employees. The opportunity

to contribute $5,000 a year to both a Lifetime Savings Account and a

Retirement Savings Account for both the business owner and his or her

spouse, without regard to adjusted gross income or contributions for

rank-and-file employees, may be a more attractive alternative to

maintaining a qualified retirement plan.  On the other hand, the

excludability of ERSA contributions and the availability of the ERSA safe

harbor, coupled with the higher contribution levels permitted under a

qualified plan, may be viewed as providing an adequate incentive for a

small employer to establish an ERSA.

 

                                  Prior Action

                                 

A similar proposal was included in the President's fiscal year 2004, 2005,

and 2006 budget proposals.  The President's fiscal year 2004 budget

proposal also included several proposals to simplify the rules for defined

contribution plans generally

 

3.  Individual development accounts

 

                                     Present Law

                                    

Individual development accounts were first authorized by the Personal Work

and Responsibility Act of 1996.  In 1998, the Assets for Independence Act

established a five-year $125 million demonstration program to permit certain

eligible individuals to open and make contributions to an individual

development account. Contributions by an individual to an individual

development account do not receive a tax preference but are matched by

contributions from a State program, a participating nonprofit organization,

or other "qualified entity."  The IRS has ruled that matching contributions

by a qualified entity are a gift and not taxable to the account owner.  

The qualified entity chooses a matching rate, which must be between 50 and

400 percent.  Withdrawals from individual development account can be made

for certain higher education expenses, a first home purchase, or small

business capitalization expenses. Matching contributions (and earnings

thereon) typically are held separately from the individuals' contributions

(and earnings thereon) and must be paid directly to a mortgage provider,

educational institution, or business capitalization account at a financial

institution. The Department of Health and Human Services administers the

individual development account program.

 

 

                                Description of Proposal

                               

The proposal provides a nonrefundable tax credit for a qualified entity

(i.e., qualified financial institutions, qualified nonprofit organizations,

and qualified Indian tribes)  that has an individual development account

program in a taxable year.  The tax credit equals the amount of matching

contributions made by the eligible entity under the program (up to $500

per account per year) plus $50 for each individual development account

maintained during the year under the program. Except in the first year

that each account is open, the $50 credit is available only for

accounts with a balance of more than $100 at year-end.  The amount of the

credit is adjusted for inflation after 2008. The $500 amount is rounded

to the nearest multiple of twenty dollars.  The $50 amount is rounded to

the nearest multiple of five dollars. No deduction or other credit is

available with respect to the amount of matching funds taken into account

in determining the credit.

 

The credit applies with respect to the first 900,000 individual development

accounts opened after December 31, 2007 and before January 1, 2013, and

with respect to matching funds for participant contributions that are made

after December 31, 2007, and before January 1, 2015.

 

Nonstudent U.S. citizens or legal residents between the ages of 18 and 60

(inclusive) who are not dependents of a taxpayer and who meet certain

income requirements are eligible to open and contribute to an individual

development account.  The income limit is modified adjusted gross income of

$20,000 for single filers, $40,000 for joint filers, and $30,000 for

head-of-household filers.   Eligibility in a taxable year is based on the

previous year's modified adjusted gross income and circumstances (e.g.,

status as a student).  Modified adjusted gross income is adjusted gross

income, plus certain items that are not includible in gross income. The

proposal does not specify which items are to be added.  The income limits

are adjusted for inflation after 2007.  This amount is rounded to the

nearest multiple of 50 dollars.

 

Under the proposal, an individual development account must:  (1) be owned

by the eligible individual for whom the account was established;

(2) consist only of cash contributions; (3) be held by a person authorized

to be a trustee of any individual retirement account under section

408(a)(2)); and (4) not commingle account assets with other property

(except in a common trust fund or common investment fund).  These

requirements must be reflected in the written governing instrument

creating the account.  The entity establishing the program is required to

maintain separate accounts for the individual's contributions (and

earnings therein) and matching funds and earnings thereon.

 

Contributions to individual development accounts by individuals are not

deductible and earnings thereon are taxable to the account holder.

Matching contributions and earnings thereon are not taxable to the

account holder.

 

The proposal permits individuals to withdraw amounts from an individual

development account for qualified expenses of the account owner, owner's

spouse, or dependents. Withdrawals other than for qualified

expenses ("nonqualified" withdrawals) may not be made from the portion

of the accounts attributable to the matching contributions before the

account owner attains age 61.  In addition, nonqualified withdrawals from

the portion of the account attributable to the individual contributions

may result in forfeiture of some or all of the amounts attributable to

matching contributions.  Qualified expenses include:  (1) qualified higher

education expenses (as generally defined in section 529(e)(3);

(2) first-time homebuyer costs (as generally provided in section 72 (t)(8);

(3) business capitalization or expansion costs (expenditures made pursuant

to a business plan that has been approved by the financial institution,

nonprofit, or Indian tribe); (4) rollovers of the balance of the account

(including the parallel account) to another individual development account

for the benefit of the same owner; and (5) final distributions in the case

of a deceased account owner. Withdrawals for qualified home and business

capitalization expenses must be paid directly to another financial

institution. Withdrawals for qualified educational expenses must be paid

directly to the educational institution. Such withdrawals generally are not

permitted until the account owner completes a financial education course

offered by a qualified financial institution, qualified nonprofit

organization, qualified Indian tribe or governmental entity. 

The Secretary of the Treasury (the "Secretary") is required to establish

minimum standards for such courses.  Withdrawals for nonqualified

expenses may result in the account owner's forfeiture of some amount of

matching funds.

 

The qualified entity administering the individual development account

program is generally required to make quarterly payments of matching funds

on a dollar-for-dollar basis for the first $500 contributed by the account

owner in a taxable year. This dollar amount is adjusted for inflation after

2008.  Matching funds may be provided also by State, local, or private

sources Balances of the individual development account and parallel account

are reported annually to the account owner. If an account owner ceases to

meet eligibility requirements, matching funds generally are not contributed

during the period of ineligibility.  Any amount withdrawn from a

parallel account is not includible in an eligible individual's gross income

or the account sponsor's gross income.

 

Qualified entities administering a qualified program are required to

report to the Secretary that the program is administered in accordance with

legal requirements.  If the Secretary determines that the program is not so

operated, the Secretary has the power to terminate the program. Qualified

entities also are required to report annually to the Secretary information

about: (1) the number of individuals making contributions to individual

development accounts; (2) the amounts contributed by such individuals;

(3) the amount of matching funds contributed; (4) the amount of funds

withdrawn and for what purpose; (5) balance information; and (6) any

other information that the Secretary deems necessary.

 

The Secretary is authorized to prescribe necessary regulations, including

rules to permit individual development account program sponsors to verify

eligibility of individuals seeking to open accounts.  The Secretary is also

authorized to provide rules to recapture credits claimed with respect to

individuals who forfeit matching funds.

 

Effective date.-- The proposal is effective for taxable years ending after

December 31,2007, and beginning before January 1, 2015.

 

 

                               Analysis

                                        

Policy issues

 

The proposal is intended to encourage individuals to save by providing a

subsidy to saving.  Proponents argue that many individuals have

sufficiently low income that saving is difficult, and that the subsidy will

help these individuals to accumulate savings, as well as to become more

financially literate through the programs required to be provided by the

eligible entities that may offer IDAs.

 

Opponents may argue that the generosity of the subsidy, which provides an

immediate 100 percent return to the individual's contribution, makes the

program more like an income transfer program and does not provide a

realistic picture of the normal returns to saving.  Others note that the

cap on the number of accounts to which the credit applies creates the

potential for unequal tax treatment of similarly situated individuals, and

may effectively allow financial and other eligible institutions to pick and

choose among potential beneficiaries of the individual development account

program.  Additionally, individuals without ready access to eligible

institutions are disadvantaged with respect to the ability to benefit

under the proposal.

 

Complexity issues

 

In general, adding a new credit to the tax law will tend to increase the

complexity of the tax law and will require additional Treasury or other

Governmental resources to be devoted to administration of the provisions

and to enforcement activities.  The individual development account proposal

requires additional record keeping by financial institutions benefiting

from the credit and also by account holders.  The annual reporting

requirements of the individual development account program will increase

the paperwork burden on individuals and financial institutions utilizing

the provision.  Arguably, the proposal will also add complexity in that it

will increase the number of savings incentives in the tax law, each with

different requirements.  Some might argue that consolidation of these

incentives will serve to simplify tax law and tax administration.

  

 

                                     Prior Action

                                    

Similar proposals were included in the President's fiscal year 2002, 2003,

2004, 2005,and 2006 budget proposals.

 

 

B.  Increase Section 179 Expensing

 

                                  Present Law

                                   

In lieu of depreciation, a taxpayer with a sufficiently small amount of

annual investment may elect to deduct (or "expense") such costs.  Present

law provides that the maximum amount a taxpayer may expense, for taxable

years beginning in 2003 through 2007, is $100,000 of the cost of qualifying

property placed in service for the taxable year. Additional section 179

incentives are provided with respect to a qualified property used by a

business in the New York Liberty Zone (sec. 1400L(f)), an empowerment zone

(sec. 1397A), a renewal community (sec. 1400J), or the Gulf Opportunity

Zone (sec. 1400N(e)). In general, qualifying property is defined as

depreciable tangible personal property that is purchased for use in the

active conduct of a trade or business. Off-the-shelf computer software

placed in service in taxable years beginning before 2008 is treated as

qualifying property.  The $100,000 amount is reduced (but not below zero)

by the amount by which the cost of qualifying property placed in service

during the taxable year exceeds $400,000.  The $100,000 and $400,000

amounts are indexed for inflation for taxable years beginning after 2003

and before 2008.

 

For taxable years beginning in 2008 and thereafter, a taxpayer with a

sufficiently small amount of annual investment may elect to deduct up to

$25,000 of the cost of qualifying property placed in service for the

taxable year.  The $25,000 amount is reduced (but not below zero) by the

amount by which the cost of qualifying property placed in service during

the taxable year exceeds $200,000.

 

The amount eligible to be expensed for a taxable year may not exceed the

taxable income for a taxable year that is derived from the active conduct

of a trade or business (determined without regard to this provision). 

Any amount that is not allowed as a deduction because of the taxable

income limitation may be carried forward to succeeding taxable years

(subject to similar limitations).  No general business credit under

section 38 is allowed with respect to any amount for which a deduction is

allowed under section 179.

 

An expensing election is made under rules prescribed by the Secretary

(sec. 179(c)(1)). Under Treas. Reg. sec. 1.179-5, applicable to property

placed in service in taxable years beginning after 2002 and before 2008, a

taxpayer is permitted to make or revoke an election under section 179

without the consent of the Commissioner on an amended Federal tax return

for that taxable year.  This amended return must be filed within the time

prescribed by law for filing an amended return for the taxable year.

For taxable years beginning in 2008 and thereafter, an expensing election

may be revoked only with consent of the Commissioner (sec. 179(c)(2)).

 

 

                           Description of Proposal

                          

The proposal increases permanently the amount a taxpayer may deduct under

section 179.  The proposal provides that the maximum amount a taxpayer may

expense, for taxable years beginning after 2006, is $200,000 of the cost

of qualifying property placed in service for the taxable year.  The

$200,000 amount is reduced (but not below zero) by the amount by which the

cost of qualifying property placed in service during the taxable year

exceeds $800,000.  The President's fiscal 2007 budget proposal separately

proposes permanent extension of the temporary provisions of section 179

that are in effect for taxable years beginning before 2008.  That proposal,

which is treated as underlying the increased dollar amounts of this

proposal, provides that the section 179 dollar limit amounts continued to

be indexed for inflation for taxable years beginning after 2007. In

addition, off-the-shelf computer software is treated as qualifying property.

Further, a taxpayer is permitted to make or revoke an election for a

taxable year under section 179 without the consent of the Commissioner on

an amended Federal tax return for that taxable year.  That proposal is

effective for taxable years beginning after 2007.

 

Effective date.--The proposal to increase the section 179 amounts to

$200,000 and $800,000 is effective for taxable years beginning after 2006.

 

 

                                    Analysis

                                   

The proposal would lower the after-tax cost of capital expenditures made by

eligible businesses by permitting the immediate deduction of the full

amount of the capital expenditure (i.e., expensing), rather than

depreciation of the expenditure over a series of years.  With a lower cost

of capital, it is argued that eligible businesses will invest in more

equipment and employ more workers, thus serving to stimulate economic

growth in the United States.

 

Expensing of capital expenditures is the appropriate treatment if the

objective is to tax consumption, because expensing effectively eliminates

tax on the normal returns to the marginal investment opportunity. If the

objective is to tax income, then depreciation deductions should coincide

with the economic depreciation of the asset in order to measure economic

income accurately.  A depreciation system more generous than economic

depreciation, but less generous than full expensing, results in an

effective tax rate on the income from capital that is less than the

statutory tax rate, but still positive.

 

In addition to promoting investment, advocates of expensing assert that

increased expensing eliminates depreciation recordkeeping requirements

with respect to expensed property.  Under the proposal, Federal income tax

accounting would be simplified by increasing the portion of capital costs

that are expensed in one taxable year and concomitantly reducing those

that are recovered through depreciation over a series of years.  It could

be argued that the simplification benefit of expensing is not fully

realized, however, so long as property is partially depreciated, or so

long as some but not all of the taxpayer's property that is eligible for

cost recovery is expensed; the taxpayer must still keep records for that

property that is subject to depreciation over a period of years.

 

Increasing the present-law $400,000 phaseout threshold amount to $800,000

can have the effect of generally permitting larger businesses to obtain the

tax benefit of expensing.  Some may argue that this result is inconsistent

with the idea of limiting expensing to small businesses, as under the

present-law provision.  They might alternatively argue that in an income

tax system, expanding the availability of expensing is not appropriate

because it results in broader income mismeasurement.  On the other hand,

it could be argued that there is no rationale for limiting expensing to

businesses below a particular size or with capital expenditures below a

certain level.

 

An advantage of making the increase in the expensing amounts permanent is

that it reduces uncertainty with respect to the tax treatment of future

investment, thus permitting taxpayers to plan capital expenditures with

greater focus on the underlying economics of the investments, and less

focus on tax-motivated timing of investment. Removing tax-motivated

distortions in the timing of investment may promote more efficient

allocation of economic resources.  On the other hand, legislative changes

to the expensing rules (principally temporary increases in the amount that

can be expensed) have been frequent in the past decade, and there is

nothing to suggest that additional legislative changes would not be made

to the expensing rules, whether the current expensing rules were permanent

or temporary.  Additionally, to the extent that the rationale for the

original increase in the amounts that may be expensed was to provide a

counter-cyclical short-term economic stimulus, it can be argued that it is

important that such provisions in fact be temporary.  If there is

uncertainty that a provision providing temporary tax relief may not

ultimately be temporary, it can be argued that the stimulative effect

of the provision is compromised because the taxpayer need not act within

the originally specified time frame of the provision in order to get the

tax benefits from the provision.

 

                                   Prior Action

                                  

H.R. 4297, as passed by the House (the "Tax Relief Extension Reconciliation

Act of 2005"), extends the present-law section temporary section 179 rules

for an additional two years (through taxable years beginning before 2010).

 

H.R. 4297, as amended by the Senate (the "Tax Relief Act of 2005"), also

extends the present-law section temporary section 179 rules for an

additional two years (through taxable years beginning before 2010).

 

 

                             C.  Health Care Provisions

                            

1.  Facilitate the growth of HSA-eligible health coverage

 

 

                                     Present Law

                                 

                                   

In general

 

Present law contains a number of provisions dealing with the Federal tax

treatment of health expenses and health insurance coverage.  The tax

treatment of health insurance expenses depends on whether a taxpayer is

covered under a health plan paid for by an employer, whether an individual

has self-employment income, or whether an individual itemizes deductions

and has medical expenses that exceed a certain threshold.  The tax benefits

available with respect to health care expenses also depends on the type

of coverage.

 

Exclusion for employer-provided coverage

 

In general, employer contributions to an accident or health plan are

excludable from an employee's gross income (and wages for employment tax

purposes).  This exclusion generally applies to coverage provided to

employees (including former employees) and their spouses,dependents, and

survivors. Benefits paid under employer-provided accident or health plans

are also generally excludable from income to the extent they are

reimbursements for medical care. If certain requirements are satisfied,

employer-provided accident or health coverage offered under a cafeteria

plan is also excludable from an employee's gross income and wages.  A

cafeteria plan allows employees to choose between cash and certain

nontaxable benefits, including health coverage.  Through the use of a

cafeteria plan, employees can pay for health coverage on a salary reduction

basis.

 

Present law provides for two general employer-provided arrangements that

can be used to pay for or reimburse medical expenses of employees on a

tax-favored basis: flexible spending arrangements ("FSAs") and health

reimbursement arrangements ("HRAs").  While these arrangements provide

similar tax benefits (i.e., the amounts paid under the arrangements for

medical care are excludable from gross income and wages for employment

tax purposes), they are subject to different rules.  A main distinguishing

feature between the two arrangements is that while FSAs are generally part

of a cafeteria plan and contributions to FSAs are made on a salary

reduction basis, HRAs cannot be part of a cafeteria plan and contributions

cannot be made on a salary reduction basis.   In addition, amounts in an

HRA may be used to purchase insurance as well as to reimburse expenses not

covered by insurance, while amounts in an FSA cannot be used for insurance,

but are used to pay for expenses not coverage by insurance.  Moreover, the

ability to carry over unused amounts from one year to the next is different.

An FSA may provide that amounts remaining as of the end of the year may

be used to reimburse expenses incurred within 2-½ months of the end of the

year.  Under an HRA, however, unused amounts generally may be carried

forward into the next year.  The different treatment for unused amounts

stems from the statutory rule that provides that cafeteria plans,

including salary reduction FSAs, generally may not provide for deferred

compensation.

 

Deduction for health insurance expenses of self-employed individuals

 

The exclusion for employer-provided health coverage does not apply to

self-employed individuals.  However, under present law, self-employed

individuals (i.e., sole proprietors or partners in a partnership) are

entitled to deduct 100 percent of the amount paid for health insurance for

themselves and their spouse and dependents for income tax purposes.

Itemized deduction for medical expenses Under present law, individuals who

itemize deductions may deduct amounts paid during the taxable year for

health insurance (to the extent not reimbursed by insurance or otherwise)

for the taxpayer, the taxpayer's spouse, and dependents, only to the extent

that the taxpayer's total medical expenses, including health insurance

premiums, exceeds 7.5 percent of the taxpayer's adjusted gross income.

 

Health care tax credit

 

Under the Trade Adjustment Assistance Reform Act of 2002,  certain

individuals are eligible for the health coverage tax credit ("HCTC"). 

The HCTC is a refundable tax credit for 65 percent of the cost of

qualified health coverage paid by an eligible individual.  In general,

eligible individuals are individuals receiving a trade adjustment

allowance(and individuals who would be eligible to receive such an

allowance but for the fact that they had not exhausted their regular

unemployment benefits), individuals eligible for the alternative trade

adjustment assistance program, and individuals over age 55 and receiving

pension benefits from the Pension Benefit Guaranty Corporation. The credit

is available for "qualified health insurance," which includes certain

employer-based insurance, certain State-based insurance, and in some

cases, insurance purchased in the individual market.  The credit is

available on an advance basis through a program established by the

Secretary.

 

Health savings accounts

 

In general

 

The Medicare Prescription Drug, Improvement, and Modernization Act of 2003

allows individuals with a high deductible health plan (and no other health

plan other than a plan that provides certain permitted coverage) to

establish a health savings account ("HSA").   An HSA is a tax-exempt trust

or custodial account. In general, HSAs provide tax-favored treatment for

current medical expenses as well as the ability to save on a tax-favored

basis for future medical expenses.

 

Eligible individuals

 

Eligible individuals for HSAs are individuals who are covered by a high

deductible health plan and no other health plan that is not a high

deductible health plan and which provides coverage for any benefit which

is covered under the high deductible health plan.  Individuals

entitled to benefits under Medicare are not eligible to make contributions

to an HSA.  An individual with other coverage in addition to a high

deductible health plan is still eligible for an HSA if such other coverage

is certain permitted insurance or permitted coverage.

 

A high deductible health plan is a health plan that has a deductible for

2006 that is at least $1,050 for self-only coverage or $2,100 for family

coverage and that has an out-of-pocket expense limit that is no more than

$5,250 in the case of self-only coverage and $10,500 in the case of family

coverage.   A plan is not a high deductible health plan if substantially

all of the coverage is for permitted coverage or coverage that may be

provided by permitted insurance, as described above.  A plan does not fail

to be a high deductible health plan by reason of failing to

have a deductible for preventive care.

 

Tax treatment of and limits on contributions

 

Contributions to an HSA by or on behalf of an eligible individual are

deductible (within limits) in determining adjusted gross income (i.e.,

"above-the-line") of the individual.  In addition, employer contributions

to HSAs (including salary reduction contributions made through a cafeteria

plan) are excludable from gross income and wages for employment tax

purposes.  The maximum aggregate annual contribution that can be made to

an HSA is the lesser of (1) 100 percent of the annual deductible under

the high deductible health plan, or (2) (for 2006) $2,700 in the case of

self-only coverage and $5,450 in the case of family coverage. The

annual contribution limits are increased for individuals who have attained

age 55 by the end of the taxable year. In the case of policyholders and

covered spouses who are age 55 or older, the HSA annual contribution limit

is greater than the otherwise applicable limit by $700 in 2006,

$800 in 2007, $900 in 2008, and $1,000 in 2009 and thereafter.

An excise tax applies to contributions in excess of the maximum

contribution amount for the HSA.  If an employer makes contributions to

employees' HSAs, the employer must make available comparable contributions

on behalf of all employees with comparable coverage during the same period.  

 

Taxation of distributions

 

Distributions from an HSA for qualified medical expenses of the individual

and his or her spouse or dependents generally are excludable from gross

income.  Qualified medical expenses generally are defined as under section

213(d). Qualified medical expenses do not include expenses for insurance

other than for (1) long-term care insurance, (2) premiums for health

coverage during any period of continuation coverage required by Federal

law, (3) premiums for health care coverage while an individual is receiving

unemployment compensation under Federal or State law, or (4) in the case of

an account beneficiary who has attained the age of Medicare

eligibility, health insurance premiums for Medicare, other than premiums

for Medigap policies  Such qualified health insurance premiums include,

for example, Medicare Part A and Part B premiums, Medicare HMO premiums,

and the employee share of premiums for employer-

sponsored health insurance including employer-sponsored retiree health

insurance.

 

For purposes of determining the itemized deduction for medical expenses,

distributions from an HSA for qualified medical expenses are not treated

as expenses paid for medical care under section 213.  Distributions from

an HSA that are not for qualified medical expenses are includible in

gross income.  Distributions includible in gross income are also subject

to an additional 10-percent tax unless made after death, disability, or

the individual attains the age of Medicare eligibility (i.e., age 65).

 

Archer MSAs

 

Like HSAs, an Archer MSA is a tax-exempt trust or custodial account to

which tax-deductible contributions may be made by individuals with a high

deductible health plan. Archer MSAs provide tax benefits similar to, but

generally not as favorable as, those provided by HSAs for certain

individuals covered by high deductible health plans.

 

The rules relating to Archer MSAs and HSAs are similar.  The main

differences include: (1) only self-employed individuals and employees of

small employers are eligible to have an Archer MSA; (2) for MSA purposes,

a high deductible health plan is a health plan with (a) an annual

deductible of at least $1,800 and no more than $2,700 in the case of

self-only coverage and at least $3,650 and no more than $5,450 in the case

of family coverage and (b) maximum out-of pocket expenses of no more than

$3,650 in the case of self-only coverage and no more than $6,650 in the

case of family coverage; (3) higher contributions may be made to HSAs,

and (4) the additional tax on distributions not used for medical expenses

is 15 percent rather than 10 percent.

 

After 2005, no new contributions can be made to Archer MSAs except by or

on behalf of individuals who previously had Archer MSA contributions and

employees who are employed by a participating employer.

 

 

                            Description of Proposal

In general

 

The proposal has four elements: (1) provide an above-the-line deduction and

refundable income tax credit for the purchase of HSA-eligible non-group

coverage to offset employment taxes; (2) increase the amounts that can be

contributed to HSAs and provide a refundable income tax credit to offset

employment taxes on HSA contributions not made by an employer;

(3) provide a refundable tax credit to lower income individuals for the

purchase of HSA-eligible health coverage; and (4) make other changes to

HSAs to facilitate their formation and administration.

 

Above-the-line deduction and income tax credit for the purchase of

HSA-eligible non-group coverage

 

Above-the-line deduction

 

The proposal provides an above-the-line deduction for insurance premiums

that meet the definition of a high deductible health plan under the rules

relating to HSAs.  The deduction is only allowed for insurance purchased

in the individual insurance market. As under the present-law rules

relating to HSA eligibility, an individual does not qualify for the

deduction if the individual is covered by any health plan other than the

high deductible plan for which the deduction is claimed, except for

certain permitted coverage.  The deduction is not allowed for individuals

covered by employer plans  or public plans.  Additionally, the deduction

is not allowed to an individual claiming the present-law HCTC or the

proposed refundable health insurance tax credit ("HITC") included in the

President's fiscal year 2007 budget proposal. The deduction is not allowed

for amounts paid from an HSA. An individual may not claim both the

deduction for health insurance expenses of self-employed individuals and

this proposed deduction for the same premiums.

 

Refundable credit

 

In addition to the above-the-line deduction for HSA-eligible premiums,

individuals who purchase insurance eligible for the proposed deduction are

entitled to a refundable credit equal to the lesser of (1) 15.3 percent of

the high deductible health plan premium or (2) 15.3 percent of the

individual's wages subject to employment taxes.  If the taxpayer has

wages above the Social Security wage base, the credit rate would be lower

to account for the lower rate of employment taxes on wages above the cap. 

The credit would not apply to amounts paid with HSA funds.

 

Increase in HSA contribution limit; refundable income tax credit to offset

employment taxes on HSA contributions not made by an employer

 

The maximum annual HSA contribution is increased to the out-of-pocket limit

for a participant's high deductible health plan (i.e., for 2006, $5,250

for self-only coverage and $10,500 for family coverage).  The maximum

contribution is pro rated for the number of months in the year that the

individual is an eligible individual with coverage by the high deductible

health plan.

 

As under present law, a special rule applies for determining HSA

contributions by married individuals with family high deductible health

plan coverage.  If one spouse has family coverage, both spouses are generally

treated as having family coverage. If both spouses have family coverage,

the coverage with the lowest bona fide out-of-pocket amount determines the

maximum annual HSA contribution by the couple. The maximum annual HSA

contribution based on the family high deductible health plan coverage is

divided between the spouses equally unless they agree on a different

division, which can include allocating the entire contribution to one

spouse.  If one spouse has family coverage that is not high deductible

health plan coverage, neither spouse may contribute to an HSA unless the

non-high deductible health plan does not cover both spouses.

 

Where married couples have non-overlapping coverage, they would be allowed

to "stack" the separate maximum contributions up to the out-of-pocket

maximum allowed for a family high deductible health plan to determine the

amount of the contribution.  The contributions to each spouse's HSA would

remain subject to that spouse's respective HSA contribution limit.  Family

high deductible health plan coverage that only covers a single eligible

individual is treated as self-only coverage for purposes of determining the

maximum HSA contribution.  Thus, if there is only a single eligible

individual covered by a family high deductible health plan, the maximum

HSA contribution is capped at the out-of- pocket maximum for self-only

plan.  With respect to catch up contributions, if both spouses are

eligible individuals, both spouses will be allowed to contribute the

contributions to a single HSA owned by one spouse.

 

In addition, in the case of HSA contributions made by an individual (rather

than the individual's employer), the individual is entitled to a

refundable credit equal to a percentage of such contributions to offset the

employment taxes on the contributions.  The credit is the lesser of

(1) 15.3 percent of the contributions to the HSA, or (2) 15.3 percent of

wages subject to employment taxes.  If the taxpayer has wages above the

Social Security wage cap, the credit would be lower to account for the

lower employment tax rate on wages above the cap.  If the taxpayer is also

eligible for a credit for high deductible health plan premium payments, the

OASDI portion of the employment tax in the above calculation would be

limited by the combined amount by which the applicable high deductible

health plan premium payments and applicable HSA contributions exceed the

amount of wages above the OASDI cap.  In order to recapture the credit

relating to employment taxes for contributions that are not used for

medical expenses, the additional tax on nonmedical distributions would be

increased to 30 percent, with a 15-percent rate on nonmedical

distributions after death, disability or attaining the age for

Medicare eligibility

.

Refundable tax credit for lower income individuals for the purchase of

HSA-eligible health coverage

 

The proposal provides a refundable tax credit ("health insurance tax

credit" or "HITC") for the cost of an HSA-eligible high deductible health

plan purchased by individuals who are under age 65 and who do not

participate in a public or employer-provided health plan.  The maximum

annual amount of the credit is 90 percent of premiums, up to a maximum

premium of $1,111 in the case of a policy covering only one adult, only one

child, or only two or more children; $2,222 for a policy or policies

covering two adults or one adult and one or more children; and $3,333 for a

policy or policies covering two adults plus one or more children. This

dollar amount is indexed in accordance with the medical care component of

the Consumer Price Index based on all-urban consumers.  Thus, the maximum

annual credit (prior to any indexing of the premium limit) is $3,000 per

tax return (for three or more covered individuals).  The maximum credit

rate is phased out for higher income taxpayers as described below.

 

The 90 percent credit rate is phased-down for higher income taxpayers.

Individual taxpayers filing a single return with no dependents and modified

adjusted gross income of $15,000 or less are eligible for the maximum

credit rate of 90 percent.  The credit percentage for individuals filing a

single return with no dependents is phased-down ratably from 90 percent to

50 percent for modified adjusted gross income between $15,000 and $20,000,

and phased-out completely at modified adjusted gross income of $30,000. 

 

Other taxpayers with modified adjusted gross income up to $25,000 are

eligible for the maximum credit rate of 90 percent.  The credit percentage

is phased-out ratably for modified adjusted gross income between $25,000

and $40,000 if the policy covers only one person, and for modified

adjusted gross income between $25,000 and $60,000 if the policy (or policies)

covers more than one person. Taxpayers may not claim the present-law HCTC

and this credit for the same coverage period.  In addition, taxpayers may

not claim the HITC for the same period as they claim the above-the-line

deduction for high deductible health plan premiums included in the

President's fiscal year 2007 budget proposal.

 

The credit can be claimed on the individual's tax return or, beginning in

2008, on an advanced basis, as part of the premium payment process, by

reducing the premium amount paid to the insurer. Health insurers will be

reimbursed by the Department of the Treasury for the amount of the credit.

Eligibility for the advanced credit option is based on the individual's prior

year return and there is no reconciliation on the current year return.

 

Qualifying health insurance can be purchased through the individual

insurance market, private purchasing groups, State-sponsored insurance

purchase pools, and State high-risk pools. At the option of States, after

December 31, 2007, the credit can be used by certain individuals

not otherwise eligible for public health insurance programs to buy into

privately contracted State-sponsored purchasing groups (such as Medicaid

or SCHIP purchasing pools for private insurance or State government

employee programs for States in which Medicaid or SCHIP does

not contract with private plans).  States can provide additional

contributions to individuals who purchase insurance through such

purchasing groups.  The maximum State contribution is $2,000

per adult (for up to two adults) for individuals with incomes up to 133

percent of the poverty level.  The maximum State contribution is

phased-down ratably, reaching $500 per adult at 200 percent of the poverty

level.  Individuals with income above 200 percent of the poverty level are

not eligible for a State contribution.  States are not allowed to offer

any other explicit or implicit cross subsidies.

 

Other changes relating to HSAs

 

For purposes of HSAs, qualified medical expenses include any medical

expense incurred on or after the first day of HSA-eligible coverage for a

year, regardless of whether the HSA had been established when the expense

was incurred. The HSA has to be established no later than the date for

filing the individual's tax return for the year, determined without regard

to extensions.

 

Qualified medical expenses that can be reimbursed by an HSA are expanded

to include the premiums for the purchase of HSA-eligible plans through the

individual market.

 

Employers are allowed to contribute existing HRA balances to the HSAs of

employees who would be eligible individuals but for the HRA coverage. The

contributions of the HRA balances are not taken into account for purposes

of the comparability rules, or the annual maximum HSA contributions.  Only

HRAs existing on the date of enactment qualify for the transfer and only

contributions of HRA balances made in prior taxable years beginning one

year after the date of enactment are covered.

 

Contributions to HSAs on behalf of employees who are chronically ill or

employees who have spouses or dependents who are chronically ill are

excluded from the comparability rules to the extend the contributions

exceed the comparable contributions for other employees.

 

Effective date.-The proposals are effective for taxable years beginning

after December 31, 2006.  The advanced payment option for the refundable

credit for low-income individuals is to be available beginning in 2008.

 

 

                                        Analysis

In general

 

The proposal increases incentives for individuals to purchase high

deductible health plans and contribute to HSAs.  The proposal raises both

tax and health policy issues.  The proposal is intended to increase equity

in the tax laws by providing more similar tax treatment for employer-

provided group insurance, individually purchased insurance, and

out-of-pocket health spending. The proposal is intended to create a more

market-oriented and consumer driven health care system, with a view toward

making health care more affordable and accessible.  There is substantial

disagreement among analysts as to whether the proposal will achieve the

stated goals, or will have an adverse effect on the affordability,

accessibility, and quality of health care coverage.

 

Issues under present law

 

The appropriateness of the present-law Federal tax treatment of health

expenses has been the subject of discussion over time from both tax and

health policy perspectives.  The exclusion for employer-provided health

care is typically a focal point of such discussions.  The exclusion

represents a departure from the normal income tax principle that

compensation should be included in income, and has consistently been one

of the largest three tax expenditure items.

 

The present-law favorable tax treatment of employer-provided health

coverage has generally been justified on the grounds that it encourages

employees to prefer health coverage over taxable compensation, thereby

increasing health insurance coverage and reducing the number of uninsured.

Employees in employer-provided health plans not only receive a tax

subsidy, but may also benefit from group rates which may make coverage

more affordable. From this perspective, the exclusion may be said to be

effective.  For 2005, approximately 90 million policyholders are estimated

to have employer-provided health coverage.

 

Nevertheless, the present-law rules have been the subject of a number of

criticisms.  One criticism is that present law is inequitable because

health expenses are not treated consistently. Some argue that this inequity

provides the worst treatment in some cases for those who need the tax

benefit the most, because many individuals who face the highest insurance

rates also receive no tax subsidy for the purchase of such insurance. 

 

The most favorable tax treatment under present law generally is provided to

individuals who are in an employer plan.  Such individuals may exclude from

income and wages employer-provided health insurance and, depending on the

employer's plan, may also exclude from income amounts expended for medical

care not covered by insurance.  Self-employed individuals receive the next

most favorable treatment, and may deduct 100 percent of the cost of

their health insurance. Individuals who are not self employed and pay for

their own health insurance receive the least favorable tax treatment; such

individuals may deduct the cost of health insurance only to the extent that

aggregate medical expenses exceed 7.5 percent of adjusted gross income

and only if they itemize deductions. In the case of individuals covered by

a high deductible health plan, the recently-enacted provisions relating to

HSAs alter this comparison to some extent; however, those with employer

coverage still have the highest potential tax benefit.

 

From a health policy perspective, the exclusion for employer-provided

health care has been criticized as contributing to higher health costs

because individuals are not faced with the full cost of health care.

That is, the cost of insurance or out-of-pocket expenses paid by the

individual is reduced by the tax benefit received, effectively reducing

the price of health care relative to other goods. In addition, some argue

that the unlimited exclusion for employer-provided coverage leads to very

generous insurance coverage, which further contributes to increases in

health costs because individuals are not as likely to question medical

treatments to the extent the cost is paid by a third party through

insurance. 

 

The present-law rules for HSAs were designed to provide an incentive to

purchase high deductible plans, thereby shifting more routine medical costs

from the third-party payor system to the individual. Proponents of HSAs

argue that this will cause individuals to be more conscious of health care

costs, which will ultimately lower the cost of health care generally. 

Under present law, HSAs provide at a minimum a tax benefit that is

equivalent to an above-the-line deduction for medical expenses, up to the

annual cap on contributions to the HSA.  To the extent that the taxpayer

is able to fund the HSA well in advance of the medical expenses, the

HSA provides the ability to save for medical expenses on a pre-tax basis.

If the funds in the HSA are not used for medical expenses, they may be

withdrawn subject to income tax and, prior to age 65, a 10-percent

additional income tax.  This feature provides a tax benefit similar to

that provided under a deductible IRA.  Further issues relating to HSAs are

discussed below.

 

Issues relating to the proposal

 

The proposal addresses the gap in the present-law treatment of health

expenses by providing a tax subsidy for individuals who are not self

employed and who purchase health coverage in the individual market.

Under present law, such individuals receive no tax subsidy

(except perhaps for the itemized deduction),  whereas under the proposal

such individuals are entitled either to a refundable credit or a deduction

(plus a refundable credit to approximate FICA taxes) for the purchase of a

high deductible health plan.  In addition, the proposal enhances the tax

benefits of HSA contributions by increasing the amount of the maximum

contribution and adding a refundable tax credit to approximate FICA taxes

on contributions not made by an employer.

 

A key issue that arises under the proposal is its focus on providing a

subsidy specifically for high deductible health insurance in the individual

market  (and HSAs).  Proponents of the proposal believe that the use of

high deductible plans promotes responsible health policy by making

individuals more conscious of their health care costs because fewer

expenses are paid by a third party insurer. This, in turn, is anticipated

to reduce overall health care costs.  Some proponents of such proposals

believe that many current health insurance policies cover routine

medical expenses and that the tax laws should provide a subsidy only for

insurance for unpredictable medical expenses. 

 

Those who do not favor providing additional tax benefits for high

deductible plans are concerned that such plans are likely to be more

attractive to healthier individuals, with the result that adverse selection

will occur which will erode the group market and result in higher insurance

costs for individuals with greater health risks. This may occur because

when insurance is priced on a group basis, individuals with lower health

risks in effect subsidize higher risk individuals. Tax-favored high

deductible plans are likely to be more attractive to lower risk

individuals.  If they leave the pool, however, the average cost increases

for those remaining. This, in turn, may cause more lower risk individuals

to leave the pool, with a concomitant rise in cost for those remaining.

Some argue that this effect, while likely to occur with any increased

subsidy for high deductible plans, is likely to be worse under the

proposal because the proposal only subsidizes high deductible insurance

purchased in the individual market and does not subsidize group insurance.

 

There is also disagreement regarding the effects of high deductible plans

(and HSAs) on health care costs.  As noted above, a basic premise

underlying high deductible plans is that individuals will make wiser

choices if faced with the cost of medical treatments and that this will

reduce health care costs overall. On the other hand, some note that the

existence of the HSA itself may undermine the goal of making individuals

more conscious of heath care costs because it provides a subsidy for the

first dollar of medical expenses.  Thus, medical expenses not covered by

the high deductible plan receive a tax subsidy, even though they are not

covered by insurance.  Others are concerned that even if individuals do

spend less on health costs with a high deductible plan, this may not

necessarily result in better health outcomes or a long-term reduction

in costs.  For example, it is noted that it may be very difficult for an

individual to determine whether a particular medical procedure is in fact

needed, and that some individuals will forgo needed care if it is not

covered by insurance, with the possibility that longer-term

medical costs increase.

 

As noted above, to the extent that amounts in HSAs are not used for current

medical expenses, HSAs provide a tax benefit similar to that of an IRA.

HSA proponents argue that this feature may help contribute to lowering

medical costs by in effect rewarding lower spending on medical care. 

Others argue that this feature operates to make HSAs primarily attractive

to higher income individuals who can afford to self insure for the higher

deductible under the high deductible plan and who are primarily interested

in a tax-favored savings vehicle.  It is argued that the increase in the

contribution limits under the proposal will make it even more likely that

an HSA is used in this way by higher income individuals. On the other hand,

the proposed increase in the additional tax on distributions that are not

for medical purposes could make the savings aspects of HSAs less attractive

for individuals who do not expect to have health costs in the future

(including in retirement). The proposed refundable credit for lower income

individuals is intended to provide an incentive to uninsured individuals to

purchase health insurance by providing assistance in paying

premiums.  Apart from the general issues relating to high deductible plans

discussed above, a key issue with respect to this credit is whether the

amount of the credit is sufficient to enable low-income individuals to

purchase health insurance.  This depends on the cost of insurance that

is available in the individual market, which may vary depending on the

characteristics of the individual, e.g., whether the individual is at

higher risk from a health standpoint.  Some argue that a credit for the

cost of high deductible insurance alone will not be a benefit to many

lower-income individuals, particularly those with chronic illnesses and

recurring medical costs, because it will be difficult for them to pay the

out-of-pocket expenses required under a high deductible plan.

 

The advanced payment feature of the credit is designed to assist intended

recipients who might not be able to purchase insurance without the

advanced credit.  Because advancing the credit merely changes the timing

of payment and does not reduce the cost of insurance (except for the time

value of money), this argument is best understood not as making the

insurance affordable, as is often stated, but rather in making it available

to those who would not otherwise be able to arrange the financing to pay

for the insurance in advance of receiving the credit. Given the target

population of the credit, it might reasonably be argued that for many

potential users of the credit, other financing mechanisms, such as credit

cards, loans from relatives or friends, personal savings, etc., would not

be available, or would not be used even if available, and the best way to

encourage individuals to buy insurance would be to provide the credit in

advance, at the time of purchase of the insurance.

 

In order to make the advance payment system more workable, the proposal

uses prior year income information, and does not require reconciliation

based on current year information. The trade off for this is that in some

cases the credit will be provided on an advance basis to those with current

incomes well in excess of the income limits for the credit.  In other

cases, individuals will have a current need for the credit on an advance

basis, but will not be eligible (e.g., if current year income is substantially

less than prior year income).

 

Experience with refundable credits under present law indicates that such

credits may lead to fraud and abuse by taxpayers, as it may be difficult

for the IRS to ensure that all taxpayers who claim the credit are in fact

eligible.  This effect could be reduced to the extent that an advance

payment system works efficiently and makes payments directly to insurers

or others providing bona fide coverage.  The experience with the

present-law HCTC may provide some indication of how an advance payment

mechanism may operate; however, that credit is significantly narrower in

scope than the proposed credit.

 

The multiplicity of the provisions, as well as the varying requirements

for each one will add complexity for taxpayers and the IRS.  By providing

additional options to individuals, the proposal may increase complexity

because individuals will have to determine which option is best for them.

For example, individuals eligible for the proposed refundable tax credit

for health insurance will have to determine which option is best for them

because such individuals are not eligible for both the credit and a

deduction.  Employees will also have to determine whether it is better to

remain in employer plans or to purchase a policy in the individual market.

 

Creating a new tax deduction and new credits will necessitate new lines on

the Form 1040 and additional information in instructions regarding the new

provisions.  The new provisions may also require IRS programming

modifications.  Additionally, the credit for lower-income individuals adds

new phase-outs to the numerous existing phase-outs in the Code, which

increases complexity. The advanced payment aspect of the credit also adds

additional complexity to the Code. Taxpayers would have to use different

income amounts to calculate the credit depending whether the credit is

claimed on an advanced basis or on the current year tax return.  The

proposal may also increase complexity for insurance companies by adding

administrative burdens with respect to the advanced payment of the credit.

Health insurers would be required to provide information statements to

taxpayers receiving the credit on an advanced payment basis and to the IRS,

including the policy number, the policy premium, and that the policy meets

the requirements for a qualified policy.

 

Requiring reporting by health insurers and employers could be helpful in

enforcing other aspects of the proposal, e.g., in ensuring that a taxpayer

who takes the above-the-line deduction is in fact covered by a high

deductible plan.  While any such reporting requirements would be likely to

increase compliance, they would also increase administrative burdens on

the part of those subject to the requirements.

 

Prior Action

 

Proposals similar to the above-the-line deduction were included in the

President's fiscal year 2005 and 2006 budget proposals.  Proposals similar

to the refundable credit for lower-income individuals were included in the

President's fiscal year 2002, 2003, 2004, 2005, and 2006 budget proposals.

2.  Modify the refundable credit for health insurance costs of eligible

individuals

 

                                    Present Law

                                    

Refundable health insurance credit: in general

 

Under the Trade Act of 2002, in the case of taxpayers who are eligible

individuals, a refundable tax credit is provided for 65 percent of the

taxpayer's expenses for qualified health insurance of the taxpayer and

qualifying family members for each eligible coverage month beginning in

the taxable year. The credit is commonly referred to as the health coverage

tax credit ("HCTC"). The credit is available only with respect to amounts

paid by the taxpayer. The credit is available on an advance basis.

Qualifying family members are the taxpayer's spouse and any dependent of

the taxpayer with respect to whom the taxpayer is entitled to claim a

dependency exemption.  Any individual who has other specified coverage is

not a qualifying family member.

 

Persons eligible for the credit

 

Eligibility for the credit is determined on a monthly basis. In general,

an eligible coverage month is any month if, as of the first day of the

month, the taxpayer (1) is an eligible individual, (2) is covered by

qualified health insurance, (3) does not have other specified

coverage, and (4) is not imprisoned under Federal, State, or local

authority.  In the case of a joint return, the eligibility requirements

are met if at least one spouse satisfies the requirements.  An eligible

month must begin after November 4, 2002.

 

An eligible individual is an individual who is (1) an eligible TAA

recipient, (2) an eligible alternative TAA recipient, and (3) an eligible

PBGC pension recipient.

 

An individual is an eligible TAA recipient during any month if the

individual (1) is receiving for any day of such month a trade adjustment

allowance  or who would be eligible to receive such an allowance but for

the requirement that the individual exhaust unemployment benefits before

being eligible to receive an allowance and (2) with respect to such

allowance, is covered under a certification issued under subchapter A or

D of chapter 2 of title II of the Trade Act of 1974.  An individual is

treated as an eligible TAA recipient during the first month that

such individual would otherwise cease to be an eligible TAA recipient.

 

An individual is an eligible alternative TAA recipient during any month

if the individual (1) is a worker described in section 246(a)(3)(B) of the

Trade Act of 1974 who is participating in the program established under

section 246(a)(1) of such Act, and (2) is receiving a benefit for

such month under section 246(a)(2) of such Act.  An individual is treated

as an eligible alternative TAA recipient during the first month that such

individual would otherwise cease to be an eligible TAA recipient.

 

An individual is a PBGC pension recipient for any month if he or she (1)

is age 55 or over as of the first day of the month, and (2) is receiving a

benefit any portion of which is paid by the Pension Benefit Guaranty

Corporation (the "PBGC").  The IRS has interpreted the definition of PBGC

pension recipient to also include certain alternative recipients and

recipients who have received certain lump-sum payments on or after

August 6, 2002.

 

An otherwise eligible taxpayer is not eligible for the credit for a month

if, as of the first day of the month, the individual has other specified

coverage.  Other specified coverage is (1) coverage under any insurance

which constitutes medical care (except for insurance substantially all of

the coverage of which is for excepted benefits) maintained by an employer

(or former employer) if at least 50 percent of the cost of the coverage is

paid by an employer  (or former employer) of the individual or his or her

spouse or (2) coverage under certain governmental health programs.

A rule aggregating plans of the same employer applies in determining

whether the employer pays at least 50 percent of the cost of coverage.

A person is not an eligible individual if he or she may be claimed as a

dependent on another person's tax return. A special rule applies with

respect to alternative TAA recipients.  For eligible alternative TAA

recipients, an individual has other specified coverage if the individual

is (1) eligible for coverage under any qualified health insurance (other

than coverage under a COBRA continuation provision, State-based

continuation coverage, or coverage through certain State arrangements)

under which at least 50 percent of the cost of coverage is paid or incurred

by an employer of the taxpayer or the taxpayer's spouse or (2) covered

under any such qualified health insurance under which any portion of the

cost of coverage is paid or incurred by an employer of the taxpayer or the

taxpayer's spouse.

 

Qualified health insurance

 

Qualified health insurance eligible for the credit is: (1) COBRA

continuation coverage; (2) State-based continuation coverage provided by

the State under a State law that requires such coverage; (3) coverage

offered through a qualified State high risk pool; (4) coverage under a

health insurance program offered to State employees or a comparable

program; (5) coverage through an arrangement entered into by a State and

a group health plan, an issuer of health insurance coverage, an

administrator, or an employer; (6) coverage offered through a State

arrangement with a private sector health care coverage purchasing pool;

(7) coverage under a State-operated health plan that does not receive any

Federal financial participation; (8) coverage under a group health plan

that is available through the employment of the eligible individual's

spouse; and (9) coverage under individual health insurance if the eligible

individual was covered under individual health insurance during the entire

30-day period that ends on the date the individual became separated from

the employment which qualified the individual for the TAA allowance, the

benefit for an eligible alternative TAA recipient, or a pension benefit

from the PBGC, whichever applies.

 

Qualified health insurance does not include any State-based coverage

(i.e., coverage described in (2)-(8) in the preceding paragraph), unless

the State has elected to have such coverage treated as qualified health

insurance and such coverage meets certain requirements.  Such State

coverage must provide that each qualifying individual is guaranteed

enrollment if the individual pays the premium for enrollment or

provides a qualified health insurance costs eligibility certificate and

pays the remainder of the premium.  In addition, the State-based coverage

cannot impose any pre-existing condition limitation with respect to

qualifying individuals.  State-based coverage cannot require a qualifying

individual to pay a premium or contribution that is greater than the

premium or contribution for a similarly situated individual who is not a

qualified individual.  Finally, benefits under the State-based coverage

must be the same as (or substantially similar to) benefits provided to

similarly situated individuals who are not qualifying individuals.  A

qualifying individual is an eligible individual who seeks to enroll

in the State-based coverage and who has aggregate periods of creditable

coverage  of three months or longer, does not have other specified

coverage, and who is not imprisoned.   A qualifying individual also

includes qualified family members of such an eligible individual.

 

Qualified health insurance does not include coverage under a flexible

spending or similar arrangement or any insurance if substantially all of

the coverage is of excepted benefits.

 

Other rules

 

Amounts taken into account in determining the credit may not be taken into

account in determining the amount allowable under the itemized deduction

for medical expenses or the deduction for health insurance expenses of

self-employed individuals.  Amounts distributed from a medical savings

account or health savings account are not eligible for the credit.  The

amount of the credit available through filing a tax return is reduced by

any credit received on an advance basis.  Married taxpayers filing

separate returns are eligible for the credit; however, if both spouses are

eligible individuals and the spouses file a separate return, then the

spouse of the taxpayer is not a qualifying family member.

 

The Secretary of the Treasury is authorized to prescribe such regulations

and other guidance as may be necessary or appropriate to carry out the

provision.

 

Health Insurance Portability and Accountability Act of 1996 ("HIPAA")

 

HIPAA imposed a number of requirements with respect to health coverage

that are designed to provide protections to health plan participants. 

Among other things, HIPAA generally provides that a pre-existing condition

exclusion may be imposed only if:  (1) the exclusion relates to a condition

(whether physical or mental), regardless of the cause of the condition,

for which medical advice, diagnosis, care, or treatment was recommended or

received with the 6-month period ending on the enrollment date; (2) the

exclusion extends for a period of not more than 12 months after the

enrollment date; and (3) the period of any pre-existing condition exclusion

is reduced by the length of the aggregate of the periods of creditable

coverage (if any) applicable to the participant as of the enrollment date.

In general terms, creditable coverage includes health care coverage without

a gap of more than 63 days.  Special limitations apply to exclusions in

the case of newborns, adopted children, and pregnancy.

 

                        Description of Proposal

                       

In general

 

The President's proposal modifies the health coverage tax credit in several

ways.

 

Pre-existing condition exclusion for State-based coverage

 

The proposal modifies the requirement that State-based coverage not impose

pre-existing condition limitations.  The proposal allows State-based

coverage to impose a modified pre-existing condition restriction similar

to the HIPAA rules.  The pre-existing condition exclusion can be imposed

for a period of up to 12 months, but must be reduced by the length of the

eligible individual's creditable coverage, as of the date the individual

applies for the State-based coverage.  The exclusion must relate to a

condition (whether physical or mental), regardless of the cause of the

condition, for which medical advice, diagnosis, care, or treatment was

recommended or received within the 6-month period ending on the date the

individual seeks to enroll in the coverage.  The present-law HIPAA

provisions relating to newborns, adopted children, and pregnancy apply.

 

Spouses of eligible individuals entitled to Medicare

 

The proposal also allows spouses of eligible individuals to claim the

credit even after the eligible individual becomes entitled to Medicare,

provided that the spouse (1) is at least age 55; (2) is covered by

qualified health insurance, the premium of which is paid by the taxpayer;

(3) does not have other specific coverage; and (4) is not imprisoned under

Federal, State, or local authority.

 

Other modifications

 

The proposal also makes other changes to the credit.  Under the proposal,

individuals who elect to receive one-time lump sum payments from the PBGC

and certain alternative PBGC payees are eligible for the credit.

 

The proposal provides that the Commonwealths of Puerto Rico and the

Northern Mariana Islands, and American Samoa, Guam, and the U.S. Virgin

Islands are deemed to be States for purposes of the State-based coverage

rules.

 

Additionally, under the proposal, State continuation coverage provided

under State law automatically qualifies as qualified health insurance, as

Federally-mandated COBRA continuation coverage, without having to meet the

requirements relating to State-based qualified coverage.

 

The proposal also changes the definition of other specified coverage for

eligible alternative TAA recipients by removing the special rule that

applies only to alternative TAA recipients.

 

Effective date.-The proposal modifying the requirement that there be no

imposition of a pre-existing condition exclusion is effective for eligible

individuals applying for coverage after December 31, 2006.  The proposal

relating to spouses of HCTC-eligible individuals is effective for taxable

years beginning after December 31, 2006.  The remaining proposals are

effective as if included in the Trade Act of 2002.

 

                                            Analysis

In general

 

The HCTC was enacted to assist certain individuals in paying for qualified

health insurance.  The various aspects of the proposal are intended to make

the credit available to more individuals.  Some aspects of the proposal may

be considered clarifications of present law based on current IRS

administrative positions.

 

Pre-existing condition exclusion for State-based coverage

 

The pre-existing condition provisions of present law have been noted by some

as a barrier to greater participation in the HCTC system by States.  The

proposal is intended to result in greater plan participation.  According to

the IRS, for the 2005 tax year, 40 States (including the District of

Columbia) had made available at least one State-based option (other than

State-based continuation coverage).  Nine States had available only

State-based continuation coverage, and two States did not have any

State-based coverage option.

 

Proponents argue that the change is necessary to allow States not currently

offering qualified health insurance to be able to offer qualified insurance.

Many States argue that it is difficult to implement qualifying State-based

coverage with the present-law requirement that there be no imposition of a

pre-existing condition exclusion.  Others argue that the proposed

modification would eliminate an important consumer protection afforded

under State-based coverage.  Proponents counter that the modified

requirement under the proposal, coupled with the other consumer

protections, including guaranteed issue, provides sufficient protections,

especially in the case of States where the alternative would be no

qualifying State-based coverage.  Critics argue that if State-based

coverage must satisfy the present-law requirement, States will eventually

produce a qualifying option which will allow its citizens access to the

credit while maintaining the protection.  They argue that since the vast

majority of States have been able to produce a qualifying option under the

present-law requirements, the few States that have not offered qualified

insurance should not be afforded a less stringent rule.

 

Spouses of eligible individuals entitled to Medicare

 

Under present law, once an otherwise eligible individual is entitled to

benefits under Medicare, the spouse of the individual is no longer eligible

for the HCTC, even if the spouse is not entitled to benefits under Medicare

(i.e., is younger). In such cases, loss of the credit may result in loss of

health care coverage.  The proposal is intended to prevent such a result.

 

Eligible individuals

 

Under the proposal, individuals who elect to receive one-time lump-sum

payments from the PBGC are eligible for the credit.  While the IRS has

interpreted the credit as applying to individuals who receive a one-time

lump sum from the PBGC and certain alternative PBGC payees, clarifying

statutorily that such individuals are eligible individuals will simplify

administration of the credit.  Many believe that individuals who receive a

one-time lump-sum pension payment in lieu of an annuity should not be

ineligible for the credit simply because they are not receiving payments

on a monthly basis.  In general, lump-sum payments are only received if

the value of the benefit is $5,000 or less.  Given the relatively small

amount of the payments, most agree that requiring participants to take

an annuity in order to qualify for the credit is not desirable. 

 

The proposal also provides that certain alternative PBGC payees are

eligible for the credit.  In general, alternative PBGC payees include

alternative payees under a qualified domestic relations order and

beneficiaries of deceased employees who are receiving payments

from the PBGC.  Many believe that fairness requires that such individuals

should be treated as eligible PBGC pension recipients.

 

Certain commonwealths and possessions

 

Under present law, if an individual meets the definition of an eligible

individual, residents of the possessions and commonwealths may be eligible

for the credit; however, because the possession or commonwealth in which

they live is not able to offer qualified health insurance, such individuals

may be unable to access the credit.  The proposal would allow certain

possessions and commonwealths to offer qualified health insurance on the

same basis as States. Proponents argue that since the credit is targeted

to specific groups of individuals (i.e., individuals receiving benefits

under TAA or from the PBGC), residents of such commonwealths and

possessions who are eligible individuals should not be denied the credit

because their residence cannot offer a qualified State-based option.

 

While residents of the possessions and commonwealths are U.S. citizens,

special tax rules apply.  Some question whether it is appropriate to

provide a refundable health tax credit to residents of possessions and

commonwealths who may never pay U.S. tax.  Certain other tax credits are

not available to such individuals.  For example, the earned income credit

and child tax credit are generally not available to such residents.

 

State continuation coverage

 

The proposal providing that State continuation coverage automatically

qualifies as qualified health insurance results in removing certain

State-based coverage requirements from State continuation coverage. 

These requirements include guaranteed issue, no imposition of pre-existing

conditions (as modified by this proposal), nondiscriminatory premiums and

similar benefits. Proponents argue that many States lack qualified

State-based coverage and allowing State continuation coverage to

automatically qualify would allow more individuals access to the

credit.  Proponents also argue that since State continuation coverage

is similar to COBRA continuation, which is not subject to the State-based

coverage requirements, it is appropriate to waive such requirements for

State continuation coverage.  Proponents argue that it is

inappropriate for the State-based coverage requirements to apply to State

continuation coverage as certain rules applicable to State continuation

coverage are inconsistent with such requirements.

 

Critics argue that it is extremely important for individuals to have the

protections relating to guaranteed issue, pre-existing conditions,

nondiscriminatory premiums and similar benefits.They argue that if the

applicable requirements are waived, individuals will lose valuable rights

with respect to their health care.  In addition, opponents argue that if

State continuation coverage automatically meets the requirements for

qualified health insurance, States will be less inclined to work towards

producing a qualifying option that includes the otherwise applicable

requirements.  Critics of the proposal argue that if all State-based

coverage must satisfy the requirements, States will eventually produce

a qualifying option which will allow its citizens access to the credit

while retaining the important consumer protections.  This change is viewed

by critics as a substantive change from what was originally intended,

rather than a clarification of present law.

 

Other specified coverage of alternative TAA recipients

 

The proposal also changes the definition of other specified coverage for

eligible alternative TAA recipients by removing the special rule that

applies only to alternative TAA recipients, which results in applying the

same definition of other specified coverage to all eligible individuals.

Under the proposal, for all eligible individuals, specified coverage would

include coverage under a health plan maintained by an employer (except for

insurance substantially all of which is for excepted benefits) than pays

at least 50 percent of the cost of coverage and certain governmental health

programs.  Proponents argue that the proposal would reduce complexity in

administering the credit, as similar rules would apply to all individuals. 

Some argue that despite the complexity in having different rules, the

special rule for alternative TAA recipients should be retained.

 

                                    Prior Action

                                   

A similar proposal was included in the President's fiscal year 2006 budget

proposal.  Several components of the proposal were included in the

President's fiscal year 2005 budget proposal.

 

3. Expand human clinical trial expenses qualifying for the orphan drug

tax credit

 

                                   Present Law

 

Taxpayers may claim a 50-percent credit for expenses related to human

clinical testing of drugs for the treatment of certain rare diseases and

conditions, generally those that afflict less than 200,000 persons in the

United States.  Qualifying expenses are those paid or incurred by the

taxpayer after the date on which the drug is designated as a potential

treatment for a rare disease or disorder by the Food and Drug

Administration ("FDA") in accordance with section 526 of the

Federal Food, Drug, and Cosmetic Act.

 

                                 Description of Proposal

                                 

The proposal expands qualifying expenses to include those expenses related

to human clinical testing paid or incurred after the date on which the

taxpayer files an application with the FDA for designation of the drug

under section 526 of the Federal Food, Drug, and Cosmetic Act as a

potential treatment for a rare disease or disorder, if certain conditions

are met.  Under the proposal, qualifying expenses include those expenses

paid or incurred after the date on which the taxpayer files an application

with the FDA for designation as a potential treatment for a rare

disease or disorder if the drug receives FDA designation before the due

date (including extensions) for filing the tax return for the taxable year

in which the application was filed with the FDA.  As under present law,

the credit may only be claimed for such expenses related to drugs

designated as a potential treatment for a rare disease or disorder

by the FDA in accordance with section 526 of such Act.

 

Effective date.–The provision is effective for qualified expenditures

incurred after December 31, 2005.

 

                                    Analysis

                                   

Approval for human clinical testing and designation as a potential

treatment for a rare disease or disorder require separate reviews within

the FDA.  As a result, in some cases, a taxpayer may be permitted to begin

human clinical testing prior to a drug being designated as a

potential treatment for a rare disease or disorder.  If the taxpayer delays

human clinical testing in order to obtain the benefits of the orphan drug

tax credit, which currently may be claimed only for expenses incurred

after the drug is designated as a potential treatment for a rare disease or

disorder, valuable time will have been lost and Congress's original intent

in enacting the orphan drug tax credit will have been partially thwarted.

 

For those cases where the process of filing an application and receiving

designation as a potential treatment for a rare disease or disorder occurs

sufficiently expeditiously to fall entirely within the taxpayer's taxable

year plus permitted filing extension, the proposal removes the

potential financial benefit from delaying clinical testing.  While such

an outcome may well describe most applications, in some cases, particularly

for applications filed near the close of a taxpayer's taxable year, there

may be some uncertainty that designation will be made in a timely

manner. In such a case, the taxpayer is in the same position as present

law and may choose to delay filing the appropriate application until the

beginning of his next taxable year.

 

The FDA is required to approve drugs for human clinical testing.  Such

approval creates a unique starting point from which human clinical testing

expenses can be measured.  An alternative proposal would be to expand

qualifying expenses to include those expenses paid or incurred after the

date on which the taxpayer files an application with FDA for designation

of the drug as a potential treatment for a rare disease or disorder,

regardless of whether the designation is approved during the taxable year

in which the application is filed.  Such an alternative proposal would

provide more certainty to the taxpayer regarding clinical expenses

eligible for the credit.  However, unlike the current proposal, such an

alternative may create the additional taxpayer burden of requiring the

taxpayer to file an amended return to claim credit for qualifying

costs related to expenses incurred in a taxable year prior to designation.

The staff of the Joint Committee on Taxation recommended a change similar

to the current proposal as part of its 2001 simplification study.

 

                                 Prior Action

 

An identical proposal was part of the President's fiscal year 2005 and 2006

budget proposals.  A similar proposal was part of the President's fiscal

year 2004 budget proposal

 

D.  Provisions Relating to Charitable Giving

 

1.  Permit tax-free withdrawals from individual retirement arrangements for

charitable contributions

 

                                  Present Law

                                 

In general

 

If an amount withdrawn from a traditional individual retirement arrangement

("IRA") or a Roth IRA is donated to a charitable organization, the rules

relating to the tax treatment of withdrawals from IRAs apply, and the

charitable contribution is subject to the normally applicable limitations

on deductibility of such contributions.

 

Charitable contributions

 

In computing taxable income, an individual taxpayer who itemizes deductions

generally is allowed to deduct the amount of cash and up to the fair market

value of property contributed to an organization described in section

170(c), including charities and Federal, State, and local governmental

entities.  The deduction also is allowed for purposes of calculating

alternative minimum taxable income. 

 

The amount of the deduction allowable for a taxable year with respect to a

charitable contribution of property may be reduced depending on the type

of property contributed, the type of charitable organization to which the

property is contributed, and the income of the taxpayer.

 

A taxpayer who takes the standard deduction (i.e., who does not itemize

deductions) may not take a separate deduction for charitable contributions.

 

A payment to a charity (regardless of whether it is termed a

"contribution") in exchange for which the donor receives an economic

benefit is not deductible, except to the extent that the donor can

demonstrate, among other things, that the payment exceeds the fair market

value of the benefit received from the charity.  To facilitate

distinguishing charitable contributions from purchases of goods or services

from charities, present law provides that no charitable contribution

deduction is allowed for a separate contribution of $250 or more unless

the donor obtains a contemporaneous written acknowledgement of the

contribution from the charity indicating whether the charity provided any

good or service (and an estimate of the value of any such good or service)

to the taxpayer in consideration for the contribution.  In addition,

present law requires that any charity that receives a contribution

exceeding $75 made partly as a gift and partly as consideration for goods

or services furnished by the charity (a "quid pro quo"contribution) is

required to inform the contributor in writing of an estimate of the value

of the goods or services furnished by the charity and that only the portion

exceeding the value of the goods or services is deductible as a charitable

contribution.

 

Under present law, total deductible contributions of an individual taxpayer

to public charities, private operating foundations, and certain types of

private nonoperating foundations may not exceed 50 percent of the

taxpayer's contribution base, which is the taxpayer's adjusted

gross income for a taxable year (disregarding any net operating loss

carryback).  To the extent a taxpayer has not exceeded the 50-percent

limitation, (1) contributions of capital gain property to public charities

generally may be deducted up to 30 percent of the taxpayer's contribution base;

(2) contributions of cash to private foundations and certain other

charitable organizations generally may be deducted up to 30 percent of the

taxpayer's contribution base; and (3) contributions of capital gain

property to private foundations and certain other charitable

organizations generally may be deducted up to 20 percent of the taxpayer's

contribution base.

 

Contributions by individuals in excess of the 50-percent, 30-percent, and

20-percent limits may be carried over and deducted over the next five

taxable years, subject to the relevant percentage limitations on the

deduction in each of those years.

 

In addition to the percentage limitations imposed specifically on

charitable contributions, present law imposes an overall limitation on

most itemized deductions, including charitable contribution deductions,

for taxpayers with adjusted gross income in excess of a threshold amount,

which is indexed annually for inflation. The threshold amount for 2006 is

$150,500 ($75,250 for married individuals filing separate returns).

For those deductions that are subject to the limit, the total amount of

itemized deductions is reduced by three percent of adjusted gross

income over the threshold amount, but not by more than 80 percent of

itemized deductions subject to the limit.  Beginning in 2006, the overall

limitation on itemized deductions phases out for all taxpayers. The overall

limitation on itemized deductions is reduced by one-third in taxable years

beginning in 2006 or 2007, and by two-thirds in taxable years beginning in

2008 or 2009. The overall limitation on itemized deductions is eliminated

for taxable years beginning after December 31, 2009; however, this

elimination of the limitation sunsets on December 31,2010.

 

In general, a charitable deduction is not allowed for income, estate, or

gift tax purposes if the donor transfers an interest in property to a

charity (e.g., a remainder) while also either retaining an interest in

that property (e.g., an income interest) or transferring an interest in

that property to a noncharity for less than full and adequate

consideration.  Exceptions to this general rule are provided for, among

other interests, remainder interests in charitable remainder annuity

trusts, charitable remainder unitrusts, and pooled income funds, and

present interests in the form of a guaranteed annuity or a fixed

percentage of the annual value of the property.   For such interests,

a charitable deduction generally is allowed to the extent of the present

value of the interest designated for a charitable organization.

 

IRA rules

 

Within limits, individuals may make deductible and nondeductible

contributions to a traditional IRA.  Amounts in a traditional IRA are

includible in income when withdrawn (except to the extent the withdrawal

represents a return of nondeductible contributions).  Individuals also

may make nondeductible contributions to a Roth IRA.  Qualified withdrawals

from a Roth IRA are excludable from gross income.  Withdrawals from a Roth

IRA that are not qualified withdrawals are includible in gross income to

the extent attributable to earnings.  Includible amounts withdrawn from a

traditional IRA or a Roth IRA before attainment of age 59-½ are

subject to an additional 10-percent early withdrawal tax, unless an

exception applies.  Under present law, minimum distributions are required

to be made from tax-forward retirement arrangements, including IRAs.

Minimum required distributions from a traditional IRA must generally begin

by the April 1 of the calendar year following the year in which the IRA

owner attains age 70-½.

 

If an individual has made nondeductible contributions to a traditional IRA,

a portion of each distribution from an IRA is nontaxable until the total

amount of nondeductible contributions has been received.  In general, the

amount of a distribution that is nontaxable is determined by multiplying

the amount of the distribution by the ratio of the remaining nondeductible

contributions to the account balance.  In making the calculation, all

traditional IRAs of an individual are treated as a single IRA, all

distributions during any taxable year are treated as a single distribution,

and the value of the contract, income on the contract, and investment in

the contract are computed as of the close of the calendar year.

 

In the case of a distribution from a Roth IRA that is not a qualified

distribution, in determining the portion of the distribution attributable

to earnings, contributions and distributions are deemed to be distributed

in the following order: (1) regular Roth IRA contributions; (2) taxable

conversion contributions; (3) nontaxable conversion contributions;

and (4) earnings.  In determining the amount of taxable distributions from

a Roth IRA, all Roth IRA distributions in the same taxable year are treated

as a single distribution, all regular Roth IRA contributions for a year are

treated as a single contribution, and all conversion contributions

during the year are treated as a single contribution.

 

 

                                   Description of Proposal

                                  

The proposal provides an exclusion from gross income for otherwise taxable

IRA withdrawals from a traditional or a Roth IRA for distributions to a

qualified charitable organization.  The exclusion does not apply to

indirect gifts to a charity through a split interest entity, such as a

charitable remainder trust, a pooled income fund, or a charitable gift

annuity.  The exclusion is available for distributions made after the date

the IRA owner attains age 65 and applies only to the extent the individual

does not receive any benefit in exchange for the transfer. Amounts

transferred directly from the IRA to the qualified charitable organization

are treated as a distribution for purposes of the minimum distribution

rules applicable to IRAs.  No charitable contribution deduction is allowed

with respect to any amount that is excluded from income under

this provision.  Amounts transferred from the IRA to the qualified

charitable organization that would not be taxable if transferred directly

to the individual, such as a qualified distribution from a Roth IRA or the

return of nondeductible contributions from a traditional IRA, are subject

to the present law charitable contribution deduction rules.

 

Effective date.  The proposal is effective for distributions made after

the date of enactment.

 

 

                                         Analysis

                                         

Policy issues

 

In general, the proposal is intended to enable IRA owners to give a portion

of their IRA assets to charity without being subject to the charitable

contribution percentage limitations or the overall limitation on itemized

deductions.  Present law requires an IRA owner to take the IRA distribution

into income, give the money to a qualified charity, and then claim a

deduction for the gift.  However, the deduction is subject to the

percentage limitations of section 170 and to the overall limit on itemized

deductions. The proposal will allow an IRA owner to avoid these limitations

and therefore might encourage additional charitable giving by increasing

the tax benefit of the donation for those who would not be able to fully

deduct the donation by reason of the present-law limitations.  However,

some argue that the proposal merely avoids present-law limitations on

charitable contributions that will be made in any event and will not

encourage additional giving.

 

Further, some question the appropriateness of limiting the tax benefits

of the provision to IRA owners.  That is, if the limits on charitable

deductions are determined to be undesirable,they should be removed for all

taxpayers, not only those that are able to make charitable contributions

through an IRA.  In addition, the proposal will alter present law and give

IRA owners a tax benefit for charitable contributions even if they do not

itemize deductions.  For example, under present law, a taxpayer who takes

the standard deduction cannot claim a charitable contribution deduction;

however, under the proposal, a taxpayer can both claim the standard

deduction and benefit from the exclusion.  Therefore, under the proposal,

it might be beneficial for taxpayers who itemize their deductions but have

a significant amount of charitable deductions to make their charitable

contributions through the IRA and then claim the standard deduction.

 

In addition, some argue that the proposal will inappropriately encourage

IRA owners to use retirement monies for nonretirement purposes (by making

such use easier and providing greater tax benefits in some cases). To the

extent that the proposal will spur additional gifts by circumventing the

percentage limitations, IRA owners may spend more of their retirement

money for nonretirement purposes than under present law.  Some also argue

that, in the early years of retirement, an individual might not accurately

assess his or her long-term retirement income needs.  For example, the

individual might not make adequate provision for health care or

long-term care costs later in life.  Some therefore argue that IRA

distributions to charity should be permitted, if at all, only after age 70.

 

Complexity issues

 

The proposal adds complexity to the tax law by creating an additional set

of rules applicable to charitable contributions.  Taxpayers who own IRAs

and make such contributions will need to review two sets of rules in order

to determine which applies to them and which is the most advantageous. 

The proposal may increase the complexity of making charitable

contributions because individuals who are able and wish to take advantage

of the tax benefits provided by the proposal will need to make the

contribution through the IRA rather than directly. The proposal also may

increase complexity in tax planning as the proposal might make it

beneficial for some taxpayers to take the standard deduction and make all

charitable contributions through their IRAs.

 

In some cases, taxpayers may need to apply both sets of rules to a single

contribution from an IRA. This will occur if the IRA distribution includes

both taxable amounts (which would be subject to the rules in the proposal)

and nontaxable amounts (which would be subject to the present-law rules).

As discussed above, the effect of the proposal is to eliminate certain

present-law limits on charitable deductions for IRA owners.  A simpler

approach is to eliminate such limits with respect to all charitable

contributions.  Providing a single rule for charitable contributions

would make the charitable deduction rules easier to understand for all

taxpayers making such contributions.

 

                                 Prior Action

                                

A similar proposal was included in the President's fiscal years 2004, 2005,

and 2006 budget proposals.  The President's fiscal years 2002 and 2003

budget proposals included a similar proposal, except that the exclusion

would have applied to distributions made on or after the date the IRA

owner attained age 59-½.

 

H.R. 4297, as amended by the Senate (the "Tax Relief Act of 2005"),

includes a similar provision that would have provided an exclusion for an

otherwise taxable distribution from an IRA that was made (1) directly to a

charitable organization on or after the date the IRA owner attains age

70-½, or (2) to a split interest entity on or after the date the IRA owner

attains age  59- ½.

 

2.  Expand and increase the enhanced charitable deduction for contributions

of food inventory

 

                                   Present Law

                                  

Under present law, a taxpayer's deduction for charitable contributions of

inventory generally is limited to the taxpayer's basis (typically, cost)

in the inventory, or if less the fair market value of the inventory. 

For certain contributions of inventory, C corporations may claim an

enhanced deduction equal to the lesser of (1) basis plus one-half of the

item's appreciation (i.e., basis plus one half of fair market value in

excess of basis) or (2) two times basis (sec. 170(e)(3)).  In general, a

C corporation's charitable contribution deductions for a year may not

exceed 10 percent of the corporation's taxable income (sec. 170(b)(2)).

To be eligible for the enhanced deduction, the contributed property

generally must be inventory of the taxpayer, contributed to a charitable

organization described in section 501(c)(3) (except for private

nonoperating foundations), and the donee must (1) use the property

consistent with the donee's exempt purpose solely for the care of the ill,

the needy, or infants, (2) not transfer the property in exchange for money,

other property, or services, and (3) provide the taxpayer a written

statement that the donee's use of the property will be consistent with

such requirements.  In the case of contributed property subject to

the Federal Food, Drug, and Cosmetic Act, the property must satisfy the

applicable requirements of such Act on the date of transfer and for 180

days prior to the transfer.

 

A donor making a charitable contribution of inventory must make a

corresponding adjustment to the cost of goods sold by decreasing the cost

of goods sold by the lesser of the fair market value of the property or

the donor's basis with respect to the inventory (Treas. Reg.

sec.1.170A-4A(c)(3)).  Accordingly, if the allowable charitable deduction

for inventory is the fair market value of the inventory, the donor reduces

its cost of goods sold by such value,with the result that the difference

between the fair market value and the donor's basis may still be recovered

by the donor other than as a charitable contribution.

 

To use the enhanced deduction, the taxpayer must establish that the fair

market value of the donated item exceeds basis.The valuation of food

inventory has been the subject of disputes between taxpayers and the IRS.

Under the Katrina Emergency Tax Relief Act of 2005, any taxpayer, whether

or not a C corporation, engaged in a trade or business is eligible to

claim the enhanced deduction for certain donations made after

August 28, 2005, and before January 1, 2006, of food inventory.  For

taxpayers other than C corporations, the total deduction for donations

of food inventory in a taxable year generally may not exceed 10 percent

of the taxpayer's net income for such taxable year from all sole

proprietorships, S corporations, or partnerships (or other entity that

is not a C corporation) from which contributions of "apparently wholesome

food" are made.  "Apparently wholesome food" is defined as food intended

for human consumption that meets all quality and labeling standards imposed

by Federal, State, and local laws and regulations even though the

food may not be readily marketable due to appearance, age, freshness,

grade, size, surplus, or other conditions.

 

                                Description of Proposal

 

Under the proposal, the enhanced deduction for donations of food inventory

is increased to the lesser of (1) fair market value, or (2) two times the

taxpayer's basis in the contributed inventory.  In addition, any taxpayer

engaged in a trade or business, whether or not a C corporation, is eligible

to claim an enhanced deduction for donations of food inventory. The

deduction for donations by S corporations and noncorporate taxpayers is

limited to 10 percent of the net income from the associated trade or

business.  The proposal provides a special rule that would permit certain

taxpayers with a zero or low basis in the food donation (e.g., taxpayers

that use the cash method of accounting for purchases and sales, and

taxpayers that are not required to capitalize indirect costs) to assume a

basis equal to 25 percent of the food's fair market value.  In such cases,

the allowable charitable deduction will equal 50 percent of the food's

fair market value.  The enhanced deduction for food inventory will be

available only for food that qualifies as "apparently wholesome food"

(defined as food that is intended for human consumption that meets all

quality and labeling standards imposed by Federal, State, and local laws

and regulations even though the food may not be readily marketable due to

appearance, age freshness, grade, size, surplus, or other conditions). 

The proposal provides that the fair market value of apparently wholesome

food that cannot or will not be sold solely due to internal

standards of the taxpayer or lack of market would be determined by taking

into account the price at which the same or substantially the same food

items (taking into account both type and quality) are sold by the taxpayer

at the time of the contribution or, if not so sold at such time, in

the recent past.

 

Effective date.--The proposal is effective for taxable years beginning

after December 31,2005.

 

                                      Analysis

Policy issues

 

In the absence of the enhanced deduction of present law, if the taxpayer

were to dispose of excess inventory by dumping the excess food in a garbage

dumpster, the taxpayer generally could claim the purchase price of the

inventory (the taxpayer's basis in the property) as an expense against his

or her gross income. In the absence of the enhanced deduction of present

law, if the taxpayer were to donate the excess food inventory to a

charitable organization that maintains a food bank, the taxpayer generally

would be able to claim a charitable deduction equal to the taxpayer's basis

in the food inventory (subject to certain limits on charitable

contributions). Viewed from the taxpayer's profit motive, the taxpayer

would be indifferent between donating the food or dumping the food in a

garbage dumpster.  If the taxpayer must incur cost to deliver the food to

the charity that maintains the food bank, the taxpayer would not find it

in his or her financial interest to donate the excess food inventory to

the food bank.  The enhanced deduction creates an incentive for the

taxpayer to contribute excess food inventory to charitable organizations

that provide hunger relief.

 

In general, the proposal is intended to give businesses greater incentive

to contribute food to those in need.  By increasing the value of the

enhanced deduction, up to the fair market value of the food, and by

clarifying the definition of fair market value, the proposal is intended

to encourage more businesses to donate more food to charitable

organizations that provide hunger relief. However, some argue that if the

intended policy is to support food programs for the needy, it would be

more direct and efficient to provide a direct government subsidy instead of

making a tax expenditure through the tax system, which may result in abuse

and cannot be monitored under the annual budgetary process. On the other

hand, proponents of the proposal likely would argue that a government

program would be less effective in identifying the needy and overseeing

delivery of the food than would the proposal.

 

More specifically, critics argue that the definition of fair market value

under the proposal is too generous because it may permit taxpayers to claim

as fair market value the full retail price of food that was no longer fresh

when donated.  If so, taxpayers might be better off contributing the food

to charity than by selling the food in the ordinary course of their

business.  For example, assume a taxpayer whose income is taxed at the

highest corporate income tax rate of 35 percent has purchased an avocado

for $0.75.  The taxpayer previously could have sold the avocado for

$1.35, but now could only sell the avocado for $0.30.  If the taxpayer

sold the avocado for $0.30,the taxpayer would incur a loss of $0.45 ($0.75

basis minus $0.30 sales revenue) on the sale. Because the loss on the

sale of the avocado reduces the taxpayer's taxable income, the taxpayer's

tax liability would decline by approximately $0.16 ($0.45 multiplied by 35

percent), so the net loss from the sale in terms of after-tax income would

be $0.29.  If, alternatively, the taxpayer had donated the avocado to the

local food bank, and under the proposal were allowed to claim a deduction

for the previous fair market value of $1.35, the taxpayer's taxable income

would be reduced by $1.35 resulting in a reduction in tax liability of

approximately $0.47 ($1.35 multiplied by 35 percent). However, the

taxpayer originally purchased the avocado for $0.75 and, as the avocado is

donated, this expense cannot be deducted as a cost of goods sold.  By

donating the avocado, the taxpayer's net loss on the avocado is $0.28

(the $0.47 in income tax reduction minus the cost of acquiring the avocado,

$0.75). Under the proposal, the taxpayer loses less on the avocado by

donating the avocado to charity than by selling the avocado. 

 

This possible outcome is a result of permitting a deduction for a value

that the taxpayer may not be able to achieve in the market.  Whether sold

or donated, the taxpayer incurred a cost to acquire the good. When a good is

donated, it creates "revenue" for the taxpayer by reducing his or her

taxes otherwise due.  When the value deducted exceeds the revenue potential

of an actual sale, the tax savings from the charitable deduction can

exceed the sales revenue from a sale. While such an outcome is possible,

in practice it may not be the norm.  In part because the proposal limits

the enhanced deduction to the lesser of the measure of fair market value

or twice the taxpayer's basis, it can only be more profitable to donate

food than to sell food if the taxpayer would otherwise be selling the food

to be donated at a loss.  In general, it depends upon the amount by which

the deduction claimed exceeds the taxpayer's basis in the food relative to

the extent of the loss the taxpayer would incur from a sale.

 

In addition, to the extent the proposal would subsidize food disposal,

companies producing food may take less care in managing their inventories

and might have less incentive to sell aging food by lowering prices,

knowing that doing so might also reduce the value of an eventual deduction.

Critics also argue that the proposal would in effect provide a deduction

for the value of services, which are not otherwise deductible, because in

some cases, services are built into the fair market value of food.

 

Complexity issues

 

The proposal has elements that may both add to and reduce complexity of

the charitable contribution deduction rules. Under present law, the general

rule is that charitable gifts of inventory provide the donor with a

deduction in the amount of the donor's basis in the inventory. 

The Code currently contains several exceptions: a special rule for

contributions of inventory that is used by the donee solely for the care

of the ill, the needy, or infants, a special rule for contributions of

scientific property used for research, and a special rule for contributions

of computer technology and equipment used for educational purposes.

Each special rule has distinct requirements.  The proposal would add

another special rule, with its own distinct requirements, thereby

increasing the complexity of an already complex section of the Code.  The

proposal also could decrease complexity, however, because it would provide

a definition of fair market value.  Under current law, valuation of food

inventory has been a disputed issue between taxpayers and the IRS and a

cause of uncertainty for taxpayers when claiming the deduction. Another

interpretative issue could arise in deciding whether the contributed food

is "substantially" the same as other food items sold by the taxpayer for

purposes of determining fair market value of the food.

 

Taxpayers who contribute food inventory must consider multiple factors to

ensure that they deduct the permitted amount (and no more than the

permitted amount) with respect to contributed food.  Taxpayers who are

required to maintain inventories for their food purchases must compare the

fair market value of the contributed food with the basis of the food (and

twice the basis of the food), and coordinate the resulting contribution

deduction with the determination of cost of goods sold.   Taxpayers who are

not required to maintain inventories for their food purchases generally

will have a zero or low basis in the contributed food, but are permitted

to use a deemed basis rule that provides such taxpayers a contribution

deduction equal to 50 percent of the food's fair market value.  Taxpayers

who are not required to maintain inventories need not coordinate cost of

goods sold deductions or inventory adjustments with contribution

deductions, and are not required to recapture the previously expensed

costs associated with the contributed food.  

 

                                     Prior Action

                                    

The President's fiscal year 2003, 2004, 2005, and 2006 budget proposals

contained a similar proposal. 

 

 

3.  Reform excise tax based on investment income of private foundations

 

                                  Present Law

                                 

Under section 4940(a) of the Code, private foundations that are recognized

as exempt from Federal income tax under section 501(a) of the Code are

subject to a two-percent excise tax on their net investment income. Private

foundations that are not exempt from tax, such as certain charitable

trusts, also are subject to an excise tax, under section 4940(b). 

 

Net investment income generally includes interest, dividends, rents,

royalties, and capital gain net income, and is reduced by expenses incurred

to earn this income. The two-percent rate of tax is reduced to one-percent

in any year in which a foundation exceeds the average historical level of

its charitable distributions.  Specifically, the excise tax rate is

reduced if the foundation's qualifying distributions (generally, amounts

paid to accomplish exempt purposes)  equal or exceed the sum of (1) the

amount of the foundation's assets for the taxable year multiplied by the

average percentage of the foundation's qualifying distributions over the

five taxable years immediately preceding the taxable year in question, and

(2) one percent of the net investment income of the foundation for the

taxable year.   In addition, the foundation cannot have been subject to

tax in any of the five preceding years for failure to meet minimum

qualifying distribution requirements.

 

The tax on taxable private foundations under section 4940(b) is equal to

the excess of the sum of the excise tax that would have been imposed under

section 4940(a) if the foundation was tax exempt and the amount of the

unrelated business income tax that would have been imposed if

the foundation were tax exempt, over the income tax imposed on the

foundation under subtitle A of the Code.  Exempt operating foundations are

exempt from the section 4940 tax.

 

Nonoperating private foundations are required to make a minimum amount of

qualifying distributions each year to avoid tax under section 4942.

The minimum amount of qualifying distributions a foundation has to make to

avoid tax under section 4942 is reduced by the amount of section 4940

excise taxes paid.

 

                            Description of Proposal

 

The proposal replaces the two rates of excise tax on private foundations

with a single rate of tax and sets the rate at one percent. Thus, under the

proposal, a tax-exempt private foundation is subject to tax on one percent

of its net investment income.  A taxable private foundation is subject to

tax on the excess of the sum of the one percent excise tax and the amount

of the unrelated business income tax (both calculated as if the foundation

were tax-exempt) over the income tax imposed on the foundation.

The proposal repeals the special one-percent excise tax for private

foundations that exceed their historical level of qualifying distributions.

 

Effective date.--The proposal is effective for taxable years beginning

after December 31, 2005.

 

 

                                      Analysis

                                     

The proposal has the effect of increasing the required minimum charitable

payout for private foundations that pay the excise tax at the two-percent

rate.   This may result in increased charitable distributions for private

foundations that pay only the minimum in charitable distributions under

present law. For example, if a foundation is subject to the two-percent

excise tax on net investment income, the foundation reduces the amount of

required charitable distributions by the amount of excise tax paid.

Because the proposal decreases the amount of excise tax paid on net

investment income for such foundations, the proposal increases such

foundations' required minimum amount of charitable distributions by an

amount equal to one percent of the foundation's net investment income.

Thus, the proposal results in an increase of required charitable

distributions in the case of foundations paying the two-percent rate and

distributing no greater than the required minimum under present law.

Foundations paying the two-percent rate that exceed the required minimum

under present law generally would not have to increase their charitable

distributions as a result of the proposal. Although the required minimum

amount of charitable distributions would increase for such foundations,

such foundations already make distributions exceeding the minimum and so

generally would not have to increase charitable distributions as a result

of the proposal (except to the extent that the increase in the required

minimum amount was greater than the excess of a private foundation's

charitable distributions over the required minimum amount of present law).

However, a reduction in the excise tax rate from 2 percent to 1 percent

may result in increased charitable distributions to the extent that a

foundation decides to pay out the amount that otherwise would

be paid in tax for charitable purposes.

 

The proposal also eliminates the present-law two-tier tax structure.  Some

have suggested that the two-tier excise tax is an incentive for foundations

to increase the amounts they distribute to charities.  Critics of the

present-law two-tier excise tax have criticized the efficiency of the

excise tax as an incentive to increase payout rates.  First, critics note,

the reduction in excise tax depends only upon an increase in the

foundation's rate of distributions to charities, not on the size of the

increase in the rate of distributions.  Thus, a large increase in

distributions is rewarded by the same reduction in excise tax rate as

is a small increase in distributions. There is no extra incentive to make a

substantial increase in distributions rather than a quite modest increase

in distributions.

 

In addition, critics assert that, under a number of circumstances, the

present-law two-tier excise tax can create a disincentive for foundations

to increase charitable distributions substantially.  In order to take

advantage of the one-percent excise tax rate, a private foundation must

increase its rate of charitable distributions in the current year above

that which prevailed in the preceding five years.  Whether the present-law

two-tier excise tax creates an incentive or disincentive to increased

payout rates depends, in part, on whether the foundation currently is

subject to the one-percent tax rate or the two-percent tax rate.  Because

modest increases in payout rates qualify a foundation for the one-percent

tax rate, some analysts suggest that a foundation may be able to manage

its distributions actively so that the foundation qualifies for the

one-percent tax rate without substantially increasing its payout rate.

For a foundation subject to the one-percent rate in the current year, an

increased payout in any year becomes part of the computation to determine

eligibility for the one-percent rate in future years. Thus, under the

present-law formula, the foundation can trigger the two-percent excise tax

rate by increasing the payout amount in a particular year because

increased payouts make it more difficult for the foundation to qualify for

the one-percent rate in subsequent years, and it increases the possibility

that the foundation will become subject to the two-percent tax rate.

Consequently, over time, the one-percent rate provides a disincentive for

increasing charitable distributions.

 

On the other hand, for a foundation currently subject to the one-percent

excise tax rate and also making charitable distributions at a rate above

the minimum required amount, the present-law two-tier excise tax can

create a disincentive for foundations to reduce their payout rate. A

reduction in payout rate in the future would reduce the foundation's

five-year moving average, thereby increasing the likelihood the

foundation's net investment income is taxed at the two-percent rate,

rather than the one-percent rate.

 

For a foundation currently subject to the excise tax at the two-percent

rate, an increase in payout may qualify the foundation for the one-percent

excise tax rate. If the increase does qualify the foundation for the

one-percent rate, and the foundation maintains the same payout for the

subsequent four years, the foundation generally will be eligible for the

one-percent tax rate in each of the five years. Hence the reduced tax rate

can create an incentive to increase payout rates. However, even in the case

of a two-percent excise tax paying foundation, the present-law two-tier

excise tax can create a disincentive for a foundation to increase

charitable distributions substantially in any one year compared to a

strategy of slowly increasing payouts over several years. For example,

consider a foundation which has had a payout rate of 5.0 percent for

several years. Suppose the foundation is considering increasing its payout

rate. Consider two possible strategies: increase the payout rate to 8.0

percent in the current year followed by rates of 5.5 percent thereafter;

or gradually increase the payout rate by increments of one-tenth of one

percent annually for five years. While a substantial increase in any one

year may qualify the foundation for the one-percent tax rate, subsequent

year payout rates of 5.5 percent would fail to qualify the foundation for

the one- percent tax rate.  Thus, under the first option, the

foundation would pay the one-percent tax rate for one year and be a

two-percent tax rate payor subsequently. Under the second option, the

foundation would qualify for the one-percent rate in

each year.  However, total payouts are greater under the first option.

 

In summary, the incentive effects of the present-law two-tier excise tax

depend upon the situation in which the foundation finds itself in the

current year. In 2001, 51.6 percent of foundations were one-percent tax

rate payors and 48.4 percent were two-percent rate payors.Among large

foundations (assets of $50 million or greater) 71.5 percent were

\one-percent rate payors and 28.5 percent were two-percent rate payors. A

number of analysts suggest the optimal tax strategy for a private

foundation is to choose a target rate of disbursement, maintain

that rate in all years, and never fall below the target in any year.

 

Critics of the present-law excise tax structure observe that the median

payout rate of large nonoperating private foundations (foundations with

total assets of $50 million or more) was 5.1 or 5.0 percent in each year

from 1991 through 1995 and was 5.0 percent in 1999.  However,the payout

rate for such foundations increased to 5.5 percent in 2001. The median

payout rates for foundations with assets between $10 million and $50

million declined annually from 5.4 percent in 1990 to 5.1 percent in 1995

and 1999.  Similarly, the median payout rates for foundations with assets

between $100,000 and $1 million declined from 6.7 percent in 1990 to

5.5 percent in 1995 and 5.4 percent in 1999  but increased to 6.2 percent

in 2001.

 

The proposal reduces complexity for private foundations by replacing the

two-tier tax on net investment income with a one-tier tax.  Under the

proposal, private foundations do not have to allocate resources to figuring

which tier of the tax would be applicable or to planning the optimum payout

rate.  The proposal also would make compliance easier for private

foundations, as they would not have to compute a five-year average of

charitable distributions on the information return they file each year.

 

 

                                      Prior Action

                                     

The President's fiscal year 2003, 2004, 2005, and 2006 budget proposals

included a similar proposal.

 

The President's fiscal year 2001 budget proposal included a similar

proposal, but would have reduced the rate of tax to 1.25 percent.

 

4. Modify tax on unrelated business taxable income of charitable remainder

trusts

 

                                      Present Law

                                      

A charitable remainder annuity trust is a trust that is required to pay,

at least annually, a fixed dollar amount of at least five percent of the

initial value of the trust to a noncharity for the life of an individual

or for a period of 20 years or less, with the remainder passing to charity.

A charitable remainder unitrust is a trust that generally is required to

pay, at least annually, a fixed percentage of at least five percent of the

fair market value of the trust's assets determined at least annually to a

noncharity for the life of an individual or for a period 20 years or less,

with the remainder passing to charity.

 

A trust does not qualify as a charitable remainder annuity trust if the

annuity for a year is greater than 50 percent of the initial fair market

value of the trust's assets.  A trust does not qualify as a charitable

remainder unitrust if the percentage of assets that are required to be

distributed at least annually is greater than 50 percent.  A trust does

not qualify as a charitable remainder annuity trust or a charitable

remainder unitrust unless the value of the remainder interest in the trust

is at least 10 percent of the value of the assets contributed to the trust.

 

Distributions from a charitable remainder annuity trust or charitable

remainder unitrust are treated in the following order as: (1) ordinary

income to the extent of the trust's current and previously undistributed

ordinary income for the trust's year in which the distribution occurred;

(2) capital gains to the extent of the trust's current capital gain and

previously undistributed capital gain for the trust's year in which the

distribution occurred; (3) other income (e.g., tax-exempt income) to the

extent of the trust's current and previously undistributed other income for

the trust's year in which the distribution occurred; and (4) corpus.

 

In general, distributions to the extent they are characterized as income

are includible in the income of the beneficiary for the year that the

annuity or unitrust amount is required to be distributed even though the

annuity or unitrust amount is not distributed until after the close of

the trust's taxable year.

 

Charitable remainder annuity trusts and charitable remainder unitrusts

are exempt from Federal income tax for a tax year unless the trust has

any unrelated business taxable income for the year.  Unrelated business

taxable income includes certain debt financed income.  A charitable

remainder trust that loses exemption from income tax for a taxable year is

taxed as a regular complex trust.  As such, the trust is allowed a

deduction in computing taxable income for amounts required to be

distributed in a taxable year, not to exceed the amount of the trust's

distributable net income for the year.

 

 

                                 Description of Proposal

                                

The proposal imposes a 100-percent excise tax on the unrelated business

taxable income of a charitable remainder trust.  This replaces the

present-law rule that removes the income tax exemption of a charitable

remainder trust for any year in which the trust has any unrelated business

taxable income. Under the proposal, the tax is treated as paid from corpus.

The unrelated business taxable income is considered income of the trust

for purposes of determining the character of the distribution made to the

beneficiary.

 

Effective date.--The proposal is effective for taxable years beginning

after December 31,2005, regardless of when the trust was created.

 

                                        Analysis

                                       

The proposal is intended to produce a better result than present law for

trusts that have only small or inadvertent amounts of unrelated business

taxable income.  The present-law rule that any amount of unrelated

business taxable income results in loss of tax-exemption for the year

discourages trusts from making investments that might generate

insignificant (or inadvertent) unrelated business taxable income.  A loss

of exemption could be particularly punitive in a year in which a trust

sells, for example, the assets that originally funded the trust and does

not distribute the proceeds.  The proposal avoids this result by requiring

a trust to pay the amount of the unrelated business taxable income as an

excise tax but does not require the trust to pay tax on all of its other

income for the year.  In addition, the proposal is helpful to trusts that

receive unrelated business taxable income as a result of a change in the

status of the entity in which trust assets are invested.  However, the

proposal also may enable trusts to choose to make certain investments that

have small amounts of unrelated business income that are and some may

argue should be discouraged by present law. For example, investments in

rental property may generate a small amount of unrelated business taxable

income from fees for services provided to tenants. Such investments may be

unattractive for charitable remainder trusts under present law because the

unrelated income causes the trust to lose exemption.  Under the proposal,

however, a rental property owner might have an incentive to contribute the

rental property to a charitable remainder trust (of which the owner was

beneficiary) to shelter the rental income from tax (to the extent the

rental income exceeds the unitrust amount or annuity payment). Some argue

that charitable remainder trusts should not be encouraged to make such

investments.

 

The proposal also is intended to be a more effective deterrent than present

law to prevent charitable remainder trusts from investing in assets that

generate large amounts of unrelated business taxable income.  Although

present law requires that a charitable remainder trust become a taxable

trust for a year in which the trust has unrelated business taxable income,

a charitable remainder trust nevertheless may invest in assets that

produce significant unrelated business income but pay tax only on the

trust's undistributed income. This is because, as a taxable trust,the trust

may take a deduction for distributions of income that are taxable to the

beneficiaries. To the extent the trust pays tax, trust assets are depleted

to the detriment of the charitable beneficiary. Thus, proponents argue that

the proposal better deters trusts from making investments that generate

significant unrelated business taxable income because the 100 percent

excise tax would be prohibitive.  On the other hand, some question whether

such a deterrent is the right policy in cases where a trustee determines

that investment in assets that produce unrelated business taxable income

will increase the (after tax) rate of return to the trust (and thus

inure to the benefit of the charitable remainderman). 

 

The proposal provides that unrelated business taxable income is treated as

ordinary income to the trust and taxes are paid from corpus. Thus, the

proposal treats the trust beneficiary the same as under present law, that

is, distributions of the unrelated business income are taxed as ordinary

income to the beneficiary.  As a result, the proposed rule in effect taxes

the unrelated business income twice, once as an excise tax (at a

100-percent rate), and again when distributed.  Double taxation presently

exists to the extent that the trust's income from all sources exceeds the

amount distributed to the beneficiary during a year in which the trust is

not exempt from income tax.  Proponents of the proposal would argue that

double taxation is not a concern because the excise tax is intended as a

penalty for incurring unrelated business income.  Proponents also would

argue that although an alternative approach, for example, to tax the

unrelated business income as an excise tax but not again when distributed,

would avoid any perceived double taxation of the unrelated income, such an

alternative would have undesired effects.  Proponents would argue that if

unrelated income is not taxed when distributed, a trust might have a strong

incentive to invest in assets that produce unrelated income in order to

convey a benefit to the beneficiary that is not available under present law

(capital gain income or tax-free return of corpus instead of ordinary

income).  In addition, proponents would note, the charitable remainderman's

interest would be diminished to the extent a trust invested significantly

in unrelated business income producing assets.

 

The proposal simplifies the operation of charitable remainder trusts in

that a trust with a small amount of unrelated business taxable income does

not lose its tax exemption and therefore does not need to file income tax

returns and compute its taxable income as if it were a taxable trust.  This

has the effect of not discouraging trustees to make investments that

might entail having a small amount of unrelated business taxable income.

 

                                 Prior Action

                                 

A similar proposal was included in the President's fiscal year 2003, 2004,

2005, and 2006 budget proposals.

 

5.    Modify the basis adjustment to stock of S corporations

contributing appreciated property

 

                                   Present Law

                                  

Under present law, a shareholder of an S corporation takes into account,

in determining its own income tax liability, its pro rata share of any

charitable contribution of money or other property made by the corporation.

A shareholder of an S corporation reduces the basis in the stock of the S

corporation by the amount of the charitable contribution that flows through

to the shareholder.

 

In the case of a contribution of appreciated property, the stock basis is

reduced by the full amount of the contribution.  As a result, when the

stock is sold, the shareholder may lose the benefit of the charitable

contribution deduction for the amount of any appreciation in the asset

contributed.

 

                               Description of Proposal

                              

The proposal allows a shareholder in an S corporation to increase the

basis of the S corporation stock by an amount equal to the excess of the

charitable contribution deduction that flows through to the shareholder

over the shareholder's pro-rata share of the adjusted basis of the

property contributed.

 

Effective date.--The proposal applies to taxable years beginning after

December 31, 2005.

 

                                       Analysis

                                      

The proposal preserves the benefit of providing a charitable contribution

deduction for contributions of property by an S corporation with a fair

market value in excess of its adjusted basis by limiting the reduction in

the shareholder's basis in S corporation stock to the proportionate share

of the adjusted basis of the contributed property. Under the proposal, the

treatment of contributions of appreciated property made by an S

corporation is similar to the treatment of contributions made by a

partnership.

 

The net reduction in basis of stock by the amount of the adjusted basis

of contributed property rather than the fair market value will have

little effect on tax law complexity.

 

                                     Prior Action

                                    

A similar proposal was included in the President's fiscal year 2003, 2004,

2005, and 2006 budget proposals.

 

H.R. 4297 as amended by the Senate (the "Tax Relief Act of 2005") contains

a similar proposal.

 

6.  Repeal the $150 million limit for qualified 501(c)(3) bonds

 

                                     Present Law

                                    

Interest on State or local government bonds generally is excluded from

income if the bonds are issued to finance activities carried out and paid

for with revenues of these governments.  Interest on bonds issued by these

governments to finance activities of other persons, e.g., private activity

bonds, is taxable unless a specific exception is provided in the Code. 

One such exception is for private activity bonds issued to finance

activities of private, charitable organizations described in section 501(c)

(3) ("section 501(c)(3) organizations") if the activities do not

constitute an unrelated trade or business.

 

Section 501(c)(3) organizations are treated as private persons; thus, bonds

for their use may only be issued as private activity "qualified 501(c)

(3) bonds," subject to the restrictions of section 145.  Prior to the

Taxpayer Relief Act of 1997 (the "1997 Act"), the most significant of

these restrictions limited the amount of outstanding bonds from which a

section 501(c)(3) organization could benefit to $150 million.  In applying

this "$150 million limit," all section 501(c)(3) organizations under common

management or control were treated as a single organization.  The limit

did not apply to bonds for hospital facilities, defined to include only

acute care, primarily inpatient, organizations.

 

The "1997 Act" repealed the $150 million limit for bonds issued after

the date of enactment (August 5, 1997), to finance capital expenditures

incurred after such date.

 

                                Description of Proposal

                               

The proposal repeals the $150 million limit for qualified 501(c)(3) bonds

in its entirety.

 

Effective date.--The proposal is effective for bonds issued after the date

of enactment.

 

                                     Analysis

                                    

Because the 1997 Act provision applies only to bonds issued with respect

to capital expenditures incurred after August 5, 1997, the $150 million

limit continues to govern the issuance of other non-hospital qualified

501(c)(3) bonds (e.g., advance refunding bonds with respect to capital

expenditures incurred on or before such date, new-money bonds for capital

expenditures incurred on or before such date, or new-money bonds for

working capital expenditures).  Thus, there are two rules governing

qualified 501(c)(3) bonds for capital expenditures.  The application of a

particular rule depends on whether the capital expenditures were incurred

on or before or after the date the 1997 Act was enacted.

 

As noted above, the $150 million volume limit continues to apply to

qualified 501(c)(3) bonds for capital expenditures incurred on or before

August 5, 1997.  (Typically, these will be advance refunding bonds). 

The limit also continues to apply to bonds more than five percent of

the net proceeds of which finance or refinance working capital expenditures

(i.e., operating expenses).  The limit does not apply to bonds to finance

capital expenditures incurred after that date.  The Senate Finance

Committee report states that the purpose of the repeal of the $150

million limit was to correct the disadvantage the limit placed on 501(c)

(3) organizations relative to substantially identical governmental

institutions: The Committee believes a distinguishing feature of American

society is the singular degree to which the United States maintains a

private, non-profit sector of private higher education and other

charitable institutions in the public service. 

 

The Committee believes it is important to assist these private

institutions in their advancement of the public good.  The Committee finds

particularly inappropriate the restrictions of present law which place

these section 501(c)(3) organizations at a financial disadvantage relative

to substantially identical governmental institutions.  For example, a

public university generally has unlimited access to tax-exempt bond

financing, while a private, non-profit university is subject to a

$150 million limitation on outstanding bonds from which it may benefit.

The Committee is concerned that this and other restrictions inhibit the

ability of America's private, non-profit institutions to modernize their

educational facilities.  The Committee believes the tax-exempt bond rules

should treat more equally State and local governments and those private

organizations which are engaged in similar actions advancing the public

good.

 

Although the conference report on the 1997 Act noted the continued

applicability of the $150 million limitation to refunding and new-money

bonds, no reason was given for retaining the rule.   Thus, it appears that

eliminating the discrepancy between pre-August 5, 1997, and post-August

5, 1997, capital expenditures would not violate the policy underlying the

repeal of the $150 million limitation.  Some may argue that the $150

million volume limit should continue to apply to qualified 501(c)(3) bonds

more than five percent of the net proceeds of which finance or refinance

working capital expenditures (i.e., operating expenses).  Unlike bond

proceeds financing capital expenditures, bond proceeds financing working

capital expenditures are not directly used to modernize educational

facilities, but are used to finance operating expenses Proponents may

respond that Congress intended to eliminate the disparity between 501(c)(3)

organizations and substantially identical governmental institutions in the

1997 Act and this only can be achieved by complete repeal of the $150

million

 

                              Prior Action

                             

A similar proposal was included in the President's fiscal year 2004, 2005,

and 2006 budget proposals.

 

7. Repeal the restrictions on the use of qualified 501(c)(3) bonds for

residential rental property

 

 

                               Present Law

                              

In general

 

Interest on State or local government bonds is tax-exempt when the proceeds

of the bonds are used to finance activities carried out by or paid for by

those governmental units.  Interest on bonds issued by State or local

governments acting as conduit borrowers for private businesses is taxable

unless a specific exception is included in the Code.  One such exception

allows tax-exempt bonds to be issued to finance activities of non-profit

organizations described in Code section 501(c)(3) ("qualified 501(c)(3)

bonds").

 

For a bond to be a qualified 501(c)(3) bond, the bond must meet certain

general requirements.  The property that is to be provided by the net

proceeds of the issue must be owned by a 501(c)(3) organization, or by a

government unit.  In addition, a bond failing both a modified private

business use test and a modified private security or payment test would

not be a qualified 501(c)(3) bond.  Under the modified private business

use test at least 95 percent of the net proceeds of the bond must be used

by a 501(c)(3) organization in furtherance of its exempt purpose.  Under a

modified private security or payment test, the debt service on not more

than 5 percent of the net proceeds of the bond issue can be (1) secured

by an interest in property, or payments in respect of property, used by a

501(c)(3) organization in furtherance of an unrelated trade or business or

by a private user, or (2) derived from payments in respect of property, or

borrowed money, used by a 501(c)(3) organization in furtherance of an

unrelated trade or business or by a private user.

 

Qualified 501(c)(3) bonds are not subject to (1) the State volume

limitations, (2) the land and existing property limitations, (3) the

treatment of interest as a preference item for purposes of the alternative

minimum tax and (4) the prohibition on advance refundings.

 

Qualified residential rental projects

 

In general

 

The Code provides that a bond which is part of an issue shall not be a

qualified 501(c)(3) bond if any portion of the net proceeds of the issue

are to be used directly or indirectly to provide residential rental

property for family units (sec. 145(d)(1)). Exceptions to this rule are

provided for facilities that meet the low-income tenant qualification

rules for qualified residential rental projects financed with exempt

facility private activity bonds,  or are new or substantially

rehabilitated (sec. 142(d) and 145(d)(2)).

 

Acquisition of existing property

 

Qualified 501(c)(3) bonds issued to acquire existing residential rental

property that is not substantially rehabilitated must meet certain

low-income tenant qualification rules.  Section 142(d) sets forth those

rules.  Section 142(d) requires for the qualified project period

(generally 15 years) that (1) at least 20 percent of the housing units must

be occupied by tenants having incomes of 50 percent or less of area median

income or (2) 40 percent of the housing units in the project must be

occupied by tenants having incomes of 60 percent or less of the area median

income.

 

New construction or substantial rehabilitation

 

In the case of a "qualified residential rental project" that consists of

new construction or substantial rehabilitation, qualified 501(c)(3) bonds

are not required to meet the low-income tenant qualification rules that

otherwise would be applicable.

 

                          Description of Proposal

                         

The proposal repeals the low-income tenant qualification and substantial

rehabilitation rules for the acquisition of existing property with qualified

501(c)(3) bonds.

 

Effective date.--The proposal is effective for bonds issued after the date

of enactment.

 

                                 Analysis

                                

The current low-income tenant rules to qualified 501(c)(3) bonds resulted

from Congressional concern that qualified 501(c)(3) bonds were being used

in lieu of exempt facility bonds to avoid the low-income tenant rules

applicable to exempt facility bonds.  The Ways and Means Committee report

noted:

 

The Committee has become aware that, since enactment of the Tax

Reform Act of 1986, many persons have sought to avoid the rules requiring

that, to qualify for tax-exempt financing, residential rental property

serve low-income tenants to a degree not previously required. The most

common proposals for accomplishing this result have been to use qualified

501(c)(3) or governmental bonds to finance rental housing. Frequently, the

proposals have involved the mere churning of "burned-out" tax shelters

with the current developers remaining as project operators under

management contracts producing similar returns to those they received in

the past. The committee finds it anomalous that section 501(c)(3)

organizations-charities-would attempt in these or any other circumstances

to finance with tax-exempt bonds rental housing projects that serve a more

affluent population group than those permitted to be served by projects

that qualify for tax-exempt exempt-facility bond financing.

 

In conference, the applicability of the low-income tenant rules was limited

to the acquisition of existing property.  It has been argued that the

disparity in the treatment of existing facilities versus new facilities

causes complexity. Some degree of simplification might be achieved through

the elimination of the low-income tenant rules.Nonetheless, some might

argue that the concerns that prompted the application of the low-income

tenant rules to existing property would once again arise upon removal of

these limitations.

 

There have been reports that there is a shortage of affordable rental

housing.  By removing the restrictions on existing property, some might

argue that charities would not be inclined to serve low-income tenants to

the same degree.  Proponents of the restrictions might argue that

charities, in particular, should provide affordable housing to low-income

persons as part of their charitable mission to serve the poor and

distressed.

 

Others might argue that an affordable housing shortage is not widespread

and that such issues would be better addressed through efforts to directly

assist low-income persons rather than by imposing restrictions on the

property acquired by the charity. Further, because qualified 501(c)(3)

bonds are to be used to further the exempt purposes of the charity, there

is a limit on the extent the charity can operate like a commercial

enterprise.

 

As noted above, the interest on qualified 501(c)(3) bonds is exempt from

tax, and is not a preference for purpose of the alternative minimum tax.

Unlike some other private activity bonds, qualified 501(c)(3) bonds are

not subject to the State volume limitations and therefore, do not

have to compete with other private activity bond projects for an allocation

from the State. Proponents of the restrictions might argue that the

restrictions are not unreasonable given the preferential status of

qualified 501(c)(3) bonds and the fact that such charities could be viewed

as helping alleviate a burden on government to benefit those most in need.

 

 

                                  Prior Action

                                 

A similar proposal was included in the President's fiscal year 2004, 2005,

and 2006 budget proposals.

 

 

E.  Extend the Above-the-Line Deduction for

Qualified Out-of-Pocket Classroom Expenses

 

                                      Present Law

                                     

Deduction for out-of-pocket classroom expenses incurred by teachers and

other educators

 

In general, ordinary and necessary business expenses are deductible

(sec. 162).  However, in general, unreimbursed employee business expenses

are deductible only as an itemized deduction and only to the extent that

the individual's total miscellaneous deductions (including employee

business expenses) exceed two percent of adjusted gross income. An

individual's otherwise allowable itemized deductions may be further limited

by the overall limitation on itemized deductions, which reduces itemized

deductions for taxpayers with adjusted gross income in excess of $150,500

(for 2006). In addition, miscellaneous itemized deductions are not

allowable under the alternative minimum tax.

 

Certain expenses of eligible educators are allowed an above-the-line

deduction. Specifically,for taxable years beginning prior to

January 1, 2006, an above-the-line deduction is allowed for up to $250

annually of expenses paid or incurred by an eligible educator for books,

supplies (other than nonathletic supplies for courses of instruction in

health or physical education), computer equipment (including related

software and services) and other equipment,and supplementary materials

used by the eligible educator in the classroom.  To be eligible for

this deduction, the expenses must be otherwise deductible under 162 as

a trade or business expense.   A deduction is allowed only to the extent

the amount of expenses exceeds the amount excludable from income under

section 135 (relating to education savings bonds), 529(c)(1)

(relating to qualified tuition programs), and section 530(d)(2)

(relating to Coverdell education savings accounts).

 

An eligible educator is a kindergarten through grade 12 teacher, instructor,

counselor,principal, or aide in a school for at least 900 hours during a

school year.  A school means any school which provides elementary education

or secondary education, as determined under State law.The above-the-line

deduction for eligible educators is not allowed for taxable years

beginning after December 31, 2005.

 

General rules regarding education expenses

 

An individual taxpayer generally may not deduct the education and training

expenses of the taxpayer or the taxpayer's dependents.  However, a

deduction for education expenses generally is allowed under section 162 if

the education or training (1) maintains or improves a skill required in a

trade or business currently engaged in by the taxpayer, or (2) meets the

express requirements of the taxpayer's employer, or requirements of

applicable law or regulations, imposed as a condition of continued

employment.  Education expenses are not deductible if they relate to

certain minimum educational requirements or to education or training that

enables a taxpayer to begin working in a new trade or business. 

 

An individual is allowed an above-the-line deduction for qualified tuition

and related expenses for higher education paid by the individual during a

taxable year that are required for the enrollment or attendance of the

taxpayer, the taxpayer's spouse, or any dependent of the taxpayer with

respect to whom the taxpayer may claim a personal exemption, at an eligible

educational institution of higher education for courses of instruction of

such individual at such institution.  

 

Unreimbursed educational expenses incurred by employees

 

In the case of an employee, education expenses (if not reimbursed by the

employer) may be claimed as an itemized deduction only if such expenses

meet the above-described criteria for deductibility under section 162 and

only to the extent that the expenses, along with other miscellaneous

itemized deductions, exceed two percent of the taxpayer's adjusted gross

income.  Itemized deductions subject to the two-percent floor are not

deductible for minimum tax purposes.  In addition, present law imposes a

reduction on most itemized deductions, including the employee business

expense deduction, for taxpayers with adjusted gross income in excess of

a threshold amount, which is indexed annually for inflation.  The

threshold amount for 2005 is $150,500 ($75,250 for married individuals

filing separate returns).  For those deductions that are subject to the

limit, the total amount of itemized deductions is reduced by three percent

of adjusted gross income over the threshold amount, but not by more than

80 percent of itemized deductions subject to the limit. Beginning in 2006

, EGTRRA phases out the overall limitation on itemized deductions for all

taxpayers.  The overall limitation on itemized deductions is reduced by

one-third in taxable years beginning in 2006 and 2007, and by two-thirds

in taxable years beginning in 2008 and 2009.  The overall limitation on

itemized deductions is eliminated for taxable years beginning after

December 31, 2009, although this elimination of the limitation

sunsets on December 31, 2010.

 

Contributions to a school may be eligible for a charitable contribution

deduction under section 170.  A contribution that qualifies both as a

business expense and a charitable contribution may be deducted only as one

or the other, but not both.

 

                          Description of Proposal

                         

The present-law provision would be made permanent.

 

Effective date.--The proposal is effective for expenses incurred in taxable

years beginning after December 31, 2005.

 

                                   Analysis

                                  

Policy issues

 

The present-law section 62 above-the-line deduction attempts to make fully

deductible many of the legitimate business expenses of eligible

schoolteachers.  As described below, and absent an above-the-line

deduction, the expenses might otherwise be deductible except for the

two-percent floor that applies to miscellaneous itemized deductions.  Some

have observed that the two-percent floor increases pressure to enact

above-the-line deductions on an expense-by-expense basis.  In addition to

increasing complexity, the expense-by-expense approach is not fair to

other taxpayers with legitimate business expenses that remain subject to the

two-percent floor.  Extending the present-law above-the-line deduction

presents compliance issues.  One reason the two-percent floor was

introduced was to reduce the administrative burden on the IRS to monitor

compliance with small deductions. Some argue that any proposal that

circumvents the two-percent floor will encourage cheating.  Others argue

that although cheating is a risk, the risk is the same for similarly

situated taxpayers (e.g., independent contractors or taxpayers with

trade or business income) who are not subject to the two-percent floor on

similar expenses.

 

Complexity issues

 

Three provisions of present law restrict the ability of teachers to deduct

as itemized deductions those expenses covered by the proposal:  (1) the

two-percent floor on itemized deductions; (2) the overall limitation on

itemized deductions; and (3) the alternative minimum tax. The staff of the

Joint Committee on Taxation has previously identified these provisions as

sources of complexity and has recommended that such provisions be repealed.

These provisions do not apply to eligible expenses under the proposal. 

While repealing these provisions for all taxpayers reduces the complexity

of the Federal tax laws, effectively repealing these provisions only for

certain taxpayers (such as teachers and other eligible educators) likely

increases complexity.

 

Some may view extending the present-law above-the-line deduction as

increasing simplification by providing for deductibility of certain

expenses without regard to the present-law restrictions applicable to

itemized deductions and the alternative minimum tax.   However,

extending the present-law above-the-line deduction may increase complexity

because of the increased recordkeeping requirements.  Taxpayers wishing to

take advantage of the above-the-line deduction are required to keep

records, even if they were not otherwise required to do so because their

expenses were not deductible as a result of the 2-percent floor for

itemized deductions. In general, enactment of additional above-the-line

deductions for specific expenses undermines the concept of the standard

deduction, which exists in part to simplify the tax code by eliminating

the need for many taxpayers to keep track of specific expenses.

 

                             Prior Action

                            

                            

Similar proposals were contained in the President's fiscal year 2003, 2004

, 2005, and 2006 budget proposals.

 

A similar provision in H.R. 4297, as passed by the House (the "Tax Relief

Extension Reconciliation Act of 2005"), extends the present-law provision

for one year.  A similar provision in H.R. 4297, as amended by the Senate

(the "Tax Relief Act of 2005"), extends the present-law provision for one

year.

 

                        F.  Establish Opportunity Zones

                       

                                   Present Law

 

In general

 

The Internal Revenue Code contains various incentives to encourage the

development of economically distressed areas, including incentives for

businesses located in empowerment zones, enterprise communities and

renewal communities, the new markets tax credit, the work opportunity tax

credit, and the welfare-to-work tax credit.

 

Empowerment zones

 

There are currently 40 empowerment zones--30 in urban areas and 10 in rural

areas--that have been designated through a competitive application process.

State and local governments nominated distressed geographic areas, which

were selected on the strength of their strategic plans for economic and

social revitalization. The urban areas were designated by the Secretary of

the Department of Housing and Urban Development. The rural areas were

designated by the Secretary of the Department of Agriculture. Designations

of empowerment zones will remain in effect until December 31, 2009.

 

Incentives for businesses in empowerment zones include (1) a 20-percent

wage credit for qualifying wages, (2) additional expensing for qualified

zone property, (3) tax-exempt financing for certain qualifying zone

facilities, (4) deferral of capital gains on sales and reinvestment in

empowerment zone assets, and (5) exclusion of 60 percent (rather than 50

percent) of the gain on the sale of qualified small business stock held

more than 5 years.

 

The wage credit provides a 20 percent subsidy on the first $15,000 of

annual wages paid to residents of empowerment zones by businesses located

in these communities, if substantially all of the employee's services are

performed within the zone. The credit is not available for wages taken

into account in determining the work opportunity tax credit.

 

Enterprise zone businesses are allowed to expense the cost of certain

qualified zone property (which, among other requirements, must be used in

the active conduct of a qualified business in an empowerment zone) up to an

additional $35,000 above the amounts generally available under section

179. In addition, only 50 percent of the cost of such qualified zone

property counts toward the limitation under which section 179 deductions

are reduced to the extent the cost of section 179 property exceeds a

specified amount

 

Qualified enterprise zone businesses are eligible to apply for tax-exempt

financing (empowerment zone facility bonds) for qualified zone property.

These empowerment zone facility bonds do not count against state private

activity bond limits, instead a limit is placed upon each zone, depending

on population and whether the zone is in an urban or rural area.

 

Enterprise communities

 

Current law authorized the designation of 95 enterprise communities, 65 in

urban areas and 30 in rural areas. Qualified businesses in these

communities were entitled to similar favorable tax-exempt financing

benefits as those in empowerment zones. Designations of enterprise

communities were made in 1994 and remained in effect through 2004. Many

enterprise communities have since been re-designated as part of an

empowerment zone or a renewal community.

 

Renewal communities

 

The Community Renewal Tax Relief Act of 2000 authorized 40 renewal

communities, at least 12 of which must be in rural areas. Forty renewal

communities have been chosen through a competitive application process

similar to that used for empowerment zones. The 40 communities were

designated by the Department of Housing and Urban Development in 2002

and that designation continues through 2009.

 

Renewal community tax benefits include: (1) a 15-percent wage credit for

qualifying wages; (2) additional section 179 expensing for qualified

renewal property; (3) a commercial revitalization deduction; and (4) an

exclusion for capital gains on qualified community assets held more than

five years.

 

The wage credit and increased section 179 expensing operate in a similar

fashion as in empowerment zones. The primary difference is that the wage

credit is smaller, equal to 15 percent for the first $10,000 of wages.

 

The commercial revitalization deduction applies to certain nonresidential

real property or other property functionally related to nonresidential

real property. A taxpayer may elect to either: (1) deduct one-half of any

qualified revitalization expenditures that would otherwise be

capitalized for any qualified revitalization building in the tax year the

building is placed in service; or (2) amortize all such expenditures

ratably over a 120-month period beginning with the month the building is

placed in service. A qualified revitalization building is any

nonresidential building and its structural components placed in service

by the taxpayer in a renewal community. If the building is new, the

original use of the building must begin with the taxpayer. If the building

is not new, the taxpayer must substantially rehabilitate the building and

then place it in service. The total amount of qualified revitalization

expenditures for any building cannot be more than the smaller of $10

million or the amount allocated to the building by the commercial

revitalization agency for the state in which the building is located. A

$12 million cap on allowed commercial revitalization expenditures is

placed on each renewal community annually.

 

New markets tax credit

 

The new markets tax credit provides a tax credit to investors who make

"qualified equity investments" in privately-managed investment vehicles

called "community development entities," or "CDEs." The CDEs must apply for

and receive an allocation of tax credit authority from the Treasury

Department and must use substantially all of the proceeds of the qualified

equity investments to make qualified low-income community investments. One

type of qualified low-income community investment is an investment in a

qualified active low-income community business. In general, a "qualified

active low-income community business" is any corporation (including a

nonprofit corporation), partnership or proprietorship that meets the

following requirements:

At least 50 percent of the gross income of the business is derived from

the active conduct of a qualified business within a low-income community

(as defined in section 45D(e)). For this purpose, a "qualified business"

generally does not include (1) the rental of real property other than

substantially improved nonresidential property; (2) the development or

holding of intangibles for sale or license; (3) the operation of a

private or commercial golf course, country club, massage parlor, hot tub

facility, suntan facility, racetrack or other facility used for gambling,

or a liquor store; or (4) farming if the value of the taxpayer's assets

used in the business exceeds $500,000.

 

At least 40 percent of the use of the tangible property of the business is

within a low-income community.

 

At least 40 percent of the services performed for the business by its

employees are performed in a low-income community.

 

Collectibles (other than collectibles held primarily for sale to customers

in the ordinary course of business) constitute less than five percent of

the assets of the business.

 

Nonqualified financial property (which includes debt instruments with a

term in excess of 18 months) comprises less than five percent of the assets

of the business. A portion of a business may be tested separately for

qualification as a qualified active low-income community business.

 

Work opportunity and welfare-to-work tax credits

 

Employers may be entitled to a work opportunity tax credit or a

welfare-to-work tax credit for certain wages paid to eligible employees.

 

                             Description of Proposal

In general

 

The proposal creates 20 opportunity zones, 14 in urban areas and 6 in rural

areas.  The zone designation and corresponding incentives for these 20

zones are in effect from January 1,2007, to December 31, 2016.  As

described below, the tax incentives applicable to opportunity zones

include: (1) an exclusion of 25 percent of taxable income for opportunity

zone businesses with average annual gross receipts of $5 million or less;

(2) additional section 179 expensing for opportunity zone businesses;

(3) a commercial revitalization deduction; and (4) a wage credit for

businesses that employ opportunity zone residents within the zone.

 

Selection of opportunity zones

 

The Secretary of Commerce selects opportunity zones through a competitive

process. A county, city or other general purpose political subdivision of

a state (a "local government") is eligible to nominate an area for

opportunity zone status if the local government is designated by

the Secretary of Commerce as a "Community in Transition."  Two or more

contiguous local governments designated as Communities in Transition may

submit a joint application.

 

A local government may be designated as a Community in Transition if it

has experienced the following: (1) a loss of at least three percent of its

manufacturing establishments from 1993 to 2003 (urban areas must have had

at least 100 manufacturing establishments in 1993); (2) a loss of at least

three percent of its retail establishments from 1993 to 2003; and (3) a

loss of at least 20 percent of its manufacturing jobs from 1993 to 2003.

 

Local governments not making the original Community in Transition list may

appeal to the Secretary of Commerce.  Other factors demonstrating a loss of

economic base within the local government may be considered in the appeal.

 

Applicants for opportunity zone status have to develop and submit a

"Community Transition Plan" and a "Statement of Economic Transition."  The

Community Transition Plan must set concrete, measurable goals for reducing

local regulatory and tax barriers to construction, residential development

and business creation.  Communities that have already worked to address

these issues receive credit for recent improvements.  The Statement of

Economic Transition must demonstrate that the local community's economic

base is in transition, as indicated by a declining job base and labor

force, and other measures, during the past decade.

 

In evaluating applications, the Secretary of Commerce may consider other

factors, including: (1) changes in unemployment rates, poverty rates,

household income, homeownership and labor force participation; (2) the

educational attainment and average age of the population;

and (3) for urban areas, the number of mass layoffs occurring in the

area's vicinity over the previous decade.

 

The majority of a nominated area must be located within the boundary of

one or more local governments designated as a Community in Transition. A

nominated area would have to have a continuous boundary (that is, an area

must be a single area; it cannot be comprised of two or more separate

areas) and may not exceed 20 square miles if an urban area or 1,000 square

miles if a rural area.

 

A nominated urban area must include a portion of at least one local

government jurisdiction with a population of at least 50,000. The

population of a nominated urban area may not exceed the lesser of:

(1) 200,000; or (2) the greater of 50,000 or ten percent of the population

of the most populous city in the nominated area.  A nominated rural area

must have a population of at least 1,000 and no more than 30,000.

 

"Rural area" is defined as any area that is (1) outside of a metropolitan

statistical area (within the meaning of section 143(k)(2)(B)) or (2)

determined by the Secretary of Commerce,after consultation with the

Secretary of Agriculture, to be a rural area.  "Urban area" is defined as

any area that is not a rural area.

 

Empowerment zones and renewal communities are eligible to apply for

opportunity zone status, but are required to relinquish their current

status and benefits once selected.  Opportunity zone benefits for converted

empowerment zones and renewal communities expire on December 31, 2009. 

The selection of empowerment zones or renewal communities to convert to

opportunity zones is based on the same criteria that apply to other

communities, but does not count against the limitation of 20 new

opportunity zones

 

Previously designated enterprise communities are also eligible to apply

for opportunity zone status.  Aside from automatically being eligible to

apply, enterprise communities are treated as other areas that do not belong

to either an empowerment zone or a renewal community once selected: benefits

are in effect for 10 years and the selection of an enterprise community as an

opportunity zone counts against the limit of 20 new opportunity zones.

 

Reporting requirements identifying construction, residential development,

job creation, and other positive economic results apply to opportunity

zones.

 

Tax incentives applicable to opportunity zones

 

Exclusion of 25 percent of taxable income for certain opportunity zone

businesses

 

A business is allowed to exclude 25 percent of its taxable income if (1)

it qualified as an "opportunity zone business" and (2) it satisfied a $5

million gross receipts test. The definition of an opportunity zone business

is based on the definition of a "qualified active low-income community

business" for purposes of the new markets tax credit, treating opportunity

zones as low-income communities.  However, a nonprofit corporation does

not qualify for treatment as an opportunity zone business.  In addition, a

portion of a business may not be tested separately for qualification as an

opportunity zone business. The $5 million gross receipts test is satisfied

if the average annual gross receipts of the business for the

three-taxable-year period ending with the prior taxable year does not

exceed $5 million.  Rules similar to the rules of section 448(c) apply.

 

Additional section 179 expensing

 

An opportunity zone business is allowed to expense the cost of section 179

property that is qualified zone property, up to an additional $100,000

above the amounts generally available under section 179.  In addition,

only 50 percent of the cost of such qualified zone property counts

toward the limitation under which section 179 deductions are reduced to

the extent the cost of section 179 property exceeds a specified amount

.

Commercial revitalization deduction

 

A commercial revitalization deduction is available for opportunity zones in

a manner similar to the deduction for renewal communities. A $12 million

annual cap on these deductions applies to each opportunity zone.

 

Wage credit

 

Individuals who live and work in an opportunity zone constitute a new

target group with respect to wages earned within the zone under a combined

work opportunity tax credit and welfare-to-work tax credit, as proposed by

the President under a separate proposal

 

Other benefits for opportunity zones

 

Individuals, organizations, and governments within an opportunity zone

receive priority designation when applying for new markets tax credits and

the following other Federal programs: 21st Century After-school, Early

Reading First, and Striving Readers funding;

Community Based Job Training Grants; Community Development Block Grants,

Economic Development Administration grants, and HOME Funding; and USDA

Telecommunications Loans, Distance Learning and Telemedicine grants, and

Broadband loans.

 

Analysis

 

The proposal is designed to provide tax benefits to local areas with

declines in manufacturing employment and other reductions of the local

economic base. In particular, the proposal encourages the development and

growth of small businesses within local areas designated as Communities in

Transition.

 

The tax benefits are available to "Communities in Transition," which

are defined as communities that have suffered declines

in manufacturing and retail industries.  The proposal may thus have the

effect of providing incentives to communities negatively affected by

increased international trade.  Economic theory provides that international

trade generates net benefits to a nation's economy, but that those benefits

are unevenly distributed among sectors within the economy.  However, the

existence of net benefits suggests that sufficient national resources

should exist to compensate fully those sectors hurt by trade.  The proposal

is consistent with the aims of this policy of compensation.

 

Opponents of the proposal might argue that the proposal extends tax

benefits not only to communities that have suffered a decline in

manufacturing and retail establishments but also to neighboring, prospering

communities.  This is because the proposal requires only that a majority

of an opportunity zone consist of territory located in a Community in

Transition.  Thus, tax benefits may potentially be allocated to individuals

and businesses whose activities may not significantly contribute to

economic development in the Community in Transition.

 

Some observers have noted that a challenge to full utilization of existing

local development tax incentives (such as empowerment zones) is the

ever-growing menu of zones and tax benefits. Local officials have a

difficult time explaining complicated sets of policies to businesses.

The proposal adds to the list of benefits in the form of a 25-percent

taxable income exclusion, which is available for opportunity zones but

not for other similar targeted areas.Critics of existing empowerment zones

and renewal communities policies argue that for full utilization of such

tax benefits to be achieved, there needs to be increased funding of

programs educating individuals and business of the benefits of existing

tax incentives.

 

Allowing the conversion of existing zones to opportunity zones offers an

opportunity consolidate and simplify tax benefits for distressed economic

areas.   However, the incentive for existing empowerment zones and renewal

communities to convert to opportunity zone status is reduced by the early

termination date.  Further, the differences in the set of tax incentives

available to the various zones may reduce the incentive of local government

officials to request conversion.  Such officials have developed expertise

and development plans based on the existing set of tax benefits.

 

The gross receipts test for a qualified opportunity zone business creates

a "cliff" with respect to this tax benefit.  Businesses who find themselves

marginally in excess of the three-year moving-average cease to qualify for

the income exclusion.  Thus, this formulation of the income exclusion

unfairly distinguishes between similarly situated businesses and offers an

incentive for abuse.  However, this formulation of the taxable income

exclusion focuses the tax benefit to small businesses.

 

Further, as is the case with other tax incentives for

economically-distressed areas, some observers note that the tax benefits

may do little to encourage new development.  Hence, such incentives may

primarily benefit existing businesses while producing little new growth.

Indeed, the establishment of local tax incentives may have the effect of

distorting the location of new investment, rather than increasing

investment overall.  If the new investments are offset by less investment

in neighboring, but not qualifying areas, the neighboring communities could

suffer.  On the other hand, the increased investment in the qualifying

areas could have spillover effects that are beneficial to the neighboring

communities.

 

                               Prior Action

                              

The President's fiscal year 2006 budget proposal included a similar

proposal (proposing twice as many new opportunity zones as proposed here).

 

G.  Permanently Extend Expensing of Brownfields Remediation Costs

 

 

                            Present Law

                           

Code section 162 allows a deduction for ordinary and necessary expenses

paid or incurred in carrying on any trade or business.  Treasury

regulations provide that the cost of incidental repairs that neither

materially add to the value of property nor appreciably prolong its

life, but keep it in an ordinarily efficient operating condition, may be

deducted currently as a business expense.  Section 263(a)(1) limits the

scope of section 162 by prohibiting a current deduction for certain

capital expenditures.  Treasury regulations define "capital expenditures"

as amounts paid or incurred to materially add to the value, or

substantially prolong the useful life,of property owned by the taxpayer,

or to adapt property to a new or different use.  Amounts paid for repairs

and maintenance do not constitute capital expenditures.  The determination

of whether an expense is deductible or capitalizable is based on the facts

and circumstances of each case

 

Under Code section 198, taxpayers can elect to treat certain environmental

remediation expenditures that would otherwise be chargeable to capital

account as deductible in the year paid or incurred. The deduction applies

for both regular and alternative minimum tax purposes.  The expenditure

must be incurred in connection with the abatement or control of hazardous

substances at a qualified contaminated site.  In general, any expenditure

for the acquisition of depreciable property used in connection with the

abatement or control of hazardous substances at a qualified contaminated

site does not constitute a qualified environmental remediation

expenditure.  However, depreciation deductions allowable for such property,

which would otherwise be allocated to the site under the principles set

forth in Commissioner v. Idaho Power Co.  and section 263A, are treated as

qualified environmental remediation expenditures.A "qualified contaminated

site" (a so-called "brownfield") generally is any property that is held

for use in a trade or business, for the production of income, or as

inventory and is certified by the appropriate State environmental agency

to be an area at or on which there has been a release (or threat of

release) or disposal of a hazardous substance. Both urban and rural

property may qualify.  However, sites that are identified on the national

priorities list under the Comprehensive Environmental Response,

Compensation, and Liability Act of 1980 ("CERCLA") cannot qualify as

targeted areas. Hazardous substances generally are defined by reference

to sections 101(14) and 102 of CERCLA, subject to additional limitations

applicable to asbestos and similar substances within buildings, certain

naturally occurring substances such as radon, and certain other substances

released into drinking water supplies due to deterioration through ordinary

use. In the case of property to which a qualified environmental

remediation expenditure otherwise would have been capitalized, any

deduction allowed under section 198 is treated as a depreciation deduction

and the property is treated as section 1245 property.  Thus, deductions for

qualified environmental remediation expenditures are subject to recapture

as ordinary income upon a sale or other disposition of the property.

In addition, sections 280B (demolition of structures) and 468 (special

rules for mining and solid waste reclamation and closing costs) do

not apply to amounts that are treated as expenses under this provision.

Eligible expenditures are generally those paid or incurred before

January 1, 2006

 

The Gulf Opportunity Zone Act of 2005 added section 1400N(g) to the

Code, which extended for two years (through December 31, 2007) the

expensing of environmental remediation expenditures paid or incurred to

abate contamination at qualified contaminated sites located in the Gulf

Opportunity Zone; in addition, for sites within the Gulf Opportunity Zone

section 1400N(g) broadens the definition of hazardous substance to include

petroleum products (defined by reference to section 4612(a)(3)).

 

Description of Proposal

 

The proposal eliminates the requirement that expenditures must be paid or

incurred before January 1, 2006, to be deductible as eligible environmental

remediation expenditures.Thus, the provision (including the special

provision under section 1400N(g) which includes petroleum products within

the definition of hazardous substance, but only within the Gulf

Opportunity Zone) becomes permanent.

 

Effective date.--The proposal is effective on the date of enactment.

 

 

                                        Analysis

                                       

Policy issues

 

The proposal to make permanent the expensing of brownfields remediation

costs would promote the goal of environmental remediation and remove doubt

as to the future deductibility of remediation expenses.  Removing the doubt

about deductibility may be desirable if the present-law expiration date is

currently affecting investment planning.  For example, the temporary nature

of relief under present law may discourage projects that require a

significant ongoing investment, such as groundwater clean-up projects.

On the other hand, extension of the provision for a limited period of time

would allow additional time to assess the efficacy of the law, adopted only

recently as part of the Taxpayer Relief Act of 1997, prior to any decision

as to its permanency. The proposal is intended to encourage environmental

remediation, and general business investment, at contaminated sites. With

respect to environmental remediation tax benefits as an incentive for

general business investment, it is possible that the incentive may have

the effect of distorting the location of new investment, rather than

increasing investment overall. If the new investments are offset by less

investment in neighboring, but not qualifying, areas, the

neighboring communities could suffer. On the other hand, the increased

investment in the qualifying areas could have spillover effects that are

beneficial to the neighboring communities.

 

Complexity issues

 

By making the present law provision permanent, the proposal may simplify

tax planning and investment planning by taxpayers by providing more

certainty.  However, in general, the proposal would treat expenditures at

certain geographic locations differently from otherwise identical

expenditures at other geographic locations. Such distinctions generally

require additional record keeping on the part of taxpayers and more

complex tax return filings.Concomitantly, such distinctions increase the

difficulty of IRS audits.

 

                               Prior Action

                              

Proposals to make section 198 permanent were included in the President's

fiscal year 1999, 2000, 2001, 2002, 2003, 2004, 2005, and 2006 budget

proposals.H.R. 4297, as passed by the House (the "Tax Relief Extension

Reconciliation Act of 2005"), extends section 198 expensing for two years

(through December 31, 2007), and also broadens the definition of hazardous

substance to include petroleum products (defined by reference to section

4612(a)(3)).   H.R. 4297, as amended by the Senate (the "Tax Relief Act of

2005"), includes the same provision.

 

H.  Restructure Assistance to New York

 

 

                                    Present Law

In general

 

Present law includes a number of incentives to invest in property located

in the New York Liberty Zone ("NYLZ"), which is the area located on or

south of Canal Street, East Broadway (east of its intersection with Canal

Street), or Grand Street (east of its intersection with East Broadway) in

the Borough of Manhattan in the City of New York, New York. These

incentives were enacted following the terrorist attack in New York City on

September 11,2001.

 

Special depreciation allowance for qualified New York Liberty Zone property

 

Section 1400L(b) allows an additional first-year depreciation deduction

equal to 30 percent of the adjusted basis of qualified NYLZ property.  In

order to qualify, property generally must be placed in service on or

before December 31, 2006 (December 31, 2009 in the case of nonresidential

real property and residential rental property). 

 

The additional first-year depreciation deduction is allowed for both

regular tax and alternative minimum tax purposes for the taxable year in

which the property is placed in service.  A taxpayer is allowed to elect

out of the additional first-year depreciation for any class of property for

any taxable year.

 

In order for property to qualify for the additional first-year depreciation

deduction, it must meet all of the following requirements. First, the

property must be property to which the general rules of the Modified

Accelerated Cost Recovery System ("MACRS")  apply with (1) an applicable

recovery period of 20 years or less,(2) water utility property (as defined

in section 168(e)(5)), (3) certain nonresidential real property and

residential rental property, or (4) computer software other than computer

software covered by section 197.  A special rule precludes the additional

first-year depreciation under this provision for (1) qualified NYLZ

leasehold improvement property  and (2) property eligible for the

additional first-year depreciation deduction under section 168(k) (i.e.,

property is eligible for only one 30 percent additional first-year

depreciation).  Second, substantially all of the use of such property must

be in the NYLZ. Third, the original use of the property in the NYLZ must

commence with the taxpayer on or after September 11, 2001.  Finally, the

property must be acquired by purchase by the taxpayer after September 10,

2001 and placed in service on or before December 31, 2006. 

For qualifying nonresidential real property and residential rental property

the property must be placed in service on or before December 31, 2009 in

lieu of December 31, 2006.  Property will not qualify if a binding written

contract for the acquisition of such property was in effect before

September 11, 2001.

 

Nonresidential real property and residential rental property is eligible

for the additional first-year depreciation only to the extent such property

rehabilitates real property damaged, or replaces real property destroyed or

condemned as a result of the terrorist attacks of September 11, 2001.

 

Property that is manufactured, constructed, or produced by the taxpayer for

use by the taxpayer qualifies for the additional first-year depreciation

deduction if the taxpayer begins the manufacture, construction, or

production of the property after September 10, 2001, and the property is

placed in service on or before December 31, 2006  (and all other

requirements are met). Property that is manufactured, constructed, or

produced for the taxpayer by another person under a contract that is

entered into prior to the manufacture, construction, or production of the

property is considered to be manufactured, constructed, or produced by the

taxpayer.

 

Depreciation of New York Liberty Zone leasehold improvements

Generally, depreciation allowances for improvements made on leased

property are determined under MACRS, even if the MACRS recovery period

assigned to the property is longer than the term of the lease. This rule

applies regardless of whether the lessor or the lessee places the leasehold

improvements in service.  If a leasehold improvement constitutes an

addition or improvement to nonresidential real property already placed

in service, the improvement generally is depreciated using the

straight-line method over a 39-year recovery period, beginning in the month

the addition or improvement is placed in service.

 

A special rule exists for qualified NYLZ leasehold improvement property,

which is recovered over five years using the straight-line method.  The

term qualified NYLZ leasehold improvement property means property defined

in section 168(e)(6) that is acquired and placed in service after September

10, 2001, and before January 1, 2007 (and not subject to a binding contract

on September 10, 2001), in the NYLZ.  For purposes of the alternative

depreciation system, the property is assigned a nine-year recovery period.

A taxpayer may elect out of the 5-year (and 9-year) recovery period for

qualified NYLZ leasehold improvement property.

 

Increased section 179 expensing for qualified New York Liberty Zone

property

 

In lieu of depreciation, a taxpayer with a sufficiently small amount of

annual investment may elect to deduct the cost of qualifying property. 

For taxable years beginning in 2003 through 2007, a taxpayer may deduct up

to $100,000 of the cost of qualifying property placed in service for the

taxable year.  In general, qualifying property for this purpose is defined

as depreciable tangible personal property (and certain computer software)

that is purchased for use in the active conduct of a trade or business.

The $100,000 amount is reduced (but not below zero) by the amount by which

the cost of qualifying property placed in service during the taxable year

exceeds $400,000.  The $100,000 and $400,000 amounts are indexed for

inflation.

 

For taxable years beginning in 2008 and thereafter, a taxpayer with a

sufficiently small amount of annual investment may elect to deduct up to

$25,000 of the cost of qualifying property placed in service for the

taxable year.  The $25,000 amount is reduced (but not below zero) by

the amount by which the cost of qualifying property placed in service

during the taxable year exceeds $200,000.  In general, qualifying property

for this purpose is defined as depreciable tangible personal property that

is purchased for use in the active conduct of a trade or business. 

 

The amount eligible to be expensed for a taxable year may not exceed the

taxable income for a taxable year that is derived from the active conduct

of a trade or business (determined without regard to this provision).  Any

amount that is not allowed as a deduction because of the taxable income

limitation may be carried forward to succeeding taxable years (subject to

similar limitations).  No general business credit under section 38 is

allowed with respect to any amount for which a deduction is allowed under

section 179.

 

The amount a taxpayer can deduct under section 179 is increased for

qualifying property used in the NYLZ.  Specifically, the maximum dollar

amount that may be deducted under section 179 is increased by the lesser

of (1) $35,000 or (2) the cost of qualifying property placed

in service during the taxable year.  This amount is in addition to the

amount otherwise deductible under section 179.

 

Qualifying property for purposes of the NYLZ provision means section 179

property  purchased and placed in service by the taxpayer after

September 10, 2001 and before January 1,2007, where (1) substantially all

of the use of such property is in the NYLZ in the active conduct

of a trade or business by the taxpayer in the NYLZ, and (2) the original

use of which in the NYLZ commences with the taxpayer after

September 10, 2001.

 

The phase-out range for the section 179 deduction attributable to NYLZ

property is applied by taking into account only 50 percent of the cost of

NYLZ property that is section 179 property.  Also, no general business

credit under section 38 is allowed with respect to any amount for which a

deduction is allowed under section 179.

 

The provision is effective for property placed in service after

September 10, 2001 and before January 1, 2007.

 

Extended replacement period for New York Liberty Zone involuntary

conversions

 

A taxpayer may elect not to recognize gain with respect to property that

is involuntarily converted if the taxpayer acquires within an applicable

period (the "replacement period") property similar or related in service

or use (section 1033).  If the taxpayer does not replace the converted

property with property similar or related in service or use, then gain

generally is recognized.  If the taxpayer elects to apply the rules of

section 1033, gain on the converted property is recognized only to the

extent that the amount realized on the conversion exceeds the cost of the

replacement property.  In general, the replacement period begins with the

date of the disposition of the converted property and ends two years after

the close of the first taxable year in which any part of the gain upon

conversion is realized.  The replacement period is extended to three years

if the converted property is real property held for the productive use in a

trade or business or for investment.

 

The replacement period is extended to five years with respect to property

that was involuntarily converted within the NYLZ as a result of the

terrorist attacks that occurred on September 11, 2001.  However, the

five-year period is available only if substantially all of the use of the

replacement property is in New York City.  In all other cases, the

present-law replacement period rules continue to apply.

 

 

                               Description of Proposal

                                    

Repeal of certain NYLZ incentives

 

The proposal repeals the four NYLZ incentives relating to the additional

first-year depreciation allowance of 30 percent, the five-year depreciation

of leasehold improvements, the additional section 179 expensing, and the

extended replacement period for involuntary conversions.

 

Effective date.--The proposal is effective on the date of enactment, with

an exception for property subject to a written binding contract in effect

on the date of enactment which is placed in service prior to the original

sunset dates under present law. The extended replacement period for

involuntarily converted property ends on the earlier of (1) the date of

enactment or (2) the last day of the five-year period specified in the Jobs

Creation and Worker Assistance Act of 2002 ("JCWAA").

 

Credit for certain payments of New York State and New York City

 

The proposal provides a Federal tax credit only for New York State and New

York City,allowable against any payment by the State or City to the Federal

Government required under a provision of the Internal Revenue Code other

than the provisions relating to payments of excise taxes, FICA, SECA, or

OASDI amounts. For example, the credit is allowable against payments

of Federal income tax withheld with respect to State or City employees. 

 

The amount of the credit may not exceed the lesser of (1) $200 million per

year (divided equally between the State and the City) for calendar years

after 2006, until a cumulative total of $2 billion is reached, or (2)

expenditures for the calendar year by the State or City, respectively,

relating to the construction or improvement of transportation

infrastructure in or connecting to the New York Liberty Zone. Any amount

of unused credit below the $200 million annual limit is carried forward to

the following year, and expenditures that exceed the $200 million annual

limit are carried forward and subtracted from the $200 million annual limit

in the following year. 

 

Treasury guidance is to be provided to ensure that the expenditures satisfy

the intended purposes. The amount of the credit would be treated as State

and local funds for purposes of any Federal program.

 

Effective date.--The proposal is effective for calendar years after 2006.

 

 

                                    Analysis

                                   

The proposal is based on the premise that some of the tax benefits provided

by the present-law incentive provisions will not be usable in the form in

which they were originally provided, and that they should be replaced with

other benefits which would have a greater impact on the recovery and

continued development in the NYLZ.  The proposal reflects a preference for

subsidizing transportation infrastructure rather than buildings and other

private property.  Even to the extent that the incentive provisions can be

used by taxpayers in their present-law form,they are arguably unnecessary

to spur investment in the NYLZ because investment would occur in the area

even without special tax incentives.

 

On the other hand, the effectiveness of the present-law NYLZ incentives may

not yet be determinable because insufficient time has passed since they

were enacted.  Furthermore, repeal of the provisions prior to their

scheduled expiration could be unfair to any taxpayers who have

begun, in reliance upon the incentive provisions, to implement long-term

plans the status of which requires them to continue with planned

investments despite the absence of a written binding contract.  Opponents

may also object to the replacement of a benefit for private taxpayers with

a cash grant to governmental entities, or the replacement of an incentive

for investment in private property with an incentive for investment in

public infrastructure.

 

The proposal could be criticized as creating an inefficient method for

delivering a Federal transportation infrastructure subsidy to New York

State and New York City.  Further, because neither New York City nor New

York State is subject to Federal income tax itself, administration

of the Federal tax law is made needlessly complex by the creation of a

credit against payment of withheld income tax of these governmental

entities' employees.  Providing a transportation infrastructure subsidy as

a direct grant outside of the tax law would be more consistent with

simplification of the tax law and administrative efficiency.

 

 

                              Prior Action

                             

A similar proposal was included in the President's fiscal year 2006 budget

proposals.

 

 

III. SIMPLY THE TAX LAWS FOR FAMILIES

 

A. Clarify Uniform Definition of Child

 

                                       Present Law

                                      

Uniform definition of qualifying child

 

In general

 

Present law provides a uniform definition of qualifying child (the "uniform

definition") for purposes of the dependency exemption, the child credit,

the earned income credit, the dependent care credit, and head of household

filing status.  A taxpayer generally may claim an individual who does not

meet the uniform definition (with respect to any taxpayer) as a

dependent if the dependency requirements are satisfied.  The uniform

definition generally does not modify other parameters of each tax benefit

(e.g., the earned income requirements of the earned income credit) or the

rules for determining whether individuals other than children of the

taxpayer qualify for each tax benefit.

 

Under the uniform definition, in general, a child is a qualifying child of

a taxpayer if the child satisfies each of three tests: (1) the child has

the same principal place of abode as the taxpayer for more than one half

the taxable year; (2) the child has a specified relationship to the

taxpayer; and (3) the child has not yet attained a specified age.

A tie-breaking rule applies if more than one taxpayer claims a child as

a qualifying child.

 

The support and gross income tests for determining whether an individual

is a dependent generally do not apply to a child who meets the

requirements of the uniform definition.

 

Residency test

 

Under the uniform definition's residency test, a child must have the same

principal place of abode as the taxpayer for more than one half of the

taxable year.  As was the case under prior law, temporary absences due to

special circumstances, including absences due to illness, education,

business, vacation, or military service, are not treated as absences. 

Relationship test

 

In order to be a qualifying child, the child must be the taxpayer's son

, daughter, stepson, stepdaughter, brother, sister, stepbrother,

stepsister, or a descendant of any such individual.  For purposes of

determining whether an adopted child is treated as a child by blood, an

adopted child means an individual who is legally adopted by the taxpayer,

or an individual who is lawfully placed with the taxpayer for legal

adoption by the taxpayer. A foster child who is placed with

the taxpayer by an authorized placement agency or by judgment, decree,

or other order of any court of competent jurisdiction is treated as the

taxpayer's child.

 

Age test

 

The age test varies depending upon the tax benefit involved.  In general,

a child must be under age 19 (or under age 24 in the case of a full-time

student) in order to be a qualifying child.In general, no age limit applies

with respect to individuals who are totally and permanently disabled within

the meaning of section 22(e)(3) at any time during the calendar year.

A child must be under age 13 (if he or she is not disabled)

for purposes of the dependent care credit,and under age 17 (whether or not

disabled) for purposes of the child credit.

 

Children who support themselves 

 

A child who provides over one half of his or her own support generally is

not considered a qualifying child of another taxpayer.  However, a child

who provides over one half of his or her own support may constitute a

qualifying child of another taxpayer for purposes of the earned income

credit.

 

Tie-breaking rules

 

If a child would be a qualifying child with respect to more than one

individual (e.g., a child lives with his or her mother and grandmother

in the same residence) and more than one person claims a benefit with

respect to that child, then the following "tie-breaking" rules apply.

First, if only one of the individuals claiming the child as a qualifying

child is the child's parent, the child is deemed the qualifying child of

the parent. Second, if both parents claim the child and the parents do

not file a joint return, then the child is deemed a qualifying child first

with respect to the parent with whom the child resides for the longest

period of time, and second with respect to the parent with the highest

adjusted gross income.  Third, if the child's parents do not claim

the child, then the child is deemed a qualifying child with respect to the

claimant with the highest adjusted gross income.

 

Interaction with other rules

 

Taxpayers generally may claim an individual who does not meet the uniform

definition with respect to any taxpayer as a dependent if the dependency

requirements (including the gross income and support tests) are satisfied.

Thus, for example, a taxpayer may claim a parent as a dependent if the

taxpayer provides more than one half of the support of the parent and the

parent's gross income is less than the personal exemption amount.  As

another example, a grandparent may claim a dependency exemption with

respect to a grandson who does not reside with any taxpayer for over one

half the year, if the grandparent provides more than one half of

the support of the grandson and the grandson's gross income is less than

the personal exemption amount.

 

Citizenship and residency

 

Children who are U.S. citizens living abroad or non-U.S. citizens living in

Canada or Mexico may qualify as a qualifying child, as is the case under

the dependency tests.  A legally adopted child who does not satisfy the

residency or citizenship requirement may nevertheless qualify as a

qualifying child (provided other applicable requirements are met) if

(1) the child's principal place of abode is the taxpayer's home and (2)

the taxpayer is a citizen or national of the United States Children of

divorced or legally separated parents Generally, a custodial parent may

release the claim to a dependency exemption (and,therefore, the child

credit) to a noncustodial parent. If a waiver is made, the waiver applies

for purposes of determining whether a child meets the definition of a

qualifying child or a qualifying relative under section 152(c) or 152(d)

as amended by the provision.  While the definition of qualifying child is

generally uniform, for purposes of the earned income credit, head of

household status, and the dependent care credit, the uniform definition is

made without regard to the waiver provision.  Thus, a waiver that applies

for the dependency exemption will also apply for the child credit, and the

waiver will not apply for purposes of the other provisions.

 

Other provisions

 

A taxpayer identification number for a child must be provided on the

taxpayer's return.  For purposes of the earned income credit, a qualifying

child is required to have a social security number that is valid for

employment in the United States (that is, the child must be a U.S. citizen,

permanent resident, or have a certain type of temporary visa).

 

Earned income credit

 

The earned income credit is a refundable tax credit available to certain

lower-income individuals.  Generally, the amount of an individual's

allowable earned income credit is dependent on the individual's earned

income, adjusted gross income and the number of qualifying children

An individual who is a qualifying child of another individual is not

eligible to claim the earned income credit.  Thus, in certain cases a

taxpayer caring for a younger sibling in a home with no parents would be

ineligible to claim the earned income credit based solely on the fact

that the taxpayer is a qualifying child of the younger sibling if the

taxpayer meets the age, relationship and residency tests.

 

 

                              Description of Proposal

                             

Limit definition of qualifying child

 

The proposal adds a new requirement to the uniform definition. Specifically,

it provides that an individual who otherwise satisfies the definition of a

qualifying child for purposes of the uniform definition is not treated a

qualifying child unless he or she is either: (1) younger than the

individual claiming him or her as a qualifying child or (2) permanently and

totally disabled.  In addition, the proposal provides that an individual

who is married and files a joint return (unless the return is filed only

as a claim for a refund) will not be considered a qualifying child for

child-related tax benefits, including the child tax credit.

 

Restrict qualifying child tax benefits to child's parent

 

The proposal provides that if a parent resides with a qualifying child for

more than half the taxable year then only the parent can claim the child

as a qualifying child.  However, the parent could allow another member of

the household to claim the qualifying child if the other individual: (1)

has a higher AGI for the taxable year; and (2) otherwise is eligible to

claim the qualifying child.  The proposal further provides that dependent

filers are not eligible for child-related tax benefits.

 

Effective date.-The proposal is effective for taxable years beginning

after December 31, 2006.

 

                                   Analysis

                                  

In general

 

The proposed changes to the uniform definition are intended to restore

eligibility for the earned income credit to certain lower-income siblings

while eliminating a tax planning opportunity for more affluent families.

As discussed below, each element of the proposal would achieve its

intended result. However, the proposal would also constitute the third

change in the earned income credit eligibility requirements since 2001.

The earned income credit eligibility requirements were changed by Economic

Growth and Tax Relief Reconciliation Act of 2001 and the Working Families

Tax Relief Act of 2004.  Beneficiaries of the earned income credit are

more likely to be less sophisticated than other taxpayers.  For this

reason, changes to the uniform definition may adversely affect the ability

of lower income individuals to understand their eligibility for

child-related benefits such as the earned income credit.  This is

particularly important in an area that has a history of high taxpayer

error rates

 

Limit definition of qualifying child

 

The first part of the proposal is intended to restore eligibility for the

earned income credit to certain individuals.  It applies to certain

working lower-income siblings with respect to their siblings where no

other taxpayers reside in the household.  Under present law, such siblings

would be ineligible for the earned income credit to the extent they could

each be the qualifying child of the other.  For example, a 20-year-old

woman who is a full-time student and the legal guardian of her 15-year-old

brother would be unable to claim him as her qualifying child. It can be

argued that denying the earned income credit in such a case was an

unintended consequence of the enactment of a uniform definition.  Further,

the earned income credit arguably is intended to provide assistance in

this kind of situation.

 

One situation that would not benefit from the proposal would be a

circumstance where a younger sibling is supporting an older sibling. 

Such a situation may arise, for example, where a younger sibling is

working but the older sibling is a full-time student. The proposal could

have addressed this circumstance and restored eligibility for the earned

income credit to this group by denying status as a qualifying child to

siblings with lower incomes rather than to siblings that are younger.

Some child-related tax benefits, such as the dependency exemption, are

already restricted where an individual is married and files a joint return.

The proposal extends this limitation by excluding all joint filers (with a

narrow exception for taxpayers who file jointly only as a claim

for refund) from the uniform definition.  This change would affect only a

small percentage of filers (such as married teenagers filing joint returns)

but would reduce complexity by eliminating the need to file a special form

in cases were a qualifying child under the uniform definition is not

a dependent.

 

Restrict qualifying child tax benefits to child's parent

 

Under certain fact patterns (e.g., certain multi-generational families),

where more than one taxpayer within a family can claim a qualifying child

for certain tax benefits, the members of the family may arrange to maximize

their tax benefits. This planning opportunity was available in the case of

the earned income credit before the enactment of the uniform definition

in 2004.  The enactment of the uniform definition potentially expanded this

planning opportunity to other child-related tax benefits.  For example, if

a grandparent, parent, and child share the same household, under present

law the grandparent and parent can decide which of them should claim

the qualifying child in order to maximize tax benefits.  If the parent

earns $40,000 a year and the grandparent $20,000, it may be more

advantageous for the grandparent to claim the qualifying child in order to

receive the earned income credit,which the parent is ineligible for due to

his level of earnings. Under the proposal, the grandparent could not claim

the qualifying child because his adjusted gross income is less than that

of the parent.

 

The uniform definition has another, arguably unintended consequence.  In

certain fact patterns, the uniform definition extends tax benefits to

certain families who otherwise would not qualify (e.g. when the parents'

income exceeds otherwise applicable income levels) or increases

benefits to certain qualifying families. For example, it may be possible

in certain circumstances and financially advantageous for the family as a

whole, for parents to forgo claiming a child as a qualifying child so that

an older child living at home may claim such child as a qualifying child.

This would be most advantageous in circumstances in which the parents have

income above the phaseout limits for the child credit or where the older

sibling becomes eligible for the earned income credit by claiming the

younger sibling as a qualifying child.

 

Under the circumstances described above, the uniform definition provides a

tax planning opportunity for families that are more affluent and arguably

less in need of a tax benefit. The proposal addresses these situations by

limiting the ability of a non-parent to claim a child as a qualifying

child when the child lives with his or her parents for over half the year.

The proposal also restricts dependent filers from being eligible for

child-related tax benefits. The result of this would be to extend the

limitation already imposed with respect to the dependency exemption to

other child-related tax benefits.

 

                                     Prior Action

                                    

A similar proposal was included in the President's fiscal year 2006 budget.

That proposal, however, did not include the proposal to exclude from the

definition of qualifying child married individuals filing a joint return.

In addition, that proposal did not exclude dependent filers from

child-related tax benefits.

 

 

B. Simplify EIC Eligibility Requirements Regarding Filing Status, Presence

of Children, and Work and Immigrant Status

 

 

                                  Present Law

                                 

Overview

 

Low and moderate-income workers may be eligible for the refundable earned

income credit (EIC). Eligibility for the EIC is based on earned income,

adjusted gross income investment income, filing status, and immigration and

work status in the United States. The amount of the EIC is based on the

presence and number of qualifying children in the worker's

family, as well as on adjusted gross income and earned income.

 

The earned income credit generally equals a specified percentage of wages

up to a maximum dollar amount. The maximum amount applies over a certain

income range and then diminishes to zero over a specified phaseout range.

For taxpayers with earned income (or adjusted gross income (AGI)), if

greater) in excess of the beginning of the phaseout range, the maximum

EIC amount is reduced by the phaseout rate multiplied by the amount of

earned income (or AGI, if greater) in excess of the beginning of the

phaseout range.  For taxpayers with earned income (or AGI, if greater)

in excess of the end of the phaseout range, no credit is allowed.

 

An individual is not eligible for the EIC if the aggregate amount of

disqualified income of the taxpayer for the taxable year exceeds $2,800

(for 2006). This threshold is indexed. Disqualified income is the sum of:

(1) interest (taxable and tax exempt); (2) dividends;(3) net rent and

royalty income (if greater than zero);(4) capital gains net income; and

(5) net passive income (if greater than zero) that is not self-employment

income.

 

The EIC is a refundable credit, meaning that if the amount of the

credit exceeds the taxpayer's Federal income tax liability, the excess is

payable to the taxpayer as a direct transfer payment. Under an advance

payment system, eligible taxpayers may elect to receive the credit

in their paychecks, rather than waiting to claim a refund on their tax

return filed by April 15 of the following year.

 

Filing status

 

An unmarried individual may claim the EIC if he or she files as a single

filer or as a head of household.  Married individuals generally may not

claim the EIC unless they file jointly. An exception to the joint return

filing requirement applies to certain spouses who are separated. Under

this exception, a married taxpayer who is separated from his or her spouse

for the last six months of the taxable year shall not be considered as

married (and, accordingly, may file a return as head of household and claim

the EIC), provided that the taxpayer maintains a household that

constitutes the principal place of abode for a dependent child (including

a son, stepson, daughter, stepdaughter, adopted child, or a foster child)

for over half the taxable year, and pays over half the cost of maintaining

the household in which he or she resides with the child during the year.

 

Presence of qualifying children and amount of the earned income credit

 

The EIC is available to low and moderate-income working taxpayers. Three

separate schedules apply: one schedule for taxpayers with no qualifying

children, one schedule for taxpayers with one qualifying child, and one

schedule for taxpayers with more than one qualifying child.

 

Taxpayers with one qualifying child may claim a credit in 2006 of 34

percent of their earnings up to $8,080, resulting in a maximum credit of

$2,747. The maximum credit is available for those with earnings between

$8,080 and $14,810 ($16,810 if married filing jointly). 

The credit begins to phase down at a rate of 15.98 percent of earnings

above $14,810 ($16,810 if married filing jointly).  The credit is phased

down to 0 at $32,001 of earnings ($34,001 if married filing jointly).

 

Taxpayers with more than one qualifying child may claim a credit in 2006

of 40 percent of earnings up to $11,340, resulting in a maximum credit of

$4,536. The maximum credit is available for those with earnings between

$11,340 and $14,810 ($16,810 if married filing jointly).  The credit

begins to phase down at a rate of 21.06 percent of earnings above $14,810

($16,810 if married filing jointly).  The credit is phased down to $0 at

$36,348 of earnings ($38,458 if married filing jointly).

 

Taxpayers with no qualifying children may claim a credit if they are over

age 24 and below age 65.  The credit is 7.65 percent of earnings up to

$5,380, resulting in a maximum credit of $412, for 2006.  The maximum is

available for those with incomes between $5,380 and $6,740 ($8,740 if

married filing jointly).  The credit begins to phase down at a rate of

7.65 percent of earnings above $6,740 ($8,740 if married filing jointly)

resulting in a $0 credit at $12,120 of earnings ($14,120 if married filing

jointly).

 

If more than one taxpayer lives with a qualifying child, only one of these

taxpayers may claim the child for purposes of the EIC.  If multiple

eligible taxpayers actually claim the same qualifying child, then a

tiebreaker rule determines which taxpayer is entitled to the EIC with

respect to the qualifying child.  The eligible taxpayer who does not claim

the EIC with respect to the qualifying child may not claim the EIC for

taxpayers without qualifying children.

 

Definition of qualifying child

 

Present law provides a uniform definition of qualifying child (the "uniform

definition") for purposes of the dependency exemption, the child credit,

the earned income credit, the dependent care credit, and head of household

filing status.  The uniform definition generally does not modify other

parameters of each tax benefit (e.g., the earned income requirements of the

earned income credit) or the rules for determining whether individuals

other than children of the taxpayer qualify for each tax benefit. Under

the uniform definition, in general, a child is a qualifying child of a

taxpayer if the child satisfies each of three tests: (1) the child has

the same principal place of abode as the taxpayer for more than one half

the taxable year; (2) the child has a specified relationship to the

taxpayer; and (3) the child has not yet attained a specified age.  A

tie-breaking rule applies if more than one taxpayer claims a child as a

qualifying child.

 

Taxpayer identification number requirements

 

Individuals are ineligible for the credit if they do not include their

taxpayer identification number (TIN) and their qualifying child's TIN

(and, if married, their spouse's TIN) on their tax return.  Solely for

these purposes and for purposes of the present-law identification test

for a qualifying child, a TIN is defined as a Social Security number issued

to an individual by the Social Security Administration other than a number

issued under section 205(c)(2)(B)(i)(II) (or that portion of sec. 205(c)

(2)(B)(i)(III) relating to it) of the Social Security Act regarding the

issuance of a number to an individual applying for or receiving federally

funded benefits.  If an individual fails to provide a correct taxpayer

identification number, such omission will be treated as a mathematical or

clerical error by the IRS.

 

A taxpayer who resides with a qualifying child may not claim the EIC with

respect to the qualifying child if such child does not have a valid TIN.

The taxpayer also is ineligible for the EIC for workers without children

because he or she resides with a qualifying child.  However, if a taxpayer

has two or more qualifying children, some of whom do not have a valid TIN,

the taxpayer may claim the EIC based on the number of qualifying children

for whom there are valid TINs.

 

                            Description of Proposal

                           

Overview

The proposal modifies present law EIC rules by (1) altering the rules with

respect to EIC claims made by separated spouses; (2) simplifying the rules

regarding claiming the EIC for workers without children; and (3) changing

the taxpayer identification number requirements for taxpayers and their

qualifying children with respect to the EIC.

 

Claims by separated spouses

 

The proposal modifies present law regarding EIC claims made by separated

spouses. Under the proposal, a married taxpayer who files a separate return

(as married filing separately) is allowed to claim the EIC if he or she

lives with a qualifying child for over half the year,provided the taxpayer

lives apart from his or her spouse for the last six months of the taxable

year and otherwise satisfies the generally applicable EIC provisions.

Under the proposal, a married taxpayer who satisfies these requirements,

and files as married filing separately,is not required to provide over

half the cost of maintaining the household in which the qualifying child

resides.

 

Claims for EIC for workers without children

 

The proposal modifies the rules for EIC claims made by multiple taxpayers

residing in the same principal place of abode in which a qualifying child

resides.  Under the proposal, if multiple taxpayers residing in the same

principal place of abode are eligible to claim the same qualifying child,

an otherwise eligible taxpayer may claim the EIC for workers without

children (maximum credit of $412 for 2006) even if another taxpayer within

the same principal place of abode claims the EIC with respect to the

qualifying child.  However, if unmarried parents reside together with

their child or children (sons, daughters, stepchildren, adopted children,

or foster children), then one parent may claim the EIC for taxpayers with

qualifying children, but neither parent may claim the EIC for workers

without children

 

TIN requirements

 

The proposal provides that a taxpayer (including his or her spouse, if

married) must have a Social Security number that is valid for employment

in the United States (that is, the taxpayer must be a United States

citizen, permanent resident, or have a certain type of temporary visa that

allows him to work in the United States). Under the proposal, taxpayers

who receive Social Security numbers for non-work reasons, such as for

purposes of receiving Federal benefits or for any other reason, are not

eligible for the EIC. The proposal also provides that if a qualifying

child does not have a valid TIN, a taxpayer is eligible to claim the EIC

for workers without children (maximum credit of $412 for 2006).

 

Effective date.–The proposal generally is effective for taxable years

beginning after December 31, 2006.

 

 

                                Analysis

                                

Claims by separated spouses

 

The proposal eliminates the household maintenance test for a separated

spouse who claims the EIC. Married taxpayers filing separate returns who

reside with qualifying children may claim the EIC if they live apart from

their spouse for the last half of the year.  As under present law, such a

taxpayer could not file as a head of household unless he or she also

satisfies a household maintenance test and resides with a dependent child.

This proposal simplifies the determination of whether a separated spouse

is eligible to claim the earned income credit, and increases the number of

separated spouses living with a qualifying child who could claim the

EIC for taxpayers with qualifying children.

 

Claims for EIC for workers without children

 

Some may argue that the proposal to permit a taxpayer to claim the EIC for

taxpayers without qualifying children (maximum of $412 for 2006) in cases

where the taxpayer has a qualifying child, but another taxpayer claims the

qualifying child for EIC purposes, has the potential to add administrative

complexity for both taxpayers and the IRS. Under the proposal, each

eligible taxpayer has an incentive to calculate his or her taxes under

two alternatives to determine the maximum aggregate EIC available to the

multiple taxpayers who could claim the qualifying child: one alternative in

which the taxpayer claims the qualifying child for the EIC (and the other

taxpayer claims the EIC for taxpayers without qualifying children), and

one in which the taxpayer claims the EIC without the qualifying child (and

the other taxpayer claims the EIC for taxpayers with a qualifying child).

Presumably the taxpayers would wish to select that filing combination that

yields the lowest tax cost, or the highest tax benefit, to the parties. 

The proposal provides flexibility to taxpayers so that they are able to

allocate the qualifying child to a taxpayer in a manner that maximizes the

aggregate earned income credit, and may increase the aggregate credit paid

when compared to present law, but might do so at the cost of increasing

the complexity of the tax system. Others may argue that the proposal does

not increase selectivity or materially increase complexity, because

multiple taxpayers who are eligible to claim the same qualifying child for

the EIC currently have an incentive to calculate their taxes under two

alternatives (each computes the EIC for qualifying children, but not the

EIC for taxpayers without qualifying children) to yield the lowest tax cost

or the highest tax benefit for the parties.

 

The proposal's adoption of different rules for unmarried parents than for

other taxpayers who reside with a qualifying child in the same residence

creates complexity, and places unmarried parents at a disadvantage when

compared with other types of extended family situations (e.g., a mother

and grandmother sharing the same principal place of abode with a qualifying

child).

 

TIN requirements

 

The proposal permits a taxpayer to claim the EIC for taxpayers without a

qualifying child (maximum credit of $412 for 2006) if the taxpayer has a

qualifying child who does not have a valid TIN.  The proposal has the

effect of reducing the amount of the lost tax benefit associated

with failing to satisfy the TIN requirement for a qualifying child. Some

may argue that this is equitable because it treats a taxpayer with a

qualifying child who lacks a valid TIN in the same manner as a taxpayer

who does not have a qualifying child.  Others may argue that in some cases

the proposal reduces the incentive for a taxpayer to obtain a valid TIN

for a qualifying child.

 

The proposal also requires that taxpayers (including spouses) claiming the

EIC have Social Security numbers that are valid for employment in the

United States.   This has the effect of denying the EIC to some taxpayers

who have valid TINs and are currently eligible to claim the credit but who

are not authorized to work in the United States.  Proponents of the

proposal may argue that individuals who are not authorized to work in the

United States should not be eligible to claim the EIC.

 

                                     Prior Action

 

A similar proposal was included in the President's fiscal year 2005 budget.

That proposal, however, required that taxpayers and any qualifying children

have Social Security numbers that were valid for employment in the United

States.

 

 

 

C. Reduce Computational Complexity of Refundable Child Tax Credit

 

                                Present Law

                               

An individual may claim a tax credit for each qualifying child under the

age of 17.  The amount of the credit per child is $1,000 through 2010.  A

child who is not a citizen, national, or resident of the United States may

not be a qualifying child.

 

The credit is phased out for individuals with income over certain threshold

amounts. Specifically, the otherwise allowable child tax credit is reduced

by $50 for each $1,000 (or fraction thereof) of adjusted gross income over

$75,000 for single individuals or heads of households, $110,000 for married

individuals filing joint returns, and $55,000 for married individuals filing

separate returns.

 

The credit is allowable against the regular tax and the alternative minimum

tax.  To the extent the child credit exceeds the taxpayer's tax liability,

the taxpayer is eligible for a refundable credit (the additional child tax

credit) equal to 15 percent of earned income in excess of $11,300 (the

"earned income" formula).  The threshold dollar amount is indexed for

inflation.

 

Families with three or more children may determine the additional child

tax credit using the "alternative formula," if this results in a larger

credit than determined under the earned income formula.  Under the

alternative formula, the additional child tax credit can equal the amount

by which the taxpayer's social security taxes exceed the taxpayer's earned

income credit ("EIC").

 

Earned income is defined as the sum of wages, salaries, tips, and other

taxable employee compensation plus net self-employment earnings. Unlike the

EIC, which also includes the preceding items in its definition of earned

income, the additional child tax credit is based only on earned income to

the extent it is included in computing taxable income.  For example, some

ministers' parsonage allowances are considered self-employment income, and

thus are considered earned income for purposes of computing the EIC, but

the allowances are excluded from gross income for individual income tax

purposes, and thus are not considered earned income for purposes of the

additional child tax credit since the income is not included in taxable

income.

 

Residents of U.S. possessions (e.g., Puerto Rico) are generally not

eligible for the refundable child credit, because the earned income formula

is based on earned income to the extent the earned income is included in

taxable income.  Because residents of possessions are not subject to the

U.S. income tax on income earned outside the U.S., they are not generally

eligible for the refundable child credit.  However, the alternative child

credit formula for taxpayers with three or more children is based on social

security taxes, and thus residents of possessions with three or more

children are eligible for the refundable child credit if they pay social

security taxes, as do Puerto Ricans on Puerto Rican or U.S. sourced earnings.

 

                            Description of Proposal

 

The proposal repeals the alternative formula based on the excess of the

social security taxes paid over the amount of the EIC.  Thus, the

additional child tax credit will be based solely on the earned income

formula, regardless of the number of children in a taxpayer's family.

 

Also, the proposal eliminates the requirement that earned income be

included in taxable income for purposes of computing the additional child

tax credit. This conforms the definition of earned income for purposes of

the refundable child credit and the EIC (i.e., earned income for both

credits equals the sum of wages, salaries, tips, and other taxable

employee compensation plus net self-employment earnings). Thus, net

self-employment earnings that are not included in taxable income will be

included in earned income for purposes the additional child credit.

 

Finally, the proposal requires taxpayers to reside with a child in the

United States to claim the additional child tax credit. For these purposes,

the principal place of abode for members of the U.S. Armed Forces is

treated as in the United States for any period the member is stationed

outside the United States while serving on extended active duty. Extended

active duty includes a call or order to such duty for a period in excess

of 90 days.

 

Effective date.–The proposal is effective for taxable years beginning

after December 31,2006.

 

                               Analysis

                              

A single rule for calculating the refundable child credit will provide

simplification for taxpayers with three or more children who otherwise must

make two separate calculations: the earned income formula and the

alternative formula. The vast majority of such taxpayers find that

the alternative formula calculation does not yield a higher credit amount

so its repeal would make the credit calculation simpler without changing

total benefits. While the vast majority of taxpayers benefit from the

simplification of this change, taxpayers for whom the alternative

formula produces the greater benefit would receive a smaller refundable

child credit than that provided by current law.  In general, taxpayers who

find the alternative formula more valuable are: (1) residents of Puerto

Rico, who do not pay U.S. income taxes and are not eligible to claim

the EIC, but who may nonetheless may file a U.S. income tax return to

claim a refundable child credit, and (2) taxpayers in the United States

who are eligible for the child credit but not eligible to claim the EIC.

 

Use of the same measure of earned income for both the refundable child

credit and the EIC will provide simplification for all taxpayers claiming

both credits.  While for virtually all taxpayers the two measures of income

yield the same result under present law, the fact that this is not true of

all taxpayers requires additional instructions for all. Taxpayers for whom

the two measures of earned income differ are those who have certain

self-employment earnings, such as a parsonage allowance, that is excluded

from gross income for individual income tax purposes.The President's

proposal to adopt the EIC definition of earned income for purposes of the

refundable child credit (that is, to eliminate the requirement that the

earned income be included in computing taxable income) will expand the

availability of the refundable child credit to income not subject to the

individual income tax, which some might view as an undesirable policy

result.  The modified definition would allow Puerto Ricans with fewer than

three children to claim the refundable child credit but for the

President's proposal that eligibility for the refundable credit be

conditioned on United States residency (discussed below).

 

An alternative proposal that modifies the definition of earned income for

both EIC and refundable child credit purposes to incorporate only such

income that is also includable in gross income would appear to achieve

similar simplification without affecting the child credit for

residents of Puerto Rico with children.  The proposal would also treat

employees and the self-employed equivalently in determining both the EIC

and refundable child credit, although it may result in the denial of the

EIC for some EIC eligible parsons with parsonage allowances.

 

The President's proposal requires taxpayers to reside in the United States

in order to claim the refundable child credit. The principal effect of this

proposal is to prevent the expansion of the refundable child credit to

residents of Puerto Rico with fewer than three children that would occur

under the President's proposal to conform the earned income

definition for purposes of the EIC and the refundable child credit.  There

does not appear to be any particular simplification that results from the

proposal other than to prevent Puerto Ricans,who are not required to file

a U.S. income tax return, from filing such a return for the sole

purpose of claiming a refundable credit.

 

The President's proposal to require U.S. residency in order to claim a

refundable child credit would deny the refundable child tax credit to

certain taxpayers living abroad who may currently claim it. In some cases

this may not be considered desirable, such as in the case of a

low-income U.S. citizen who works in the U.S. but who happens to live in

Canada or Mexico.  In other cases the result may be viewed as desirable.

For example, a married U.S. taxpayer with two children who lives and works

in a foreign country with $100,000 foreign earned income would have a

gross income of only $20,000 as a result of the $80,000 foreign earned

income (section 911) exclusion. As a result of other provisions of U.S.

law such as the personal exemptions and child credits, such a taxpayer

would have no U.S. income tax liabilityHowever, because the refundable

child credit is based on only earned income included in taxable

income, the taxpayer is eligible for a refundable credit of 15 percent

of the amount by which such income (in this case $20,000) exceeds $11,300

, or $8,700, for a refundable credit of $1,305.Under present law, and

under the proposal, the taxpayer is not eligible for the EIC. The policy

for paying a refundable child credit in such a case is questionable,

especially considering the refundable credit is only payable once the

taxpayer's earned income reaches $91,300 ($80,000 section 911 exclusion

plus refundable child credit earned income threshold of $11,300).

 

Another situation where present law leads to a potentially undesirable

result occurs where a U.S. taxpayer with children living abroad has foreign

tax liability and claims a foreign tax credit.  In some such cases, the

taxpayer could pay the foreign tax, use the foreign tax credit to eliminate

any U.S. tax liability, and then claim a refundable child credit.

Under the proposal, the child credit would not be available to such a

taxpayer. 

 

                                  Prior Action

                                 

A similar proposal was included in the President's fiscal year 2005 budget.

 

IV. PROVISIONS RELATED TO THE EMPLOYER-BASED PENSION SYSTEM

 

A.  Provisions Relating to Cash Balance Plans

 

                                       Present Law

                                       

Overview

 

Types of qualified plans in general

 

Qualified retirement plans are broadly classified into two categories,

defined benefit pension plans and defined contributions plans, based on the

nature of the benefits provided.  In some cases, the qualification

requirements apply differently depending on whether a plan is a defined

benefit pension plan or a defined contribution plan.Under a defined benefit

pension plan, benefits are determined under a plan formula, generally based

on compensation and years of service. For example, a defined benefit

pension plan might provide an annual retirement benefit of two percent of

final average compensation multiplied by total years of service completed

by an employee.  Benefits under a defined benefit pension plan are funded

by the general assets of the trust established under the plan; individual

accounts are not maintained for employees participating in the plan.

 

Employer contributions to a defined benefit pension plan are subject to

minimum funding requirements under the Internal Revenue Code and the

Employee Retirement Income Security Act of 1974 ("ERISA") to ensure that plan

assets are sufficient to pay the benefits under the plan. 

An employer is generally subject to an excise tax for a failure to make

required contributions.  Benefits under a defined benefit pension plan are

generally guaranteed (within limits) by the Pension Benefit Guaranty

Corporation ("PBGC").

 

Benefits under defined contribution plans are based solely on the

contributions (and earnings thereon) allocated to separate accounts

maintained for each plan participant.  Profit sharing plans and qualified

cash or deferred arrangements (commonly called "401(k) plans" after the

section of the Internal Revenue Code regulating such plans) are examples of

defined contribution plans.

 

Cash balance plans

 

A cash balance plan is a defined benefit pension plan with benefits

resembling the benefits associated with defined contribution plans. Cash

balance plans are sometimes referred to as "hybrid" plans because they

combine features of a defined benefit pension plan and a defined

contribution plan. Other types of hybrid plans exist as well, such as

pension equity plans.

 

Under a cash balance plan, benefits are defined by reference to a

hypothetical account balance.  An employee's hypothetical account balance

is determined by reference to hypothetical annual allocations to the

account ("pay credits"), for example, a certain percentage of the

employee's compensation for the year, and hypothetical earnings on the

account ("interest credits").The method of determining interest credits

under a cash balance plan is specified in the plan.  Under one common plan

design, interest credits are determined in the form of hypothetical

interest on the account at a rate specified in the plan or based on a

specified market index, such as the rate of interest on certain Treasury

securities.  Alternatively, interest credits are sometimes based on

hypothetical assets held in the account, similar to earnings on an

individual account under a defined contribution plan, which are based on

the assets held in the individual account.

 

Cash balance plans are generally designed so that, when a participant

receives a pay credit for a year of service, the participant also receives

the right to future interest on the pay credit, regardless of whether the

participant continues employment (referred to as "front-loaded" interest

credits).  That is, the participant's hypothetical account continues to be

credited with interest after the participant stops working for the

employer.  As a result, if an employee terminates employment and defers

distribution to a later date, interest credits will continue to be

credited to that employee's hypothetical account.  Some early cash balance

plans provided interest credits only while participants' remained employed

(referred to as "back-loaded" interest credits).  That is, a participant's

hypothetical account was not credited with interest after the participant

stopped working for the employer.

 

Overview of qualification issues with respect to cash balance plans

 

Cash balance plans are subject to the qualification requirements applicable

to defined benefit pension plans generally.  However, because such plans

have features of both defined benefit pension plans and defined

contributions plans, questions arise as to the proper application

of the qualification requirements to such plans.  Some issues arise if a

defined benefit pension plan with a traditional defined benefit formula is

converted to a cash balance plan formula, while others arise with respect

to all cash balance plans.  Issues that commonly arise include: (1) in

the case of a conversion to a cash balance plan formula, the application of

the rule prohibiting a cutback in accrued benefits;  (2) the proper method

for determining lump-sum distributions;  and (3) the application of the age

discrimination rules.   These rules are discussed below. 

Other issues have been raised in connection with cash balance plans,

including the proper method for applying the accrual rules.

 

There is little guidance under present law with respect to many of the

issues raised by cash balance conversions.  In 1999, the IRS imposed a

moratorium on determination letters for cash balance conversions pending

clarification of applicable legal requirements. Under the moratorium, all

determination letter requests regarding converted cash balance plans are

sent to the National Office for review; however, the National Office is

not currently acting on these plans.

 

Benefit accrual requirements

 

Several of the requirements that apply to qualified retirement plans relate

to a participant's accrued benefit. For example, the vesting requirements

apply with respect to a participant's accrued benefit.  In addition, as

discussed below, a plan amendment may not have the effect of reducing a

participant's accrued benefit. In the case of a defined benefit pension

plan, a participant's accrued benefit is generally the accrued benefit

determined under the plan,expressed in the form of an annuity commencing

at normal retirement age 

 

The accrued benefit to which a participant is entitled under a defined

benefit pension plan must be determined under a method (referred as the

plan's accrual method) that satisfies one of three accrual rules.  These

rules relate to the pattern in which a participant's normal retirement

benefit (i.e., the benefit payable at normal retirement age under the

plan's benefit formula) accrues over the participant's years of service,

so that benefit accruals are not "back-loaded" (i.e., delayed until years

of service close to attainment of normal retirement age).

 

A participant's accrued benefit under a cash balance plan is determined

by converting the participant's hypothetical account balance at normal

retirement age to an actuarially equivalent

annuity.

 

Under a plan providing front-loaded interest credits, benefits attributable

to future interest credits on a pay credit become part of the participant's

accrued benefit when the participant receives the pay credit.  Thus, for

purposes of determining the accrued benefit, the participant's hypothetical

account balance includes projected future pay credits for the period

until normal retirement age.  This has the effect of front-loading benefit

accruals.

 

Under a plan providing back-loaded interest credits, benefits attributable

to interest credits do not accrue until the interest credits are credited

to the employee's account.  Thus, as a participant's account balance grows

over time, the amount of interest credited to the account increases, with a

resulting increase in the participant's accrued benefit. The IRS has indicated

that plans that provide back-loaded interest credit typically will not

satisfy any of the accrual rules.

 

Protection of accrued benefits; "wearaway" under cash balance plans

 

In general

 

The Code generally prohibits an employer from amending a plan's benefit

formula to reduce benefits that have already accrued (the "anticutback

rule").  For this purpose, an amendment is treated as reducing accrued

benefits if it has the effect of eliminating or reducing an early

retirement benefit or a retirement-type subsidy or of eliminating an

optional form of benefit provided with respect to benefits that have

already accrued.

 

The anticutback rule applies in the context of cash balance plan

conversions.  Because of this rule, after conversion to a cash balance

formula, a plan must provide employees at least with the normal retirement

benefit that he or she had accrued before the conversion, as well as with

any early retirement benefits or other optional forms of benefit provided

with respect to the accrued benefit before the conversion.  However, the

plan may determine benefits for years following the conversion in a variety

of ways, while still satisfying the anticutback rule. 

Common plan designs are discussed below.

 

Wearaway (or "greater of" approach)

Upon a conversion to a cash balance plan, participants are generally given

an opening account balance.  The pay and interest credits provided under

the plan are then added to this opening account balance. The opening account

balance may be determined in a variety of ways and is generally a question

of plan design.  For example, an employer may create an opening account

balance that is designed to approximate the benefit a participant would

have had, based on the participant's compensation and years of service, if

the cash balance formula had been in effect in prior years.  As another

example, an employer may convert the preconversion accrued

benefit into a lump-sum amount and establish this amount as the opening

account balance. Depending on the interest and mortality assumptions used,

this lump-sum amount may or may not equal the actuarial present value of

the participant's accrued benefit as of the date of conversion, determined

using the statutory interest and mortality assumptions required in

determining minimum lump-sum distributions (as discussed below).

 

Under the wearaway approach, the participant's protected benefit (i.e., the

preconversion accrued benefit) is compared to the normal retirement benefit

that is provided by the account balance (plus pay and interest credits),

and the participant does not earn any new benefits until the new benefit

exceeds the protected accrued benefit. That is, the participant's benefit

is the greater of the preconversion accrued benefit and the benefit

provided by the cash balance account.  Because of this effect, plans with a

wearaway are also referred to as using the "greater of" method of

calculating benefits. For example, suppose the value of the protected accrued

benefit is $40,000, and the opening account balance under the cash balance

formula provides a normal retirement benefit of $35,000. The participant

will not earn any new benefits until the hypothetical balance under the

cash balance formula increases to the extent that it provides a normal

retirement benefit exceeding $40,000.  Plan design can greatly affect the

length of any wearaway period.

 

No wearaway (or "sum of " approach)

Under a plan without a wearaway, a participant's benefit under the cash

balance plan consists of the sum of (1) the benefit accrued before

conversion, plus (2) benefits under the cash balance formula for years of

service after the conversion. This approach is more favorable to plan

participants than the wearaway approach because they earn additional

benefits under the new plan formula immediately. This approach is also

sometimes referred to as the "A + B" method, where A is the protected

benefit and B is the benefit under the cash balance formula.

 

Grandfathering

 

For older and longer-service participants, benefits under a cash balance

formula may be lower than the benefits a participant may have expected to

receive under the traditional defined benefit formula (the "old" formula).

The employer might therefore provide some type of "grandfather" to

participants already covered by the plan or to older or longer-service

employees.  For example, the old formula might continue to apply to

participants who were already covered by the plan before the conversion;

such participants might be given a choice between the old

formula and the cash balance formula for future benefit accruals; or,

in the case of a final average pay plan, the plan may stop crediting

service under the old formula, but continue to apply post-conversion pay

increases, so the employee's preconversion benefit increases with

post-conversion pay increases. These approaches go beyond merely preserving

the benefit protected by the anticutback rule.

 

Age discrimination

 

In general

 

The Code and ERISA prohibit any reduction in the rate of a participant's

benefit accrual (or the cessation of accruals) under a defined benefit

pension plan because of the attainment of any age.  A parallel requirement

applies under the Age Discrimination in Employment Act ("ADEA").  These

provisions do not necessarily prohibit all benefit formulas under which a

reduction in accruals is correlated with participants' age in some manner.

Thus, for example, a plan may limit the total amount of benefits, or may

limit the years of service or participation considered in determining

benefits. In general terms, an age discrimination issue arises as a result

of front-loaded interest credits under cash balance plans because there is

a longer time for interest credits to accrue on hypothetical contributions

to the account of a younger participant.  For example, a $1,000

hypothetical contribution made when a plan participant is age 30 will be

worth more at normal retirement age (e.g., age 65) and thus provide a

higher annuity benefit at normal retirement age than the same contribution

made on behalf of an older participant closer to normal retirement age. 

This age discrimination issue is not limited to cash balance plan

conversions,but arises with respect to cash balance plans generally.

 

Proposed Treasury regulations

 

In December 2002, the Treasury Department issued proposed regulations

relating to the application of age discrimination prohibitions to defined

benefit pension plans, including special rules for cash balance plans. The

proposed regulations provided guidance on how to determine the rate of

benefit accrual under a defined benefit pension plan or rate of allocation

under a defined contribution plan.

 

The proposed regulations provided that an employee's rate of benefit

accrual for a year under a defined benefit pension plan is generally the

increase in the employee's accrued normal retirement benefit (i.e., the

benefit payable at normal retirement age) for the plan year.  However,

the proposed regulations provided a special rule under which an employee's

rate of benefit accrual under a cash balance plan meeting certain

requirements (an "eligible" cash balance plan) was based on the rate of

pay credit provided under the plan. Thus, under the proposed regulations,

an eligible cash balance plan would not violate the prohibition on age

discrimination solely because pay credits for younger employees earn

interest credits for a longer period. In order for a plan converted to a

cash balance plan to be an eligible cash balance plan, the regulations

generally required the conversion to be accomplished in one of two ways.

 

In general,the converted plan had to either: (1) determine each

participant's benefit as not less than the sum of the participant's

benefits accrued under the traditional defined benefit pension plan formula

and the cash balance formula; or (2) establish each participant's opening

account balance as an amount not less than the actuarial present value of

the participant's prior accrued benefit, using reasonable actuarial

assumptions. The proposed regulations also allowed a converted plan to

continue to apply the traditional defined benefit formula to some

participants.

 

Section 205 of the Consolidated Appropriations Act, 2004

(the "2004 Appropriations Act"), enacted January 24, 2004, provides that

none of the funds made available in the 2004 Appropriations Act may be used

by the Secretary of the Treasury, or his designee, to issue any

rule or regulation implementing the proposed Treasury regulations or any

regulation reaching similar results.  The 2004 Appropriations Act also

required the Secretary of the Treasury within 180 days of enactment to

present to Congress a legislative proposal for providing transition relief

for older and longer-service participants affected by conversions of their

employers' traditional pension plans to cash balance plans.On

June 15, 2004, the Treasury Department and the IRS announced the

withdrawal of the proposed age discrimination regulations including the

special rules on cash balance plans and cash balance conversions. 

According to the Announcement, "[t]his will provide Congress an

opportunity to review and consider the Administration's legislative

proposal and to address cash balance and other hybrid plan issues through

legislation."   Treasury and the IRS announced that they do not intend to

issue guidance on compliance with the age discrimination rules for

cash balance plans, cash balance conversions, or other hybrid plans or

hybrid plan conversions while the issues are under consideration by

Congress.  As previously discussed, Treasury and the IRS also announced

that they do not intend to process the technical advice cases pending with

the National Office while cash balance issues are under consideration by

Congress.

 

Case law

 

In response to employers' decisions to implement or convert to cash

balance plans, several class action lawsuits have been brought by employees

claiming that age discrimination requirements have been violated. Four

Federal district court cases have addressed whether cash balance plans

violate the age discrimination rules.

 

In Eaton v. Onan,  a case of first impression, the court held that a cash

balance plan did not violate the prohibition on reducing the rate of

benefit accrual because of age.  Under the plan,participants received pay

credits for each year of service as well as front-loaded interest credits. 

The court considered how the rate of an employee's benefit accrual is

determined for purpose of the age discrimination rules and concluded that

the statute does not require the rate of benefit accrual to be measured

solely by the value of a participant's annuity payable at normal retirement

age.  The court found that, in the case of a cash balance plan, the rate of

benefit accrual should be defined as the change in the employee's cash

balance account from one year to the next. The court held that a cash

balance plan does not violate the prohibition on reducing the rate of

benefit accrual because of age.

 

After the proposed Treasury regulations were issued, a Federal district

court in Cooper v IBM Personal Pension Plan  held that cash balance

formulas are inherently age discriminatory because identical interest

credits necessarily buy a smaller age annuity at normal retirement age

for older workers than for younger workers due to the time value of money.

The court interpreted "rate of benefit accrual" as referring to an

employee's age 65 annual benefit (i.e.,the annuity payable at normal

retirement age) and the rate at which the age 65 annual benefit

accrues. The court held that the interest credits must be valued as an age

65 annuity, so that interest credits would always be more valuable to a

younger employee as opposed to an older employee, thus violating the

prohibition on reducing the rate of benefit accrual because of age.

 

More recently, the analysis in Eaton v. Onan Corporation has also been

applied in two other cases, Tootle v. ARINC Inc., and Register v. PNC

Financial Services Group, Inc.

 

Calculating minimum lump-sum distributions

 

Defined benefit pension plans are required to provide benefits in the form

of a life annuity commencing at a participant's normal retirement age.  If

the plan permits benefits to be paid in certain other forms, such as a

lump sum, the alternative form of benefit cannot be less than the present

value of the annuity payable at normal retirement age, determined using

certain statutorily prescribed interest and mortality assumptions. 

 

Although a participant's benefit under a cash balance plan is described in

terms of a hypothetical account balance, a cash balance plan (like other

defined benefit pension plans) is required to provide benefits in the form

of an annuity payable at normal retirement age.  Most cash balance plans

are designed to permit lump-sum distributions of the participant's

hypothetical account balance upon termination of employment.  As is the

case with defined benefit pension plans generally, such a lump-sum amount

is required to be the actuarial equivalent to the annuity payable at

normal retirement age, determined using the statutory interest and

mortality assumptions.

 

IRS Notice 96-8 provides that determination of an employee's minimum

lump sum under a cash balance plan that provides for

front-loaded interest credits is calculated by: (1) projecting the

participant's hypothetical account balance to normal retirement age by

crediting future interest credits, the right to which has already accrued;

(2) converting the projected account balance to an actuarially equivalent

life annuity payable at normal retirement age, using the interest and

mortality assumptions specified in the plan; and (3) determining the

present value of the annuity (i.e., the lump-sum value) using the statutory

interest and mortality assumptions.

 

A difference in the rate of interest credits provided under the plan, which

is used to project the account balance forward to normal retirement age,

and the statutory rate used to determine the minimum lump-sum value (i.e.,

present value) of the accrued benefit will generally cause a discrepancy

between the value of the minimum lump-sum and the employee's hypothetical

account balance.  In particular, if the plan's interest crediting rate is

higher than the statutory interest rate, then the resulting lump-sum amount

will generally be greater than the hypothetical account balance.  This

result is sometimes referred to as "whipsaw."  Several Federal appellate

courts that have addressed the calculation of lump-sum distributions under

cash balance plans have followed an approach similar to the approach

described in IRS Notice 96-8.

 

                               Description of Proposal

                              

In general

 

The proposal provides rules for conversions of defined benefit pension

plans to cash balance plans, applying the age discrimination requirements

to cash balance plans, and determining minimum lump-sum distributions from

cash balance plans.  The proposal makes conforming amendments to ERISA and

ADEA.

 

Conversions to cash balance plans

 

Under the proposal, for the first five years following the conversion of a

traditional defined benefit pension plan to a cash balance plan, the

benefits earned by any participant in the cash balance plan who was a

participant in the traditional plan must be at least as valuable as the

benefits the participant would have earned under the traditional plan had

the conversion not occurred.  Additionally, wearaway of normal and early

retirement benefits in connection with a conversion to a cash balance plan

is prohibited.Failure to follow these requirements will not result in

disqualification of the plan.  However, a 100-percent excise payable by

the plan sponsor will be imposed on any difference between required

benefits and the benefits actually provided under a plan which has been

converted to a cash balance formula.  The amount of the excise tax cannot

exceed the plan's surplus assets at the time of the conversion or the plan

sponsor's taxable income, whichever is greater.  The excise tax does not

apply if participants are given a choice between the traditional defined

benefit pension plan formula and the cash balance formula or if current

participants are "grandfathered," i.e., permitted to continue to earn

benefits under the traditional formula rather than the cash balance formula.

 

Age discrimination

 

Under the proposal, a cash balance plan satisfies age discrimination

requirements if it provides pay credits for older participants that are not

less than the pay credits for younger participants (in the same manner as

under a defined contribution plan).  Additionally, certain transition

approaches used in conversions, such as preserving the value of early

retirement subsidies, do not violate the age discrimination or other

qualification rules.  The proposal provides similar rules for other types

of hybrid plans and for conversions from traditional defined benefit

pension plans to other types of hybrid plans.

 

Calculating lump-sum distributions

 

The proposal permits the value of a lump-sum distribution to be determined

as the amount of a participant's hypothetical account balance under a cash

balance plan as long as the plan does not provide interest credits in

excess of a market rate of return.  The Secretary of the Treasury is

authorized to provide safe harbors for market rates of return and to

prescribe appropriate conditions regarding the calculation of plan

distributions

 

Effective date.-The proposal is effective prospectively. No inference is

intended as to the status of cash balance plans or cash balance conversions

under present law.

 

                                  Analysis

                                 

In general

 

Issues relating to cash balance plans raise broader issues relating to the

defined benefit pension plan system and retirement income security, as

discussed below.  The proposal addresses certain issues relating to cash

balance plans, with three stated objectives:  (1) to ensure fairness

for older workers in cash balance conversions, (2) to protect the defined benefit pension plan

system by clarifying the status of cash balance plans, and (3) to remove the effective ceiling on

interest credits in cash balance plans due to the manner in which lump-sum benefits are

calculated.  Specific issues arise with respect to each part of the proposal.  In addition, because

the proposal is effective only prospectively, there will be continued uncertainty as to the legal

status of cash balance plans created or converted before the date of enactment.

Retirement income security and cash balance plans

Helping to ensure that individuals have retirement income security is the major objective

of the U.S. private pension system.  The system is a voluntary system, relying heavily on tax

incentives in order to encourage employers to establish qualified retirement plans for their

employees.  Although qualified plans are subject to a variety of legal requirements, employers

generally may choose whether or not to adopt a qualified plan, the type of plan to adopt, the level

of benefits to be provided, and many other plan features.

Over time, there has been a decline in defined benefit pension plan coverage compared to

coverage under defined contribution plans.  This has caused some to be concerned about a

possible decline in retirement income security and has focused attention on both defined

contribution plans and defined benefit pension plans.  Issues of retirement income security with

respect to both types of plans have been the subject of recent Congressional action.

Traditional defined benefit pension plans are viewed by many as providing greater

retirement income security than defined contribution plans.  This is primarily because such plans

provide a specific promised benefit.  Employers bear the risk of investment loss; if plan

contributions plus earnings are insufficient to provide promised benefits, the employer is

responsible for making up the difference.  Within certain limits, most defined benefit pension

plan benefits are guaranteed by the PBGC.  Investments of defined benefit pension plan assets

are subject to ERISA's fiduciary rules and limitations on the amount of plan assets that may be

invested in stock of the employer.  In addition, defined benefit pension plans are subject to

certain spousal benefit requirements that do not apply to most defined contribution plans.  That

is, defined benefit plans are required to provide benefits in the form of a joint and survivor

annuity unless the participant and spouse consent to another form of benefit.

In contrast, defined contribution plans do not promise a specific benefit, but instead pay

the value of the participant's account.  The plan participant bears the risk of investment loss. 

Benefits provided by defined contribution plans are not guaranteed by the PBGC.  The extent to

which ERISA's fiduciary rules apply to a defined contribution plan depends on the particular

plan structure; in many cases defined contribution plans allow plan participants to direct the

investment of their accounts, in which case more limited fiduciary protections may apply than in

the case of defined benefit pension plans.  ERISA's limitations on the amount of plan assets that

may be invested in employer stock generally do not apply to defined contribution plans.  In

addition, under most defined contribution plans, the spouse has only the right to be named the

beneficiary of the amount (if any) remaining upon the death of the employee.

Cash balance plans have become an increasing prevalent plan design and, as well, an

increasing element in discussions regarding retirement income security and the future of the

defined benefit pension plan system.

During the 1990s, conversions of traditional defined benefit pension plans to cash

balance formulas were common among mid- to large-size employers.  There was considerable

media attention regarding such conversions, particularly in cases in which the plan contained a

"wearaway" or in which older or longer-service employees close to retirement were denied the

opportunity to continue to accrue benefits under the old plan formula.  While perhaps complying

with the law, such plan designs were viewed by many as unfair to certain participants.  There

was concern that some employers were adversely affecting participants in order to reduce costs. 

There was also concern that participants might not understand the effect of the conversion on

their benefits (including future benefits the participant may have accrued under the old

formula).

Since then, cash balance plans have continued to be popular.  While certain legal issues

have remained, employers have continued to adopt cash balance plans.  In many cases,

employers have structured conversions to avoid or minimize potential adverse effects on older

and longer-service employees. 

Attention again focused on cash balance plans following the IBM decision, which found

the basic cash balance formula to violate the age discrimination rules.  This case applies not only

to conversions, but to all cash balance plans.  This decision called into question whether cash

balance plans are a permitted form of pension benefit.  Although a previous case and two

subsequent cases have upheld the cash balance plan design, continued litigation of this issue has

resulted in uncertainty for employers that currently offer cash balance plans and employees who

are participants in such plans.  It has also focused attention on the future of defined benefit

pension plans and the role that cash balance plans play within the overall pension system.

Some believe that traditional defined benefit pension plans, and final average pay

formulas under such plans, generally provide greater benefits than cash balance plans,

particularly because traditional plans often provide subsidized early retirement benefits.  Some

argue that cash balance plans are primarily adopted by employers who wish to cut costs and

reduce future benefits.  They argue that reductions in benefits are not as obvious with a

conversion to a cash balance plan compared to plan changes within the traditional defined benefit

pension plan structure.  Even with the present-law requirements relating to notices of reductions

in future benefit accruals, it is argued that plan participants do not understand how to compare

cash balance benefits with traditional defined benefit pension plan benefits and that many

employees mistakenly think that the cash balance formula, expressed as an account balance,

provides comparable benefits when it does not.  It is also argued that cash balance plans

inherently discriminate against longer-service older workers, and thus should not be encouraged

as a plan design.

On the other hand, others point out that employers sponsor qualified retirement plans

voluntarily.  While tax incentives encourage employers to establish and maintain such plans,

they are not required to do so.  Thus, if employers wish to reduce future benefits, or eliminate

future benefits altogether, they may do so and many have.  Some view preserving cash balance

plans as a means of preserving the defined benefit pension plan system and as an important step

in helping to ensure retirement income security.   Cash balance plans may be attractive to

employers for various reasons.  The adoption of a cash balance plan may enable employers to

better manage pension liabilities.  Some employers are concerned about the level of contributions

that may be required to fund traditional defined benefit pension plans, especially because the

required contributions may fluctuate over time.  They argue that a cash balance plan design does

not result in such unpredictable funding obligations.

Some say that, rather than whether workers are better off with a traditional defined

benefit pension plan than with a cash balance plan, a more appropriate question is whether

workers are better off with a cash balance plan or no defined benefit pension plan.  They note

that defined benefit pension plan coverage is falling and that the traditional defined benefit

pension plan continues to be a less and less viable and attractive option for many employers. 

They argue that the flexibility offered by cash balance plans enables employers to continue a

defined benefit pension plan, as well as in many cases also provide a defined contribution plan,

thus enhancing retirement income security.

Some also argue that cash balance plans are more beneficial to many employees than a

traditional defined benefit pension plan and should be a permitted plan design option.  Unlike

traditional defined benefit pension plans, which tend to benefit long-service participants who

remain with a company until retirement, cash balance plans often benefit shorter service, more

mobile workers.  Cash balance plans may also provide more portable benefits than traditional

defined benefit pension plans.  Thus, cash balance plans may be popular in industries or markets

in which workers are relatively mobile or among groups of workers who go in and out of the

workforce.  Some participants also find cash balance plans easier to understand than a traditional

defined benefit pension plan because their benefit is described in terms of an account balance.

However, some note that cash balance plans, while legally defined benefit pension plans,

operate in a way that does not deliver the full protections of a traditional defined benefit pension

plan.  For example, many traditional defined benefit pension plans do not offer lump-sum

distributions.  In contrast, cash balance plans typically do.  While some argue that this increases

portability of benefits, others argue that cash balance plans discourage annuity benefits, which

may erode retirement income security and may undermine spousal rights.

Some also comment that the risk of investment loss borne by employers, and the

protections against such losses for employees, are fundamentally different in cash balance plans

than in traditional defined benefit pension plans.  In the case of a traditional defined benefit plan,

the plan formula promises a specific benefit payable at normal retirement age.  Although the

employer may benefit from favorable investment returns by making lower contributions, the

employer also bears the risk that plan assets will not be sufficient to provide the promised

benefits and generally must make up investment losses.  Rather than providing a specified

benefit, a cash balance plan specifies interest credits.  This design may reduce the employer's

risk that plan assets will underperform compared to the interest credits provided under the plan,

while still giving the employer the benefit of greater than expected investment performance.  

Some argue that, under certain cash balance plan designs, plan participants face

investment risk similar to the risk under defined contribution plans.  For example, this risk may

exist to the extent that the hypothetical account balance in a cash balance plan is subject to

investment losses and well as investment gains.  While many cash balance plans are designed to

protect against loss in value, some argue that it is permissible to tie interest credits to

hypothetical investments that may incur losses.  In that case, a decline in the value of a

participant's hypothetical account balance may result in a decline in the participant's accrued

benefit.  Some argue that such declines are inconsistent with the basic concept of a defined

benefit pension plan, i.e., a plan that provides a specified benefit to participants, in contrast to a

defined contribution plan under which participants bear the risk of loss.  They argue that cash

balance plan designs under which participants bear the risk of investment loss (even if only on

hypothetical investments) should not be permitted. 

Some argue that, to the extent proposals relating to cash balance plans are motivated by

concerns about retirement income security, other proposals to address such concerns should also

be considered, including ways to make defined benefit pension plans more attractive to

employers on an ongoing basis.  Some also argue that it may be appropriate to consider whether

changes to the rules relating to defined contribution plans should be considered to enable such

plans to provide greater retirement income security.

Conversions to cash balance plans; wearaway

The proposal is intended to ensure fairness for older workers in conversions of traditional

defined benefit pension plans to cash balance plans.  It provides rules relating to the benefits

accrued by participants in defined benefit pension plans that are converted to cash balance plans. 

The proposal provides greater protection for longer-service participants than is currently required

under the present-law rules prohibiting cutbacks in accrued benefits. 

By requiring that the benefits earned by a participant for the first five years following a

conversion must be at least as valuable as the benefits the participant would have earned under

the traditional plan had the conversion not occurred, the proposal protects participants in the plan

who are close to retirement age against possible disadvantages of conversion to a cash balance

plan.  Further, prohibiting wearaway in a conversion to a cash balance plan with respect to the

benefits of such participants will reduce possible adverse effects on older and longer-service

participants.

Some argue that the proposal does not go far enough in ensuring that older and longer

service employees will not be disadvantaged.  Some argue that all plan participants, or at least

participants who have attained a certain age or number of years of service, should automatically

be given the greater of benefits under the old plan formula or under the new plan formula. 

Others argue that any such additional requirement would cause employers' qualified retirement

plan costs to increase and could cause employers to reduce benefits further or terminate existing

plans.  They argue that the proposal provides an appropriate balance between concerns about

older workers and the need to provide flexibility to employers in order to maintain the voluntary

pension system.  On the other hand, some consider the present-law anticutback rules to provide

adequate protection for participants and view the proposal as protecting employees' expectations

of future benefits in a manner that is likely to increase employers' costs and discourage

employers from continuing to offer defined benefit pension plans.

Some argue that the 100-percent excise tax on any difference between required benefits

and the benefits actually provided under a plan which has been converted to a cash balance

formula is sufficient to encourage compliance with the proposal.  However, others argue that

limiting the amount of the excise tax to the plan's surplus assets at the time of the conversion or

the plan sponsor's taxable income, whichever is greater, will allow plan sponsors to manipulate

the timing of a conversion so that the requirements of the proposal can be avoided without

imposition of the excise tax.  They argue that absent the potential for plan disqualification, the

efficacy of the proposal is diminished, or even eliminated. 

Some argue that the proposal provides appropriate flexibility to employers and additional

safeguards for employees, by allowing employers to avoid the excise tax by grandfathering

participants under the old formula or giving employees a choice between the old and new

formula.  On the other hand, some point out that giving employees options increases complexity

for plan participants, and that many participants may not adequately understand the differences

between the new plan formula and the old plan formula.  These concerns may be addressed, at

least to some extent, by requiring that participants receive sufficient information to make an

informed decision.  As mentioned above, others would go further, and require that at least some

employees be automatically given the greater of the two formulas.  This would avoid the need

for elections, and the possibility that an employee may unwittingly choose an option that is

clearly worse than the old plan formula.  On the other hand, some view such a requirement as

unduly restricting employers' options in plan design.

Age discrimination

By providing that cash balance plans satisfy the age discrimination rules if the plan

provides pay credits for older participants that are not less than the pay credits for younger

participants, the proposal provides certainty in this regard.  Some have argued that if such

certainty is not provided, employers will be disinclined to offer defined benefit pension plans,

including cash balance plans, to their employees.  Some argue that, by reducing uncertainty as to

how cash balance plans can meet the age discrimination requirements, the proposal will make

employers more likely to sponsor (or continue to sponsor) defined benefit pension plans,

including cash balance plans.

The age discrimination issue results from the effect of front-loaded interest credits, under

which a participant receiving a pay credit also receives the right to future interest on the pay

credit, regardless of whether the participant continues employment.  Front-loaded interest credits

cause benefits to accrue more quickly, which is generally viewed as advantageous to

participants, especially participants who leave employment after a short period of service. 

However, some argue that front-loaded pay credits inherently favor younger participants and are

thus inherently age discriminatory.  They believe that for this, and other reasons, cash balance

plans should not be permitted.

Calculating lump-sum distributions

The proposal is intended to eliminate situations in which the amount of a minimum lump-

sum distribution required from a cash balance plan is greater than a participant's hypothetical

account balance because the plan's interest crediting rate is higher than the statutory interest rate. 

The proposal departs from the analysis set out in IRS Notice 96-8 and followed by several

Federal courts that have considered this issue.

Proponents argue that the cases are based on IRS rulings that pre-date the prevalence of

cash balance plans and that apply rules that are inappropriate in a cash balance context.  Further,

they argue that, as a result of the present-law rules, employers have reduced the rate of interest

credits under cash balance plans, thus reducing benefits for participants.  The proposal avoids

this result and thus, it is argued, will benefit plan participants by encouraging employers to use a

higher rate of return than the statutorily-prescribed rate.

Others note that, for purposes of satisfying the accrual rules, benefits attributable to front-

loaded interest credits are treated as part of the accrued benefit.  They argue that, if benefits

attributable to front-loaded interest credits are part of the accrued benefit, such benefits should be

reflected in determining the minimum value of lump-sum distributions as required under present

law.  To the extent that a participant's hypothetical account balance is less than such minimum

lump-sum value, a participant who receives a distribution of the hypothetical account balance has

not received the full value of his or her accrued benefit.  They argue that such a result is

inconsistent with the protections provided by the vesting and accrual rules.

In order for the proposal to apply, the plan must not use interest credits in excess of a

market rate of return, and the Secretary is to provide safe harbors as to what is a market rate. 

This aspect of the proposal raises issues as to how to determine a market rate of return.  Recent

discussions over what constitutes an appropriate replacement for the interest rate on 30-year

Treasury obligations for purposes related to defined benefit pension plans reflects the degree of

complexity which may be involved in prescribing such safe harbors.  The effect of the proposal

on plan benefits, and the ease with which the proposal can be implemented by employers,

understood by employees, and administered by the IRS will depend in large part on the ability to

determine measures of market rates of return.  Some argue that because so much depends on

what is a market rate of return under the proposal, it would be more appropriate to provide

statutory guidance on this issue, rather than leave the issue for the Secretary to resolve.

Complexity

As a result of its study of Enron Corporation, performed at the direction of the Senate

Committee on Finance, the staff of the Joint       Committee on Taxation ("Joint Committee staff")

found that the lack of guidance with respect to cash balance plan conversions and cash balance

plans generally creates uncertainty for employers and employees.  The Joint Committee staff

recommended that clear rules for such plans should be adopted in the near future.

The budget proposals help to reduce uncertainty with respect to cash balance plans by

addressing certain issues that frequently arise with respect to cash balance plans.  However, the

proposals do not address all issues with respect to such plans.  In addition, certain aspects of the

proposals need further clarification, or may add some additional complexities.  For example,

additional clarification is needed with respect to types of transition approaches in conversions

that do not violate age discrimination or other qualification rules, allowing participants to choose

between a traditional defined benefit formula and cash balance formula in order to avoid the 100-

percent excise tax, and the determination of a market rate of return for purposes of calculating

lump-sum distributions.

Prior Action

An identical proposal was included in the President's fiscal year 2005 and 2006 budget

proposals.

H.R. 2830 (the "Pension Protection Act of 2005"), as passed by the House, and S. 1783,

(the "Pension Security and Transparency Act of 2005"), as passed by the Senate, both include

provisions relating to the application of the Code and ERISA to hybrid plans, including cash

balance plans.

 

 

B.      Strengthen Funding for Single-Employer Pension Plans

1.      Background and summary

Helping to assure that individuals have retirement income security is the major objective

of the U.S. private pension system.  Federal law attempts to further this goal in various ways. 

The Code provides tax-favored treatment for employer-sponsored qualified retirement plans. 

ERISA applies many of the same requirements as the Code and provides employees with the

means of pursuing their rights.

Defined benefit pension plans are considered by many to provide greater retirement

income security than defined contribution plans.  Factors that contribute to this view include the

fact that such plans offer a specified benefit payable as an annuity for life, the employer bears the

risk of investment loss, and benefits are guaranteed (within limits) by the PBGC in the event the

plan terminates and plan assets are not sufficient to pay promised benefits.  The minimum

funding rules are designed to promote retirement income security by helping to assure that plan

assets will be sufficient to pay promised benefits when due.  If plans are not adequately funded

by the employer, then the benefits promised under the plan may not be paid in full.  In particular,

if a plan terminates and the assets are not sufficient to pay benefits, participants may not receive

the full value of the benefits due, even with the PBGC guarantee.

The minimum funding rules have been the focus of much attention in recent years.  On

one hand, attention has focused on the increase in required contributions under the deficit

reduction contribution rules, caused in part by the combination of low interest rates that have

increased the value of plan liabilities and market declines that have decreased the value of plan

assets.  Some view this combination as a temporary situation that has artificially increased the

extent of pension plan underfunding.  On the other hand, attention has focused also on large,

severely underfunded plans maintained by insolvent employers that have terminated with

resulting benefit losses to employees and increases in PBGC liabilities.  Some therefore believe

the present-law funding rules are inadequate.  Many believe that resolution of funding issues is

essential to the long-term viability of the defined benefit pension system.

As of September 30, 2005, the PBGC reported a total deficit of $22.8 billion, a slight

improvement from the 2004 fiscal year end deficit of $23.5 billion, but almost double the 2003

fiscal year end deficit of $11.5 billion.  The PBGC's deficit is the amount by which its liabilities

exceed its assets.   The PBGC has noted that its financial state is a cause for concern.  The

Government Accountability Office ("GAO") has placed the PBGC on its high risk list.  Although

the PBGC is a Federal agency, it does not receive financing from general revenues.   Instead, the

PBGC is funded by assets in terminated plans, amounts recovered from employers who terminate

undefended plans, premiums paid with respect to plans covered by the PBGC insurance program,

and investment earnings.  Underfunding of defined benefit pension plans presents a risk to

PBGC premium payors, who may have to pay for the unfunded liabilities of terminating plans,

and plan participants, who may lose benefits if a plan terminates (even with the PBGC

guarantee). 

The President's budget contains a series of proposals designed to strengthen funding

levels in defined benefit pension plans and the ability of the PBGC to provide guaranteed

benefits.  These proposals consist of:  (1) changes to the funding rules to measure a plan's

funding status more accurately and to require faster funding of shortfalls, along with increased

deduction limits to encourage additional contributions; (2) more accurate and timely reporting of

funding status; (3) elimination of a grandfather rule that allows certain plans to exceed the limits

on investments in employer securities and real property; (4) restrictions on benefit increases and

accelerated distributions that result in increases in unfunded liabilities; (5) a prohibition on

providing shutdown benefits; and (6) redesign of the PBGC variable-rate premium structure,

limits on the PBGC guarantee when an employer enters bankruptcy, and enabling the PBGC to

perfect a lien for required contributions against the assets of an employer in bankruptcy.

2.      Funding and deduction rules

Present Law

In general

Defined benefit pension plans are subject to minimum funding requirements.   The

minimum funding requirements are designed to ensure that plan assets are sufficient to pay plan

benefits when due.  The amount of contributions required for a plan year under the minimum

funding rules is generally the amount needed to fund benefits earned during that year plus that

year's portion of other liabilities that are amortized over a period of years, such as benefits

resulting from a grant of past service credit.  The amount of required annual contributions is

determined under one of a number of acceptable actuarial cost methods.  Additional

contributions are required under the deficit reduction contribution rules in the case of certain

underfunded plans.  No contribution is required under the minimum funding rules in excess of

the full funding limit (described below).

An employer sponsoring a defined benefit pension plan generally may deduct amounts

contributed to a defined benefit pension plan to satisfy the minimum funding requirements for a

plan year.  In addition, contributions in excess of the amount needed to satisfy the minimum

funding requirements may be deductible, subject to certain limits.

General minimum funding rules

Funding standard account

As an administrative aid in the application of the funding requirements, a defined benefit

pension plan is required to maintain a special account called a "funding standard account" to

which specified charges and credits are made for each plan year, including a charge for normal

cost and credits for contributions to the plan.   Other charges or credits may apply as a result of

decreases or increases in past service liability as a result of plan amendments, experience gains

or losses, gains or losses resulting from a change in actuarial assumptions, or a waiver of

minimum required contributions.

In determining plan funding under an actuarial cost method, a plan's actuary generally

makes certain assumptions regarding the future experience of a plan.  These assumptions

typically involve rates of interest, mortality, disability, salary increases, and other factors

affecting the value of assets and liabilities.  If the plan's actual unfunded liabilities are less than

those anticipated by the actuary on the basis of these assumptions, then the excess is an

experience gain.  If the actual unfunded liabilities are greater than those anticipated, then the

difference is an experience loss.  Experience gains and losses for a year are generally amortized

as credits or charges to the funding standard account over five years.

If the actuarial assumptions used for funding a plan are revised and, under the new

assumptions, the accrued liability of a plan is less than the accrued liability computed under the

previous assumptions, the decrease is a gain from changes in actuarial assumptions.  If the new

assumptions result in an increase in the accrued liability, the plan has a loss from changes in

actuarial assumptions.  The accrued liability of a plan is the actuarial present value of projected

pension benefits under the plan that will not be funded by future contributions to meet normal

cost or future employee contributions.  The gain or loss for a year from changes in actuarial

assumptions is amortized as credits or charges to the funding standard account over ten years.

If minimum required contributions are waived (as discussed below), the waived amount

(referred to as a "waived funding deficiency") is credited to the funding standard account.  The

waived funding deficiency is then amortized over a period of five years, beginning with the year

following the year in which the waiver is granted.  Each year, the funding standard account is

charged with the amortization amount for that year unless the plan becomes fully funded.

If, as of the close of a plan year, the funding standard account reflects credits at least

equal to charges, the plan is generally treated as meeting the minimum funding standard for the

year.  If, as of the close of the plan year, charges to the funding standard account exceed credits

to the account, then the excess is referred to as an "accumulated funding deficiency."  Thus, as a

general rule, the minimum contribution for a plan year is determined as the amount by which the

charges to the funding standard account would exceed credits to the account if no contribution

were made to the plan.  For example, if the balance of charges to the funding standard account of

a plan for a year would be $200,000 without any contributions, then a minimum contribution

equal to that amount would be required to meet the minimum funding standard for the year to

prevent an accumulated funding deficiency.

Credit balances

If credits to the funding standard account exceed charges, a "credit balance" results.  A

credit balance results, for example, if contributions in excess of minimum required contributions

are made.  Similarly, a credit balance may result from large net experience gains.  The amount of

the credit balance, increased with interest at the rate used under the plan to determine costs, can

be used to reduce future required contributions.

Funding methods and general concepts

A defined benefit pension plan is required to use an acceptable actuarial cost method to

determine the elements included in its funding standard account for a year.  Generally, an

actuarial cost method breaks up the cost of benefits under the plan into annual charges consisting

of two elements for each plan year.  These elements are referred to as:  (1) normal cost; and

(2) supplemental cost.

The plan's normal cost for a plan year generally represents the cost of future benefits

allocated to the year by the funding method used by the plan for current employees and, under

some funding methods, for separated employees.  Specifically, it is the amount actuarially

determined that would be required as a contribution by the employer for the plan year in order to

maintain the plan if the plan had been in effect from the beginning of service of the included

employees and if the costs for prior years had been paid, and all assumptions as to interest,

mortality, time of payment, etc., had been fulfilled.  The normal cost will be funded by future

contributions to the plan:  (1) in level dollar amounts; (2) as a uniform percentage of payroll;

(3) as a uniform amount per unit of service (e.g., $1 per hour); or (4) on the basis of the actuarial

present values of benefits considered accruing in particular plan years.

The supplemental cost for a plan year is the cost of future benefits that would not be met

by future normal costs, future employee contributions, or plan assets.  The most common

supplemental cost is that attributable to past service liability, which represents the cost of future

benefits under the plan:  (1) on the date the plan is first effective; or (2) on the date a plan

amendment increasing plan benefits is first effective.  Other supplemental costs may be

attributable to net experience losses, changes in actuarial assumptions, and amounts necessary to

make up funding deficiencies for which a waiver was obtained.  Supplemental costs must be

amortized (i.e., recognized for funding purposes) over a specified number of years, depending on

the source.  For example, the cost attributable to a past service liability is generally amortized

over 30 years.

Normal costs and supplemental costs under a plan are computed on the basis of an

actuarial valuation of the assets and liabilities of a plan.  An actuarial valuation is generally

required annually and is made as of a date within the plan year or within one month before the

beginning of the plan year.   However, a valuation date within the preceding plan year may be

used if, as of that date, the value of the plan's assets is at least 100 percent of the plan's current

liability (i.e., the present value of benefit liabilities under the plan, as described below).

For funding purposes, the actuarial value of plan assets is generally used, rather than fair

market value.  The actuarial value of plan assets is the value determined under an actuarial

valuation method that takes into account fair market value and meets certain other requirements. 

The use of an actuarial valuation method allows appreciation or depreciation in the market value

of plan assets to be recognized gradually over several plan years.

In applying the funding rules, all costs, liabilities, interest rates, and other factors are

required to be determined on the basis of actuarial assumptions and methods, each of which is

reasonable (taking into account the experience of the plan and reasonable expectations), or

which, in the aggregate, result in a total plan contribution equivalent to a contribution that would

be obtained if each assumption and method were reasonable.  In addition, the assumptions are

required to offer the actuary's best estimate of anticipated experience under the plan.

Additional contributions for underfunded plans

Under special funding rules (referred to as the "deficit reduction contribution" rules), 

in the case of a single-employer plan, an additional contribution to a plan is generally required if

the plan's funded current liability percentage is less than 90 percent.   A plan's "funded current

liability percentage" is the actuarial value of plan assets as a percentage of the plan's current

liability.   In general, a plan's current liability means all liabilities to employees and their

beneficiaries under the plan, determined on a present-value basis.

The amount of the additional contribution required under the deficit reduction

contribution rules is the sum of two amounts:  (1) the excess, if any, of (a) the deficit reduction

contribution (as described below), over (b) the contribution required under the normal funding

rules; and (2) the amount (if any) required with respect to unpredictable contingent event

benefits.  The amount of the additional contribution cannot exceed the amount needed to increase

the plan's funded current liability percentage to 100 percent.  The amount of the additional

contribution is applied as a charge to the funding standard account.

The deficit reduction contribution is the sum of (1) the "unfunded old liability amount,"

(2) the "unfunded new liability amount," and (3) the expected increase in current liability due to

benefits accruing during the plan year.   The "unfunded old liability amount" is the amount

needed to amortize certain unfunded liabilities under 1987 and 1994 transition rules.  The

"unfunded new liability amount" is the applicable percentage of the plan's unfunded new

liability.  Unfunded new liability generally means the unfunded current liability of the plan (i.e.,

the amount by which the plan's current liability exceeds the actuarial value of plan assets), but

determined without regard to certain liabilities (such as the plan's unfunded old liability and

unpredictable contingent event benefits).  The applicable percentage is generally 30 percent, but

decreases by .40 of one percentage point for each percentage point by which the plan's funded

current liability percentage exceeds 60 percent.  For example, if a plan's funded current liability

percentage is 85 percent (i.e., it exceeds 60 percent by 25 percentage points), the applicable

percentage is 20 percent (30 percent minus 10 percentage points (25 multiplied by .4)).

A plan may provide for unpredictable contingent event benefits, which are benefits that

depend on contingencies that are not reliably and reasonably predictable, such as facility

shutdowns or reductions in workforce.  The value of any unpredictable contingent event benefit

is not considered in determining additional contributions until the event has occurred.  The event

on which an unpredictable contingent event benefit is contingent is generally not considered to

have occurred until all events on which the benefit is contingent have occurred.

Required interest rate and mortality table

Specific interest rate and mortality assumptions must be used in determining a plan's

current liability for purposes of the special funding rule.  For plans years beginning before

January 1, 2004, and after December 31, 2005, the interest rate used to determine a plan's current

liability must be within a permissible range of the weighted average  of the interest rates on 30-

year Treasury securities for the four-year period ending on the last day before the plan year

begins.  The permissible range is generally from 90 percent to 105 percent (120 percent for plan

years beginning in 2002 or 2003).   The interest rate used under the plan generally must be

consistent with the assumptions which reflect the purchase rates which would be used by

insurance companies to satisfy the liabilities under the plan.

Under the Pension Funding Equity Act of 2004 ("PFEA 2004"),  a special interest rate

applies in determining current liability for plan years beginning in 2004 or 2005.   For these

years, the interest rate used must be within a permissible range of the weighted average of the

rates of interest on amounts invested conservatively in long term investment-grade corporate

bonds during the four-year period ending on the last day before the plan year begins.  The

permissible range for these years is from 90 percent to 100 percent.  The interest rate is to be

determined by the Secretary of the Treasury on the basis of two or more indices that are selected

periodically by the Secretary and are in the top three quality levels available.

The Secretary of the Treasury is required to prescribe mortality tables and to periodically

review (at least every five years) and update such tables to reflect the actuarial experience of

pension plans and projected trends in such experience.   The Secretary of the Treasury has

required the use of the 1983 Group Annuity Mortality Table.

Other rules

Full funding limitation

No contributions are required under the minimum funding rules in excess of the full

funding limitation.  The full funding limitation is the excess, if any, of (1) the accrued liability

under the plan (including normal cost), over (2) the lesser of (a) the market value of plan assets

or (b) the actuarial value of plan assets.   However, the full funding limitation may not be less

than the excess, if any, of 90 percent of the plan's current liability (including the current liability

normal cost) over the actuarial value of plan assets.  In general, current liability is all liabilities to

plan participants and beneficiaries accrued to date, whereas the accrued liability under the full

funding limitation may be based on projected future benefits, including future salary increases.

Timing of plan contributions

In general, plan contributions required to satisfy the funding rules must be made within

8½ months after the end of the plan year.  If the contribution is made by such due date, the

contribution is treated as if it were made on the last day of the plan year.

In the case of a plan with a funded current liability percentage of less than 100 percent for

the preceding plan year, estimated contributions for the current plan year must be made in

quarterly installments during the current plan year.   The amount of each required installment is

25 percent of the lesser of (1) 90 percent of the amount required to be contributed for the current

plan year or (2) 100 percent of the amount required to be contributed for the preceding plan year.

Funding waivers

Within limits, the IRS is permitted to waive all or a portion of the contributions required

under the minimum funding standard for a plan year.   A waiver may be granted if the

employer (or employers) responsible for the contribution could not make the required

contribution without temporary substantial business hardship and if requiring the contribution

would be adverse to the interests of plan participants in the aggregate.  Generally, no more than

three waivers may be granted within any period of 15 consecutive plan years.

The IRS is authorized to require security to be granted as a condition of granting a waiver

of the minimum funding standard if the sum of the plan's accumulated funding deficiency and

the balance of any outstanding waived funding deficiencies exceeds $1 million.

Failure to make required contributions

An employer is generally subject to an excise tax if it fails to make minimum required

contributions and fails to obtain a waiver from the IRS.   The excise tax is 10 percent of the

amount of the funding deficiency.  In addition, a tax of 100 percent may be imposed if the

funding deficiency is not corrected within a certain period.

If the total of the contributions the employer fails to make (plus interest) exceeds $1

million and the plan's funded current liability percentage is less than 100 percent, a lien arises in

favor of the plan with respect to all property of the employer and the members of the employer's

controlled group.  The amount of the lien is the total amount of the missed contributions (plus

interest).

Reversions of defined benefit pension plan assets

Defined benefit pension plan assets generally may not revert to an employer before

termination of the plan and the satisfaction of all plan liabilities.  In addition, the plan must

provide for the reversion.  A reversion prior to plan termination may result in disqualification of

the plan and may constitute a prohibited transaction.  Certain limitations and procedural

requirements apply to a reversion upon plan termination.  Any assets that revert to the employer

upon plan termination are includible in the gross income of the employer and subject to an excise

tax.   The excise tax rate is generally 20 percent, but increases to 50 percent if the employer

does make contributions to a replacement plan or make certain benefit increases.  Upon plan

termination, the accrued benefits of all plan participants are required to be fully vested.

If certain requirements are satisfied, a qualified transfer of excess assets of a defined

benefit pension plan may be made to a separate account within the plan in order to fund retiree

health benefits.   Excess assets generally means the excess, if any, of the value of the plan's

assets  over the greater of (1) the accrued liability under the plan (including normal cost) or

(2) 125 percent of the plan's current liability.  No transfer after December 31, 2013, is a qualified

transfer.

Deductions for contributions

Employer contributions to qualified retirement plans are deductible, subject to certain

limits.  In the case of a defined benefit pension plan, the employer generally may deduct the

greater of: (1) the amount necessary to satisfy the minimum funding requirement of the plan for

the year; or (2) the amount of the plan's normal cost for the year plus the amount necessary to

amortize certain unfunded liabilities over 10 years, but limited to the full funding limitation for

the year.

The maximum amount of deductible contributions is generally not less than the plan's

unfunded current liability.   For this purpose, current liability is generally determined using the

statutory assumptions used in determining current liability for funding purposes.  However, for

purposes of determining the maximum amount of deductible contributions for 2004 and 2005, an

employer may elect to disregard the temporary interest rate change under PFEA 2004.  In such a

case, the interest rate used in determining current liability for deduction purposes must be within

the permissible range (90 to 105 percent) of the weighted average of the interest rates on 30-year

Treasury securities for the preceding four-year period.

Subject to certain exceptions, an employer that makes nondeductible contributions to a

plan is subject to an excise tax equal to 10 percent of the amount of the nondeductible

contributions for the year.

Description of Proposal

In general

Under the proposal, the interest rate used in determining current liability for plan years

beginning in 2004 and 2005 is extended to 2006.  Thus, in determining current liability for plan

years beginning in 2006, the interest rate used must be within the permissible range (90 to 100

percent) of the weighted average of the rates of interest on amounts invested conservatively in

long-term investment-grade corporate bonds during the four-year period ending on the last day

before the plan year begins.

In the case of single-employer plans, for plan years beginning after December 31, 2006,

the proposal repeals the present-law funding rules and provides a new set of rules for

determining minimum required contributions.   Under the proposal, the minimum required

contribution to a defined benefit pension plan for a plan year is generally the sum of two

amounts:  (1) the payments  required to amortize over seven years the amount by which the

plan's funding target exceeds the market value of the plan assets; and (2) the plan's normal cost

for the plan year.

The plan's funding target is generally the present value of benefits earned as of the

beginning of the plan year.  The plan's normal cost is generally the present value of benefits

expected to be earned during the plan year.  Under the proposal, present value is determined

using interest rates drawn from a corporate bond yield curve and a mortality table prescribed by

the Secretary of Treasury.   However, other assumptions used to determine the plan's funding

target and normal cost depend on the financial status of the employer.

The proposal also changes the limit on deductible contributions.

Determination of funding target and normal cost

In general

In general, under the proposal, the funding target and normal cost for a plan are the plan's

"ongoing liability" and "ongoing" normal cost.  However, in the case of a plan maintained by a

financially weak plan sponsor, the funding target and normal cost for the plan are the plan's "at-

risk liability" and "at-risk" normal cost.  Different actuarial assumptions apply in determining

ongoing or at-risk liability and normal cost.

Ongoing liability and ongoing normal cost

A plan's ongoing liability for a plan year is the present value of future payments expected

to be made from the plan to provide benefits earned as of the beginning of the plan year. 

Benefits taken into account for this purpose include early retirement benefits and similar benefits

that participants will become entitled to as a result of future service, to the extent such benefits

are attributable to benefits accrued as of the beginning of the plan year.

For purposes of determining a plan's ongoing liability, the present value of benefits is

determined by discounting future expected payments under the plan using a corporate bond yield

curve, as described below.  Future expected benefit payments under the plan are determined

using a mortality table prescribed by the Secretary of Treasury.  The proposal generally does not

require other specified assumptions to be used in determining ongoing liability.  However, other

assumptions, such as the rate of turnover among participants and early and normal retirement

rates, must be actuarially reasonable based on experience for the plan (or other relevant historical

experience if there is no experience for the plan).  In addition, a reasonable assumption as to

future benefits that will be paid in the form of a lump sum must be used.

Ongoing normal cost for a plan year is the present value of future payments expected to

be made from the plan to provide benefits that accrue during the plan year.  Benefits that accrue

during the plan year include any benefit accruals that result from compensation increases during

the plan year that are applied to previous years of service, such as under a plan that bases

benefits on final average compensation.  Ongoing normal cost is determined using the same

actuarial assumptions used to determine ongoing liability.

At-risk liability and at-risk normal cost

A plan's at-risk liability for a plan year is also the present value of future payments

expected to be made from the plan to provide benefits earned as of the beginning of the plan

year, determined using a corporate bond yield curve and a mortality table prescribed by the

Secretary of Treasury.  However, certain specified additional assumptions must be used in

determining at-risk liability.  Specifically, at-risk liability must be determined by assuming that

participants retire at the earliest retirement age permitted under the plan and that benefits are paid

in the form of a lump sum (or in whatever form permitted under the plan results in the largest

present value).   In addition, at-risk liability includes an additional amount, referred to as a

loading factor.   The loading factor is $700 per plan participant plus four percent of the amount

of the plan's at-risk liability, as determined without regard to the loading factor.

At-risk normal cost is the present value of future payments expected to be made from the

plan to provide benefits that accrue during the plan year, determined using the same actuarial

assumptions used to determine at-risk liability, including a loading factor of four percent of the

amount of the plan's at-risk normal cost, as determined without regard to the loading factor.

Financially weak status

Financially weak status applies if, as of the plan's valuation date, any plan sponsor has

senior unsecured debt that is rated as not being investment grade by each nationally recognized

rating organization that has issued a credit rating for the debt.  Alternatively, if no plan sponsor

has senior unsecured debt that is rated, financially weak status applies if all of the nationally

recognized statistical rating organizations that have made an issuer credit rating for any plan

sponsor have rated the sponsor as less than investment grade.  However, financially weak status

does not apply if any significant member of the plan sponsor's controlled group has senior

unsecured debt that is rated as investment grade, regardless of whether that controlled group

member is a plan sponsor of the plan.

Special rules apply in the case of plan sponsors that have neither unsecured debt that is

rated nor an issuer credit rating.  Such a plan sponsor is automatically treated as not being

financially weak, provided that the total number of participants covered by defined benefit

pension plans maintained by the sponsor is less than 500.  If  the total number of participants

covered by defined benefit pension plans maintained by such a plan sponsor is 500 or more,

whether the plan sponsor is financially weak is determined under regulations.  It is expected that,

under such regulations, financially weak status will be determined based on financial measures,

such as whether the ratio of long-term debt to equity for the plan sponsor's controlled group is

1.5 or more.  For this purpose, debt is expected to include the unfunded at-risk liability of any

plans maintained by the plan sponsor, and equity is expected to be based on: (1) fair market

value in the case of a privately held company; or (2) market capitalization in the case of a

company, the stock of which is publicly traded.

If a plan sponsor becomes financially weak during a plan year, any resulting change in

the plan's funding target (i.e., from ongoing liability to at-risk liability) and normal cost (i.e.,

from ongoing normal cost to at-risk normal cost) is phased in ratably over a five-year period

beginning with the plan year following the year in which the plan sponsor becomes financially

weak.  This rule applies if a plan sponsor becomes financially weak either before or after

enactment of the proposal, and the five-year phase-in period is determined without regard to

whether any of the relevant years occurred before enactment of the proposal.  If a plan sponsor's

financial status changes during a plan year so that it is no longer financially weak, the plan's

ongoing liability is the applicable funding target for the next plan year.

Interest rate based on corporate bond yield curve and transition rule

The funding target and normal cost applicable to a plan are determined using a series of

interest rates drawn from a yield curve for high-quality zero-coupon corporate bonds ("corporate

bond yield curve").  That is, the interest rates used to determine the present value of payments

expected to be made under the plan reflect the interest rates for corporate bonds maturing at the

times when the payments are expected to be made.   The corporate bond yield curve is to be

issued monthly by the Secretary of Treasury, based on the interest rates (averaged over 90

business days) for high-quality corporate bonds (i.e., bonds rated AA) with varying maturities.

A special method of calculating a plan's funding target applies for plan years beginning

in 2007 and 2008.  For those years, the plan's funding target is the weighted average of:  (1) the

plan's funding target (i.e., ongoing or at-risk liability, as applicable) determined using a

corporate bond yield curve; and (2) the plan's funding target determined using the "transition"

interest rate.  The transition interest rate is the interest rate that would apply if the statutory

interest rate applicable under the proposal in determining current liability for plan years

beginning in 2006 continued to apply for plan years beginning in 2007 and 2008.  That is, the

interest rate used must be within a permissible range (from 90 to 100 percent) of the weighted

average of the rates of interest on amounts invested conservatively in long term investment-grade

corporate bonds during the four-year period ending on the last day before the plan year begins. 

For plan years beginning in 2007, a weighting factor of 2/3 applies to the plan's funding target

determined using the transition interest rate, and a weighting factor of 1/3 applies to the plan's

funding target determined using a corporate bond yield curve.  For plan years beginning in 2008,

the respective weighting factors are 1/3 and 2/3.

A similar method applies in determining a plan's normal cost (i.e., ongoing or at-risk

normal cost, as applicable) for plan years beginning in 2007 and 2008.

Valuation date

Under the proposal, a plan's funding target (i.e., ongoing or at-risk liability, as

applicable), the plan's normal cost (i.e., ongoing or at-risk normal cost, as applicable), the market

value of the plan's assets, and the minimum required contribution for a plan year are determined

as of the valuation date for the plan year.  If a plan has more than 100 participants, the plan's

valuation date must be the first day of the plan year.  If the plan has 100 or fewer participants, the

plan's valuation date may be any day in the plan year.

If a plan's valuation date is after the first day of the plan year, benefits accruing between

the first day of the plan year and the valuation date are disregarded in determining the plan's

funding target for the plan year.   In addition, in determining the market value of plan assets as

of the valuation date, any contribution made to the plan for the current plan year is disregarded

and any contribution to be made to the plan for the prior year that has not yet been made is

included in plan assets as a contribution receivable.  For plan years beginning in 2008 or later,

the present value of the contribution receivable is included in plan assets, and present value is

determined using the average effective interest rate that applied in determining the plan's

funding target for the prior plan year.

Minimum required contributions

Under the proposal, the minimum contribution required to be made to a plan for a plan

year is generally the sum of:  (1) the plan's normal cost for the plan year (i.e., ongoing or at-risk

normal cost, as applicable); and (2) the payments required (as described below) to amortize the

amount by which the plan's funding target for the plan year (i.e., ongoing or at-risk liability, as

applicable) exceeds the market value of plan assets.

Under the proposal, if the plan's funding target for the plan year beginning in 2007

exceeds the market value of the plan's assets for that year, an initial amortization base is

established in the amount of the shortfall.  Payments are then required in the amount needed to

amortize the initial amortization base over seven years, starting with the plan year beginning in

2007.  The required amortization payments are determined on a level basis, using the applicable

interest rates under the corporate bond yield curve.

For each subsequent plan year, the plan's funding target is compared with the sum of:

(1) the market value of the plan's assets; and (2) the present value of any future required

amortization payments (determined using the applicable interest rates under the corporate bond

yield curve).  If the plan's funding target exceeds that sum, an additional amortization base is

established in the amount of the shortfall, and payments are required in the amount needed to

amortize the additional amortization base over seven years.  If, for a plan year, the sum of the

market value of plan assets and the present value of any future required amortization payments

exceeds the plan's funding target, no additional amortization base is established for that plan

year.

All required amortization payments generally must be made over the applicable seven-

year period.   However, if, for a plan year, the market value of the plan's assets is at least equal

to the plan's funding target, any existing amortization bases are eliminated and no amortization

payments are required.

If no amortization payments are required for a plan year, the minimum required

contribution for the plan year is based solely on the plan's normal cost.  Specifically, the

minimum required contribution is the plan's normal cost, reduced by the amount (if any) by

which the market value of the plan's assets exceeds the plan's funding target.  Accordingly, no

contribution is required for a plan year if the market value of the plan's assets is at least equal to

the sum of the plan's funding target and the plan's normal cost for the plan year.

A contribution in excess of the minimum required contribution does not create a credit

balance that can be used to offset minimum required contributions for later years.  However,

contributions in excess of the minimum (and income thereon) increase plan assets, which may

have the effect of accelerating the elimination of amortization bases or of reducing contributions

required with respect to normal cost.

Timing rules for contributions

As under present law, contributions required for a plan year generally must be made

within 8-½ months after the end of the plan year.  However, quarterly contributions are required

to be made during a plan year if, for the preceding plan year, the plan's funding target exceeded

the market value of the plan's assets, determined as of the valuation date for the preceding plan

year.

A contribution made after the valuation date for a plan year is credited against the

minimum required contribution for the plan year based on its present value as of the valuation

date for the plan year.  Present value is determined by discounting the contribution from the date

the contribution is actually made to the valuation date, using the average effective interest rate

applicable in determining the plan's funding target for the plan year.

Maximum deductible contributions

Under the proposal, the limit on deductible contributions for a year is generally the

amount by which the sum of the plan's funding target, the plan's normal cost, and the plan's

cushion amount exceeds the market value of the plan's assets.  The plan's cushion amount is the

sum of:  (1) 30 percent of the plan's funding target; and (2) the amount by which the plan's

funding target and normal cost would increase if they were determined by taking into account

expected future salary increases for participants (or, in the case of a plan under which previously

accrued benefits are not based on compensation, expected future benefit increases, based on

average increases for the previous six years).  The increase in the plan's funding target and

normal cost as a result of taking into account expected future salary or benefit increases is

determined by applying the expected salary or benefit increase with respect to participants'

service as of the valuation date for the plan year.  For this purpose, the dollar limits on benefits

and on compensation that apply for the plan year are used.

In addition, the limit on deductible contributions for a year is not less than the sum of:

(1) the plan's at-risk normal cost for the year; and (2) the amount by which the plan's at-risk

liability for the year exceeds the market value of the plan's assets.  For this purpose, at-risk

liability and at-risk normal cost are used regardless of the financial status of the plan sponsor.

Present-law rules permitting an employer to deduct a contribution made within the time

for filing its tax return for a taxable year continue to apply.

Effective date.-The proposal is effective for plan years beginning after December 31,

2005.

Analysis

General policy issues relating to the funding and deduction rules for defined benefit

pension plans

The funding rules are a cornerstone of the defined benefit pension plan system and, over

time, have been a frequent source of discussion and change.  Proposals relating to the funding

rules involve balancing competing policy interests.

The present-law minimum funding rules recognize that pension benefits are generally

long-term liabilities that can be funded over a period of time.  On the other hand, benefit

liabilities are accelerated when a plan terminates before all benefits have been paid, as many

plans do, and the deficit reduction contribution rules to some extent reflect the amount that

would be needed to provide benefits if the plan terminated.  Some argue that if minimum funding

requirements are too stringent, funds may be unnecessarily diverted from the employer's other

business needs and may cause financial problems for the business, thus jeopardizing the future of

not just the employees' retirement benefits, but also their jobs.  This suggestion tends to arise

during a period of economic downturn, either generally or in a particular industry.  Some also

argue that overly stringent funding requirements may discourage the establishment or

continuation of defined benefit pension plans.

The limits on deductible contributions, the excise tax on nondeductible contributions, and

the rules relating to reversions of defined benefit pension plan assets have as a major objective

preventing the use of defined benefit pension plans as a tax-favored funding mechanism for the

business needs of the employer.  They also serve to limit the tax expenditure associated with

defined benefit pension plans.  Some argue that if the maximum limits on plan funding are too

low, then benefit security will be jeopardized.  They argue that employers need flexibility to

make greater contributions when possible, in order to ensure adequate funding in years in which

the business may not be as profitable.   Others note that such flexibility is available as a result

of the increases in the deduction limits under EGTRRA, but the full effect of the increases may

not be apparent yet because of recent economic conditions.  With respect to reversions, some

argue that if restrictions on reversions are too strict, employers may be discouraged from making

contributions in excess of the required minimums.

The desire to achieve the proper balance between these competing policy objectives has

resulted in a variety of legislative changes to address the concerns arising at particular times.  For

example, the Omnibus Budget Reconciliation Act of 1987 made comprehensive changes to the

minimum funding rules (including enactment of the deficit reduction contribution rules)

prompted by concerns regarding the solvency of the defined benefit pension plan system.  That

Act also added the current liability full funding limit.   Legislation enacted in 1990 allowed

employers access to excess assets in defined benefit pension plans in order to pay retiree health

liabilities.  The Retirement Protection Act of 1994 again made comprehensive changes to the

funding rules.  Recent changes to the funding rules have focused on increasing the maximum

deductible contribution and on the interest rate that must be used to calculate required

contributions.  For example, EGTRRA increased the current liability full funding limit and then

repealed the current liability full funding limit for 2004 and thereafter.

General analysis of the funding and deduction proposal

The proposed changes to the funding rules reflect the view that the present-law rules are

ineffective in assuring that plans are adequately funded.  For example, the valuation methods and

amortization periods applicable under present law may have the effect of disguising a plan's true

funding status.  In some cases, these factors result in artificial credit balances that can be used to

reduce required contributions.  Thus, employers may fully comply with the present-law funding

rules, yet still have plans that are substantially underfunded.  In general, the proposal is intended

to more accurately measure the unfunded liability of a plan and accelerate the rate at which

contributions are made to fund that liability.

Under the proposal, a plan's funding status is measured by reference to the present value

of plan liabilities, using a current interest rate, and the market value of plan assets.  This

approach is intended to provide a more accurate and up-to-date picture of the plan's financial

condition.  On the other hand, some point out that most plans are long-term arrangements and a

measurement of assets and liabilities as of a particular date does not necessarily provide an

accurate picture of the plan's status.  Some are also concerned that elimination of the averaging

and smoothing rules that apply under present law may result in increased volatility of required

contributions.  They also note that the present-law averaging and smoothing rules allow

employers to know in advance that higher plan contributions will be required, thereby providing

some predictability in required contributions.  They suggest that, by making required

contributions more volatile and unpredictable, the proposal may discourage employers from

continuing to maintain plans and thus may harm, rather than strengthen, the defined benefit

pension plan system.

The proposal applies a more rigorous funding target in the case of a plan maintained by a

financially weak employer.  Under the proposal, financially weak status is generally based on a

rating of the employer's debt as below investment grade by nationally recognized rating

organizations.  In some cases, financially weak status is determined in accordance with standards

to be established under regulations.  Some argue that credit ratings are simply not a reliable

indicator of whether a plan will terminate on an underfunded basis.  They note that many

businesses with below investment grade ratings continue to operate and to maintain a defined

benefit pension plan.  Some also suggest that the possibility of greater required contributions

could itself drive down an employer's credit rating.  Some also express concern that, in some

cases, Treasury and the IRS would be responsible for determining financial status.

If a plan terminates, in addition to the cost of benefits, costs are incurred to purchase

annuity contracts to provide the benefits due under the plan.  In addition, an economic decline in

a business may cause employees to retire earlier and to take benefits in the form of a lump sum. 

The proposal requires these factors to be reflected in the determination of a plan's funding target

in the case of a financially weak employer.  This approach has the effect of increasing such

liabilities and required contributions.  Some view this approach as appropriate in order to reduce

the financial risk posed by underfunded plans maintained by financially weak employers.  Others

argue that requiring such employers to make even greater required contributions may increase

the risk that the plan will terminate on an underfunded basis.

Under the proposal, the changes to the deduction limits are intended to allow employers

to make higher contributions when funds are available, thus improving the plan's funding status

and reducing the contributions that may be required during a downturn in business.  However,

some argue that the elimination of the credit balance concept (which limits the ability to reduce

future required contributions by additional contributions made in the past) undercuts the

incentive to make additional contributions.  In addition, some employers may have made

additional contributions and generated credit balances as part of a planned funding strategy and

elimination of existing credit balances may be viewed as disruptive.  Some suggest that credit

balances should be adjusted to reflect changes in plan asset values, but not eliminated.  On the

other hand, with respect to the proposed increase in the deduction limits, some note that,

currently, most employers do not make contributions up to the present-law deduction limits. 

They suggest that raising the limits will primarily benefit employers who want to use the plan as

a source of tax-free savings to provide funds for other purposes.

The present-law funding rules are complex, in part because they essentially consist of two

sets of rules - the general rules that determine required contributions on an ongoing basis and the

deficit reduction contribution rules that determine required contributions on a present-value

basis. The proposal replaces these rules with a single set of rules, which reduces complexity.  In

addition, the methods used to determine minimum required contributions under the proposal are

less complex than the present-law rules involving the funding standard account and various

amortization periods and valuation methods.

Background relating to interest rate used to measure pension liabilities

Recent attention has focused on the issue of the rate of interest used to determine the

present value of benefits under defined benefit pension plans for purposes of the plan's current

liability (and hence the amount of contributions required under the funding rules) and the

minimum amount of lump-sum benefits under the plan.   For plan funding purposes, the use of

a lower interest rate in determining current liability results in a higher present value of the

benefits and larger contributions required to fund those benefits.  Alternatively, the use of a

higher interest rate results in a lower present value of future liabilities and therefore lower

required contributions. 

Under present law, the theoretical basis for the interest rate to be used to determine the

present value of pension plan benefits for funding purposes is an interest rate that would be used

in setting the price for private annuity contracts that provide similar benefits.  Some studies have

shown that it is not practicable to identify such a rate accurately because of variation in the

manner in which prices of private annuity contracts are determined.  As a result, the interest rate

used to value pension benefits is intended to approximate the rate used in pricing annuity

contracts.   Some have described this standard as a rate comparable to the rate earned on a

conservatively invested portfolio of assets.

Under present law (except for 2004 and 2005), the interest rate used to determine current

liability (and minimum lump-sum benefits) is based on the interest rate on 30-year Treasury

obligations.  The interest rate issue has received attention recently, in part because the Treasury

Department stopped issuing 30-year obligations in 2001, which meant that a change to the

statutory interest rate was needed.  Because the Treasury Department recently resumed the

issuance of 30-year obligations, some view a statutory change as no longer necessary.   However,

apart from the availability of 30-year Treasury obligations, some have argued that the 30-year

Treasury rate has been too low compared to annuity rates, resulting in inappropriately high levels

of minimum funding requirements on employers that are not necessary to maintain appropriate

retirement income security.

Analysis of interest rate proposal

Under the proposal, the rate of interest on 30-year Treasury securities is replaced with the

rate of interest on high quality corporate bonds in calculating the present value of plan benefits

for purposes of determining minimum required contributions.  Initially, the interest rate used is

based on a weighted average of the yields on high-quality long-term corporate bonds.  After a

transition period, the proposal provides for the use of a series of interest rates drawn from a yield

curve of high-quality zero-coupon bonds with various maturities, selected to match the timing of

benefit payments expected to be made from the plan.

Some believe that, compared with the rate of interest on 30-year Treasury securities, an

interest rate based on long-term corporate bonds better approximates the rate that would be used

in determining the cost of settling pension liabilities, i.e., by purchasing annuity contracts to

provide the benefits due under the plan.   However, the proposal reflects the view that use of an

interest rate based solely on long-term corporate bonds is inappropriate, and rather that multiple

interest rates should be used to reflect the varying times when benefits become payable under a

plan, because of, for example, different expected retirement dates of employees.  The rationale

for this approach is that interest rates differ depending, in part, on the term of an obligation. 

Because plan liabilities may be payable both in the short term and the long term, this approach

would determine the present value of these liabilities with multiple interest rates, chosen to

match the times at which the benefits are payable under the plan.

Some have raised concerns that a yield curve approach is more complicated than the use

of a single rate, particularly for smaller plans.  Some have suggested that this could have the

effect of increasing administrative costs associated with maintaining a defined benefit pension

plan (and, in some cases, required contributions) and discourage the continuation and

establishment of such plans.  Some also question whether using a yield curve would result in

such increased accuracy as to justify the complexity.  Some have suggested that the use of a

single rate, such as the long-term corporate bond rate, with an appropriate adjustment factor can

produce results similar to the use of a yield curve, but much more simply.

Others have responded to these concerns by suggesting that, although a single interest

rate is used to determine required contributions under the present-law funding rules, a yield

curve approach is commonly used for other purposes, such as corporate finance.  Some also note

that the determination of plan liabilities already involves the application of complicated actuarial

concepts and the proposal does not add significant complexity.  They argue moreover that any

additional complexity is outweighed by the importance of measuring pension liabilities

accurately, including the timing of benefit payments from the plan.  In addition, it has been

suggested that simplified methods (such as the use of a single composite rate) can be provided

for smaller plans.

Some have questioned whether it is possible to construct a yield curve of corporate bond

rates that is appropriate for measuring pension liabilities.  They suggest that, for example,

corporate bonds of certain durations that are available on the market are too limited to provide a

reliable basis for constructing a yield curve.  Some have also suggested that the proposal may be

intended to encourage employers to invest plan assets more heavily in bonds, rather than in

equities.  Although, over time, returns on equity investments are expected to be higher than bond

returns, equity investments are also subject to greater value changes, which can lead to volatility

in plan asset values, which in turn may increase unfunded liabilities and minimum required

contributions.  Thus, investments in bonds may reduce volatility in the value of plan assets and in

required contributions.  Some argue that, to the extent plan assets are invested more heavily in

bonds in order to reduce volatility in plan assets, the long term return on such plan might be

lower than that achieved with an alternative portfolio invested less heavily in bonds, thus

requiring greater employer contributions over time to meet plan liabilities.  However, employers

today face similar issues in the management of pension plans under the existing funding rules.

The proposal also eliminates the four-year averaging period used to determine the interest

rate applicable for purposes of determining current liability under present law.  Some have

suggested that such an averaging period is necessary to prevent rapid interest rate changes from

causing corresponding changes in the value of pension liabilities, which in turn may result in

volatility in the amount of minimum required contributions.  The use of a yield curve, however,

should to some extent mitigate volatility relative to the use of a single rate, as short and long

term interest rates fluctuate to differing degrees and do not necessarily even move in the same

direction.  Others believe that the interest rate used to value pension liabilities should be

designed to measure those liabilities as accurately as possible and that volatility in required

contributions should be addressed through modifications to the funding and deduction rules. 

However, some argue that the proposal fails to address such volatility.

Prior Action

A similar proposal was included in the President's fiscal year 2006 budget proposal.  The

President's fiscal year 2005 budget proposal included a proposal to use a yield curve of interest

rates on corporate bonds in determining current liability.

H.R. 2830 (the "Pension Protection Act of 2005"), as passed by the House, and S. 1783,

(the "Pension Security and Transparency Act of 2005"), as passed by the Senate, both include

provisions relating to the funding and deduction rules for single-employer defined benefit

pension plans.

3.    Form 5500, Schedule B actuarial statement and summary annual report

Present Law

Form 5500 and Schedule B actuarial statement

The plan administrator of a qualified retirement plan generally must file an annual return

with the Secretary of the Treasury, an annual report with the Secretary of Labor, and certain

information with the Pension Benefit Guaranty Corporation ("PBGC").   Form 5500, which

consists of a primary form and various schedules, includes the information required to be filed

with all three agencies. The plan administrator satisfies the reporting requirement with respect to

each agency by filing the Form 5500 with the Department of Labor.

In the case of a defined benefit pension plan, the annual report must include an actuarial

report (filed on Schedule B of the Form 5500).   The actuarial report must include, for

example, information as to the value of plan assets, the plan's accrued and current liabilities,

expected disbursements from the plan for the year, plan contributions, the plan's actuarial cost

method and actuarial assumptions, and amortization bases established in the year.  The report

must be signed by an actuary enrolled to practice before the IRS, Department of Labor and the

PBGC.

The Form 5500 is due by the last day of the seventh month following the close of the plan

year.  The due date may be extended up to two and one-half months.  Copies of filed Form 5500s

are available for public examination at the Department of Labor.

Summary annual report

ERISA requires that plans furnish a summary annual report of the Form 5500 to plan

participants and beneficiaries.   The summary annual report must include a statement whether

contributions were made to keep the plan funded in accordance with minimum funding

requirements, or whether contributions were not made and the amount of the deficit.  The current

value of plan assets is also required to be disclosed.  The summary annual report must be

furnished within nine months after the close of the plan year.  If an extension applies for the

Form 5500, the summary annual report must be provided within two months after the extended

due date.  A plan administrator who fails to provide a summary annual report to a participant

within 30 days of the participant making request for the report may be liable to the participant for

a civil penalty of up to $100 a day from the date of the failure.

Participant notice of underfunding

Plan administrators of plans required to pay variable rate premiums to the PBGC are

required to provide notice to plan participants and beneficiaries of the plan's funding status and

the limits on the PBGC's guaranty should the plan terminate while underfunded.   The notice is

generally due no later than two months after the filing deadline for the Form 5500 for the

previous plan year and may be distributed with the plan's summary annual report.

Disclosure of certain plan actuarial and company financial information

In certain circumstances, the contributing sponsor of a single-employer plan covered by

the PBGC (and members of the contributing sponsor's controlled group) must provide certain

information to the PBGC.  This information (referred to as "section 4010 information") includes

financial information with respect to the contributing sponsor (and controlled group members)

and actuarial information with respect to single-employer plans maintained by the sponsor (and

controlled group members).    This reporting is required if:  (1) the aggregate unfunded vested

benefits (determined using the interest rate used in determining variable-rate premiums) as of the

end of the preceding plan year under all plans maintained by members of the controlled group

exceed $50 million (disregarding plans with no unfunded vested benefits); (2) the conditions for

imposition of a lien (i.e., required contributions totaling more than $1 million have not been

made) have occurred with respect to an underfunded plan maintained by a member of the

controlled group; or (3) minimum funding waivers in excess of $1 million have been granted

with respect to a plan maintained by any member of the controlled group and any portion of the

waived amount is still outstanding.  The PBGC may assess a penalty for a failure to provide the

required information in the amount of up to $1,000 a day for each day the failure continues.

In general, the contents of annual reports, statement, and other documents filed with the

Department of Labor under the reporting and disclosure provisions of ERISA are generally

public information that must be made available for public inspection.  Section 4010 information

is exempt from disclosure under the Freedom of Information Act ("FOIA") and no such

information or documentary materials may be made public, except as may be relevant to an

administrative or judicial action or proceeding. 

Description of Proposal

Form 5500, Schedule B actuarial statement

Under the proposal, a plan's ongoing liability, at-risk liability (regardless of whether the

employer is financially weak),  and the market value of the plan assets are required to be

reported in the actuarial report (i.e., the Schedule B) filed with the plan's annual report.  The

proposal applies to all PBGC-covered, single-employer defined benefit pension plans. 

In addition, if quarterly contributions are required with respect to a plan covering more

than 100 participants (i.e., a plan that has assets less than the funding target as of the prior

valuation date), the deadline for the actuarial report is accelerated.  The actuarial report is due on

the 15th day of the second month following the close of the plan year (February 15 for calendar

year plans).  If any contribution is subsequently made for the plan year, the additional

contribution is required to be reflected in an amended Schedule B to be filed with the Form 5500.

Summary annual report

Under the proposal, the summary annual report provided to participants is required to

include information on the funding status of the plan for each of the last three years.  The

funding status is required to be shown as a percentage based on the ratio of the plan's assets to its

funding target.  Information on the employer's financial status and on the PBGC benefit

guarantee must also be provided.  The proposal replaces the requirement of notice to participants

of underfunding  with the summary annual report disclosure. 

The summary annual report must be provided to participants no later than 15 days after

the due date for filing the plan's annual report.  A plan administrator that fails to provide a

summary annual report on a timely basis is subject to a penalty.

Public disclosure of certain PBGC filings

The proposal eliminates the nondisclosure rules of section 4010(c) of ERISA, which

exempt section 4010 information from disclosure under FOIA.  Under the proposal, section 4010

information can be made available to the public, except for confidential trade secrets and

commercial or financial information protected under FOIA.

Effective date.-The proposal is effective for plan years beginning in 2006.  The proposal

relating to elimination of the nondisclosure rules is effective with respect to filings made under

section 4010 of ERISA on or after 30 days after date of enactment.

Analysis

In general

The proposal is intended to provide more detailed and timely information to plan

participants, government agencies, and the public regarding the financial status of pension plans

and their sponsors and to make such information publicly available.  Participants should be

adequately and timely informed about the security of their retirement benefits.  Many believe

that the asset and liability measures under current law do not provide participants with an

accurate and meaningful measure of a plan's funding status.  They believe that present law does

not require adequate disclosure about a plan's funding status and does not provide enough

advance warning to participants of underfunding.  Thus, in some cases, participants have learned

of the extent of a plan's underfunding only when the plan terminated on an underfunded basis. 

Form 5500, Schedule B actuarial statement

The proposal requires the Schedule B actuarial statement filed with the Form 5500 of all

single-employer defined benefit pension plans to include the market value of the plan's assets,

ongoing liability, and at-risk liability.  This will provide participants greater information

regarding the financial position of their pension plans, including the increased liability that will

result if the financial condition of the plan sponsor deteriorates.  Some argue that if a plan

sponsor is not financially weak, the Form 5500 should only be required to include the liability

applicable to the plan (i.e., ongoing liability), rather than both ongoing and at-risk liability.

In the case of plans that cover more than 100 participants and are subject to the quarterly

contributions requirement, the proposal accelerates the filing deadline for the Schedule B

actuarial report to the 15th day of the second month following the close of the plan year.  Thus,

in the case of a calendar year plan, the due date is February 15.  Proponents argue that this will

provide timely information on the financial situation of defined benefit pension plans.  Others

may argue that the accelerated deadline does not provide enough time for completion of the

actuarial statement.  In the case of plans covering more than 100 participants, the funding

proposal previously discussed requires the valuation date to be the first day of the plan year.  In

such case, the valuation date will be more than one year before the actuarial statement is due.

Summary annual report

The proposal requires the summary annual report to include the funding status of the plan

for each of the last three years.  The funding status must be shown as a percentage based on the

ratio of the plan's assets to its funding target.  Proponents believe that requiring disclosure of the

plan's funding target, along with a comparison of that liability to the market value of assets, will

provide participants more accurate and useful information on the financial status of the plan. 

The proposal also requires the summary annual report to include information on the company's

financial health and on the PBGC guarantee.  The proposal is unclear as to what information

would be required to show the company's financial health. 

The proposal requires that the summary annual report be provided to participants and

beneficiaries by 15 days after the filing date for the Form 5500.  A penalty is imposed for failure

to furnish a summary annual report in a timely manner.  Specific information regarding the

penalty is unclear.  The proposal eliminates the participant notice requirement under section

4011, as the proposal assumes that the summary annual report disclosure will provide more

accurate and timely information. 

Public disclosure of certain PBGC filings

Eliminating the nondisclosure rules of ERISA section 4010(c) allows section 4010

information to be available to the public, with the exception of confidential trade secrets and

commercial or financial information protected under FOIA.  By eliminating the nondisclosure

rule, the proposal is intended to provide more public information on the financial status of

pension plans and plan sponsors.  The proposal is intended to provide greater information to

participants so that they know when their plan is underfunded or when the plan sponsor's

financial condition may impair the ability of the company to maintain or fund the plan. 

Under the proposal, information disclosed to the PBGC generally is subject to the

present-law FOIA provisions.  FOIA provides that commercial or financial information that is

required to be submitted to the Government is protected from disclosure if it is privileged or

confidential.   Some argue that FOIA's commercial and financial information exception

provides adequate protection for confidential business information.  Others believe that certain

financial information outside of the scope of the exception should remain confidential.

Public availability of financial information will allow participants and the public more

transparency as to the true financial picture of pension plans.  The proposal is similar to certain

securities laws that require public disclosure of material financial information.  Proponents argue

that public disclosure of financial information results in greater scrutiny and accountability

without requiring the draining of government resources.  Some consider public disclosure to be a

securities law issue, rather than a pension law issue.  Others are concerned that shortfalls in the

PBGC insurance program could ultimately become taxpayers' responsibility, so that public

disclosure under the pension laws is appropriate.

Some argue that greater public availability is inappropriate as some participants may not

have the financial sophistication to appropriately evaluate such information.  They also argue

that because the pension system is voluntary, additional requirements on plans and plan

sponsors, particularly small employers, may result in some sponsors discontinuing plan

sponsorship.

Prior Action

A similar proposal was included in the President's fiscal year 2006 budget proposal.

H.R. 2830 (the "Pension Protection Act of 2005"), as passed by the House, and S. 1783,

(the "Pension Security and Transparency Act of 2005"), as passed by the Senate, both include

provisions relating to reporting and disclosure requirements with respect to single-employer

defined benefit pension plans.

4.      Treatment of grandfathered floor-offset plans

Present Law

ERISA generally prohibits defined benefit pension plans from acquiring employer

securities or employer real property if, after the acquisition, more than 10 percent of the assets of

the plan would be invested in employer securities or employer real property.   This 10-percent

limitation generally does not apply to most defined contribution plans.

A floor offset arrangement is an arrangement under which benefits payable to a

participant under a defined benefit pension plan are reduced by benefits under a defined

contribution plan.  The defined benefit pension plan provides the "floor" or minimum benefit

which is offset or reduced by the annuitized benefit under the defined contribution plan.

Pursuant to the Pension Protection Act of 1987, the 10-percent limitation on the

acquisition of employer securities and employer real property applies to a defined contribution

plan that is part of a floor-offset arrangement, unless the floor offset arrangement was established

on or before December 17, 1987.  Thus, for floor-offset plans established after that date, the 10-

percent limit applies on an aggregated basis to the combined assets of the defined benefit pension

plan and the defined contribution plan that form the arrangement.

An employee stock ownership plan (an "ESOP") is an individual account plan that is

designed to invest primarily in employer securities and which meets certain other requirements. 

ESOPs are not subject to the 10-percent limit on the acquisition of employer securities, unless

the ESOP is part of a floor-offset arrangement.

Description of Proposal

The exception to the 10-percent limit on holding employer securities and employer real

property for floor-offset plans established on or before December 17, 1987, is eliminated.  Floor-

offset arrangements affected by the proposal are required to reduce their holdings of employer

real property and employer securities to no more than 10 percent of the combined assets of both

plans over a period of seven years.  The requirement to dispose of such property will be phased

in pursuant to regulations.

Effective date.–The proposal is effective for plan years beginning after 2005.

Analysis

The present-law 10-percent limit on holding employer securities and real property

reflects the concern that assets in defined benefit plans should be adequately diversified and that

allowing such plans to hold significant amounts of assets that rely on the financial status of the

employer creates a greater risk that the plan will become underfunded in the event of employer

financial distress and that benefits under the plan will become the obligation of the PBGC.  The

potential problems with such arrangements are illustrated by the recent experience with Enron

Corporation, which maintained a grandfathered floor-offset arrangement.   The proposal

addresses this concern by eliminating the grandfather for such arrangements.  Thus, all floor-

offset plans will be subject to the same rules under the proposal.  The proposal recognizes that it

may take some time for a plan to dispose of affected property by allowing a seven-year period

for plans to comply.

Prior Action

A similar proposal was included in the President's fiscal year 2006 budget proposal.

5.      Limitations on plans funded below target levels

Present Law

In general

Under present law, various restrictions may apply to benefit increases and distributions

from a defined benefit pension plan, depending on the funding status of the plan.

Funding waivers

Within limits, the IRS is permitted to waive all or a portion of the contributions required

under the minimum funding standard for a plan year.   A waiver may be granted if the

employer (or employers) responsible for the contribution could not make the required

contribution without temporary substantial business hardship and if requiring the contribution

would be adverse to the interests of plan participants in the aggregate.  Generally, no more than

three waivers may be granted within any period of 15 consecutive plan years.

If a funding waiver is in effect for a plan, subject to certain exceptions, no plan

amendment may be adopted that increases the liabilities of the plan by reason of any increase in

benefits, any change in the accrual of benefits, or any change in the rate at which benefits vest

under the plan.

Security for certain plan amendments

If a plan amendment increasing current liability is adopted and the plan's funded current

liability percentage is less than 60 percent (taking into account the effect of the amendment, but

disregarding any unamortized unfunded old liability), the employer and members of the

employer's controlled group must provide security in favor of the plan.  The amount of security

required is the excess of:  (1) the lesser of (a) the amount by which the plan's assets are less than

60 percent of current liability, taking into account the benefit increase, or (b) the amount of the

benefit increase and prior benefit increases after December 22, 1987, over (2) $10 million.  

The amendment is not effective until the security is provided.

The security must be in the form of a bond, cash, certain U.S. government obligations, or

such other form as is satisfactory to the Secretary of the Treasury and the parties involved. The

security is released after the funded liability of the plan reaches 60 percent.

Prohibition on benefit increases during bankruptcy

Subject to certain exceptions, if an employer maintaining a plan (other than a

multiemployer plan) is involved in bankruptcy proceedings, no plan amendment may be adopted

that increases the liabilities of the plan by reason of any increase in benefits, any change in the

accrual of benefits, or any change in the rate at which benefits vest under the plan.

Liquidity shortfalls

In the case of a plan with a funded current liability percentage of less than 100 percent for

the preceding plan year, estimated contributions for the current plan year must be made in

quarterly installments during the current plan year.  If quarterly contributions are required with

respect to a plan, the amount of a quarterly installment must also be sufficient to cover any

shortfall in the plan's liquid assets (a "liquidity shortfall").   In general, a plan has a liquidity

shortfall for a quarter if the plan's liquid assets (such as cash and marketable securities) are less

than a certain amount (generally determined by reference to disbursements from the plan in the

preceding 12 months).

If a quarterly installment is less than the amount required to cover the plan's liquidity

shortfall, limits apply to the benefits that can be paid from a plan during the period of

underpayment.   During that period, the plan may not make:  (a) any payment in excess of the

monthly amount paid under a single life annuity (plus any social security supplement provided

under the plan) in the case of a participant or beneficiary whose annuity starting date occurs

during the period; (b) any payment for the purchase of an irrevocable commitment from an

insurer to pay benefits (e.g., an annuity contract); or (c) any other payment specified by the

Secretary of the Treasury by regulations.

Nonqualified deferred compensation

Qualified retirement plans, including defined benefit pension plans, receive tax-favored

treatment under the Code.  A deferred compensation arrangement that is not eligible for tax-

favored treatment is generally referred to as a nonqualified deferred compensation

arrangement.   In general, a nonqualified deferred compensation arrangement is exempt from

the requirements of ERISA only if it is maintained primarily for the purpose of providing

deferred compensation for a select group of management or highly compensated employees.  As

a result, nonqualified deferred compensation arrangements generally cover only higher-paid

employees, such as executives.

Nonqualified deferred compensation arrangements may be merely unfunded contractual

arrangements, or the employer may establish a trust to hold assets from which nonqualified

deferred compensation payments will be made.  In some cases, even though trust assets are

generally not available for purposes other than to provide nonqualified deferred compensation,

the terms of the trust provide that the assets are subject to the claims of the employer's creditors

in the case of insolvency or bankruptcy.  Such an arrangement is referred to as a "rabbi" trust,

based on an IRS ruling issued with respect to such an arrangement covering a rabbi.

Amounts deferred under a nonqualified deferred compensation plan for all taxable years

are currently includible in gross income to the extent not subject to a substantial risk of forfeiture

and not previously included in gross income, unless certain requirements are satisfied.   In

addition, certain arrangements involving assets transferred or set aside to provide benefits under

a nonqualified deferred compensation plan are treated as a transfer of property in connection

with the performance of services, resulting in income inclusion.  If the requirements applicable to

nonqualified deferred compensation plan are not satisfied, in addition to current income

inclusion, interest applies at the underpayment rate plus 1 percentage point and the amount

required to be included in income is subject to a 20-percent additional tax.

Description of Proposal

Restrictions on benefit increases

Under the proposal, the present-law rule prohibiting amendments that increase benefits

while the employer is in bankruptcy continues to apply.  The present-law rule requiring security

for amendments that increase benefits and result in a funded current liability percentage of less

than 60 percent is replaced with a new rule.  Under the new rule, if the plan's funding percentage

(i.e., the market value of the plan's assets as a percentage of the plan's funding target,

determined as of the plan's valuation date) does not exceed 80 percent, any amendment

increasing benefits is prohibited unless, in addition to the otherwise required minimum

contribution, the employer contributes the amount of the increase in the plan's funding target

attributable to the amendment.  If the plan's funding percentage exceeds 80 percent, but was less

than 100 percent for the preceding plan year, an amendment that increases benefits and reduces

the plan's funding percentage to less than 80 percent is prohibited unless, in addition to the

otherwise required minimum contribution, the employer contributes the lesser of: (1) the amount

of the increase in the plan's funding target attributable to the amendment; or (2) the amount

needed to increase the plan's funding percentage to 80 percent.  If the plan's funding percentage

is at least 100 percent, amendments increasing benefits are not restricted.  In addition, the

restrictions do not apply for the first five years after a plan is established.

Restrictions on distributions and accruals

Under the proposal, the restrictions on distributions during a period of a liquidity shortfall

continue to apply (i.e., only annuity payments are permitted).  In addition, such restrictions apply

if: (1) the plan's percentage does not exceed 60 percent; (2) in the case of a financially weak

employer, the plan's funding percentage does not exceed 80 percent; or (3) the employer is in

bankruptcy and the plan's funding percentage is less than 100 percent.  In addition, no benefit

accruals are permitted if: (1) the employer is financially weak and the plan's funding percentage

does not exceed 60 percent (i.e., theplan is "severely underfunded"); or (2) the employer is in

bankruptcy and the plan's funding percentage is less than 100 percent.

Prohibition on funding nonqualified deferred compensation

Under the proposal, if a financially weak employer maintains a severely underfunded

plan, ERISA prohibits the funding of nonqualified deferred compensation for top executives of

the employer's controlled group (or any former employee who was a top executive at the time of

termination of employment).  The proposal also prohibits any funding of executive compensation

that occurs within six months before or after the termination of a plan, the assets of which are

less than the amount needed to provide all benefits due under the plan.  For this purpose, funding

includes the use of an arrangement such as a rabbi trust, insurance contract, or other mechanism

that limits immediate access to resources of the employer by the employer or by creditors. 

However, the prohibition on funding nonqualified deferred compensation does not apply for the

first five years after a plan is established.

Under the proposal, an employer maintaining a severely underfunded or terminating plan

must notify fiduciaries of the plan if any prohibited funding of a nonqualified deferred

compensation arrangements occurs.  The proposal provides plan fiduciaries with the right to

examine the employer's books and records to ascertain whether the employer has met its

obligation in this regard.

Under the proposal, a plan has a cause of action under ERISA against any top executive

whose nonqualified deferred compensation arrangement is funded during a period when funding

is prohibited.  The proposal permits the plan to recover the funded amount plus attorney's fees. 

Plan fiduciaries have the duty to take reasonable steps to pursue the cause of action provided

under the proposal.

Timing rules for restrictions

Under the proposal, certain presumptions apply in determining whether restrictions apply

with respect to a plan, subject to certifications provided by the plan actuary.  If a plan was

subject to a restriction for the preceding year, the plan's funding percentage is presumed not to

have improved in the current year until the plan actuary certifies that the plan's funding

percentage for the current year is such that the restriction does not apply.  If a plan was not

subject to a restriction for the preceding year, but its funding percentage did not exceed the

restriction threshold by more than 10 percentage points, the plan's funding percentage is

presumed to be reduced by 10 percentage points as of the first day of the fourth month of the

current plan year.  As a result, the restriction applies as of that day and until the plan actuary

certifies that the plan's funding percentage for the current year is such that the restriction does

not apply.  In any other case, if an actuarial certification is not made by the first day of the tenth

month of the plan year, as of that day the plan's funding percentage is presumed not to exceed 60

percent for purposes of the restrictions.

If the employer maintaining a plan enters bankruptcy, the plan's funding percentage is

presumed to be less than the plan's funding target.  As a result, no benefit accruals are permitted

until the plan actuary certifies that the plan's funding percentage is at least 100 percent.

For purposes of the timing rules, the actuary's certification must be based on information

available at the time of the certification regarding the market value of the plan's assets and the

actuary's best estimate of the plan's funding target as of the valuation date for the current plan

year.  If the actuary determines that the plan's funding percentage using the plan's actual funding

target causes a change in the application of restrictions, the actuary must notify the plan

administrator of the change.

Notice to participants

If a restriction applies with respect to a plan (including a plan maintained by an employer

that enters bankruptcy), the plan administrator must provide notice of the restriction to affected

participants within a reasonable time after the date the restriction applies (or, to the extent

provided by the Secretary of Labor, a reasonable period of time before the restriction applies). 

Notice must also be provided within a reasonable period of time after the date the restriction

ceases to apply.  A plan administrator that fails to provide the required notice is subject to a

penalty.  The Secretary of Labor is authorized to prescribe regulations relating to the form,

content, and timing of the notice.

Restoration of benefits

If restrictions on distributions and accruals apply with respect to plan, distributions and

accruals may resume in a subsequent plan year only by a plan amendment.  Such an amendment

may be adopted at any time after the first valuation date as of which the plan's funding

percentage exceeds the applicable threshold, subject to applicable restrictions on plan

amendments that increase benefits.  In addition, benefits provided under the amendment are

subject to the phase-in of the PBGC guarantee of benefit increases.

Effective date.-The proposals are generally effective for plan years beginning after

December 31, 2007.  In the case of a plan maintained pursuant to a collective bargaining

agreement in effect on the date of enactment, the proposals are not effective before the first plan

year beginning after the earlier of: (1) the date the collective bargaining agreement terminates

(determined without regard to any extension thereof); or (2) December 31, 2009. 

Analysis

Underfunded plans, particularly those maintained by employers experiencing financial

problems, pose the risk that the plan will terminate and the employer will be unable to provide

the additional assets needed to provide the benefits due under the plan (a distress termination). 

In some cases, because of the limit on the PBGC benefit guarantee, employees bear the cost of

underfunding through the loss of benefits.  In addition, the PBGC bears the cost of the shortfall

to the extent plan assets are insufficient to provide guaranteed benefits. 

Providing benefit increases under an unfunded plan increases these costs.  In addition, the

payment of lump sums and similar forms of benefit to some participants drains assets from the

plan, thus increasing the cost to the PBGC and other participants.  Cases have also arisen in

which assets were used to provide nonqualified deferred compensation to corporate executives

shortly before bankruptcy and the termination of an underfunded plan covering rank and file

employees.  The proposal is intended to address these situations by restricting benefit increases,

lump sums and similar forms of distribution, and the funding of nonqualified deferred

compensation in the case of underfunded plans.  Under the proposal, the extent of the restrictions

depends on the funding status of the plan and, in some cases, whether the employer is financially

weak or has entered bankruptcy.

Some view such restrictions as an appropriate means of limiting the risk presented by

underfunded plans.  Others may consider some of the restrictions (such as the restriction on lump

sums) as unfairly penalizing plan participants and potentially disrupting their retirement income

arrangements.  Some also suggest that the prospect of being unable to receive lump-sum

distributions may itself cause employees to elect lump sums while they are still available, thus

triggering a drain on plan assets.  On the other hand, some consider it unfair to allow participants

to rely on benefits that might never be paid and to favor some participants over others.

With respect to the restriction on funding nonqualified deferred compensation, some may

consider it inappropriate to target assets used for that particular purpose without targeting assets

used for other purposes.  Some also argue that companies in financial difficulty should be able to

use competitive compensation methods, including funding methods under which assets will be

available to creditors in the event of bankruptcy or insolvency, such as a rabbi trust.  Others

believe that such funding methods provide executives with the opportunity to cash out their

nonqualified deferred compensation before an employer enters bankruptcy, thus giving

executives an unfair advantage over rank-and-file participants.  Some may also consider it

inappropriate to allow a plan to bring action against the executive rather than against the

employer.  On the other hand, the proposal applies only in the case of a "top" executive. 

Although the concept of top executive is not defined, it suggests that the proposal is aimed at

company officials who have the authority to decide whether to adequately fund the employer's

defined benefit pension plan or instead to fund nonqualified deferred compensation benefits.

Prior Action

Similar proposals were included in the President's fiscal year 2005 and 2006 budget

proposals.

H.R. 2830 (the "Pension Protection Act of 2005"), as passed by the House, and S. 1783,

(the "Pension Security and Transparency Act of 2005"), as passed by the Senate, both include

provisions relating to benefit limitations applicable to underfunded single-employer defined

benefit pension plans.

6.      Eliminate plant shutdown benefits

Present Law

Unpredictable contingent event benefits

A plan may provide for unpredictable contingent event benefits, which are benefits that

depend on contingencies other than age, service, compensation, death or disability or that are not

reliably and reasonably predictable as determined by the Secretary.  Some of these benefits are

commonly referred to as "plant shutdown" benefits.  Under present law, unpredictable contingent

event benefits generally are not taken into account for funding purposes until the event has

occurred.

Early retirement benefits

Under present law, defined benefit pension plans are not permitted to provide "layoff"

benefits (i.e., severance benefits).   However, defined benefit pension plans may provide

subsidized early retirement benefits, including early retirement window benefits.

Prohibition on reductions in accrued benefits

An amendment of a qualified retirement plan may not decrease the accrued benefit of a

plan participant.  This restriction is sometimes referred to as the "anticutback" rule and applies to

benefits that have already accrued.   In general, an amendment may reduce the amount of

future benefit accruals, provided that, in the case of a significant reduction in the rate of future

benefit accrual, certain notice requirements are met.

For purposes of the anticutback rule, an amendment is also treated as reducing an accrued

benefit if, with respect to benefits accrued before the amendment is adopted, the amendment has

the effect of either (1) eliminating or reducing an early retirement benefit or a retirement-type

subsidy, or (2) except as provided by Treasury regulations, eliminating an optional form of

benefit.  This protection applies to participants who satisfy, either before or after the plan

amendment, the pre-amendment conditions for the benefit, and even if the condition on which

eligibility for the benefit depends is an unpredictable event such as a plan shutdown.

PBGC benefit guarantee

Within certain limits, the PBGC guarantees any retirement benefit that was vested on the

date of plan termination (other than benefits that vest solely on account of the termination), and

any survivor or disability benefit that was owed or was in payment status at the date of plan

termination.   Generally only that part of the retirement benefit that is payable in monthly

installments (rather than, for example, lump sum benefits payable) is guaranteed.

Retirement benefits that begin before normal retirement age are guaranteed, provided

they meet the other conditions of guarantee (such as that, before the date the plan terminates, the

participant had satisfied the conditions of the plan necessary to establish the right to receive the

benefit other than application for the benefit).  Contingent benefits (for example, early retirement

benefits provided only if a plant shuts down) are guaranteed only if the triggering event occurs

before plan termination. 

In the case of a plan or a plan amendment that has been in effect for less than five years

before a plan termination, the amount guaranteed is phased in by 20 percent a year.

Description of Proposal

Prohibition on providing unpredictable contingent event benefits

Under the proposal, plans are not permitted to provide benefits that are payable upon a

plant shutdown or any similar unpredictable contingent event as determined under regulations. 

A plan that contains such a benefit is required to eliminate the benefit, but only with respect to an

event that occurs after the effective date.  Such a plan amendment is deemed not to violate the

anticutback rule.

Effective date.–The prohibition on providing unpredictable contingent event benefits

generally is effective for plan years beginning in 2008.  In the case of a collective bargaining

agreement that provides for an unpredictable contingent event benefit on February 1, 2006, the

prohibition on unpredictable contingent event benefits is not effective before the end of the term

of that agreement (without regard any to extension of the agreement) or, if earlier, the first plan

year beginning in 2009.

Elimination of PBGC guarantee

The proposal amends the guarantee provisions of Title IV of ERISA to provide that the

PBGC guarantee does not apply to benefits that are payable upon a plant shutdown or any similar

contingent event.

Effective date.–The elimination of the PBGC guarantee is effective for benefits that

become payable as a result of a plant shutdown or similar contingent event that occurs after

February 1, 2006.

Analysis

Benefits for plant shutdowns and similar unpredictable contingent events and the PBGC

guarantee of such benefits present many issues, including the lack of funding of the benefits and

their nature as retirement or severance-type benefits.  These issues are relevant with respect to

the proposals to eliminate such benefits and the PBGC guarantee. 

Unlike most benefits under a defined benefit pension plan, plant shutdown benefits may

be predictable only a short while before the shutdown occurs, to the extent that they can be

predicted at all.  On the other hand, some shutdowns may be the result of business decisions. 

Notwithstanding, under the funding rules, a plan's liabilities for plant shutdown benefits

generally remain unfunded until the triggering contingency occurs.  After the contingency

occurs, the liabilities may be funded over a period of years.  In some cases, contingencies may be

followed by the employer's insolvency, making it difficult for employers to fully fund the

triggered benefits.  Additionally, the departure of employees from the company may follow a

shutdown or other contingency.  Many such employees may take distributions from the plan,

thereby draining assets from the plan.  If the plan later terminates, assets might not be sufficient

to provide the benefits due other plan participants.  In addition, the PBGC may be left with

increased unfunded liabilities as a consequence of the shutdown and the related benefits.  Thus,

plant shutdown benefits may significantly increase the underfunding taken on by the PBGC. 

Some argue that liabilities for such benefits make up a significant percentage of PBGC losses.

Some view plant shutdown benefits as severance-type benefits which should not be

provided under a retirement plan.  Plant shutdown benefits may, however, be considered a

variety of subsidized early retirement benefits, similar to early retirement window benefits which

are provided as an incentive for employees to voluntarily terminate employment.  Some believe

that it is appropriate for a defined benefit pension plan to provide such benefits to employees

whose employment is involuntarily terminated.  They argue that concerns about the effect of

such benefits on funding status and PBGC liability can be addressed by providing rules under

which these benefits are taken into account in determining required contributions and limiting

the PBGC guarantee, rather than prohibiting plans from providing the benefits. 

Others argue that plant shutdown benefits that are promised to participants under the

terms of a plan should be guaranteed by the PBGC like any other benefits under the plan.  Plant

shutdown benefits may represent a significant portion of a participant's benefits under a plan. 

Moreover, unlike some other types of benefits subject to contingent events, plant shutdown

benefits may be intertwined with the employer's financial well-being.  Some feel that eliminating

the PBGC guarantee applicable to plant shutdown benefits might further disadvantage plan

participants who are experiencing the effects of their employer's troubled financial status.  As an

alternative, some suggest that, rather than eliminating the PBGC guarantee, the occurrence of an

event giving rise to unpredictable contingent event benefits could be treated as a plan

amendment, so that the PBGC guarantee of such benefits is phased in over five years.

Prior Action

A similar proposal was included in the President's fiscal year 2006 budget proposal.

H.R. 2830 (the "Pension Protection Act of 2005"), as passed by the House, and S. 1783,

(the "Pension Security and Transparency Act of 2005"), as passed by the Senate, both include

provisions relating to plant shutdown and similar benefits provided under single-employer

defined benefit pension plans.

7.      Proposals relating to the Pension Benefit Guaranty Corporation ("PBGC")

(a)  Single-employer plan premiums that reflect risk

Present Law

In general

The minimum funding requirements permit an employer to fund defined benefit pension

plan benefits over a period of time.  Thus, it is possible that a plan may be terminated at a time

when plan assets are not sufficient to provide all benefits accrued by employees under the plan. 

In order to protect plan participants from losing retirement benefits in such circumstances, the

PBGC, a corporation within the Department of Labor, was created in 1974 under ERISA to

provide an insurance program for benefits under most defined benefit pension plans maintained

by private employers.

Premiums paid to the PBGC

The PBGC is funded by assets in terminated plans, amounts recovered from employers

who terminate underfunded plans, premiums paid with respect to covered plans, and investment

earnings.  Single-employer plans covered by the PBGC insurance program are required to pay a

flat-rate per participant premium.  Underfunded plans are subject to an additional variable-rate

premium based on the level of underfunding.  In addition, as discussed below, additional

termination premiums apply in certain circumstances if a plan terminates on an underfunded

basis.

Beginning in 1991, the flat-rate premium was $19 per participant.   Under the Deficit

Reduction Act of 2005,  for plan years beginning after 2005, the flat-rate premium is increased

to $30, with indexing after 2006 based on increases in average wages.

In the case of an underfunded plan, variable-rate premiums are required in the amount of

$9 per $1,000 of unfunded vested benefits (the amount which would be the unfunded current

liability if only vested benefits were taken into account and if benefits were valued at the variable

premium interest rate).   No variable-rate premium is imposed for a year if contributions to the

plan for the prior year were at least equal to the full funding limit for that year.

Under the Deficit Reduction Act of 2005, a new premium generally applies in the case of

certain plan terminations occurring after 2005 and before 2011.  A premium of $1,250 per

participant is imposed generally for the year of the termination and each of the following 2 years. 

The premium applies in the case of a plan termination by the PBGC or a distress termination due

to reorganization in bankruptcy, the inability of the employer to pay its debts when due, or a

determination that a termination is necessary to avoid unreasonably burdensome pension costs

caused solely by a decline in the workforce.  In the case of a termination due to reorganization,

the liability for the premium does not arise until the employer is discharged from the

reorganization proceeding.  The premium does not apply with respect to a plan terminated during

bankruptcy reorganization proceedings pursuant to a bankruptcy filing before October 18, 2005.

Interest on premium payments

If any premium required to be paid to the PBGC is not paid by the last date prescribed for

a payment, interest on the amount of such premium is charged at the rate imposed on

underpayment, nonpayment, or extensions of time for payment of tax  for the period from such

date to the date paid.   The PBGC is not authorized to pay interest on premium overpayments.

Description of Proposal

Under the proposal, variable rate premiums are replaced by risk-based premiums, which

are charged to all plans with assets less than their funding target (i.e., ongoing liability or at-risk

liability, depending on the financial status of the plan sponsor).   The risk-based premium is set

by the PBGC, and adjusted by the PBGC, based on forecasts of the PBGC's expected claims and

future financial condition.  The premium rate per dollar of underfunding is uniform for all plans. 

A plan with a financially-weak sponsor is required to pay premiums for each dollar of unfunded

at-risk liability, while a financially-healthy sponsor is required to pay premiums for each dollar

of unfunded ongoing liability.  The full-funding exception is eliminated so that all underfunded

plans are required to pay risk-based premiums.  The proposal also authorizes the PBGC to pay

interest on premium overpayments.

Effective date.–The proposal is effective for plan years beginning on or after January 1,

2006.

Analysis

Risk-based premiums

ERISA requires the pension insurance system to be self-financed, i.e., it is not funded by

general revenues.  The PBGC's principal sources of revenue are premiums collected from

PBGC-covered plans, assets assumed from terminated plans, collection of employer liability

payments due under ERISA, and investment income. 

The present-law variable rate premium is intended to reflect the greater potential risk of

exposure from underfunded plans.  The variable rate premium is also believed to provide an

incentive to plan sponsors to better fund their plans.  However, the current premium structure is

described by the Administration as resulting in the shifting of costs from financially-troubled

companies to healthy companies with adequately-funded plans, owing to the overdependence on

flat-rate premiums and lack of appropriate risk-based premiums.

The proposed risk-based premiums are intended to better correlate with the risk a plan

poses to the pension insurance system because they are based on a more accurate measure of

underfunding and reflect the financial condition of the plan sponsor's controlled group.  The

periodic adjustment of premium rates, based on the PBGC's expected claims and future financial

condition, is intended to more accurately reflect the cost of the PBGC program by providing the

funds necessary to meet expected future claims and to retire PBGC's deficit over a reasonable

time period. 

Some express concerns, however, that the proposed risk-based premiums would make

financially unstable employers, and those in bankruptcy, liable for substantial premium increases

if their plans are not fully funded.  An increase in premiums may be a source of volatility and

burden for companies struggling to recover from financial hardships.  These issues are similar to

the issues raised with respect to basing funding requirements on the financial condition of the

employer and are discussed in more detail above.

Additionally, some feel that it is not appropriate for the PBGC to set and adjust the risk-

based premium, based on forecasts of its expected claims and future financial condition.  It may

be viewed as more appropriate for the amount of, and increases, in premiums to be determined

by Congressional action. 

The proposal repeals the present-law exception to variable-rate premiums for plans at the

full funding limit.  According to the PBGC, some of the companies maintaining plans that have

resulted in the largest claims against the PBGC insurance fund have not been required to pay a

variable rate premium because they were at the full funding limit.   Imposing the risk-based

premium on all plans, without a full funding limit exception, will subject more plans to the

premium compared to the present-law variable rate premium.  The present-law exception for

plans at the full funding limit reflects concerns that it may be unfair to impose the premium on

employers making contributions as required under the funding rules, even if the plan remains

underfunded.  Under the proposal, contributions to eliminate underfunding are fully deductible,

so that an employer may avoid the risk-based premium by making sufficient contributions to

eliminate underfunding.  In some cases, however, the amount of contributions required to

eliminate underfunding could be substantial.

Some raise the concern that variable-rate premium increases, in addition to the recent

increase in flat-rate premiums, may cause more employers to freeze their plans.  Because

sponsoring a retirement plan for employees is voluntary, if the burden of sponsoring a plan

becomes too onerous, in part because burdensome premium payments are required, more

companies may freeze or terminate defined benefit pension plans.  Further, companies

considering whether to establish a defined benefit pension plan may be discouraged from doing

so by increased premium costs.

The PBGC premium proposal is one part of the President's overall proposal to increase

defined benefit pension plan security.  Some feel that improved funding rules will adequately

address underfunding issues and that better funding rules should be enacted and the effects of

those rules should be determined before additional premium increases are adopted.

Interest on premium overpayments

Some believe that premium payers should receive interest on premium overpayment

amounts that are owed to them.  Others feel that it is inappropriate for the PBGC to pay interest

and that providing for such interest may further impair the financial condition of the PBGC. 

Some argue that interest may not be appropriate in some cases, depending on how the

overpayment arose. 

Prior Action

A similar proposal was included in the President's fiscal year 2006 budget proposal.

H.R. 2830 (the "Pension Protection Act of 2005"), as passed by the House, and S. 1783,

(the "Pension Security and Transparency Act of 2005"), as passed by the Senate, both include

provisions relating to PBGC premiums.

(b)  Freeze benefit guarantee when contributing sponsor enters bankruptcy

Present Law

Termination of single-employer defined benefit pension plans

In general

An employer may voluntarily terminate a single-employer plan only in a standard

termination or a distress termination.   The participants and the PBGC must be provided notice

of the intent to terminate.  The PBGC may also involuntarily terminate a plan (that is, the

termination is not voluntary on the part of the employer).

Standard terminations

A standard termination is permitted only if plan assets are sufficient to cover benefit

liabilities.   Generally, benefit liabilities equal all benefits earned to date by plan participants,

including vested and nonvested benefits (which automatically become vested at the time of

termination), and including certain early retirement supplements and subsidies.   Benefit

liabilities may also include certain contingent benefits (for example, early retirement subsidies). 

If assets are sufficient to cover benefit liabilities (and other termination requirements, such as

notice to employees, are met), the plan distributes benefits to participants.  The plan provides for

the benefit payments it owes by purchasing annuity contracts from an insurance company, or

otherwise providing for the payment of benefits, for example, by providing the benefits in lump-

sum distributions.

If certain requirements are satisfied, and the plan so provides, assets in excess of the

amounts necessary to cover benefit liabilities may be recovered by the employer in an asset

reversion.  Reversions are generally subject to an excise tax, described above.

Distress terminations and involuntary terminations by the PBGC

Distress terminations

If assets in a defined benefit pension plan are not sufficient to cover benefit liabilities, the

employer may not terminate the plan unless the employer meets one of four criteria necessary for

a ''distress'' termination:

?     The contributing sponsor, and every member of the controlled group of which the

sponsor is a member, is being liquidated in bankruptcy or any similar Federal law or

other similar State insolvency proceedings;

?     The contributing sponsor and every member of the sponsor's controlled group is

being reorganized in bankruptcy or similar State proceeding;

?     The PBGC determines that termination is necessary to allow the employer to pay its

debts when due; or

?     The PBGC determines that termination is necessary to avoid unreasonably

burdensome pension costs caused solely by a decline in the employer's work force. 

These requirements are designed to ensure that the liabilities of an underfunded plan

remain the responsibility of the employer, rather than of the PBGC, unless the employer meets

strict standards of financial need indicating genuine inability to continue funding the plan.

Involuntary terminations by the PBGC

The PBGC may institute proceedings to terminate a plan if it determines that the plan in

question has not met the minimum funding standards, will be unable to pay benefits when due,

has a substantial owner who has received a distribution greater than $10,000 (other than by

reason of death) while the plan has unfunded nonforfeitable benefits, or may reasonably be

expected to increase PBGC's long-run loss unreasonably.  The PBGC must institute proceedings

to terminate a plan if the plan is unable to pay benefits that are currently due.

Asset allocation

ERISA contains rules for allocating the assets of a single-employer plan when the plan

terminates.   Plan assets available to pay for benefits under a terminating plan include all plan

assets remaining after subtracting all liabilities (other than liabilities for future benefit payments),

paid or payable from plan assets under the provisions of the plan.  On termination, the plan

administrator must allocate plan assets available to pay for benefits under the plan in the manner

prescribed by ERISA.  In general, plan assets available to pay for benefits under the plan are

allocated to six priority categories.   If the plan has sufficient assets to pay for all benefits in a

particular priority category, the remaining assets are allocated to the next lower priority category. 

This process is repeated until all benefits in the priority category are provided or until all

available plan assets have been allocated.  

Guaranteed benefits

Single-employer plans

When an underfunded plan terminates, the amount of benefits that the PBGC will pay

depends on legal limits, asset allocation, and recovery on the PBGC's employer liability claim. 

The PBGC guarantee applies to "basic benefits."  Basic benefits generally are benefits accrued

before a plan terminates, including (1) benefits at normal retirement age; (2) most early

retirement benefits; (3) disability benefits for disabilities that occurred before the plan was

terminated; and (4) certain benefits for survivors of plan participants.  Generally only that part of

the retirement benefit that is payable in monthly installments is guaranteed (rather than, for

example, lump-sum benefits). 

Retirement benefits that begin before normal retirement age are guaranteed, provided

they meet the other conditions of guarantee (such as that, before the date the plan terminates, the

participant had satisfied the conditions of the plan necessary to establish the right to receive the

benefit other than application for the benefit).  Contingent benefits (for example, subsidized early

retirement benefits) are guaranteed only if the triggering event occurs before plan termination.

For plans terminating in 2006, the maximum guaranteed benefit for an individual retiring

at age 65 is $3,971.59 per month or $47,659.08 per year.   The dollar limit is indexed annually

for inflation.  The guaranteed amount is reduced for benefits starting before age 65.  In the case

of a plan or a plan amendment that has been in effect for less than five years before a plan

termination, the amount guaranteed is phased in by 20 percent a year.

Description of Proposal

Under the proposal, certain aspects of the PBGC benefit guarantee are frozen when a

contributing sponsor enters bankruptcy or a similar proceeding.  The freeze continues for two

years after the sponsor emerges from bankruptcy.  If the plan terminates during the contributing

sponsor's bankruptcy or within two years after the sponsor emerges from bankruptcy, the amount

of guaranteed benefits payable by the PBGC is determined based on plan provisions, salary,

service, and the guarantee in effect on the date the employer entered bankruptcy.  The priority for

allocating plan assets and employer recoveries to non-guaranteed benefits in the event of plan

termination is determined as of the date the sponsor enters bankruptcy or a similar proceeding.

The administrator of a plan for which guarantees are frozen is required to notify plan

participants about the limitations on benefit guarantees, and potential receipt of non-guaranteed

benefits in a termination on account of the bankruptcy.

Effective date.–The proposal is effective with respect to Federal bankruptcy or similar

proceedings or arrangements for the benefit of creditors which are initiated on or after the date

that is 30 days after enactment.

Analysis

A recent report of the Government Accountability Office said that the termination of

large, underfunded defined benefit pension plans of bankruptcy firms in troubled industries has

been the major cause of the PBGC's single employer program's worsening net financial

position.

The funded status of a defined benefit pension plan may deteriorate during the pendency

of the employer's bankruptcy for various reasons.  For example, ongoing benefit accruals

increase plan liabilities.  The ability of the employer to make contributions may be impaired,

reducing the amount of assets that would be available to pay benefits if contributions continued. 

In addition, distributions to participants, especially lump-sum distributions, decrease plan assets. 

Nonetheless, under present law, the amount of PBGC-guaranteed benefit is not determined until

a plan terminates.  Thus, the PBGC's losses attributable to paying unfunded guaranteed benefits

may worsen during bankruptcy.  In addition, the rights of some participants under the priority in

which assets are allocated may be adversely affected by changes that occur during the period that

bankruptcy proceedings are pending.

Using the date a plan sponsor enters bankruptcy as the determinative date for freezing the

amount of guaranteed benefits may decrease the PBGC's losses for unfunded guaranteed

benefits.  This will also provide certainty as to priorities in asset allocations.  Some feel that the

date a plan sponsor files a bankruptcy petition is the appropriate measure for setting PBGC-

guaranteed benefit levels and priorities for asset allocations.  Using this date, it is argued, would

more effectively and appropriately limit the PBGC's exposure for unfunded liabilities.  Drains on

plan assets and increases in unfunded liabilities that may occur during the period after the

bankruptcy petition is filed and before termination of the plan may no longer result in

disproportionate losses for the PBGC.  For these same reasons, some argue that the bankruptcy

filing date is the appropriate date for allocating assets to priority categories.

On the other hand, freezing the amount of PBGC-guaranteed benefits on the date a plan

sponsor enters bankruptcy and maintaining the freeze for two years after the plan sponsor

emerges from bankruptcy may be viewed as unfair to plan participants.  Plan sponsors may be in

bankruptcy for years; an additional two years may exacerbate the negative impact on plan

participants.  The guaranteed benefits paid by the PBGC to participants whose plans are

terminated may already be considerably lower than the benefits they were promised under the

plan terms.  Freezing the level of benefits provided by the PBGC as of the date of the bankruptcy

petition may further harm participants.

Prior Action

A similar proposal was included in the President's fiscal year 2006 budget proposal.

S. 1783 (the "Pension Security and Transparency Act of 2005"), as passed by the Senate,

includes a provision under which certain aspects of the PBGC guarantee are determined as of the

date a plan sponsor enters bankruptcy.

(c)  Allow PBGC to perfect liens in bankruptcy for missed required pension

contributions

Present Law

Funding rules

The Code and the ERISA impose minimum funding requirements with respect to defined

benefit pension plans.   Under the minimum funding rules, the contribution required for a plan

year ("minimum required contribution") is generally the plan's normal cost for the year (i.e., the

cost of benefits allocated to the year under the plan's funding method) plus that year's portion of

other liabilities that are amortized over a period of years, such as benefits resulting from a grant

of past service credit.  In addition, for single-employer plans covering more than 100 participants

and, in general, having a funded current liability percentage of less than 90%, an additional

deficit reduction contribution may be required, based on the sum of:  (1) the expected increase in

current liability for benefits accruing in the current year; and (2) a percentage of unfunded

current liability.  Minimum required contributions generally must be made within 8-1/2 months

after the end of the plan year.  If the contribution is made by such due date, the contribution is

treated as if it were made on the last day of the plan year.

A plan with a funded current liability percentage of less than 100 percent for the

preceding plan year must make estimated contributions for the current plan year in quarterly

installments ("installment payments") during the current plan year.  A plan's "funded current

liability percentage" is the actuarial value of plan assets (i.e., the average fair market value over a

period of years) as a percentage of the plan's current liability.  In general, a plan's current

liability means all liabilities to employees and their beneficiaries under the plan.

PBGC liens for missed contributions

Under certain conditions, if an employer fails to timely make a required installment

payment or minimum required contribution to a defined benefit pension plan (other than a

multiemployer plan), a lien automatically arises in favor of the plan.   For such a lien to arise,

(1) the plan's current liability percentage must be less than 100 percent for the plan year; (2) the

plan must be covered by the PBGC termination insurance program; (3) the installment payment

minimum required contribution was not made before the due date for the contribution; and

(4) the unpaid balance of the installment payments or required minimum contributions (including

interest), when added to the aggregate unpaid balance of all preceding installment payments or

minimum required contributions which were not paid before the due date (including interest)

exceeds $1,000,000.

The lien is upon all property and rights to property, whether real or personal, belonging to

the employer or a member of the employer's controlled group.   The amount of the lien is equal

to the aggregate unpaid balance of required contributions (including interest) for plan years

beginning after 1987 and for which payment has not been made before the due date for the

installment payment or required minimum contribution. 

The lien arises after the due date for which the installment payment or minimum required

contribution is not made and continues through the end of the plan year in which such liabilities

exceed $1,000,000.  The PBGC may perfect and enforce such a lien, or such a lien may be

perfected and enforced at the direction of the PBGC by the contributing sponsor or any member

of the controlled group of the contributing sponsor. 

Bankruptcy rules affecting liens for missed contributions

Automatic stays

Federal bankruptcy law provides for an automatic stay against certain actions by creditors

once a bankruptcy petition is filed.   The automatic stay prevents the commencement or

continuation of actions against the debtor or the debtor's property and applies to all entities,

including governmental entities.  The automatic stay protects the debtor's property against

attempts to create, perfect, or enforce liens against it, including liens which arise solely by force

of a statute on specified circumstances or conditions ("statutory liens").   The automatic stay

generally remains in effect, absent modification or termination by the court, until the earliest of

(1) the time the case is closed; (2) the time the case is dismissed; or (3) the time a discharge is

granted or denied.

The automatic stay applies to PBGC liens for missed contributions.

Lien avoidance powers

Federal bankruptcy law allows a bankruptcy trustee  to avoid statutory liens that are not

perfected or enforceable against a hypothetical bona fide purchaser as of the date the bankruptcy

petition is filed.   This power generally allows a bankruptcy trustee to avoid liens for missed

contributions which are not perfected by the PBGC at the time a bankruptcy petition is filed. 

Description of Proposal

The proposal amends Federal bankruptcy law to provide an exemption from the

automatic stay under Federal bankruptcy law to allow the creation and perfection of PBGC liens

for missed contributions against a plan sponsor and controlled group members.  The proposal

also provides an exemption for PBGC liens for missed contributions from the lien avoidance

provisions of Federal bankruptcy law.

Effective date.–The proposal is effective with respect to initiations of Federal bankruptcy

or similar proceedings on or after the date 30 days after enactment.

Analysis

Federal bankruptcy law allows a debtor to preserve some of its assets and discharges the

debtor's legal obligation to pay certain debts.  In many cases, bankruptcy law allows a debtor the

chance to cure its financial ills and continue in business.  The automatic stay, a fundamental

feature of the protections afforded a debtor under Federal bankruptcy law, provides the debtor

relief from collection efforts by creditors and protects the bankruptcy estate from being depleted

and from seizures of property before the bankruptcy trustee has marshaled and distributed the

debtor's assets.  The lien avoidance provisions under Federal bankruptcy law grant special

protections to the debtor in certain cases, allowing a bankruptcy trustee to avoid creditor's

claims.  Like other creditors, the PBGC is subject to these provisions as they apply to a plan

sponsor which has petitioned for bankruptcy.

It may be argued that the automatic stay and lien avoidance provisions of Federal

bankruptcy law unfairly allow employers to escape liability for required contributions to defined

benefit pension plans.  The PBGC and plan participants may be adversely affected as a result. 

An employer with significant aggregate unpaid required installment payments or minimum

required contributions may avoid its funding obligations as to the missed contributions during

the pendency of a bankruptcy proceeding.  If a plan terminates while the employer is in

bankruptcy, the PBGC may experience losses on account of its inability to perfect liens for

missed contributions and the lien avoidance rules which may allow the trustee to avoid the

PBGC lien.  In addition, plan participants may receive lower benefits in that the employer's

failure to make contributions results in less plan assets.  Some feel that the PBGC lien for missed

contributions should not be made ineffective by a plan sponsor's entering bankruptcy

notwithstanding whether it has been perfected.  In many cases, an employer's liability for unpaid

contributions ultimately leads to unfunded liabilities that are taken on by the PBGC once the plan

is terminated.

On the other hand, the automatic stay and lien avoidance provisions assist in preserving

Federal bankruptcy law's distributional scheme for distributing the debtors' assets.  These

provisions generally allow the trustee to take stock of the debtor's property interests so as to be

apprised of the various rights and interests involved without the threat of immediate estate

dismemberment by zealous creditors.  Additionally, they prevent creditors from gaining

preference, forestall the depletion of a debtor's assets, and avoid interference with or disruption

of the administration of the bankruptcy estate in an orderly liquidation or reorganization.  It may

be argued that exempting PBGC liens for missed contributions from these provisions would

interfere with these fundamental principles of Federal bankruptcy law and may ultimately harm

the interests of defined benefit pension plan participants, for example, by making it more

difficult for the employer to emerge from bankruptcy. 

Some feel that a more appropriate solution to obstacles the PBGC encounters when a plan

sponsor enters bankruptcy is to modify the non-bankruptcy laws which affect PBGC's financial

position, including the funding rules.

Prior Action

A similar proposal was included in the President's fiscal year 2006 budget proposal.

 

 

 

C.      Reflect Market Interest Rates in Lump-Sum Payments

Present law

Accrued benefits under a defined benefit pension plan generally must be paid in the form

of an annuity for the life of the participant unless the participant consents to a distribution in

another form.  Defined benefit pension plans generally provide that a participant may choose

among other forms of benefit offered under the plan, such as a lump-sum distribution.  These

optional forms of benefit generally must be actuarially equivalent to the life annuity benefit

payable to the participant.

A defined benefit pension plan must specify the actuarial assumptions that will be used in

determining optional forms of benefit under the plan in a manner that precludes employer

discretion in the assumptions to be used.  For example, a plan may specify that a variable interest

rate will be used in determining actuarial equivalent forms of benefit, but may not give the

employer discretion to choose the interest rate.

Statutory assumptions must be used in determining the minimum value of certain

optional forms of benefit, such as a lump sum.   That is, the lump sum payable under the plan

may not be less than the amount of the lump sum that is actuarially equivalent to the life annuity

payable to the participant, determined using the statutory assumptions.  The statutory

assumptions consist of an applicable mortality table (the 1994 Group Annuity Reserving Table

projected through 2002) and an applicable interest rate.

The applicable interest rate is the annual interest rate on 30-year Treasury securities,

determined as of the time that is permitted under regulations.  The regulations provide various

options for determining the interest rate to be used under the plan, such as the period for which

the interest rate will remain constant ("stability period") and the use of averaging.

Annual benefits payable under a defined benefit pension plan generally may not exceed

the lesser of (1) 100 percent of average compensation, or (2) $175,000 (for 2006).   The dollar

limit generally applies to a benefit payable in the form of a straight life annuity.  If the benefit is

not in the form of a straight life annuity (e.g., a lump sum), the benefit generally is adjusted to an

equivalent straight life annuity.  For purposes of adjusting a benefit in a form that is subject to

the minimum value rules, such as a lump-sum benefit, the interest rate used generally must be

not less than the greater of: (1) the rate applicable in determining minimum lump sums, i.e., the

interest rate on 30-year Treasury securities; or (2) the interest rate specified in the plan.   In the

case of plan years beginning in 2004 or 2005, the interest rate used must be not less than the

greater of: (1) 5.5 percent; or (2) the interest rate specified in the plan.

Description of Proposal

The proposal changes the interest rate used to calculate lump sums payable from a

defined benefit pension plan for plan years beginning in 2008.  For plan years beginning in 2006

and 2007, the present-law interest rate applies in determining minimum lump sums from defined

benefit pension plans, i.e., minimum lump-sum values are determined using the rate of interest

on 30-year Treasury securities.

For plan years beginning after December 31, 2007, the proposal provides that minimum

lump-sum values are calculated using rates drawn from a zero-coupon corporate bond yield

curve.  Under the proposal, the yield curve is to be issued monthly by the Secretary of Treasury

and based on the interest rates (averaged over 90 business days) for high quality corporate bonds

with varying maturities.  Thus, the interest rate that applies depends upon how many years in the

future a participant's annuity payment will be made.  Typically, a higher interest applies for

payments made further out in the future.

For distributions in 2008 and 2009, lump-sum values are determined as the weighted

average of two values: (1) the value of the lump sum determined under the methodology under

present law (the "old" methodology); and (2) the value of the lump sum determined using the

methodology applicable for 2010 and thereafter (the "new" methodology).  For distributions in

2008, the weighting factor is 2/3 for the lump-sum value determined under the old methodology

and 1/3 for the lump-sum value determined under the new methodology.  For distributions in

2009, the weighting factors are reversed.

Effective date.-The proposal is effective for plan years beginning after December 31,

2007.

Analysis

As previously discussed, recent attention has focused on the issue of the rate of interest

used to determine the present value of benefits under defined benefit pension plans for purposes

of the plan's current liability and the amount of lump-sum benefits under the plan.   Because

minimum lump-sum distributions are calculated as the present value of future benefits, the

interest rate used to calculate this present value will affect the value of the lump-sum benefit.  

Specifically, the use of a lower interest rate results in larger lump-sum benefits; the use of a

higher interest rate results in lower lump-sum benefits.

Under present law, the interest rate used for valuing lump-sum benefits is based on the

interest rate on 30-year Treasury obligations.  The interest rate issue has received attention

recently in part because the Treasury Department stopped issuing 30-year obligations in 2001,

which meant that a change to the statutory interest rate was needed.  Because the Treasury

Department recently resumed the issuance of 30-year obligations, some view a statutory change

as no longer necessary.   However, apart from the availability of 30-year Treasury obligations,

some have argued that the 30-year Treasury rate has been inappropriately low, causing lump-sum

benefits to be disproportionately large in comparison with annuity benefit payable under the

plan.  This raises the concern that use of a low interest rate provides an incentive for employees

to take benefits in a lump sum rather than in the form of a life annuity.  Annuity distributions are

generally considered to provide greater retirement income security in that they assure an

individual (and generally the individual's spouse) of an income stream for life.  On the other

hand, even if a lump-sum distribution is rolled over to an IRA or other retirement plan, it does

not assure a lifetime stream of income.  Some also argue that lump sums should not be favored

as a form of benefit because they can cause a cash drain on the plan.

Under the proposal, the rate of interest on 30-year Treasury securities is replaced with the

rate of interest on high quality corporate bonds for purposes of determining a plan's minimum

lump-sum values.  In determining lump-sum values, the proposal provides for the use of a series

of interest rates drawn from a yield curve of high-quality zero-coupon bonds with various

maturities, selected to match the timing of benefit payments expected to be made from the plan.

Some have raised concerns that a yield curve approach is more complicated than the use

of a single rate, particularly for purposes of determining lump-sum distributions.  Others argue

that, once the stream of expected future benefit payments is determined, the difference in

difficulty between discounting using one rate for all payments, or discounting with varying rates

(i.e., the yield curve), is minor.

Some believe that the same interest rate should be used in valuing a plan's liabilities for

funding purposes and in determining minimum lump-sum benefits under the plan because to do

otherwise would undermine the accuracy of funding computations.  However, the assumptions

used to determine other optional forms of benefit under a plan, such as early retirement benefits,

often differ from the assumptions used to value the liabilities attributable to those benefits for

funding purposes.  The difference in assumptions does not undermine the accuracy of funding

computations, provided that the benefits expected to be paid from the plan, which form the basis

for valuing plan liabilities, are determined using the assumptions that apply under the plan.  

Moreover, even though, under present law, an interest rate based on 30-year Treasury securities

is used both in valuing plan liabilities for funding purposes and in determining minimum lump

sums, the interest rates actually used can be very different, for example, because different

averaging periods apply. 

The proposal includes a transition period so that employees who are expecting to retire in

the near future are not subject to a change in the expected amount of their lump sum.  While

most agree that a transition period is necessary, views may differ on the appropriate length of the

transition period.

The proposal does not directly change the interest rate used in applying the limitations on

benefits to lump-sum distributions.  As discussed above, in applying these limitations to lump-

sum benefits, the interest rate that must be used must be not less than the greater of (1) the

interest rate used in determining minimum lump sums,  or (2) the interest rate used in the plan. 

Because this rule uses the rate applicable in determining minimum lump sums, the proposal to

change the rate used for minimum lump-sum purposes would automatically apply for purposes

of applying this rule.  In addition, many plans use the statutory minimum lump-sum rate to

determine lump-sum benefits under the plan.  In such a case, the proposal to use a corporate

bond yield curve in determining minimum lump sums has the effect of also making the corporate

bond yield curve the rate used in the plan.  Thus, the proposal indirectly affects the computation

of the limitations on benefits.

Prior Action

A similar proposal was included in the President's fiscal year 2005 and 2006 budget

proposals.

Pension Protection Act of 2005, as passed by the House, and Pension Security and

Transparency Act of 2005, as passed by the Senate, both include provisions relating to the

determination of minimum lump sums.

 

 

 

V.    TAX SHELTERS, ABUSIVE TRANSACTIONS, AND TAX COMPLIANCE

A.    Combat Abusive Foreign Tax Credit Transactions

Present Law

The United States employs a "worldwide" tax system, under which residents generally

are taxed on all income, whether derived in the United States or abroad.  In order to mitigate the

possibility of double taxation arising from overlapping claims of the United States and a source

country to tax the same item of income, the United States provides a credit for foreign income

taxes paid or accrued, subject to several conditions and limitations. 

For purposes of the foreign tax credit, regulations provide that a foreign tax is treated as

being paid by "the person on whom foreign law imposes legal liability for such tax."   Thus,

for example, if a U.S. corporation owns an interest in a foreign partnership, the U.S. corporation

can claim foreign tax credits for the tax that is imposed on it as a partner in the foreign entity. 

This would be true under the regulations even if the U.S. corporation elected to treat the foreign

entity as a corporation for U.S. tax purposes.  In such a case, if the foreign entity does not meet

the definition of a controlled foreign corporation or does not generate income that is subject to

current inclusion under the rules of subpart F, the income generated by the foreign entity might

never be reported on a U.S. return, and yet the U.S. corporation might take the position that it

can claim credits for taxes imposed on that income.  This is one example of how a taxpayer

might attempt to separate foreign taxes from the related foreign income, and thereby attempt to

claim a foreign tax credit under circumstances in which there is no threat of double taxation.

The Treasury Department currently has substantial authority to promulgate regulations

under section 901 and other provisions of the Code to address transactions and structures that

produce inappropriate foreign tax credit results.

Description of Proposal

The proposal enhances the regulatory authority of the Treasury Department to address

transactions that involve the inappropriate separation of foreign taxes from the related foreign

income in cases in which taxes are imposed on any person in respect of income of an entity. 

Regulations issued pursuant to this authority could, for example, provide for the disallowance of

a credit for all or a portion of the foreign taxes, or for the allocation of the foreign taxes among

the participants in the transaction in a manner more consistent with the economics of the

transaction.

Effective date.–The proposal generally is effective after the date of enactment.

Analysis

The proposal clarifies and centralizes existing regulatory authority to facilitate efforts on

the part of the Treasury Department and the IRS to address abusive transactions involving

foreign tax credits.   This grant of regulatory authority would supplement existing authority and

thereby provide greater flexibility in addressing a wide range of transactions and structures. 

However, the proposal does not identify in great detail the scope of transactions that would be

covered.  Consequently, the effectiveness of these rules would depend on the degree to which the

Treasury Department provides greater detail with respect to the scope of transactions covered

and the means by which these transactions would be curtailed.

Prior Action

An identical proposal was included in the President's fiscal year 2005 and 2006 budget

proposals.

The proposal is also included in H.R. 4297, as amended by the Senate (the "Tax Relief

Act of 2005").

 

 

B.    Modify the Active Trade or Business Test for Certain Corporate Divisions

Present Law

A corporation generally is required to recognize gain on the distribution of property

(including stock of a subsidiary) to its shareholders as if the corporation had sold such property

for its fair market value.   In addition, the shareholders receiving the distributed property are

ordinarily treated as receiving a dividend of the value of the distribution (to the extent of the

distributing corporation's earnings and profits), or capital gain in the case of a stock buyback that

significantly reduces the shareholder's interest in the parent corporation.  

An exception to these rules applies if the distribution of the stock of a controlled

corporation satisfies the requirements of section 355 of the Code. If all the requirements are

satisfied, there is no tax to the distributing corporation or to the shareholders on the distribution.

If the requirements are satisfied, section 355 provides tax-free treatment both to pro-rata

distributions of stock of a subsidiary to the parent's shareholders and also to non-pro-rata

distributions, in which the former parent company shareholders own the distributed and former

parent corporations in different proportions after the transaction.  In these cases, one or more

former parent shareholders not only may own the resulting corporations in different proportions

after the transaction than their ownership in the parent prior to the transaction, but also might

terminate any stock relationship in one or the other of the corporations.

One requirement to qualify for tax-free treatment under section 355 is that both the

distributing corporation and the controlled corporation must be engaged immediately after the

distribution in the active conduct of a trade or business that has been conducted for at least five

years and was not acquired in a taxable transaction during that period (the "active trade or

business test").   For this purpose, a corporation is engaged in the active conduct of a trade or

business only if (1) the corporation is directly engaged in the active conduct of a trade or

business, or (2) the corporation is not directly engaged in an active business, but substantially all

its assets consist of stock and securities of one or more corporations that it controls immediately

after the distribution, each of which is engaged in the active conduct of a trade or business.

There is no statutory requirement that a certain percentage of the distributing or

controlled corporation's assets be used in the conduct of an active trade or business in order for

the active trade or business test to be satisfied. 

In determining for advance ruling purposes whether a corporation is directly engaged in

an active trade or business that satisfies the requirement, prior IRS guidelines required that the

fair market value of the gross assets of the active trade or business ordinarily must constitute at

least five percent of the total fair market value of the gross assets of the corporation.   The IRS

recently suspended this specific rule in connection with its general administrative practice of

devoting fewer IRS resources to advance rulings on factual aspects of section 355 transactions.

Description of Proposal

Under the proposal, in order for a corporation to satisfy the active trade or business test in

the case of a non-pro-rata distribution, as of the date of the distribution at least 50 percent of its

assets, by value, must be used or held for use in a trade or business that satisfies the active trade

or business test.

Effective date.-No effective date for the proposal is specified in the President's budget

proposal.  For revenue estimating purposes, the staff of the Joint Committee on Taxation has

assumed the provision to be effective for distributions made on or after the date of enactment. 

Analysis

The purpose of section 355 is to permit existing shareholders to separate existing

businesses for valid business purposes without immediate tax consequences.  Absent section 355,

a corporate distribution of property (including stock of a subsidiary) to shareholders would be a

taxable event both to the distributing corporation and to the shareholders.  

Present law arguably has permitted taxpayers to use section 355 as a vehicle to make, in

effect, tax-free distributions of large amounts of cash by combining a relatively small business

with such cash in a distributed corporation.  Recent press reports have referred to these

transactions as "cash-rich" tax-free corporate divisions.   For example, the addition of a

relatively small business to an otherwise cash stock redemption transaction can convert an

essentially cash stock buyback, which would have been taxed to the recipient shareholder, into a

tax-free transaction for the recipient shareholder.  Increasing the active business asset

requirement to a level such as 50 percent in the case of a non-pro-rata distribution could provide

some limit to the proportion of cash that can be distributed in such transactions.

The 50-percent active trade or business test of the proposal could be criticized as

inadequate to accomplish its policy objectives, since the proposal still permits at least 50 percent

of assets to be mere investment assets or cash that are neither used nor held for use in the active

conduct of a trade or business.   Consideration could be given to increasing the threshold above

50 percent.  For example, present law requires that 80 percent of gross assets by value be "used"

in the active conduct of one or more qualified trades or businesses for favorable tax treatment of

investments in certain small business corporations, with specific statutory definitions of what is

considered "use" for this purpose.

In some cases, it is possible that an active trade or business might require large amounts

of cash or other investment assets to prepare for upcoming business needs.  The proposal does

appear to give some leeway for such situations by permitting assets "held for use" in the active

conduct of a trade or business to count towards the 50-percent requirement.  While the intended

scope of this "held for use" standard is not entirely clear, it is possible that it would be

interpreted at least to cover working capital needs of the business and possibly broader expansion

or other needs.  The test might also be interpreted to provide the necessary flexibility to address,

for example, situations involving financial institutions or insurance companies that might hold

significant investment-type assets as part of their business.  Specific clarification of the intended

scope of the phrase could be desirable, both from the viewpoint of the government and of

taxpayers.  On the one hand, expressly stating any limitations might provide a more

administrable limit on the extent to which a taxpayer can assert possible expansion or other

potential plans to justify a very high percentage of cash or investment assets.  On the other hand,

even if that phrase is limited in any way to provide greater certainty, from the taxpayer's point of

view there would appear to be significant leeway for additional cash and investment assets, since

half the entire value of the entity can consist of cash or other assets that are neither used nor held

for use in the active conduct or a trade or business.  

Some may argue that any significant absolute cut-off test might prove inflexible in

accommodating situations where corporations legitimately need to equalize values to

shareholders in a division of business assets. However, if cash in excess of 50 percent of the

assets transferred is necessary to equalize values, the question arises whether such an amount of

cash should be allowed to be transferred tax-free. A corporation could distribute the excess cash

prior to the division if necessary, keeping the basic business division tax-free but causing a

taxable event to shareholders who are being economically cashed out in part in connection with

the business division.

It also might be argued that in corporate divisions such as those affected by the proposal,

the distributed cash or investment assets remain in corporate solution and thus have not been

paid directly to the shareholder.  However, in such situations, the value of such cash or

investment assets may be very accessible to the shareholder even without a further distribution. 

A divisive transaction has occurred that has qualitatively changed the shareholder's investment

by separating the cash from the assets in which the shareholder had previously invested. Such a

transaction may allow the shareholder indirectly to obtain the value of the cash in the separated

corporation, by borrowing against stock that carries little business risk.

Similarly, it could be argued that as long as the assets in question have a carryover basis

in the hands of the corporation, it is not necessary to impose a tax at the time of distribution of

the corporate stock.  However, a corporation generally is not permitted to sell assets to another

corporation at carryover basis without tax; nor is a corporation generally permitted to distribute

stock of a subsidiary without tax (absent the application of section 355).  Moreover, section 355

provides tax-free treatment to both the corporation and the shareholders, so no tax is paid even

though there has been a readjustment of the shareholders' investment.  

The proposal applies only to non-pro-rata distributions and does not change the present

law active business requirement for pro-rata tax-free corporate divisions in which each existing

shareholder of the parent receives an interest in each of the resulting separate corporations that is

the same proportionate interest as the interest held in the parent corporation.   Consideration

should be given to whether such a disparity in treatment could result in pro-rata transactions

structured to meet the old law requirements, followed by additional steps to achieve a result

similar to the current cash-rich stock redemption transactions.  In general, it would appear that

any outright sales of stock for cash among shareholders, or other subsequent stock repurchases

by the corporation following a pro-rata spin off, would either be taxable as an outright cash sale

or would again be subject to the non-pro-rata rules of the proposal if structured as a corporate

division.  However, general anti-abuse rules might be desirable to prevent the use of partnerships

or other arrangements to restructure the benefits and burdens of stock ownership among the

shareholders after a pro-rata distribution.  At the same time, consideration should be given to

whether there may be situations where the definition of "non-pro rata" requires clarification,

such as cases involving distributions with respect to different classes of stock, or cases where

some small shareholders might be able to receive cash in lieu of stock.   

Applying the new "active business" test only to non-pro-rata distributions might still

permit some pro-rata transactions to occur that largely isolate cash or investment assets in one

entity and risky business assets in the other, thus significantly changing the nature of the

shareholders' holdings after the transaction.  The limited application of the proposal does include

the specific type of transaction that has attracted recent press attention as the "cash rich"

redemption type division.  Arguably, however, applying the new rule to all tax-free corporate

divisions could provide greater consistency.  Separating corporate assets to enable shareholders

to have an interest in at least one corporation with a large proportion of cash or non-business

investment assets could be considered contrary to the purpose of section 355 because such a

transaction may effect a change in the shareholders' investment more similar to the distribution

of a dividend than to a restructuring of business holdings.

If the proposal were adopted, consideration might also be given to expanding the manner

of its application so that the 50-percent active trade or business test would apply to each of the

distributing and distributed corporation affiliated groups immediately after the transaction, rather

than solely on a corporation by corporation basis. This could provide some additional structural

flexibility to situations involving holding companies in a chain of entities and could reduce the

complexity and possible difficulty of meeting the new 50-percent standard on the basis only of

the parent distributing or distributed corporation.

Prior Action

An identical provision was contained in the President's fiscal year 2006 budget proposal.

The Tax Relief Act of 2005  would deny tax-free treatment under section 355 if,

immediately after the distribution of a controlled corporation, 50 percent of either the vote or

value of either the distributing or controlled corporation is owned by a person that did not

previously own such a 50 percent interest and that corporation is a "disqualified investment

company."  The definition of a "disqualified investment company" requires 75 percent or more

of the value of the company to be in cash or certain other investment assets (as defined) before

the provision applies.  Certain corporate stock and partnership interests are "looked through" for

this purpose to their underlying assets, and certain securities of such entities are disregarded, as

are certain assets held for use in the active and regular conduct of  a lending or finance, banking,

or insurance businesses, and securities held by a dealer that are marked to market. 

 

 

C.    Impose Penalties on Charities that Fail to Enforce Conservation Easements

Present Law

Section 170(h) provides special rules that apply to qualified conservation contributions,

which include charitable contributions of conservation easements and façade easements. 

Qualified conservation contributions are not subject to the "partial interest" rule, which generally

denies deductions for charitable contributions of partial interests in property.  Accordingly,

qualified conservation contributions are contributions of partial interests that are eligible for a

fair market value deduction. 

A qualified conservation contribution is a contribution of a qualified real property interest

to a qualified organization exclusively for conservation purposes.  A qualified real property

interest is defined as: (1) the entire interest of the donor other than a qualified mineral interest;

(2) a remainder interest; or (3) a restriction (granted in perpetuity) on the use that may be made

of the real property.   Qualified organizations include certain governmental units, public

charities that meet certain public support tests, and certain supporting organizations. 

Conservation purposes include:  (1) the preservation of land areas for outdoor recreation by, or

for the education of, the general public; (2) the protection of a relatively natural habitat of fish,

wildlife, or plants, or similar ecosystem; (3) the preservation of open space (including farmland

and forest land) where such preservation will yield a significant public benefit and is either for

the scenic enjoyment of the general public or pursuant to a clearly delineated Federal, State, or

local governmental conservation policy; and (4) the preservation of an historically important land

area or a certified historic structure.

In general, no deduction is available if the property may be put to a use that is

inconsistent with the conservation purpose of the gift.   A contribution is not deductible if it

accomplishes a permitted conservation purpose while also destroying other significant

conservation interests.

Description of Proposal

The Administration's proposal imposes "significant" penalties on any charity that

removes or fails to enforce a conservation restriction for which a charitable contribution

deduction was claimed, or transfers such an easement without ensuring that the conservation

purposes will be protected in perpetuity.  The amount of the penalty is determined based on the

value of the conservation restriction shown on the appraisal summary provided to the charity by

the donor.

Under the proposal, the Secretary is authorized to waive the penalty in certain cases, such

as if it is established to the satisfaction of the Secretary that, due to an unexpected change in the

conditions surrounding the real property, retention of the restriction is impossible or impractical,

the charity receives an amount that reflects the fair market value of the easement, and the

proceeds are used by the charity in furtherance of conservation purposes.  The Secretary also is

authorized to require such additional reporting as may be necessary or appropriate to ensure that

the conservation purposes are protected in perpetuity.

Effective date.–The proposal is effective for taxable years beginning after December 31,

2005.

Analysis

The proposal addresses the concern that charitable contributions of conservation

restrictions, which are required to be in perpetuity, are being removed, or are being transferred

without securing the conservation purpose.  The proposal's solution to the problem is to impose

penalties on the charity in such cases.

The intended scope of the proposal is not clear.  The proposal applies to "removals,"

which some might argue includes significant modifications to conservation restrictions.  A fair

reading of the proposal would impose taxes in a case where a conservation restriction that

prohibits development on 100 acres of property is modified after the contribution to prohibit

development on only 50 of the acres.  Although the conservation restriction is not removed in its

entirety, a portion of the restriction is removed, constituting a "removal" for purposes of the

proposal.  Some might argue, however, that if modifications to conservation restrictions are

penalized, certain non significant modifications, such as for mistake or clarity, or de minimis

modifications, should not be penalized, and that determining whether a modification is

significant introduces administrative complexity.  On the other hand, some might argue that any

such complexity could be overcome and that a proposal that is directed to enforcing the

perpetuity requirement and that does not address significant modifications to property

restrictions is not sufficient. 

The suggested penalty of the proposal is "based on the value of the conservation

restriction shown on the appraisal summary provided to the charity by the donor."  The amount

of the penalty is not clear.  Under this standard, the penalty could be any percentage of such

value.  Some might argue that the penalty should recapture the tax benefit to the donor, and thus

should equal the value of the conservation restriction that is removed or transferred times the

highest applicable tax rate of the donor at the time of the contribution, plus interest.  Others

might argue that the penalty should equal such amount, plus an additional amount to penalize the

charity for removing or transferring the easement.  In either case, knowing the highest applicable

tax rate of the donor may be difficult; thus in the alternative, a rate could be established by law. 

In addition, arguably the penalty also should take into account the present value of the

restriction.  For example, the removal or transfer of the restriction could occur many years after

the donation and in such a case, a penalty based on the value of the restriction at the time of the

donation would not recover the tax benefit unless the present value is taken into account. 

If the proposal applies to modifications of restrictions, however, a penalty based on

recapture of the tax benefit presents additional complexity, in that a before and after appraisal

would be required to determine the effect of the modification on the value of the property.  For

modifications, a better approach might be to impose as a penalty an established percentage

(perhaps using the same percentage established for removals and transfers) times the value of the

restriction (taking into account present value).  Although such a penalty would recover more than

the tax benefit, the excess above such benefit could be viewed as the additional penalty amount,

mentioned above, that is imposed on the charity for permitting the modification.  Alternatively,

some might argue that the penalty need not recover the tax benefit, but should just be sufficiently

high to deter the donee organization from removing the restriction.

The proposal provides the Secretary the authority to require additional reporting to ensure

that conservation purposes are protected in perpetuity.  Some might argue that such authority

should specifically require a notification mechanism whereby a charity is required to inform the

Secretary of modifications, removals, or transfers of conservation restrictions.  Some might

argue that notification is an important element of enforcement of the perpetuity requirement, and

if made publicly available, would inform interested members of the public.  Others might argue

that a mere notification requirement would not accomplish much because charities that are

subject to the penalty would not have an incentive honestly to notify the Secretary in any event.

The proposal applies not only to removals and transfers of conservation restrictions, but

also to "failures to enforce" a conservation restriction.  It is not clear what will constitute a

failure for this purpose.  A penalty could be triggered, for example, if a landowner violates the

terms of a conservation restriction, and (i) the charity was aware of such violation before it

occurred, (ii) the charity should have been aware of such violation, or (iii) the charity failed to

take remedial measures after learning of such violation.  In addition, in the case of a failure to

enforce, the amount of the penalty is not clear.  Arguably, as is the case with modifications of

restrictions, if the violation is only with respect to certain terms of a restriction, calculating

recovery of the tax benefit is complex.  In addition, some would argue that any penalty for

failure to enforce a conservation restriction also should be accompanied by a means of requiring

that charities show the Secretary as part of their annual information return filings that sufficient

amounts have been set aside for enforcement of conservation restrictions and that the charity has

in place a program regularly to monitor property restrictions.

The proposal imposes penalties on charities and not on other qualified organizations that

are eligible to accept qualified conservation contributions, such as governmental entities.  Some

would argue that a penalty also should be imposed on such entities, irrespective of their

governmental status.

Prior Action

The President's fiscal year 2006 budget proposal included a similar proposal.

 

 

D.      Eliminate the Special Exclusion from Unrelated Business Taxable 

Income ("UBIT") for Gain or Loss on Sale or Exchange of

Certain Brownfield Properties

Present Law

In general

In general, an organization that is otherwise exempt from Federal income tax is taxed on

income from a trade or business regularly carried on that is not substantially related to the

organization's exempt purposes.  Gains or losses from the sale, exchange, or other disposition of

property, other than stock in trade, inventory, or property held primarily for sale to customers in

the ordinary course of a trade or business, generally are excluded from unrelated business taxable

income.  Gains or losses are treated as unrelated business taxable income, however, if derived

from "debt-financed property."  Debt-financed property generally means any property that is

held to produce income and with respect to which there is acquisition indebtedness at any time

during the taxable year. 

In general, income of a tax-exempt organization that is produced by debt-financed

property is treated as unrelated business income in proportion to the acquisition indebtedness on

the income-producing property.  Acquisition indebtedness generally means the amount of unpaid

indebtedness incurred by an organization to acquire or improve the property and indebtedness

that would not have been incurred but for the acquisition or improvement of the property. 

Acquisition indebtedness does not include: (1) certain indebtedness incurred in the performance

or exercise of a purpose or function constituting the basis of the organization's exemption;

(2) obligations to pay certain types of annuities; (3) an obligation, to the extent it is insured by

the Federal Housing Administration, to finance the purchase, rehabilitation, or construction of

housing for low and moderate income persons; or (4) indebtedness incurred by certain qualified

organizations to acquire or improve real property. 

Special rules apply in the case of an exempt organization that owns a partnership interest

in a partnership that holds debt-financed property.  An exempt organization's share of

partnership income that is derived from debt-financed property generally is taxed as debt-

financed income unless an exception provides otherwise.

Exclusion for sale, exchange, or other disposition of brownfield property

Present law provides an exclusion from unrelated business taxable income for the gain or

loss from the qualified sale, exchange, or other disposition of a qualifying brownfield property

by an eligible taxpayer.  The exclusion from unrelated business taxable income generally is

available to an exempt organization that acquires, remediates, and disposes of the qualifying

brownfield property.  In addition, there is an exception from the debt-financed property rules for

such properties. 

In order to qualify for the exclusions from unrelated business income and the debt-

financed property rules, the eligible taxpayer is required to:  (a) acquire from an unrelated person

real property that constitutes a qualifying brownfield property; (b) pay or incur a minimum level

of eligible remediation expenditures with respect to the property; and (c) transfer the remediated

site to an unrelated person in a transaction that constitutes a sale, exchange, or other disposition

for purposes of Federal income tax law.

Qualifying brownfield properties

The exclusion from unrelated business taxable income applies only to real property that

constitutes a qualifying brownfield property.  A qualifying brownfield property means real

property that is certified, before the taxpayer incurs any eligible remediation expenditures (other

than to obtain a Phase I environmental site assessment), by an appropriate State agency (within

the meaning of section 198(c)(4)) in the State in which the property is located as a brownfield

site within the meaning of section 101(39) of the Comprehensive Environmental Response,

Compensation, and Liability Act of 1980 (CERCLA).  The taxpayer's request for certification

must include a sworn statement of the taxpayer and supporting documentation of the presence of

a hazardous substance, pollutant, or contaminant on the property that is complicating the

expansion, redevelopment, or reuse of the property given the property's reasonably anticipated

future land uses or capacity for uses of the property (including a Phase I environmental site

assessment and, if applicable, evidence of the property's presence on a local, State, or Federal

list of brownfields or contaminated property) and other environmental assessments prepared or

obtained by the taxpayer.

Eligible taxpayer

An eligible taxpayer with respect to a qualifying brownfield property is an organization

exempt from tax under section 501(a) that acquired such property from an unrelated person and

paid or incurred a minimum amount of eligible remediation expenditures with respect to such

property.  The exempt organization (or the qualifying partnership of which it is a partner) is

required to pay or incur eligible remediation expenditures with respect to a qualifying brownfield

property in an amount that exceeds the greater of: (a) $550,000; or (b) 12 percent of the fair

market value of the property at the time such property is acquired by the taxpayer, determined as

if the property were not contaminated. 

An eligible taxpayer does not include an organization that is: (1) potentially liable under

section 107 of CERCLA with respect to the property; (2) affiliated with any other person that is

potentially liable thereunder through any direct or indirect familial relationship or any

contractual, corporate, or financial relationship (other than a contractual, corporate, or financial

relationship that is created by the instruments by which title to a qualifying brownfield property

is conveyed or financed by a contract of sale of goods or services); or (3) the result of a

reorganization of a business entity which was so potentially liable.

Qualified sale, exchange, or other disposition

A sale, exchange, or other disposition of a qualifying brownfield property shall be

considered as qualified if such property is transferred by the eligible taxpayer to an unrelated

person, and within one year of such transfer the taxpayer has received a certification (a

"remediation certification") from the Environmental Protection Agency or an appropriate State

agency (within the meaning of section 198(c)(4)) in the State in which the property is located

that, as a result of the taxpayer's remediation actions, such property would not be treated as a

qualifying brownfield property in the hands of the transferee.  A taxpayer's request for a

remediation certification shall be made no later than the date of the transfer and shall include a

sworn statement by the taxpayer certifying that: (1) remedial actions that comply with all

applicable or relevant and appropriate requirements (consistent with section 121(d) of CERCLA)

have been substantially completed, such that there are no hazardous substances, pollutants or

contaminants that complicate the expansion, redevelopment, or reuse of the property given the

property's reasonably anticipated future land uses or capacity for uses of the property; (2) the

reasonably anticipated future land uses or capacity for uses of the property are more

economically productive or environmentally beneficial than the uses of the property in existence

on the date the property was certified as a qualifying brownfield property;  (3) a remediation

plan has been implemented to bring the property in compliance with all applicable local, State,

and Federal environmental laws, regulations, and standards and to ensure that remediation

protects human health and the environment; (4) the remediation plan, including any physical

improvements required to remediate the property, is either complete or substantially complete,

and if substantially complete,  sufficient monitoring, funding, institutional controls, and

financial assurances have been put in place to ensure the complete remediation of the site in

accordance with the remediation plan as soon as is reasonably practicable after the disposition of

the property by the taxpayer; and (5) public notice and the opportunity for comment on the

request for certification (in the same form and manner as required for public participation

required under section 117(a) of CERCLA (as in effect on the date of enactment of the

provision)) was completed before the date of such request.  Public notice shall include, at a

minimum, publication in a major local newspaper of general circulation.

A copy of each of the requests for certification that the property was a brownfield site,

and that it would no longer be a qualifying brownfield property in the hands of the transferee,

shall be included in the tax return of the eligible taxpayer (and, where applicable, of the

qualifying partnership) for the taxable year during which the transfer occurs.

Eligible remediation expenditures 

Eligible remediation expenditures means, with respect to any qualifying brownfield

property: (1) expenditures that are paid or incurred by the taxpayer to an unrelated person to

obtain a Phase I environmental site assessment of the property; (2) amounts paid or incurred by

the taxpayer after receipt of the certification that the property is a qualifying brownfield property

for goods and services necessary to obtain the remediation certification; and (3) expenditures to

obtain remediation cost-cap or stop-loss coverage, re-opener or regulatory action coverage, or

similar coverage under environmental insurance policies,  or to obtain financial guarantees

required to manage the remediation and monitoring of the property.  Eligible remediation

expenditures include expenditures to (1) manage, remove, control, contain, abate, or otherwise

remediate a hazardous substance, pollutant, or contaminant on the property; (2) obtain a Phase II

environmental site assessment of the property, including any expenditure to monitor, sample,

study, assess, or otherwise evaluate the release, threat of release, or presence of a hazardous

substance, pollutant, or contaminant on the property, or (3) obtain environmental regulatory

certifications and approvals required to manage the remediation and monitoring of the hazardous

substance, pollutant, or contaminant on the property.  Eligible remediation expenditures do not

include (1) any portion of the purchase price paid or incurred by the eligible taxpayer to acquire

the qualifying brownfield property; (2) environmental insurance costs paid or incurred to obtain

legal defense coverage, owner/operator liability coverage, lender liability coverage, professional

liability coverage, or similar types of coverage;  (3) any amount paid or incurred to the extent

such amount is reimbursed, funded or otherwise subsidized by: (a) grants provided by the United

States, a State, or a political subdivision of a State for use in connection with the property;

(b) proceeds of an issue of State or local government obligations used to provide financing for

the property, the interest of which is exempt from tax under section 103; or (c) subsidized

financing provided (directly or indirectly) under a Federal, State, or local program in connection

with the property; or (4) any expenditure paid or incurred before the date of enactment of the

proposal.

Qualified gain or loss

In general, the exempt organization's gain or loss from the sale, exchange, or other

disposition of a qualifying brownfield property is excluded from unrelated business taxable

income.  Income, gain, or loss from other transfers is not excluded.   The amount of gain or

loss excluded from unrelated business taxable income is not limited to or based upon the increase

or decrease in value of the property that is attributable to the taxpayer's expenditure of eligible

remediation expenditures.  The exclusion does not apply to an amount treated as gain that is

ordinary income with respect to section 1245 or section 1250 property, including any amount

deducted as a section 198 expense that is subject to the recapture rules of section 198(e), if the

taxpayer had deducted such amount in the computation of its unrelated business taxable

income.

Special rules for qualifying partnerships

In general

In the case of a tax-exempt organization that is a partner of a qualifying partnership that

acquires, remediates, and disposes of a qualifying brownfield property, the exclusion applies to

the tax-exempt partner's distributive share of the qualifying partnership's gain or loss from the

disposition of the property.   A qualifying partnership is a partnership that (1) has a partnership

agreement that satisfies the requirements of section 514(c)(9)(B)(vi) at all times beginning on the

date of the first certification received by the partnership that one of its properties is a qualifying

brownfield property; (2) satisfies the requirements of the proposal if such requirements are

applied to the partnership (rather than to the eligible taxpayer that is a partner of the partnership);

and (3) is not an organization that would be prevented from constituting an eligible taxpayer by

reason of it or an affiliate being potentially liable under CERCLA with respect to the property.

The exclusion is available to a tax-exempt organization with respect to a particular

property acquired, remediated, and disposed of by a qualifying partnership only if the exempt

organization is a partner of the partnership at all times during the period beginning on the date of

the first certification received by the partnership that one of its properties is a qualifying

brownfield property, and ending on the date of the disposition of the property by the

partnership.

The Secretary is required to prescribe such regulations as are necessary to prevent abuse

of the requirements of the provision, including abuse through the use of special allocations of

gains or losses, or changes in ownership of partnership interests held by eligible taxpayers.

Certifications and multiple property elections

If the property is acquired and remediated by a qualifying partnership of which the

exempt organization is a partner, it is intended that the certification as to status as a qualified

brownfield property and the remediation certification will be obtained by the qualifying

partnership, rather than by the tax-exempt partner, and that both the eligible taxpayer and the

qualifying partnership will be required to make available such copies of the certifications to the

IRS.  Any elections or revocations regarding the application of the eligible remediation

expenditure rules to multiple properties (as described below) acquired, remediated, and disposed

of by a qualifying partnership must be made by the partnership.  A tax-exempt partner is bound

by an election made by the qualifying partnership of which it is a partner.    

Special rules for multiple properties

The eligible remediation expenditure determinations generally are made on a property-

by-property basis.  An exempt organization (or a qualifying partnership of which the exempt

organization is a partner) that acquires, remediates, and disposes of multiple qualifying

brownfield properties, however, may elect to make the eligible remediation expenditure

determinations on a multiple-property basis.  In the case of such an election, the taxpayer

satisfies the eligible remediation expenditures test with respect to all qualifying brownfield

properties acquired during the election period if the average of the eligible remediation

expenditures for all such properties exceeds the greater of: (a) $550,000; or (b) 12 percent of the

average of the fair market value of the properties, determined as of the dates they were acquired

by the taxpayer and as if they were not contaminated.  If the eligible taxpayer elects to make the

eligible remediation expenditure determination on a multiple property basis, then the election

shall apply to all qualifying sales, exchanges, or other dispositions of qualifying brownfield

properties the acquisition and transfer of which occur during the period for which the election

remains in effect.

An acquiring taxpayer makes a multiple-property election with its timely filed tax return

(including extensions) for the first taxable year for which it intends to have the election apply.  A

timely filed election is effective as of the first day of the taxable year of the return in which the

election is included or a later day in such taxable year selected by the taxpayer.  An election

remains effective until the earliest of a date selected by the taxpayer, the date which is eight

years after the effective date of the election, the effective date of a revocation of the election, or,

in the case of a partnership, the date of the termination of the partnership.

A taxpayer may revoke a multiple-property election by filing a statement of revocation

with a timely filed tax return (including extensions).  A revocation is effective as of the first day

of the taxable year of the return in which the revocation is included or a later day in such taxable

year selected by the eligible taxpayer or qualifying partnership.  Once a taxpayer revokes the

election, the taxpayer is ineligible to make another multiple-property election with respect to any

qualifying brownfield property subject to the revoked election.

Debt-financed property

Debt-financed property, as defined by section 514(b), does not include any property the

gain or loss from the sale, exchange, or other disposition of which is excluded by reason of the

provisions of the proposal that exclude such gain or loss from computing the gross income of any

unrelated trade or business of the taxpayer.  Thus, gain or loss from the sale, exchange, or other

disposition of a qualifying brownfield property that otherwise satisfies the requirements of the

provision is not taxed as unrelated business taxable income merely because the taxpayer incurred

debt to acquire or improve the site.

Termination date

The Code provides for a termination date of December 31, 2009, by applying to gain or

loss on the sale, exchange, or other disposition of property that is acquired by the eligible

taxpayer or qualifying partnership during the period beginning January 1, 2005, and ending

December 31, 2009.  Property acquired during the five-year acquisition period need not be

disposed of by the termination date in order to qualify for the exclusion.  For purposes of the

multiple property election, gain or loss on property acquired after December 31, 2009, is not

eligible for the exclusion from unrelated business taxable income, although properties acquired

after the termination date (but during the election period) are included for purposes of

determining average eligible remediation expenditures.

Description of Proposal

The proposal eliminates the special exclusion from unrelated business income and the

debt-financed property rules.

Effective date.–The proposal is effective for taxable years beginning after December 31,

2006.

Analysis

The proposal repeals the recently enacted exclusion for gains from the disposition of

remediated brownfield property from unrelated business income tax rules, citing administrative

and policy concerns. 

Administrative concerns

The proposal states that the exclusion adds significant new complexity to the Code and

would be difficult to administer.  By any measure, the exclusion is complicated; and the

exclusion's complexity presents several administrative challenges.  In general, although the

policy of the proposal is simple - exempt entities should not be deterred by unrelated business

income tax rules from investing in contaminated properties for the purposes of remediating the

property prior to sale - the exclusion mechanically is complex in order to prevent abuse and

because of the difficult and technical nature of the problem being addressed.  The question raised

by the proposal essentially is whether such requisite complexity makes the exclusion too difficult

to administer and thus, ineffective policy at best, and a potentially abusive provision at worst. 

Although the proposal does not cite specific administrative concerns, there are several

aspects of the exclusion that might be at issue.  For example, the exclusion requires that

remediation expenses on brownfield property be incurred in an amount that exceeds the greater

of $550,000 or 12 percent of the fair market value of the property determined at the time the

property is acquired and as if the property were not contaminated.  Such a determination of value

may be difficult for the IRS to enforce, with the effect of making the $550,000 component of the

test a ceiling and not a floor for required remediation expenses.  Also, the remediation expense

test may be applied on a property-by-property basis or, by an election, on a multiple property

basis.  Under the multiple property test, in general, all the remediation expenses and

noncontaminated values of properties acquired within an eight-year period are taken into

account.  Because the election period potentially is eight years, and tens or hundreds of

properties could be sold during such time, it could be difficult for the IRS to determine whether

bona fide remediation expenses were made with respect to each property or what the respective

noncontaminated values of the properties are. 

Another area of concern for the IRS might be that the exclusion is not extended to certain

persons that are potentially liable under CERCLA with respect to the acquired property.  This

may require the IRS to make determinations under environmental laws, which may prove

difficult.  The exclusion also requires the taxpayer to provide the IRS with copies of

certifications that the property was, prior to remediation, a qualified brownfield property and

that, at the time of disposition, the property no longer is a brownfield property.  Although the

IRS is not involved in the certification process (the EPA and State agencies generally are

responsible for issuing such certifications), the IRS must maintain the certifications, perhaps for

many years, and examine them in order to test the validity of the exclusion. 

A significant administrative concern also might be determining whether an expense is an

eligible remediation expense, which is a matter of critical importance to the policy supporting the

exclusion.  The definition of an eligible expense is detailed and descriptive, but not precise. 

Given the complexity of the definition, it likely will be resource intensive and difficult for the

IRS to challenge a taxpayer's accounting of remediation expenses. 

Another complicating factor is that qualified property may have gain that is excludable

because of the special rules and gain that is not excludable, such as rental income from the

property.  The exclusion also does not apply to an amount treated as gain that is ordinary income

with respect to section 1245 or section 1250 property, including certain section 198 expenses. 

Although these rules are clear, it may nonetheless be difficult for the IRS to administer in the

context of a provision that excludes some kinds of gain and taxes others.

The exclusion also has special rules for partnerships (which likely is the vehicle that will

often be utilized for purposes of the exclusion), which require, among other things that the

Secretary issue regulations to prevent abuse, including abuse through the use of special

allocations of gains or losses or changes in ownership of partnership interests held by eligible

taxpayers.  The exclusion also contains a related-party rule and a recapture provision, which

contribute to the administrative complexity of the exclusion. 

By virtue of the proposal to repeal the exclusion, the President has concluded, albeit

without identifying specific areas of concern, that the administrative complexity engendered by

the exclusion outweighs any policy benefits that may result from the exclusion.  Some might

argue that the exclusion should be given time to see whether it proves as complicated to

administer as it appears.  Others might agree that the self-evident complexity of the conclusion

warrants repeal.

Policy concerns

The President expresses the concern that the exclusion is not sufficiently targeted because

it excludes from unrelated business income all of the gain from the disposition of qualified

property, irrespective of whether the gain is attributable to remediation by the taxpayer.  Under

this view, arguably the exclusion should be provided only to gain that results from remediation

activity, and permitting the exclusion of gain resulting from nonremediation-related property

development provides an unwarranted windfall to the taxpayer.  Some might argue that the

proposal is broad by design in order to encourage the development of contaminated sites,

because without the benefit of exclusion for all of a property's gain, taxpayers will not have a

sufficient incentive to acquire and remediate contaminated property.  Nevertheless, the multiple

property election of the proposal may permit taxpayers to acquire a brownfield site where little

remediation is required, significantly develop the property, and sell the property without paying

tax on the gain so long as the average expenses over all the properties meet the requirements of

the multiple property election.

Prior Action

The President's fiscal year 2006 budget proposal included a similar proposal.

 

 

E.    Limit Related-Party Interest Deductions

Present Law

A U.S. corporation with a foreign parent may reduce the U.S. tax on its U.S.-source

income through the payment of deductible amounts such as interest, rents, royalties, and

management service fees to the foreign parent or other foreign affiliates that are not subject to

U.S. tax on the receipt of such payments.  Although foreign corporations generally are subject to

a gross-basis U.S. tax at a flat 30-percent rate on the receipt of such payments, this tax may be

reduced or eliminated under an applicable income tax treaty.  Consequently, foreign-owned U.S.

corporations may use certain treaties to facilitate earnings stripping transactions without having

their deductions offset by U.S. withholding taxes.

Generally, present law limits the ability of corporations to reduce the U.S. tax on their

U.S.-source income through earnings stripping transactions.  Section 163(j) generally disallows a

deduction for so called "disqualified interest" paid or accrued by a corporation in a taxable year,

if two threshold tests are satisfied: the payor's debt-to-equity ratio exceeds 1.5 to 1 (the so-called

"safe harbor"); and the payor's net interest expense exceeds 50 percent of its "adjusted taxable

income" (generally taxable income computed without regard to deductions for net interest

expense, net operating losses, and depreciation, amortization, and depletion).  Disqualified

interest includes interest paid or accrued to: (1) related parties when no Federal income tax is

imposed with respect to such interest; or (2) unrelated parties in certain instances in which a

related party guarantees the debt ("guaranteed debt").  Interest amounts disallowed under these

rules can be carried forward indefinitely.  In addition, any excess limitation (i.e., the excess, if

any, of 50 percent of the adjusted taxable income of the payor over the payor's net interest

expense) can be carried forward three years.

Under section 424 of the American Jobs Creation Act of 2004 ("AJCA"), the Treasury

Secretary is required to submit to the Congress a report examining the effectiveness of the

earnings stripping provisions of present law.  This report was due no later than June 30, 2005.

Description of Proposal

The proposal eliminates the safe harbor and the excess limitation carryforward of present

law.  In addition, the proposal reduces the present-law threshold of 50 percent of adjusted taxable

income to 25 percent with respect to interest on related-party debt.  With respect to interest on

guaranteed debt, the present-law threshold of 50 percent of adjusted taxable income is retained. 

The carryforward of disallowed interest is limited to 10 years.

Effective date.–The proposal is effective on the date of first committee action.

Analysis

Recent inversion transactions led some to question the efficacy of the present-law

earnings stripping rules.   In some cases, it appeared that the earnings stripping benefit

achieved when a U.S. corporation paid deductible amounts to its new foreign parent or other

foreign affiliates constituted the primary intended tax benefit of the inversion transaction, which

should not have been the case if the earnings stripping rules had been functioning properly.  

By eliminating the debt-equity safe harbor, reducing the adjusted taxable income threshold from

50 percent to 25 percent for interest on related-party debt, limiting the carryforward of

disallowed interest to 10 years, and eliminating the carryforward of excess limitation, the

proposal would significantly strengthen rules that have proven ineffective in preventing certain

recent earnings stripping arrangements.

On the other hand, some view the proposal as unnecessary and overbroad, arguing that

there is no empirical evidence of a significant earnings stripping problem outside the context of

inversion transactions.  Under this view, the recently enacted anti-inversion rules of section

7874, combined with recent treaty developments (mainly the 2004 protocol to the U.S.-Barbados

income tax treaty), should constitute a sufficient response to any earnings stripping problem that

might have existed.  Proponents of the proposal respond that, although recent legislative and

treaty developments have removed some significant opportunities for earnings stripping, other

opportunities may remain, and thus erosion of the U.S. tax base will continue until the statutory

earnings stripping rules themselves are strengthened.

Some take the view that the proposal does not go far enough in curtailing earnings

stripping.  While the proposal would have the effect of further limiting the ability of taxpayers to

erode the U.S. tax base through earnings stripping transactions involving interest, the proposal

does not address earnings stripping transactions involving the payment of deductible amounts

other than interest (e.g., rents, royalties, and service fees), or the payment of deductible amounts

by taxpayers other than corporations.  These transactions also may erode the U.S. tax base, and

thus it may be argued that a more comprehensive response to earnings stripping is needed. 

Indeed, as opportunities for stripping earnings in the form of interest are reduced, taxpayers may

find it increasingly attractive to strip earnings through other means.  Proponents of the proposal

respond that earnings stripping is much more readily achieved through the use of debt than

through other means, and that there is insufficient evidence to suggest that these other forms of

stripping warrant a new legislative response.

Finally, some argue that further action in this area should be deferred until the Treasury

Department completes its earnings stripping study and submits its report of the study to the

Congress.  The Treasury Department has indicated that the study is underway and that the report

may include further recommendations in this area, but has not announced when the report will be

released.  It is hoped that this report will provide new data and analysis that will further inform

the discussion in this area.

Prior Action

The identical proposal was included in the President's fiscal year 2005 and 2006 budget

proposals.  The President's fiscal year 2004 budget proposal contained a different earnings

stripping proposal that changed present law by modifying the safe harbor provision, reducing the

adjusted taxable income threshold, adding a new disallowance provision based on a comparison

of domestic to worldwide indebtedness, and limiting carryovers.

 

 

 

 

F.    Modify Certain Tax Rules for Qualified Tuition Programs

Present Law

Overview

Section 529 provides specified income tax and transfer tax rules for the treatment of

accounts and contracts established under qualified tuition programs.   A qualified tuition

program is a program established and maintained by a State or agency or instrumentality thereof,

or by one or more eligible educational institutions, which satisfies certain requirements and

under which a person may purchase tuition credits or certificates on behalf of a designated

beneficiary that entitle the beneficiary to the waiver or payment of qualified higher education

expenses of the beneficiary (a "prepaid tuition program").   In the case of a program

established and maintained by a State or agency or instrumentality thereof, a qualified tuition

program also includes a program under which a person may make contributions to an account

that is established for the purpose of satisfying the qualified higher education expenses of the

designated beneficiary of the account, provided it satisfies certain specified requirements (a

"savings account program").   Under both types of qualified tuition programs, a contributor

establishes an account for the benefit of a particular designated beneficiary to provide for that

beneficiary's higher education expenses. 

For this purpose, qualified higher education expenses means tuition, fees, books,

supplies, and equipment required for the enrollment or attendance of a designated beneficiary at

an eligible educational institution, and expenses for special needs services in the case of a special

needs beneficiary that are incurred in connection with such enrollment or attendance.  

Qualified higher education expenses generally also include room and board for students who are

enrolled at least half-time.

In general, prepaid tuition contracts and tuition savings accounts established under a

qualified tuition program involve prepayments or contributions made by one or more individuals

for the benefit of a designated beneficiary, with decisions with respect to the contract or account

to be made by an individual who is not the designated beneficiary.  Qualified tuition accounts or

contracts generally require the designation of a person (generally referred to as an "account

owner") whom the program administrator (oftentimes a third party administrator retained by the

State or by the educational institution that established the program) may look to for decisions,

recordkeeping, and reporting with respect to the account established for a designated beneficiary. 

The person or persons who make the contributions to the account need not be the same person

who is regarded as the account owner for purposes of administering the account.  Under many

qualified tuition programs, the account owner generally has control over the account or contract,

including the ability to change designated beneficiaries and to withdraw funds at any time and

for any purpose.  Thus, in practice, qualified tuition accounts or contracts generally involve a

contributor, a designated beneficiary, an account owner (who oftentimes is not the contributor or

the designated beneficiary), and an administrator of the account or contract.

Under present law, section 529 does not establish eligibility requirements for designated

beneficiaries.  Accordingly, a beneficiary of any age may be named as a designated beneficiary. 

Special considerations generally apply to accounts that are funded by amounts subject to

Uniform Gifts to Minors Act ("UGMA") or Uniform Transfers to Minors Act ("UTMA") laws.   

Section 529 does not provide for any quantitative limits on the amount of contributions,

account balances, or prepaid tuition benefits relating to a qualified tuition account, other than to

require that the program provide adequate safeguards to prevent contributions on behalf of a

designated beneficiary in excess of those necessary to provide for the qualified higher education

expenses of the beneficiary.   Many qualified tuition programs impose limits on the maximum

amount of contributions that may be made, or account balances that may accrue, for the benefit

of a designated beneficiary under that program.

Under present law, contributions to a qualified tuition account must be made in cash.  

A qualified tuition program may not permit any contributor to, or designated beneficiary under,

the program to directly or indirectly direct the investment of any contributions (or earnings

thereon),  and must provide separate accounting for each designated beneficiary.   A qualified

tuition program may not allow any interest in an account or contract (or any portion thereof) to

be used as security for a loan.

Special rules apply to coordinate qualified tuition programs with other education benefits,

including Coverdell education savings accounts, the HOPE credit, and the lifetime learning

credit.

Income tax treatment

A qualified tuition program, including a savings account or a prepaid tuition contract

established thereunder, generally is exempt from income tax, although it is subject to the tax on

unrelated business income.   Contributions to a qualified tuition account (or with respect to a

prepaid tuition contract) are not deductible to the contributor or includible in income of the

designated beneficiary or account owner.  Earnings accumulate tax-free until a distribution is

made.  If a distribution is made to pay qualified higher education expenses, no portion of the

distribution is subject to income tax.   If a distribution is not used to pay qualified higher

education expenses, the earnings portion of the distribution is subject to Federal income tax, 

and a 10-percent additional tax (subject to exceptions for death, disability, or the receipt of a

scholarship).   A change in the designated beneficiary of an account or prepaid contract is not

treated as a distribution for income tax purposes if the new designated beneficiary is a member of

the family of the old beneficiary.

Gift and generation-skipping transfer (GST) tax treatment

A contribution to a qualified tuition account (or with respect to a prepaid tuition contract)

is treated as a completed gift of a present interest from the contributor to the designated

beneficiary.   Such contributions qualify for the per-donee annual gift tax exclusion ($12,000

for 2006), and, to the extent of such exclusions, also are exempt from the generation-skipping

transfer (GST) tax.  A contributor may contribute in a single year up to five times the per-donee

annual gift tax exclusion amount to a qualified tuition account and, for gift tax and GST tax

purposes, treat the contribution as having been made ratably over the five-year period beginning

with the calendar year in which the contribution is made.

A distribution from a qualified tuition account or prepaid tuition contract generally is not

subject to gift tax or GST tax.   Those taxes may apply, however, to a change of designated

beneficiary if the new designated beneficiary is in a generation below that of the old beneficiary

or if the new beneficiary is not a member of the family of the old beneficiary.

Estate tax treatment

Qualified tuition program account balances or prepaid tuition benefits generally are

excluded from the gross estate of any individual.   Amounts distributed on account of the death

of the designated beneficiary, however, are includible in the designated beneficiary's gross

estate.   If the contributor elected the special five-year allocation rule for gift tax annual

exclusion purposes, any amounts contributed that are allocable to the years within the five-year

period remaining after the year of the contributor's death are includible in the contributor's gross

estate.

Powers of appointment

Special income tax and transfer tax rules apply to instances where a person holds a power

of appointment or certain other powers with respect to property.  In general, a power of

appointment includes all powers which are in substance and effect powers of appointment

regardless of the nomenclature used in creating the power and regardless of local property law

connotations, and may include, for example, the power to consume or appropriate the property,

or to affect the beneficial enjoyment of principal or income through a power to revoke, alter or

amend the terms of the instrument (such as changing the designated beneficiary of property).  

The nature of the power held by a person affects whether the holder of the power is taxed on the

income on the property, and whether the property subject to the power is treated as includible

within the estate of the holder of the power or is subject to gift tax.

Description of Proposal

Overview

The proposal modifies certain income tax, gift tax, generation-skipping transfer tax, and

estate tax rules with respect to changes in designated beneficiaries of qualified tuition accounts. 

The proposal modifies the present-law provisions regarding the imposition of the 10-percent

additional tax, and imposes new excise taxes on amounts that are used other than for qualified

higher education expenses.

Changes in designated beneficiaries

The proposal modifies present law by providing that a change in the designated

beneficiary of a qualified tuition account does not cause the imposition of gift tax or GST tax,

regardless of whether the new designated beneficiary is in a generation below that of the former

designated beneficiary.  The proposal also provides that gift tax and GST tax is not imposed even

if the new designated beneficiary is not a member of the family of the old beneficiary.  The

proposal modifies the income tax treatment of a change in a designated beneficiary to provide

that a change of designated beneficiary to a new eligible designated beneficiary who is not a

member of the family of the old beneficiary is not treated as a distribution for income tax

purposes.

The proposal provides that upon the death of a designated beneficiary, the account is to

be distributed to the estate of the designated beneficiary, thereby triggering potential income tax

and estate tax consequences, unless a new eligible designated beneficiary is named in a timely

manner or the contributor withdraws the funds from the account.  The designated beneficiary's

gross estate would include only amounts (if any) paid to the estate or pursuant to the designated

beneficiary's general power of appointment.

Rules applicable to contributors; account administrators

Under the proposal, each section 529 account may have only one contributor.  A section

529 program is permitted to accept contributions to a section 529 account only from the account

contributor (or the contributor's irrevocable trust) and, to the extent provided by the Secretary,

from other persons in a de minimis amount. 

As under present law, the contributor to a section 529 account is permitted to withdraw

funds from the account during the contributor's lifetime, subject to income tax on the income

portion of the withdrawal.  An additional tax applies to the income portion of a withdrawal

unless the withdrawal is due to the designated beneficiary's death, disability, receipt of a

scholarship or attendance at a U.S. military academy.  Under the proposal, the amount of the

additional tax is generally 10 percent and is increased to 20 percent if the withdrawal occurs

more than 20 years after the account was originally created.

Under the proposal, the contributor may name another person to administer the account

(the "account administrator").  The account administrator would have no beneficial interest in the

account.  The account administrator would be permitted to change the designated beneficiary

"from time to time".  Neither the account administrator nor the administrator's spouse could be

or become a designated beneficiary, except as provided by the Secretary.

Imposition of excise tax on nonqualifying distributions

The proposal retains the present-law income tax treatment of distributions from a

qualified tuition account that are used for qualified higher education expenses.  Such

distributions are not subject to income tax, regardless of the distributee's identity.  As under

present law, distributions used for purposes other than qualified higher education expenses are

subject to income tax on the earnings portion of the distribution.  Further, the proposal imposes

additional excise taxes with respect to distributions that are used other than for qualified higher

education expenses if the distribution is made to someone other than the contributor or the initial

designated beneficiary.  Nonqualified distributions in excess of $50,000 but less than or equal to

$150,000 (computed on a cumulative basis for each designated beneficiary, including for this

purpose the entire amount of the distribution, not just earnings) are subject to a new excise tax

imposed at the rate of 35 percent.  Nonqualified distributions in excess of $150,000 (computed

on a cumulative basis for each designated beneficiary, including for this purpose the entire

amount of the distribution, not just earnings) are subject to an excise tax imposed at the rate of

50 percent.  The excise tax is payable from the account and is required to be withheld by the

program administrator.    

Changes in reporting requirements

The proposal modifies the reporting requirements applicable to qualified tuition accounts. 

For example, new reporting requirements would be established to facilitate the administration of

excise tax withholding by administrators.  Such requirements might include certifications

provided by designated beneficiaries to administrators of qualified tuition programs, so that

administrators may withhold appropriate amounts of excise taxes with respect to distributions

used other than for qualified higher education expenses.   

Grant of regulatory authority to Treasury

The proposal grants the Secretary of the Treasury broad regulatory authority to ensure

that qualified tuition accounts are used in a manner consistent with Congressional intent.

Effective dates

The proposal generally is effective for qualified tuition accounts (including savings

accounts and prepaid tuition contracts) established after the date of enactment of the proposal,

including prepaid tuition contracts if additional prepaid tuition benefits are purchased on or after

the date of enactment of the proposal.  The proposal does not apply to qualified tuition savings

accounts that are in existence on the date of enactment unless an election is made to be covered

by the new rules.  No additional contributions to savings accounts in existence on the date of

enactment of the proposal would be permitted without such election.

The modified reporting requirements apply after the date of enactment of the proposal to

all qualified tuition accounts (including savings accounts and prepaid tuition contracts).

Analysis

Overview

The President's budget proposal addresses certain transfer tax anomalies with regard to

changes in designated beneficiaries by providing that a change of beneficiary to another eligible

beneficiary does not constitute a transfer for gift or generation-skipping transfer tax purposes or a

distribution for income tax purposes.  In addition, by requiring that no person other than a

designated beneficiary possess any beneficial interest in a qualified tuition account, the proposal

attempts to more closely align the gift tax treatment of contributions to qualified tuition accounts

(i.e., a completed gift of a present interest to the designated beneficiary) with the treatment of

contributions under generally applicable transfer tax principles. The proposal addresses potential

abuses of qualified tuition accounts by establishing eligibility rules for designated beneficiaries,

and imposing an excise tax on distributions that are not used for qualified higher education

expenses and increasing the additional tax on nonqualified withdrawals by the contributor more

than 20 years after the creation of the account.

Section 529 transfer tax treatment and generally applicable transfer tax provisions

Overview

Certain aspects of present-law section 529 depart from otherwise generally applicable

transfer tax principles.  For example, present law treats a contribution to a qualified tuition

account as a completed gift of a present interest to the designated beneficiary,  even though in

most instances, the designated beneficiary possesses no rights to control the qualified tuition

account or withdraw funds, and such control (including the right to change beneficiaries or to

withdraw funds, including for the benefit of someone other than the designated beneficiary) is

vested in the account owner.  Absent section 529, such contributions generally would not be

treated as completed gifts to the designated beneficiary under otherwise applicable transfer tax

principles.   Further, present-law section 529 does not address the transfer tax consequences of

a change of account owners of a qualified tuition account.

Treatment of changes of designated beneficiaries

Under present-law section 529, a change of designated beneficiary to a beneficiary who is

in a generation lower than the former beneficiary (or who is not a family member of the former

beneficiary) constitutes a taxable gift, even though the new designated beneficiary would, under

otherwise applicable transfer tax principles, be regarded as not receiving a completed gift. 

Further, present-law section 529 does not identify which party is responsible for payment of the

transfer tax when it is imposed in such instances.  Also, under present-law section 529, there is

no express requirement that the multiple annual present interest exclusion is available only if

there is a present intent to allow the designated beneficiary to receive the benefits of the qualified

tuition program.

Present law also has different change-of-beneficiary rules for income tax and transfer tax

purposes.  A change of beneficiary to a person who is not a member of the same family as the

old beneficiary is treated as a distribution for income tax purposes, regardless of whether the new

beneficiary is in a lower generation than the former beneficiary.  Under present law, a change of

beneficiary to a person who is in a lower generation than the former beneficiary is treated as a

transfer for transfer tax purposes, regardless of whether the new beneficiary is of the same family

as the former beneficiary. 

The proposal eliminates these disparities and provides that a change of beneficiary will

not be treated as a distribution or transfer.

Because the proposal expands the class of permissible successor designated beneficiaries

without the imposition of any income or transfer taxes, individuals interested in establishing a

qualified tuition account as a means to fund qualified higher education expenses for their

children, relatives, or others, might view these changes as being a liberalization and

simplification of existing law.   

Potential abuses addressed by the proposal

The proposal attempts to discourage substantial multi-generational accumulations of

qualified tuition account assets by imposing new excise taxes on distributions that are ultimately

used other than for qualified higher education expenses.  The proposed excise tax is imposed

only if an actual distribution occurs and the distributed amounts are not used for qualified higher

education expenses.  The excise tax does not apply if a distribution is made to the estate of a

deceased designated beneficiary, or to a designated beneficiary on account of the designated

beneficiary's disability, receipt of a scholarship, or attendance at a military academy.  Excise

taxes on the entire amount of a distribution that exceeds certain cumulative thresholds, including

on both the principal and earnings components, would be imposed.  Such excise taxes are

intended to serve as deterrents to using the funds other than for qualified higher education

expenses.  However, the excise taxes are not imposed unless an actual or deemed distribution

occurs, and thus would not be imposed so long as the funds are maintained in a qualified tuition

account that continues to be held for the benefit of an eligible designated beneficiary.  The

proposal does not impose a specific deadline by which time the funds must be used for education

expenses or become subject to income, excise, and transfer taxes.

Some may argue that this proposal does not go far enough to deter (or in fact may create

an opportunity to achieve) substantial multi-generational accumulations of qualified tuition

account assets, and that a better approach would be to impose caps on the amounts that can be

contributed to such accounts, or on the length of time that such assets can be held.  Enforcing

such caps, however, would impose significant administrative burdens on administrators,

taxpayers, and the IRS.  Others may argue that the present-law requirement that the account or

contract provide adequate safeguards to prevent contributions on behalf of a designated

beneficiary in excess of those necessary to provide for the qualified higher education expenses of

the beneficiary, combined with the maximum contribution or account balance limits established

by many of the various qualified tuition programs, adequately address any concerns that such

accounts might be used to improperly accumulate assets for purposes other than providing for

qualified higher education expenses of the designated beneficiary.  Others may counter that

program-imposed limits are applied only on a per-State basis, and further, that the ability of an

individual to establish accounts for an unlimited number of designated beneficiaries means there

are no effective limits under present law.

Prior Action

A similar proposal was contained in the President's fiscal year 2005 and 2006 budget

proposals.

 

 

 

 

VI.   TAX ADMINISTRATION PROVISIONS AND UNEMPLOYMENT INSURANCE

A.    IRS Restructuring and Reform Act of 1998

1.    Modify section 1203 of the IRS Restructuring and Reform Act of 1998

Present Law

Section 1203 of the IRS Restructuring and Reform Act of 1998 requires the IRS to

terminate an employee for certain proven violations committed by the employee in connection

with the performance of official duties. The violations include: (1) willful failure to obtain the

required approval signatures on documents authorizing the seizure of a taxpayer's home,

personal belongings, or business assets; (2) providing a false statement under oath material to a

matter involving a taxpayer; (3) with respect to a taxpayer, taxpayer representative, or other IRS

employee, the violation of any right under the U.S. Constitution, or any civil right established

under titles VI or VII of the Civil Rights Act of 1964, title IX of the Educational Amendments of

1972, the Age Discrimination in Employment Act of 1967, the Age Discrimination Act of 1975,

sections 501 or 504 of the Rehabilitation Act of 1973 and title I of the Americans with

Disabilities Act of 1990; (4) falsifying or destroying documents to conceal mistakes made by any

employee with respect to a matter involving a taxpayer or a taxpayer representative; (5) assault

or battery on a taxpayer or other IRS employee, but only if there is a criminal conviction or a

final judgment by a court in a civil case, with respect to the assault or battery; (6) violations of

the Internal Revenue Code, Treasury Regulations, or policies of the IRS (including the Internal

Revenue Manual) for the purpose of retaliating or harassing a taxpayer or other IRS employee;

(7) willful misuse of section 6103 for the purpose of concealing data from a Congressional

inquiry; (8) willful failure to file any tax return required under the Code on or before the due date

(including extensions) unless failure is due to reasonable cause; (9) willful understatement of

Federal tax liability, unless such understatement is due to reasonable cause; and (10) threatening

to audit a taxpayer for the purpose of extracting personal gain or benefit.

Section 1203 also provides non-delegable authority to the Commissioner to determine

that mitigating factors exist, that, in the Commissioner's sole discretion, mitigate against

terminating the employee. The Commissioner, in his sole discretion, may establish a procedure

to determine whether an individual should be referred for such a determination by the

Commissioner.

Description of Proposal

The proposal removes the following from the list of violations requiring termination:

(1) the late filing of refund returns; and (2) employee versus employee acts.  The proposal also

adds unauthorized inspection of returns and return information to the list of violations requiring

termination.  Additionally, the proposal requires the Commissioner to establish guidelines

outlining specific penalties, up to and including termination, for specific types of wrongful

conduct covered by section 1203 of the IRS Restructuring and Reform Act of 1998.  The

Commissioner retains the non-delegable authority to determine whether mitigating factors

support a personnel action other than that specified in the guidelines for a covered violation. 

Effective date.–The proposal is effective on the date of enactment.

Analysis

Policy issues

Late filing of refund returns

The proposal has the effect of treating IRS employees more like individuals employed by

any other employer, with respect to late filing of refund returns.  Late filing generally is not

grounds for termination by most employers.  In addition, late filing of refund returns is generally

not subject to penalty under the Code.   Proponents of the proposal relating to late filings may

argue that the late filing of a refund return is not the type of serious conduct for which the severe

penalties imposed by the IRS Restructuring and Reform Act should apply.  Others may argue

that IRS employees, as the enforcers of the country's tax laws, should be held to a higher

standard and be required to timely file all income tax returns.

Employee vs. employee allegation

Advocates of removing employee versus employee conduct from the list of grounds for

IRS employee termination may argue that allegations of willful conduct by IRS employees

against other IRS employees can be addressed by existing administrative and statutory

procedures.  Other means, such as the Whistleblower Protection Act, negotiated grievance

processes, and civil rights laws, exist to address employee complaints and appeals.  Moreover, it

is argued that under present-law rules, parallel investigative and adjudicative functions for

addressing employee complaints and appeals are confusing to employees and burdensome for the

IRS. 

Proponents also believe that it is appropriate to remove employee versus employee

conduct from the list of section 1203 violations because, unlike other section 1203 violations,

such conduct does not violate taxpayer protections.  On the other hand, opponents may point out

that Congress believed it appropriate to include such conduct in the statutory list of grounds for

IRS employee termination.  They may argue that including employee versus employee conduct

in the section 1203 violation list benefits tax administration.  Another issue to consider is the

extent to which the inclusion of employee versus employee conduct on the list of section 1203

violations deters inappropriate behavior (by reducing the likelihood of real employee versus

employee actions) or increases inappropriate behavior (by increasing the number of allegations

of inappropriate behavior against other employees for purposes of intimidation, harassment, or

retribution).

Unauthorized inspection of returns

Advocates of the proposal argue that unauthorized inspection of tax returns and return

information is a serious act of misconduct that should be included in the list of violations subject

to termination, as unauthorized inspection is as serious as the other taxpayer rights protections

covered by section 1203.  Code section 7213A already makes the unauthorized inspection of

returns and return information illegal, with violations punishable by fine, imprisonment, and

discharge from employment.  Even though unauthorized inspection is punishable under a

separate law, it is argued that extending section 1203 coverage to unauthorized inspection will

strengthen the IRS' power to discipline without the penalty being overturned. 

On the other hand, opponents of this part of the proposal may point out that most

violations of Code section 7213A are not prosecuted, but employees are subject to discipline

based on administrative determination.  The IRS policy has been to propose termination of

employment in cases of unauthorized inspection, but in a number of recent cases, arbitrators and

the Merit Systems Protection Board have overturned the IRS' determination to terminate

employees for such violations. 

Advocates may also argue that adding unauthorized inspection of returns to the list of

section 1203 violations will prevent overturning of the IRS' determination of the level of

appropriate employee punishment.  Some might question whether it is appropriate to use an

internal administrative process to achieve a result that the IRS states that it has been unable to

achieve through judicial or external administrative processes.  In addition, adding unauthorized

inspection of returns to the list of section 1203 violations could add to the fear of IRS employees

that they will be subject to unfounded allegations and lose their jobs as a result, which might

deter fair enforcement of the tax laws.

The position taken by the IRS with respect to this part of the proposal can be criticized as

inconsistent with its position on the employee versus employee allegations piece of the proposal. 

The IRS argues that employee versus employee conduct should be removed from the list of

section 1203 violations because such conduct can be addressed by existing administrative and

statutory procedures, while at the same time argues that unauthorized inspection of returns

should be added to the list of violations even though it is punishable under a separate law.  Some

might view these positions as inconsistent.

While the proposal makes unauthorized inspection (which is a misdemeanor) a section

1203 violation, it does not make unauthorized disclosure (which is a felony under Code section

7213) a section 1203 violation.  Arguably, more damage can be done by disclosing sensitive tax

information to a third party than by looking at a return out of curiosity.  Thus, the proposal can

be criticized as lacking the proper focus.

Penalty guidelines

Some are concerned that the IRS' ability to administer the tax laws efficiently is

hampered by a fear among employees that they will be subject to false allegations and possibly

lose their jobs.  Proponents of the proposal requiring the IRS to publish detailed guidelines argue

that these guidelines are needed to provide notice to IRS employees of the most likely

punishment that will result from specific violations.  They believe that the certainty provided by

specific guidelines would improve IRS employee morale and enhance the fundamental fairness

of the statute. 

Others argue that since Congress intended for the section 1203 violations to warrant

termination, it is not appropriate to allow the IRS to determine a lesser level of punishment. 

Additionally, they argue that the claim that penalty guidelines are necessary is inconsistent with

the proposal to remove from the list the two violations that are said to most often warrant

punishment other than that required under section 1203 (late filed refund returns and employee

versus employee allegations).

Complexity issues

The proposal has elements that may both increase and decrease complexity.  The IRS

must review and investigate every allegation of a section 1203 violation.  Removing late filing of

refund returns and employee versus employee conduct from the list of section 1203 violations

may make it easier for the IRS to administer section 1203, as there would be fewer types of

allegations that would require section 1203 review and investigation.  Similarly, adding

unauthorized inspection of returns to the list of violations may complicate IRS administration, as

there would likely be an increase in the number of 1203 violations requiring IRS review and

investigation.  Additionally, because unauthorized inspection of returns violations under Code

section 7213A are currently subject to discipline based on administrative determination by the

IRS, adding such violations to the list of section 1203 violations would require the IRS to change

current practice and follow section 1203 procedures instead.

Additional penalty guidelines may also either increase or decrease complexity. 

Additional guidelines may increase complexity by creating more rules for the IRS to establish

and follow.  The guidelines would also have to be periodically updated to ensure that

punishments for specific violations continue to be appropriate.  On the other hand, additional

penalty guidelines may decrease complexity by providing clarity as to specific punishments for

specific employee violations, which may enhance the IRS' effectiveness in administering section

1203.

Prior Action

An identical proposal was included in the President's fiscal year 2003, 2004, 2005, and

2006 budget proposals.

2.      Modifications with respect to frivolous returns and submissions

Present Law

The Code provides that an individual who files a frivolous income tax return is subject to

a penalty of $500 imposed by the IRS.   The Code also permits the Tax Court  to impose a

penalty of up to $25,000 if a taxpayer has instituted or maintained proceedings primarily for

delay or if the taxpayer's position in the proceeding is frivolous or groundless.

Description of Proposal

The proposal modifies this IRS-imposed penalty by increasing the amount of the penalty

to $5,000 for frivolous income tax returns.

The proposal also modifies present law with respect to certain submissions that raise

frivolous arguments or that are intended to delay or impede tax administration. The submissions

to which this provision applies are: (1) requests for a collection due process hearing;

(2) installment agreements; and (3) offers-in-compromise.  First, the proposal permits the IRS to

dismiss such requests.  Second, the proposal permits the IRS to impose a penalty of $5,000 for

repeat behavior or failing to withdraw the request after being given an opportunity to do so.

The proposal permits the IRS to maintain administrative records of frivolous submissions

by taxpayers.   The proposal also requires that this designation be removed after a reasonable

period of time if the taxpayer makes no further frivolous submissions to the IRS.

The proposal requires the IRS to publish (at least annually) a list of positions, arguments,

requests, and proposals determined to be frivolous for purposes of these provisions.

Effective date.–The proposal is effective for submissions made on or after the date of

enactment.

Analysis

In general

Genuinely frivolous returns and submissions are those that raise arguments that have

been repeatedly rejected by the courts.  Dealing with genuinely frivolous returns and submissions

consumes resources at the IRS and in the courts that can better be utilized in resolving legitimate

disputes with taxpayers.  Accordingly, the proposals may improve the overall functioning of the

tax system and improve the level of service provided to taxpayers who do not raise these

frivolous arguments.

Some may question why this IRS-imposed penalty should be applied only to individuals

instead of applying it to all taxpayers who raise frivolous arguments.  Expanding the scope of the

penalty to cover all taxpayers would treat similarly situated taxpayers who raise identical

arguments in the same manner, which would promote fairness in the tax system.  Similarly, some

may question why this penalty should apply only to income tax returns and not to all other types

of returns, such as employment tax and excise tax returns.  Applying this penalty to all taxpayers

and all types of tax returns would make this IRS-imposed penalty more parallel to the Tax Court

penalty, where these constraints do not apply. 

Complexity issues

Increasing the amount of an existing penalty arguably would have no impact on tax law

complexity.  It could be argued that the procedural changes made by the proposal, taken as a

whole, would simplify tax administration by speeding the disposition of frivolous submissions,

despite the fact that some elements of the proposals (such as the requirement to publish a list of

frivolous positions) may entail increased administrative burdens.

Prior Action

A substantially similar proposal was included in the President's fiscal year 2003, 2004,

2005, and 2006 budget proposals.  

3.      Termination of installment agreements

Present Law

The Code authorizes the IRS to enter into written agreements with any taxpayer under

which the taxpayer is allowed to pay taxes owed, as well as interest and penalties, in installment

payments, if the IRS determines that doing so will facilitate collection of the amounts owed.  

An installment agreement does not reduce the amount of taxes, interest, or penalties owed. 

Generally, during the period installment payments are being made, other IRS enforcement

actions (such as levies or seizures) with respect to the taxes included in that agreement are held

in abeyance.

Under present law, the IRS is permitted to terminate an installment agreement only if: 

(1) the taxpayer fails to pay an installment at the time the payment is due; (2) the taxpayer fails

to pay any other tax liability at the time when such liability is due; (3) the taxpayer fails to

provide a financial condition update as required by the IRS; (4) the taxpayer provides inadequate

or incomplete information when applying for an installment agreement; (5) there has been a

significant change in the financial condition of the taxpayer; or (6) the collection of the tax is in

jeopardy.  

Description of Proposal

The proposal grants the IRS authority to terminate an installment agreement when a

taxpayer fails to timely make a required Federal tax deposit  or fails to timely file a tax return

(including extensions).  The termination could occur even if the taxpayer remained current with

payments under the installment agreement.

Effective date.–The proposal is effective for failures occurring on or after the date of

enactment.

Analysis

The proposal may lead to some additional complexity in the administration of installment

agreements.  For example, taxpayers might not understand why their installment agreement is

being terminated, leading to additional phone calls to the IRS.  In addition, the proposal would

require that additional explanatory information be provided to taxpayers, which will increase

complexity.  It might be possible to reduce this increase in complexity by implementing these

termination procedures in a manner as parallel as possible to the similar termination procedures

for offers in compromise.  It may also be beneficial to permit the reinstatement of terminated

installment agreements for reasonable cause, parallel to the procedures applicable to offers in

compromise.

The proposal reflects the policy determination that taxpayers who are permitted to pay

their tax obligations through an installment agreement should also be required to remain current

with their other Federal tax obligations.  Some might be concerned that this does not take into

account the benefits of making continued installment payments.  A key benefit to the Federal

Government of continued installment payments is that the Federal Government continues to

receive payments, whereas if the installment agreement is terminated payments under that

agreement stop.  Some might note that termination of the installment agreement permits the IRS

to begin immediate collection actions, such as reinstating liens and levies, which could increase

Federal Government receipts.  In the past several years, however, there has been a significant

decline in IRS' enforced collection activities, so that others might respond that terminating

installment agreements might not lead to increased receipts to the Federal Government, in that

the cessation of receipts due to termination of installment agreements may outweigh increases in

receipts through additional enforcement activities.

The proposal is effective for failures occurring on or after the date of enactment.  Some

may question whether it is fair to taxpayers who are currently in an installment agreement to

terminate those agreements. 

Prior Action

An identical proposal was included in the President's fiscal year 2003, 2004, 2005, and

2006 budget proposals. 

4.      Consolidate review of collection due process cases in the United States Tax Court

Present Law

In general, the IRS is required to notify taxpayers that they have a right to a fair and

impartial hearing before levy may be made on any property or right to property.   Similar rules

apply with respect to liens.   The hearing is held by an impartial officer from the IRS Office of

Appeals, who is required to issue a determination with respect to the issues raised by the

taxpayer at the hearing.  The taxpayer is entitled to appeal that determination to a court.  That

appeal must be brought to the United States Tax Court, unless the Tax Court does not have

jurisdiction over the underlying tax liability.  If that is the case, then the appeal must be brought

in the district court of the United States.   Special rules apply if the taxpayer files the appeal in

the incorrect court.

The United States Tax Court is established under Article I of the United States

Constitution  and is a court of limited jurisdiction.

Description of Proposal

The proposal consolidates all judicial review of these collection due process

determinations in the United States Tax Court.

Effective date.–The proposal applies to IRS Office of Appeals determinations made after

the date of enactment.

Analysis

Because the Tax Court is a court of limited jurisdiction, it does not have jurisdiction over

all of the taxes (such as, for example, most excise taxes) that could be at issue in collection due

process cases.  The judicial appeals structure of present law was designed in recognition of these

jurisdictional limitations; all appeals must be brought in the Tax Court unless that court does not

have jurisdiction over the underlying tax liability.  Accordingly, the proposal would give the Tax

Court jurisdiction over issues arising from a collection due process hearing, while the Tax Court

will not have jurisdiction over an identical issue arising in a different context.  

The proposal would provide simplification benefits to taxpayers and to the IRS by

requiring that all appeals be brought in the Tax Court, because doing so will eliminate confusion

over which court is the proper venue for an appeal and will significantly reduce the period of

time before judicial review.  

Some believe that present law "entitles a taxpayer patently seeking delay to achieve his

goal by refiling in the District Court."   The proposal would provide simplification benefits by

eliminating this opportunity for delay.

Prior Action

A substantially similar proposal was included in the President's fiscal year 2003 and

2004 budget proposals.    An identical proposal was included in the President's fiscal year 2005

and 2006 budget proposals.  The right to a hearing and judicial review of the determinations

made at these hearings were enacted in the IRS Restructuring and Reform Act of 1998.

5.    Office of Chief Counsel review of offers in compromise

Present Law

The IRS has the authority to settle a tax debt pursuant to an offer in compromise.  IRS

regulations provide that such offers can be accepted if the taxpayer is unable to pay the full

amount of the tax liability and it is doubtful that the tax, interest, and penalties can be collected

or there is doubt as to the validity of the actual tax liability.  Amounts of $50,000 or more can

only be accepted if the reasons for the acceptance are documented in detail and supported by a

written opinion from the IRS Chief Counsel.

Description of Proposal

The proposal repeals the requirement that an offer-in-compromise of $50,000 or more

must be supported by a written opinion from the Office of Chief Counsel.  The Secretary must

establish standards for determining when a written opinion is required with respect to a

compromise.

Effective date.–The proposal applies to offers-in-compromise submitted or pending on or

after the date of enactment.

Analysis

Repealing the requirement that an offer-in-compromise of $50,000 or more be supported

by a written opinion from the Office of Chief Counsel will simplify the administration of the

offer-in-compromise provisions by the IRS.  Repealing this requirement also would increase the

level of discretionary authority that the IRS may exercise, which may lead to increasingly

inconsistent results among similarly situated taxpayers. Some may believe that Chief Counsel

review is appropriate for all offers-in-compromise above specified dollar thresholds, similar to

the review of large refund cases by the Joint Committee on Taxation.

Prior Action

An identical proposal was included in the President's fiscal year 2003, 2004, 2005, and

2006 budget proposals.  The $50,000 threshold was raised from $500 in 1996.

 

 

B.      Initiate Internal Revenue Service ("IRS") Cost Saving Measures

1.    Allow the Financial Management Service to retain transaction fees from levied amounts

Present Law

To facilitate the collection of tax, the IRS can generally levy upon all property and rights

to property of a taxpayer.   With respect to specified types of recurring payments, the IRS may

impose a continuous levy of up to 15 percent of each payment, which generally continues in

effect until the liability is paid.   Continuous levies imposed by the IRS on specified Federal

payments are administered by the Financial Management Service (FMS) of the Department of

the Treasury.  FMS is generally responsible for making most non-defense related Federal

payments.  FMS is required to charge the IRS for the costs of developing and operating this

continuous levy program.  The IRS pays these FMS charges out of its appropriations.

Description of Proposal

The proposal allows FMS to retain a portion of the levied funds as payment of these FMS

fees.  The amount credited to the taxpayer's account would not, however, be reduced by this fee.

Effective date.–The provision is effective on the date of enactment.

Analysis

Proponents believe that altering the bookkeeping structure of these costs will provide for

cost savings to the Federal Government.

Prior Action

An identical proposal was included in the President's fiscal year 2005 and 2006 budget

proposals. 

2.    Expand the authority to require electronic filing by large businesses and exempt

organizations

Present Law

The Code authorizes the IRS to issue regulations specifying which returns must be filed

electronically.   There are several limitations on this authority.  First, it can only apply to

persons required to file at least 250 returns during the year.   Second, the IRS is prohibited

from requiring that income tax returns of individuals, estates, and trusts be submitted in any

format other than paper (although these returns may by choice be filed electronically).

Description of Proposal

The proposal expands the authority of the IRS to require businesses (including

corporations, partnerships, and other business entities) and exempt organizations to file their

returns electronically.  The proposal statutorily lowers the number of returns that trigger the

requirement to file electronically from 250 to "a minimum at a high enough level to avoid

imposing an undue burden on taxpayers."   Taxpayers required to file electronically but who

fail to do so would be subject to a monetary penalty, which could be waived for reasonable

cause.

Effective date.–The proposal is effective for taxable years beginning after December 31,

2006; these returns will be filed in 2008.

Analysis

In general, the goal of the proposal is to reduce the administrative burdens on the IRS by

providing IRS authority to require more taxpayers to file electronically.  The Congress set a goal

for the IRS to have 80 percent of tax returns filed electronically by 2007.  The overwhelming

majority of tax returns are already prepared electronically.  Thus, expanding the scope of returns

that are required to be filed electronically may be viewed as both helping the IRS to meet the 80

percent goal set by the Congress and improving tax administration.

Prior Action

A similar proposal was included in the President's fiscal year 2006 budget proposal. 

 

 

C.    Other Provisions

1.    Allow Internal Revenue Service ("IRS") to access information in the National Directory

of New Hires ("NDNH")

Present Law

The Office of Child Support Enforcement of the Department of Health and Human

Services ("HHS") maintains the National Directory of New Hires (NDNH), which is a database

that contains newly-hired employee data from Form W-4, quarterly wage data from State and

Federal employment security agencies, and unemployment benefit data from State

unemployment insurance agencies.  The NDNH was created to help State child support

enforcement agencies enforce obligations of parents across State lines.

Under current provisions of the Social Security Act, the IRS may obtain data from the

NDNH, but only for the purpose of administering the Earned Income Tax Credit (EIC) and

verifying a taxpayer's employment that is reported on a tax return. 

Under various State laws, the IRS may negotiate for access to employment and

unemployment data directly from State agencies that maintain these data.  Generally, the IRS

obtains such employment and unemployment data less frequently than quarterly, and there are

significant internal costs of preparing these data for use.

Description of Proposal

The proposal amends the Social Security Act to allow the IRS access to NDNH data for

general tax administration purposes, including data matching, verification of taxpayer claims

during return processing, preparation of substitute returns for non-compliant taxpayers, and

identification of levy sources.  Data obtained by the IRS under the proposal is subject to the

confidentiality and disclosure rules applicable to taxpayer information.

Effective date.–The proposal is effective upon enactment.

Analysis

The proposal could enhance tax administration by providing the IRS with a more

efficient method to obtain taxpayer data.  Obtaining taxpayer data from a centralized source such

as the NDNH, rather than from separate State agencies, should increase the productivity of the

IRS by reducing the amount of IRS resources dedicated to obtaining and processing such data. 

Some may argue that allowing the IRS to access the NDNH for general tax administration

purposes infringes on individual privacy and extends the use of the database beyond that which

was originally intended; to enable state child support enforcement agencies to be more effective

in locating noncustodial parents.  On the other hand, data obtained by the IRS from the NDNH is

protected by existing disclosure law.  Thus, the proposal does not reduce the current levels of

taxpayer privacy.

Prior Action

An identical proposal was included in the President's fiscal year 2006 budget proposal.

 

 

2.      Extension of IRS authority to fund undercover operations

Present Law

IRS undercover operations are statutorily  exempt from the generally applicable

restrictions controlling the use of Government funds (which generally provide that all receipts

must be deposited in the general fund of the Treasury and all expenses be paid out of

appropriated funds).  In general, the Code permits the IRS to use proceeds from an undercover

operation to pay additional expenses incurred in the undercover operation, through 2006.  The

IRS is required to conduct a detailed financial audit of large undercover operations in which the

IRS is churning funds and to provide an annual audit report to the Congress on all such large

undercover operations. 

Description of Proposal

The proposal extends this authority through December 31, 2011.

Analysis

Some believe the extension of this authority is appropriate because they believe that it

assists the fight against terrorism.  Some also believe that it is appropriate for IRS to have this

authority because other law enforcement agencies have churning authority.  Others, however,

point to the four and a half year gap during which the provision had lapsed as evidence that this

authority is not essential to the operation of the IRS.  However, it is difficult to show what

investigative opportunities were lost due to the lack of churning authority during that period. 

Some believe that extension is inappropriate because the provision may provide incentives to

continue undercover operations for extended periods of time.  IRS data for fiscal years 2002,

2003, and 2004 reveal that a total of approximately $748,000 was churned while only $6,700

was deposited in the general fund of the Treasury due to the cessation of undercover operations.

Prior Action

The provision was originally enacted in The Anti-Drug Abuse Act of 1988.   The

exemption originally expired on December 31, 1989, and was extended by the Comprehensive

Crime Control Act of 1990  to December 31, 1991.   There followed a gap of approximately

four and a half years during which the provision had lapsed.  In the Taxpayer Bill of Rights II, 

the authority to churn funds from undercover operations was extended for five years, through

2000.   The Community Renewal Tax Relief Act of 2000  extended the authority of the IRS

to "churn" the income earned from undercover operations for an additional five years, through

2005.  The Gulf Opportunity Zone Act of 2005 extended this authority through 2006.

 

 

 

D.    Reduce the Tax Gap

1.      Implement standards clarifying when employee leasing companies can be held liable for

their clients' Federal employment taxes

Present Law

In general

Employment taxes generally consist of the taxes under the Federal Insurance

Contributions Act ("FICA"), the tax under the Federal Unemployment Tax Act ("FUTA"), and

the requirement that employers withhold income taxes from wages paid to employees ("income

tax withholding").   

FICA tax consists of two parts: (1) old age, survivor, and disability insurance ("OASDI"),

which correlates to the Social Security program that provides monthly benefits after retirement,

disability, or death; and (2) Medicare hospital insurance ("HI").  The OASDI tax rate is 6.2

percent on both the employee and employer (for a total rate of 12.4 percent).  The OASDI tax

rate applies to wages up to the OASDI wage base ($94,200 for 2006).  The HI tax rate is 1.45

percent on both the employee and the employer (for a total rate of 2.9 percent).  Unlike the

OASDI tax, the HI tax is not limited to a specific amount of wages, but applies to all wages.

Under FUTA, employers must pay a tax of 6.2 percent of wages up to the FUTA wage

base of $7,000.  An employer may take a credit against its FUTA tax liability for contributions to

a State unemployment fund and certain other amounts.

Employers are required to withhold income taxes from wages paid to employees. 

Withholding rates vary depending on the amount of wages paid, the length of the payroll period,

and the number of withholding allowances claimed by the employee.

Wages paid to employees, and FICA and income taxes withheld from the wages, are

required to be reported on employment tax returns and on Forms W-2.

Responsibility for employment tax compliance

Employment tax responsibility generally rests with the person who is the employer of an

employee under a common-law test that has been incorporated into Treasury regulations.  

Under the regulations, an employer-employee relationship generally exists if the person for

whom services are performed has the right to control and direct the individual who performs the

services, not only as to the result to be accomplished by the work, but also as to the details and

means by which that result is accomplished.  That is, an employee is subject to the will and

control of the employer, not only as to what is to be done, but also as to how it is to be done.  It is

not necessary that the employer actually control the manner in which the services are performed,

rather it is sufficient that the employer have a right to control.  Whether the requisite control

exists is determined on the basis of all the relevant facts and circumstances.  The test of whether

an employer-employee relationship exists often arises in determining whether a worker is an

employee or an independent contractor.  However, the same test applies in determining whether

a worker is an employee of one person or another.

In some cases, a person other than the common-law employer (a "third party") may be

liable for employment taxes.  For example, if wages are paid to an employee by a third party and

the third party, rather than the employer, has control of the payment of the wages, the third party

is the statutory employer responsible for complying with applicable employment tax

requirements.   In addition, an employer may designate a reporting agent to be responsible for

FICA tax and income tax withholding compliance,  including filing employment tax returns

and issuing Forms W-2 to employees.   In that case, the reporting agent and the employer are

jointly and severally liable for compliance.

Employee leasing arrangements

Under an employee leasing arrangement, a leasing company provides workers ("leased

employees") to perform services in the businesses of the leasing company's clients.   In many

cases, before the leasing arrangement is entered into, the leased employees already work for the

client's business as employees of the client.  Under the terms of a typical leasing arrangement,

the leasing company is assumed to be the employer of the leased employees and is responsible

for paying the leased employees and the related employment tax compliance.  The client

typically pays the leasing company a fee based on payroll costs plus an additional amount.  

In many cases, leased employees are legally the employees of the client and the client is

legally responsible for employment tax compliance.  Nonetheless, clients generally rely on the

leasing company for employment tax compliance (without designating the leasing company as a

payroll agent) and often take the position that the leased employees are employees of the leasing

company.

Description of Proposal

The proposal contemplates the establishment of standards for holding employee leasing

companies jointly and severally liable with their clients for Federal employment taxes and for

holding employee leasing companies solely liable for such taxes if they meet specified

requirements.  Details of the proposal have not yet been provided.

Effective date.-The proposal is effective for employment tax returns filed with respect to

wages paid on or after January 1, 2007.

Analysis

In the absence of a detailed proposal, the following analysis discusses general issues

relating to employee leasing companies and employment taxes.

The IRS estimates that the portion of the 2001 tax gap attributable to FICA and FUTA

taxes is $15 billion.   An additional portion of the tax gap is attributable to income taxes due on

unreported wages.  The proposal is aimed at narrowing the tax gap attributable to employment

taxes.

In an employee leasing arrangement, clients typically rely on the leasing company to

comply with the applicable employment tax requirements, regardless of whether legal

responsibility for employment taxes rests with the leasing company or with the client.  In

addition, if a leasing company files employment tax returns and pays employment taxes, absent

an audit, the IRS generally has no way of knowing whether the leasing company or the client is

the employer, or even that a leasing arrangement exists.  Moreover, in situations in which neither

the leasing company nor the client complies with the applicable employment tax requirements, it

may be difficult to determine which party is liable for employment taxes.  Uncertainty as to who

is liable for employment taxes in an employee leasing arrangement may mean that, as a practical

matter, no one is held liable.  Providing clear rules for determining who is liable for employment

taxes in employee leasing arrangements would address those issues and could improve

compliance.

Some believe that leasing companies offer a greater likelihood of employment tax

compliance than can be expected from clients (particularly clients that are small businesses) on

an individual basis.  On the other hand, the payroll of a leasing company typically includes the

payroll for employees leased to many client businesses, as well as payroll for employees working

directly for the leasing company.  Accordingly, failure of a leasing company to comply may

result in noncompliance on a larger scale than the level of noncompliance that would otherwise

occur among client businesses.  Rules for holding leasing companies solely liable for

employment taxes should therefore include adequate standards and procedural safeguards to

assure that the leasing company will in fact comply.

Some argue that existing rules, such as the designated payroll agent rules, are sufficient to

permit leasing companies to assume employment tax responsibility and that the need for rules

under which only the leasing company is liable is really a marketing issue for leasing companies,

rather than a true compliance issue.  On the other hand, leasing companies argue that, in addition

to improving employment tax compliance with respect to clients, they also often provide leased

employees with employee benefits that cannot be provided by their smaller clients.

To the extent that the proposal provides clear standards for determining whether a leasing

company, its clients, or both, are liable for employment taxes, without the need to determine

which is the employer of the leased employees or which has control of the payment of wages, it

may reduce the complexity related to employment tax compliance.  On the other hand, allowing

a leasing company to be solely liable for employment taxes may require complicated rules and

procedures.  In addition, employer status is relevant for employment tax purposes other than

compliance.  For example, employment tax exceptions for certain services or compensation may

depend on the type of employer, such as agricultural employers.  In addition, certain aspects of

the FUTA rules are based on an employer's liability for contributions to a State unemployment

system.   Similarly, certain income tax credits are available to employers, such as the credit for

a portion of employer social security taxes paid with respect to cash tips.  Application of these

provisions may therefore be more difficult if a leasing company is the person handling

employment tax compliance rather than the client businesses.

Prior Action

No prior action.

2.      Increased information reporting on payment card transactions

Present Law

Present law imposes a variety of information reporting requirements that enable the IRS

to verify the correctness of taxpayers' returns.  For example, every person engaged in a trade or

business generally is required to file information returns for each calendar year for payments of

$600 or more made in the course of the payor's trade or business.   By regulation, payments to

corporations generally are excepted from this requirement.  Certain payments subject to

information reporting also are subject to backup withholding if the payee has not provided a

valid taxpayer identification number ("TIN"), or if the IRS determines that there has been payee

underreporting and notice has been provided to the taxpayer with respect to that underreporting. 

Description of Proposal

The proposal provides the Secretary with authority to promulgate regulations requiring

issuers of credit cards and debit cards to report to the IRS annually the aggregate reimbursement

payments made to merchants in a calendar year.  The proposal also requires backup withholding

on reimbursement payments made to merchants in the event that a merchant payee fails to

provide a TIN, if the IRS notifies the payor that the TIN furnished by the payee is incorrect, or in

the event of payee underreporting.  Under the proposal, the Secretary is expected to exclude

certain categories of merchant payees, such as corporations, and certain categories of payments

from the reporting and backup withholding requirements.

Effective date.-The proposal is effective for payments made by payment card issuers on

or after January 1, 2007.

Analysis

Requiring issuers of payment cards (credit cards and debit cards) to annually report to the

IRS the aggregate reimbursement payments made to merchants, and to impose backup

withholding in certain cases on such payments, could be expected to generate additional positive

effects on compliance and IRS collection efforts.  In general, income that is subject to

information reporting and withholding is less likely to be underreported.  In contrast, the absence

of information reporting or withholding on many types of payments results in underreporting and

contributes to the tax gap.   In general, the more payments to which information reporting

and/or withholding applies, the greater improvement in compliance.  While some consider it

inappropriate to single out payment card reimbursements made to merchants for additional

information reporting, others respond that reporting is appropriate in this instance because of the

large amount of income derived by businesses from payment card transactions and because the

unreported income of businesses represents a significant part of the tax gap.  Information

reporting for payment card reimbursements would also help the IRS focus its audit resources on

taxpayers who are more likely to have unreported income.

Although the proposal can be expected to increase tax compliance, the extent of the

increase will depend on the details of the reporting requirements and any exceptions, which have

not yet been specified.  For example, the proposal is not expected to apply to reimbursement

payments to corporations, which suggests that it is more likely to apply to payments to small

businesses rather than to larger businesses.  Thus, the proposal could have the effect of

discouraging small businesses from accepting payment cards, which could reduce the

compliance benefit of the proposal.  Moreover, the proposal does not provide a definition for

"merchant," so issues arise as to the scope of the proposal, for example, whether it applies to

service providers that accept payment cards, as well as to retail businesses.  Clarification of these

issues is necessary to implement the proposal. 

Finally, imposing additional information reporting and withholding requirements will

increase the paperwork burden on financial institutions subject to the provision.  The extent of

the increase in burden and any associated costs will depend on the details of the proposal.  Any

additional burden will be lessened to the extent that the proposal relies on existing information

gathering systems.

Prior Action

No prior action.

3.      Increased information reporting for certain government payments for goods and

services

Present Law

Present law imposes numerous information reporting requirements that enable the

Internal Revenue Service ("IRS") to verify the correctness of taxpayers' returns.  For example,

every person engaged in a trade or business generally is required to file information returns for

each calendar year for payments of $600 or more made in the course of the payor's trade or

business.   By regulation, payments to corporations generally are excepted from this

requirement.  Certain payments subject to information reporting also are subject to backup

withholding if the payee has not provided a valid taxpayer identification number ("TIN"), or if

the IRS determines that there has been payee underreporting and notice has been provided to the

taxpayer with respect to that underreporting.  Special information reporting requirements exist

for employers required to deduct and withhold tax from employees' income.   In addition, any

service recipient engaged in a trade or business and paying for services is required to make a

return according to regulations when the aggregate of payments is $600 or more.

Government entities also are required to make an information return, reporting payments

for services to corporations as well as individuals.   Moreover, the head of every Federal

executive agency that enters into certain contracts must file an information return reporting the

contractor's name, address, TIN, date of contract action, amount to be paid to the contractor, and

any other information required by Forms 8596 (Information Return for Federal Contracts) and

8596A (Quarterly Transmittal of Information Returns for Federal Contracts).  

Description of Proposal

The proposal provides the Secretary with authority to promulgate regulations requiring

information reporting on all non-wage payments by Federal, State and local governments to

procure property and services.  The proposal also requires backup withholding on such payments

in the event that the payee fails to provide a TIN, or if the IRS notifies the payor that the TIN

furnished by the payee is incorrect, or in the event of payee underreporting.  Under the proposal,

the Secretary is expected to exclude certain categories of payments from the information

reporting and backup withholding requirements, including payments of interest, payments for

real property, payments to tax-exempt entities or foreign governments, intergovernmental

payments, and payments made pursuant to a classified or confidential contract.

Effective date.-The proposal is effective for payments made by Federal, State and local

governments to procure property and services on or after January 1, 2007.

Analysis

The proposal could have a positive impact on compliance with the tax laws by requiring

additional information reporting and backup withholding on certain non-wage payments.  In

general, the more payments to which information reporting and withholding applies, the greater

improvement in compliance.  However, the extent to which the proposal improves compliance

depends on details which have not been specified, such as the scope of payments subject to the

proposal and any exceptions.  For example, under present law, government entities are required

to report payments to a service provider when the aggregate of payments to such service provider

is $600 or more.  The proposal does not specify whether a similar dollar threshold would apply

to payments subject to the reporting requirements.  Because the extent to which the proposal

expands upon present-law requirements is unclear, it is difficult to fully assess the relative

benefits and detriments of the proposal. 

Imposing additional information reporting requirements also will impose new costs on

payors.  The extent of any new burden and associated costs will depend on the details of the

proposal.  In general, new burdens will be lessened to the extent the proposal relies on

procedures already in place.  For example, present law imposes information reporting

requirements on governmental entities.  Arguably, the proposal only will require the expansion

of existing procedures to satisfy the broader requirements under the proposal, not the creation of

wholly new procedures.  Similarly, certain Federal payments to vendors of goods or services are

subject to continuous levy authority under present law.   Thus, government entities are likely to

have existing procedures for deducting and remitting taxes from payments to businesses and

individuals that may be tailored to the specific requirements of the proposal.

Some might consider it inappropriate to single out payments by Federal, State and local

governments for additional information reporting, rather than expanding the reporting

requirements for all payors.  Proponents respond that additional information reporting is

appropriate in this instance because unreported income received by government contractors

represents an important part of the tax gap.

Prior Action

No prior action.

4.    Amend collection due process procedures for employment tax liabilities

Present Law

Levy is the IRS's administrative authority to seize a taxpayer's property to pay the

taxpayer's tax liability.  The IRS is entitled to seize a taxpayer's property by levy if the Federal

tax lien has attached to such property.  A Federal tax lien arises automatically where (1) a tax

assessment has been made, (2) the taxpayer has been given notice of the assessment stating the

amount and demanding payment, and (3) the taxpayer has failed to pay the amount assessed

within 10 days after the notice and demand.

In general, the IRS is required to notify taxpayers that they have a right to a fair and

impartial collection due process ("CDP") hearing before levy may be made on any property or

right to property.   Similar rules apply with respect to notices of tax liens, although the right to

a hearing arises only on the filing of a notice.   The CDP hearing is held by an impartial officer

from the IRS Office of Appeals, who is required to issue a determination with respect to the

issues raised by the taxpayer at the hearing.  The taxpayer is entitled to appeal that determination

to a court.  Under present law, taxpayers are not entitled to a pre-levy CDP hearing if a levy is

issued to collect a Federal tax liability from a State tax refund or if collection of the Federal tax

is in jeopardy.  However, levies related to State tax refunds or jeopardy determinations are

subject to post-levy review through the CDP hearing process.

Employment taxes generally consist of the taxes under the Federal Insurance

Contributions Act ("FICA"), the tax under the Federal Unemployment Tax Act ("FUTA"), and

the requirement that employers withhold income taxes from wages paid to employees ("income

tax withholding").    Income tax withholding rates vary depending on the amount of wages

paid, the length of the payroll period, and the number of withholding allowances claimed by the

employee.

Description of Proposal

Under the proposal, levies issued to collect Federal employment taxes are excepted from

the pre-levy CDP hearing requirement.  Thus, taxpayers would not have a right to a CDP hearing

before a levy is issued to collect employment taxes.  As with the current procedures applicable to

levies issued to collect a Federal tax liability from State tax refunds, the taxpayer would be

provided an opportunity for a hearing within a reasonable period of time after the levy. 

Collection by levy would be allowed to continue during the CDP proceedings.

Effective date.-The proposal is effective for levies issued on or after January 1, 2007.

Analysis

Congress enacted the CDP hearing procedures to afford taxpayers adequate notice of

collection activity and a meaningful hearing before the IRS deprives them of their property.  By

permitting the IRS to seize property prior to the CDP hearing, the proposal may increase the

burden on taxpayers with employment tax liabilities who are legitimately seeking alternatives to

IRS forced collection through levy.  Opponents of the proposal argue that if such a taxpayer is

making a legitimate effort to resolve a tax liability, and the interests of the United States are

adequately protected, it would be appropriate to preclude enforced collection of the liability.

On the other hand, proponents argue that taxpayers frequently abuse the CDP procedures

by raising frivolous arguments simply for the purpose of delaying or evading collection of tax. 

Moreover, proponents argue that the opportunity to delay collection of employment tax liabilities

presents a greater risk to the government than delay may present in other contexts because

employment tax liabilities continue to increase as ongoing wage payments are made to

employees.  In addition, much of an employer's employment tax liability consists of FICA tax

and income tax withheld from employees' wages and held in trust for the government by the

employer.  Others respond that the opportunity to use the present-law rules in unintended ways to

delay or defeat the collection process is not unique to taxpayers with employment tax liabilities. 

In addition, opponents argue that it is unnecessary to provide special rules for employment tax

liabilities because present law permits the IRS to levy property prior to providing the CDP

hearing if collection of the tax is in jeopardy. 

Prior Action

No prior action.

5.    Expand the signature requirement and penalty provisions applicable to paid preparers

Present Law

An income tax return preparer is defined as any person who prepares for compensation,

or who employs other people to prepare for compensation, all or a substantial portion of an

income tax return or claim for refund.   Under present law, the definition of an income tax

return preparer does not include a person preparing non-income tax returns, such as estate and

gift, excise, or employment tax returns.

Income tax return preparers are required to sign and include their taxpayer identification

numbers on income tax returns and income return-related documents prepared for compensation. 

Penalties are imposed on any income tax return preparer who, in connection with the preparation

of an income tax return, fails to (1) furnish a copy of a return or claim for refund to the taxpayer,

(2) sign the return or claim for refund, (3) furnish his or her identifying number, (4) retain a copy

of the completed return or a list of the taxpayers for whom a return was prepared, (5) file a

correct information return, and (6) comply with certain due diligence requirements in

determining a taxpayer's eligibility for the earned income credit.   The penalty is $50 for each

failure and the total penalties imposed for any single type of failure for any calendar year are

limited to $25,000.

Under present law, income tax return preparers also are subject to a penalty of $250 with

respect to any return if a portion of an understatement of tax liability is due to a position for

which there was not a realistic possibility of success on the merits, the preparer knew or

reasonably should have known of the position, and the position was not disclosed or was

frivolous.   In addition, present law imposes a penalty on income tax return preparers of $1,000

with respect to a tax return if a portion of an understatement of tax liability is due to a willful

attempt to understate liability or to reckless or intentional disregard of rules or regulations.

Description of Proposal

The proposal expands preparer identification and penalty provisions to non-income tax

returns (such as estate and gift, employment tax, and excise tax returns) and non-income tax

return-related documents prepared for compensation.  The proposal also subjects paid preparers

to penalties for preparing non-income tax return-related documents that contain false,

incomplete, or misleading information or contain frivolous positions that delay collection.

Effective date.-The proposal is effective for returns filed on or after January 1, 2007.

Analysis

Penalties for the failure to comply with tax laws are a necessary component of any tax

system if broad compliance is to be expected.  The present-law penalties that apply to income tax

return preparers serve to establish and validate the standards of behavior set forth by the tax laws

themselves, as well as to prevent specific departures from and enforce such laws.  The proposal

to expand present-law penalties for income tax return preparers to paid preparers of all types of

tax returns and documents may enhance compliance by imposing on non-income tax return

preparers the same or similar requirements that apply to income tax return preparers.  In addition,

the proposal may achieve a measure of uniformity and promote fairness in the tax system by

treating similarly situated individuals in the same manner.  However, the extent to which the

proposal improves the overall functioning of the tax system depends on details which have not

been specified, such as the definition of a "non-income tax return preparer" and whether such

preparers will be subject to the same standards as income tax return preparers for purposes of

imposing penalties for submitting false, incomplete, misleading, or frivolous returns.

Prior Action

No prior action.

 

 

E.      Strengthen the Financial Integrity of Unemployment Insurance

1.    Reduce improper benefit payments and tax avoidance

Present Law

The Federal Unemployment Tax Act ("FUTA") imposes a 6.2-percent gross tax rate on

the first $7,000 paid annually by covered employers to each employee.  Employers in States with

programs approved by the Federal Government and with no delinquent Federal loans may credit

5.4 percentage points against the 6.2 percent tax rate, making the net Federal unemployment tax

rate 0.8 percent.  Because all States have approved programs, 0.8 percent is the Federal tax rate

that generally applies.  The net Federal unemployment tax revenue finances the administration of

the unemployment system, half of the Federal-State extended benefits program, and a Federal

account for State loans.  Also, additional distributions ("Reed Act distributions") may be made to

the States, if the balance of the Federal unemployment trust funds exceeds certain statutory

ceilings.  The States use Reed Act distributions to finance their regular State programs (which

are mainly funded with State unemployment taxes) and the other half of the Federal-State

extended benefits program.

State Unemployment Insurance taxes are deposited into the State's Federal

Unemployment Insurance Trust Fund and are used by the State to pay unemployment benefits.

State recoveries of overpayments of unemployment insurance benefits must be similarly

deposited and used exclusively to pay unemployment benefits.  While States may enact penalties

for overpayments, amounts collected as penalties or interest on benefit overpayments may be

treated as general receipts by the States.

Under present law, all States operate experience rating systems.  Under these systems an

employer's State unemployment tax rate is based on the amount of unemployment benefits paid

to the employer's former employees.  Generally, the more unemployment benefits paid to former

employees, the higher the State unemployment tax rates.

The Office of Child Support Enforcement of the Department of Health and Human

Services ("HHS") maintains the National Directory of New Hires ("NDNH"), which is a

database that contains newly-hired employee data from Form W-4, quarterly wage data from

State and Federal employment security agencies, and unemployment benefit data from state

unemployment insurance agencies.  The NDNH was created to help state child support

enforcement agencies enforce obligations of parents across state lines.

Description of Proposal

The proposal provides States with an incentive to recover unemployment benefit

overpayments, and delinquent employer taxes.  The proposal allows States to redirect up to five

percent of overpayment recoveries to additional enforcement activity.  The proposal requires

States to impose a 15 percent penalty on recipients of fraudulent overpayments; the penalty

would be used exclusively for additional enforcement activity.

Under the proposal, States are prohibited from relieving an employer of benefit charges

due to a benefit overpayment if the employer had caused the overpayment.  In certain

circumstances relating to fraudulent overpayments or delinquent employer taxes, States are

permitted to employ private collection agencies to retain a portion (up to 25 percent) of such

overpayments or delinquent taxes collected.  In addition, the proposal provides that the Secretary

of the Treasury, upon request of a State, will reduce any income tax refund owed to a benefit

recipient when that recipient owes a benefit overpayment to the requesting State.

The proposal requires employers to report the starting date of employment for all new

hires to the NDNH.  Finally, the proposal authorizes the Secretary of Labor to waive certain

requirements to allow states to conduct Demonstration Projects geared to reemployment of

individuals eligible for unemployment benefits.

Effective date.–The proposal is effective on the date of enactment.

Analysis

States' abilities to reduce unemployment benefit overpayments and increase overpayment

recoveries are limited by funding.  In addition, the present-law requirement that States redeposit

recoveries of overpayments to the Federal Unemployment Insurance Trust Fund creates a

relative disincentive for States to increase enforcement activity.  Permitting States to redirect five

percent of overpayment recoveries to additional enforcement activity provides States with

additional resources to detect and recover overpayments.  The proposal also deters

noncompliance by imposing a 15 percent penalty on fraudulent overpayments and provides

States additional resources by requiring penalty proceeds to be used exclusively for enforcement

activity.  However, the proposal does not provide a definition of what will be considered

fraudulent.  The lack of a uniform definition of a fraudulent overpayment may result in disparate

treatment of individuals in different States.  In addition, there is a question as to whether the

Federal Government can ensure that amounts redirected from the Federal Unemployment

Insurance Trust Fund are used exclusively for State enforcement purposes.

The proposal also prohibits States from relieving employers of benefit charges due to a

benefit overpayment if the employer caused the overpayment.  Proponents may argue this will

decrease overpayments resulting from employer error.  In addition, the proposal ensures that

employers with high error rates bear the burden of additional costs associated with such errors. 

On the other hand, the proposal does not provide a definition of what will be considered

employer fault.  Without providing the States criteria for making this determination, there are

issues regarding the administrability of such a standard.

The proposal permitting States to employ private collection agencies to retain a portion of

certain fraudulent overpayments or delinquent employer taxes collected may permit States to

more efficiently allocate resources to enforcement activities.  The proposal does not, however,

describe the circumstances when private collection agencies will be allowed to retain a portion of

taxes collected and some may question whether it is appropriate to compensate such agencies

based on the success in collecting taxes that are due.

There are administrability issues regarding the proposal requiring the Secretary to reduce

any income tax refund owed to an unemployment benefit recipient when that recipient owes a

overpayment to a State requesting offset.  Present law provides States a limited right of offset

with respect to legally enforceable State income tax obligations.  Present law also establishes the

priority of State income tax obligations relative to other liabilities.  The proposal neither defines

how the IRS will determine whether unemployment overpayments are legally owed to a State

nor describes the relative priority of such offsets.  Clarification of these issues is necessary to

implement this element of the proposal.  Finally, some may question whether it is appropriate to

provide States an offset right in non-income tax cases, thus, expanding the circumstances in

which the Federal Government acts a collection agent for the States.

Proponents may argue that the proposal requiring employers to report the starting date of

employment for all new hires to the NDNH will reduce unemployment benefit overpayments. 

Obtaining taxpayer data from a centralized source such as the NDNH, rather than from separate

State agencies, should increase the efficiency of enforcement efforts.  Some may argue, however,

that allowing States to access the NDNH for administering unemployment benefits extends the

use of the database beyond that which was originally intended; to enable state child support

enforcement agencies to be more effective in locating noncustodial parents. 

Prior Action

A similar proposal was included in the President's fiscal year 2006 budget proposal.

2.      Extension of Federal Unemployment Surtax

Present Law

The Federal Unemployment Tax Act (FUTA) imposes a 6.2 percent gross tax rate on the

first $7,000 paid annually by covered employers to each employee.  Employers in States with

programs approved by the Federal Government and with no delinquent Federal loans may credit

5.4 percentage points against the 6.2 percent tax rate, making the minimum, net Federal

unemployment tax rate 0.8 percent.  Since all States have approved programs, 0.8 percent is the

Federal tax rate that generally applies.  This Federal revenue finances administration of the

unemployment system, half of the Federal-State extended benefits program, and a Federal

account for State loans.  The States use the revenue turned back to them by the 5.4 percent credit

to finance their regular State programs and half of the Federal-State extended benefits program.

In 1976, Congress passed a temporary surtax of 0.2 percent of taxable wages to be added

to the permanent FUTA tax rate.  Thus, the current 0.8 percent FUTA tax rate has two

components: a permanent tax rate of 0.6 percent, and a temporary surtax rate of 0.2 percent.  The

temporary surtax subsequently has been extended through 2007.

Description of Proposal

The proposal extends the temporary surtax rate through December 31, 2012.

Effective date.-The proposal is effective for labor performed on or after January 1, 2008.

Analysis

The proposal reflects the belief that a surtax extension is needed in order to increase

funds for the Federal Unemployment Trust Fund to provide a cushion against future Trust Fund

expenditures.  The monies retained in the Federal Unemployment Account of the Federal

Unemployment Trust Fund can then be used to make loans to the 53 State Unemployment

Compensation benefit accounts as needed.

An argument against the proposal is that an extension is not necessary at this time

because Federal Unemployment Trust Fund projected revenues are sufficient to cover projected

expenditures for the next several years.  Some argue that the proposal is simply an attempt to

improve the unified Federal budget by collecting the surtax for five additional years. 

Prior Action

No prior action.

 

 

 

VII.  MODIFY ENERGY POLICY ACT OF 2005

A.    Repeal Temporary 15-Year Recovery Period for Natural Gas Distribution Lines

Present Law

The applicable recovery period for assets placed in service under the Modified

Accelerated Cost Recovery System is based on the "class life of the property."  Except where

provided specifically by statute, the class lives of assets placed in service after 1986 are generally

set forth in Revenue Procedure 87-56.   In the Revenue Procedure, natural gas distribution

pipelines are assigned a 20-year recovery period and a class life of 35 years.  However, natural

gas distribution pipelines the original use of which commences with the taxpayer after April 11,

2005, and which are placed in service before January 1, 2011 are assigned a statutory 15-year

recovery period.

Description of Proposal

Under the proposal, the temporary 15-year recovery period for natural gas distribution

lines is repealed for property placed in service after December 31, 2006.  Thus, under the

proposal, all natural gas distribution lines placed in service after December 31, 2006 are assigned

a recovery period of 20 years and a class life of 35 years.

Analysis

The temporary reduced recovery period for natural gas distribution lines under present

law encourages investment in such property by reducing the present-value after-tax cost of

investment.  In considering the shorter recovery period, the Senate Committee on Finance and

the House Ways and Means Committee each cited an aging energy infrastructure and a desire to

encourage investment in energy property:

"The Committee recognizes the importance of modernizing our aging energy

infrastructure to meet the demands of the twenty-first century, and the Committee also

recognizes that both short-term and long-term solutions are required to meet this

challenge.  The Committee understands that investment in our energy infrastructure has

not kept pace with the nation's needs.  In light of this, the Committee believes it is

appropriate to reduce the recovery period for investment in certain energy infrastructure

property to encourage investment in such property."

However, supporters of the proposal to repeal the reduced recovery period argue that the

nation's energy policy should be focused not just on modernization but on increased energy

supply, and that incentives for investment should therefore be offered to suppliers rather than

distributors.   This argument suggests that the reduced recovery period should be repealed in

favor of incentives for energy production and energy efficiency.

Proponents also argue that the shorter recovery period unfairly benefits gas utilities over

competitors such as electric utilities.   This argument raises two primary questions.  The first

question is whether it is accurate that the 15-year and 20-year recovery periods for gas utilities

and electric utilities, respectively, favor investment in gas distribution lines over electric

distribution lines.  The second question is, if so, whether there is a policy justification for doing

so.

The first question is one of neutrality, and requires analysis of the economic lives of the

properties whose recovery periods are being compared.  Conforming the recovery period of a

property as closely as possible to the economic life of the property results in a more accurate

measure of economic income derived from such property.  Additionally, to the extent that the

depreciation schedules of other property are designed to accurately measure economic

depreciation, a depreciation schedule for an asset class that deviates from economic depreciation

may distort investment decisions.  If the depreciation schedule provides for faster cost recovery

than economic depreciation, an incentive is created to invest in such assets relative to other

assets.  Similarly, if the depreciation schedule provides for slower cost recovery than economic

depreciation, a disincentive to invest in such assets is created.  If the depreciation schedules

uniformly match economic depreciation, the depreciation system will be generally neutral as to

the choice of investment across asset classes.  Such neutrality promotes economically efficient

investment choices by helping to insure that investments with the highest post-tax return (the

return that the investor cares about) are also those with the highest pre-tax return (the measure of

the value of the investment to society).  Thus, the 15-year recovery period for gas distribution

lines creates an advantage for gas distributors over electric utilities only if it is shorter than the

economic life of the gas distribution lines to a greater degree than the 20-year recovery period for

electric utility lines is shorter than their economic life. 

The relationship between the economic lives of gas distribution lines and electric utility

lines is unclear and would require an empirical study to determine.  As part of the Tax and Trade

Relief Extension Act of 1998,  Congress directed the Secretary of the Treasury to conduct a

study of recovery periods and depreciation methods, in part due to concerns that present-law

depreciation rules may create competitive disadvantages such as the one which could be asserted

with respect to gas and electric utilities.   In the resulting report, Treasury cited time, cost, and

difficulty as reasons not to address the recovery periods of specific assets as part of a study of the

overall depreciation system:

"Resolution of the issue of how well the current recovery periods and methods

reflect useful lives and economic depreciation rates would involve detailed empirical

studies and years of analysis.  In addition, the data required for this analysis would be

costly and difficult to obtain."

While the time, cost, and difficulty of empirically studying the economic lives of all

assets makes doing so impractical, addressing individual assets such as those used in the electric

and gas utility industries would be feasible.  

The question of whether a policy justification exists for providing an incentive to invest

in gas distribution lines rather than electric utility lines is primarily one of efficiency.  On one

hand, it could be argued that such an incentive is inappropriate policy because it reduces the

efficiency of the market, making it less likely to steer consumption decisions toward the least

expensive energy sources.  However, it could also be argued that an incentive to invest in gas

distribution lines overcomes an existing market inefficiency.  While certain household appliances

and systems can be operated using gas or electric energy, many others require only electricity

(e.g., a microwave oven).  Thus, electric utilities are likely to be offered to every residential

consumer while not all of those consumers are also offered the option of natural gas.  An

incentive to invest in gas distribution lines may result in more customers having the option to

choose between gas and electric energy, allowing them to efficiently choose household

appliances according to cost and performance.  This would also promote increased competition

among energy sources, forcing producers and distributors to become more efficient.

Prior Action

No prior action.

 

 

B.    Modify Amortization for Certain Geological and Geophysical Expenditures

Present Law

Geological and geophysical expenditures ("G&G costs") are costs incurred by a taxpayer

for the purpose of obtaining and accumulating data that will serve as the basis for the acquisition

and retention of mineral properties by taxpayers exploring for minerals.  G&G costs incurred in

connection with oil and gas exploration in the United States may be amortized over two years

(sec. 167(h)).  In the case of property abandoned during the two year period, no abandonment

loss deduction for G&G costs is allowed.  G&G costs associated with abandoned property

continue to be recovered over the two-year amortization period.

Description of Proposal

The proposal establishes a five-year amortization period for G&G costs incurred in

connection with oil and gas exploration in the United States.  The five-year amortization period

applies even if the property to which the G&G costs relate is abandoned, and any remaining

unamortized G&G costs associated with the abandoned property are recovered over the

remainder of the five-year period.

Effective date.–The proposal is effective for G&G costs paid or incurred in taxable years

beginning after December 31, 2006.

Analysis

Prior to the enactment of the two-year amortization period for G&G costs such costs were

treated as capital expenditures deductible over the useful life of the property to which they

related.  In the event the G&G costs associated with a particular area of interest did not result in

the acquisition or retention of property, the entire amount of the G&G costs allocable to the area

of interest was deductible as a loss under section 165 for the taxable year in which such area of

interest was abandoned as a potential source of mineral production.

As part of the Energy Policy Act of 2005, the amortization period for G&G costs was

fixed at two years, regardless of whether such costs resulted in the acquisition or abandonment of

any property.  While this simplified the process for recovering G&G costs, it also had the result

of extending the recovery period for G&G costs associated with abandoned property.  On

average, however, the two-year amortization period accelerated the recovery of G&G costs. 

Having a more rapid recovery period was intended to foster increased exploration for sources of

oil and natural gas within the United States.

Extending the recovery period for domestic G&G costs from two to five years increases

the after-tax costs associated with oil and gas exploration in the United States and thus reduces

the incentive to engage in such activities.  Proponents of the proposal believe that high energy

prices are already providing sufficient incentives for companies to invest in oil and gas

exploration.  While a five year amortization period may more closely match the useful life of

property acquired for mineral production as a result of the geological and geophysical

expenditures, the longer amortization period also increases the difference between the assumed

life of the asset for tax purposes versus its actual economic life, in cases where property is

abandoned.   

Prior Action

The Tax Relief Act of 2005 contains a provision that would require certain large

integrated oil companies to amortize their G&G costs over the useful life of the property to

which those costs relate.

 

 

VIII.      EXPIRING PROVISIONS

A.    Extend Alternative Minimum Tax Relief for Individuals

Present Law

The alternative minimum tax is the amount by which the tentative minimum tax exceeds

the regular income tax.  An individual's tentative minimum tax is the sum of (1) 26 percent of so

much of the taxable excess as does not exceed $175,000 ($87,500 in the case of a married

individual filing a separate return) and (2) 28 percent of the remaining taxable excess.  The

taxable excess is so much of the alternative minimum taxable income ("AMTI") as exceeds the

exemption amount.  The maximum tax rates on net capital gain and dividends used in computing

the regular tax are used in computing the tentative minimum tax.  AMTI is the individual's

taxable income adjusted to take account of specified preferences and adjustments.

The exemption amount is: (1) $45,000 ($58,000 for taxable years beginning after 2002

and before 2006) in the case of married individuals filing a joint return and surviving spouses;

(2) $33,750 ($40,250 for taxable years beginning before 2006) in the case of other unmarried

individuals; (3) $22,500 ($29,000 for taxable years beginning after 2002 and before 2006) in the

case of married individuals filing a separate return; and (4) $22,500 in the case of an estate or

trust.  The exemption amount is phased out by an amount equal to 25 percent of the amount by

which the individual's AMTI exceeds (1) $150,000 in the case of married individuals filing a

joint return and surviving spouses, (2) $112,500 in the case of other unmarried individuals, and

(3) $75,000 in the case of married individuals filing separate returns, an estate, or a trust.  These

amounts are not indexed for inflation.

Present law provides for certain nonrefundable personal tax credits (i.e., the dependent

care credit, the credit for the elderly and disabled, the adoption credit, the child tax credit, the

credit for interest on certain home mortgages, the HOPE Scholarship and Lifetime Learning

credits, the credit for savers, the credit for certain nonbusiness energy property, the credit for

residential energy efficient property, and the D.C. first-time homebuyer credit).   In addition, the

Energy Tax Incentives Act of 2005 enacted, effective for 2006, nonrefundable tax credits for

alternative motor vehicles, and alternative motor vehicle refueling property.

For taxable years beginning in 2005, the nonrefundable personal credits are allowed to

the extent of the full amount of the individual's regular tax and alternative minimum tax.

For taxable years beginning after 2005, the nonrefundable personal credits (other than the

adoption credit, child credit and saver's credit) are allowed only to the extent that the individual's

regular income tax liability exceeds the individual's tentative minimum tax, determined without

regard to the minimum tax foreign tax credit.  The adoption credit, child credit, and saver's credit

are allowed to the full extent of the individual's regular tax and alternative minimum tax.  

Description of Proposal

The proposal extends the higher individual AMT exemption amounts ($58,000, $40,250,

and $29,000) through 2006.

For 2006, the proposal allows an individual to offset the entire regular tax liability and

alternative minimum tax liability by the nonrefundable personal credits.

Effective date.–The proposal is effective for taxable years beginning in 2006.

Analysis

Allowing the nonrefundable personal credits to offset the regular tax and alternative

minimum tax, and increasing the exemption amounts results in significant simplification. 

Substantially fewer taxpayers need to complete the alternative minimum tax form (Form 6251),

and the forms and worksheets relating to the various credits can be simplified.

Congress, in legislation relating to expiring provisions in recent years, has determined

that allowing these credits to fully offset the regular tax and alternative minimum tax does not

undermine the policy of the individual alternative minimum tax and promotes the important

social policies underlying each of the credits.

Congress also has temporarily increased the exemption amount in recent years to limit

the impact of the AMT.

The following example compares the effect of not extending minimum tax relief with the

effect of the proposal extending minimum tax relief:

Example.–Assume in 2006, a married couple has an adjusted gross income of $80,000,

they do not itemize deductions, and they have four dependent children, two of whom are eligible

for the child tax credit and two of whom are eligible for a combined $3,000 HOPE Scholarship

credit.  The couple's net tax liability (without and with an extension) is shown in Table 1.

 

Table 1.–Comparison of Individual Tax Liability, Without

and With Extension of Rules, 2006

 

 

Present Law

(Without

Extension)

Proposal

(With

Extension)

Adjusted gross income

$80,000

$80,000

Less standard deduction1

10,300

10,300

Less personal exemptions (6 @ $3,300)

19,800

19,800

Taxable income

49,900

49,900

Regular tax

6,730

6,730

Tentative minimum tax

9,100

5,720

HOPE Scholarship credit before tax limitation

3,000

3,000

HOPE credit after tax limitation

0

3,000

Child tax credit

2,000

2,000

Net tax (greater of tentative minimum tax or

regular tax, less allowable credits)

      7,100

      1,730

Net tax reduction due to extension of provisions

 

5,370

 

1  This example assumes the taxpayers claim the standard deduction and have no itemized

      deductions (other than taxes and miscellaneous itemized deductions).

Prior Action

A similar proposal was included in the President's fiscal year 2004 and 2005 budget

proposals.

H.R. 4297, as passed by the House (the "Tax Relief Extension Reconciliation Act of

2005") and H.R. 4297, as amended by the Senate (the "Tax Relief Act of 2005"), both extend the

use of the nonrefundable personal credits against the AMT for 2006.

H.R. 4096, as passed by the House (the "Stealth Tax Act of 2005"), extends the 2005

AMT exemption amounts for 2006 and indexes the amounts for inflation.  H.R. 4297, as

amended by the Senate (the "Tax Relief Act of 2005"), increases the AMT exemption amounts

for 2006 to $62,550 for joint returns, to $42,500 for unmarried taxpayers, and to $31,275 for

separate returns.

 

 

 

 

B.      Permanently Extend the Research and Experimentation

("R&E") Tax Credit

Present Law

General rule

Prior to January 1, 2006, a taxpayer could claim a research credit equal to 20 percent of

the amount by which the taxpayer's qualified research expenses for a taxable year exceeded its

base amount for that year.   Thus, the research credit was generally available with respect to

incremental increases in qualified research.

A 20-percent research tax credit was also available with respect to the excess of (1) 100

percent of corporate cash expenses (including grants or contributions) paid for basic research

conducted by universities (and certain nonprofit scientific research organizations) over (2) the

sum of (a) the greater of two minimum basic research floors plus (b) an amount reflecting any

decrease in nonresearch giving to universities by the corporation as compared to such giving

during a fixed-base period, as adjusted for inflation.  This separate credit computation was

commonly referred to as the university basic research credit (see sec. 41(e)).

Finally, a research credit was available for a taxpayer's expenditures on research

undertaken by an energy research consortium.  This separate credit computation was commonly

referred to as the energy research credit.  Unlike the other research credits, the energy research

credit applied to all qualified expenditures, not just those in excess of a base amount.

The research credit, including the university basic research credit and the energy research

credit, expired on December 31, 2005.

Computation of allowable credit

Except for energy research payments and certain university basic research payments

made by corporations, the research tax credit applied only to the extent that the taxpayer's

qualified research expenses for the current taxable year exceeded its base amount.  The base

amount for the current year generally was computed by multiplying the taxpayer's fixed-base

percentage by the average amount of the taxpayer's gross receipts for the four preceding years. 

If a taxpayer both incurred qualified research expenses and had gross receipts during each of at

least three years from 1984 through 1988, then its fixed-base percentage was the ratio that its

total qualified research expenses for the 1984-1988 period bore to its total gross receipts for that

period (subject to a maximum fixed-base percentage of 16 percent).  All other taxpayers (so-

called start-up firms) were assigned a fixed-base percentage of three percent.  

In computing the credit, a taxpayer's base amount could not be less than 50 percent of its

current-year qualified research expenses.

To prevent artificial increases in research expenditures by shifting expenditures among

commonly controlled or otherwise related entities, a special aggregation rule provided that all

members of the same controlled group of corporations were treated as a single taxpayer (sec.

41(f)(1)).  Under regulations prescribed by the Secretary, special rules applied for computing the

credit when a major portion of a trade or business (or unit thereof) changed hands, under which

qualified research expenses and gross receipts for periods prior to the change of ownership of a

trade or business were treated as transferred with the trade or business that gave rise to those

expenses and receipts for purposes of recomputing a taxpayer's fixed-base percentage (sec.

41(f)(3)).

Alternative incremental research credit regime

Taxpayers were allowed to elect an alternative incremental research credit regime.   If a

taxpayer elected to be subject to this alternative regime, the taxpayer was assigned a three-tiered

fixed-base percentage (that is lower than the fixed-base percentage otherwise applicable under

present law) and the credit rate likewise was reduced.  Under the alternative incremental credit

regime, a credit rate of 2.65 percent applied to the extent that a taxpayer's current-year research

expenses exceeded a base amount computed by using a fixed-base percentage of one percent

(i.e., the base amount equaled one percent of the taxpayer's average gross receipts for the four

preceding years) but did not exceed a base amount computed by using a fixed-base percentage of

1.5 percent.  A credit rate of 3.2 percent applied to the extent that a taxpayer's current-year

research expenses exceeded a base amount computed by using a fixed-base percentage of 1.5

percent but did not exceed a base amount computed by using a fixed-base percentage of two

percent.  A credit rate of 3.75 percent applied to the extent that a taxpayer's current-year research

expenses exceeded a base amount computed by using a fixed-base percentage of two percent. 

An election to be subject to this alternative incremental credit regime could be made for any

taxable year beginning after June 30, 1996, and such an election applied to that taxable year and

all subsequent years unless revoked with the consent of the Secretary of the Treasury.

Eligible expenses

Qualified research expenses eligible for the research tax credit consisted of:  (1) in-house

expenses of the taxpayer for wages and supplies attributable to qualified research; (2) certain

time-sharing costs for computer use in qualified research; and (3) 65 percent of amounts paid or

incurred by the taxpayer to certain other persons for qualified research conducted on the

taxpayer's behalf (so-called contract research expenses).   Notwithstanding the limitation for

contract research expenses, qualified research expenses included 100 percent of amounts paid or

incurred by the taxpayer to an eligible small business, university, or Federal laboratory for

qualified energy research.

To be eligible for the credit, the research did not only have to satisfy the requirements of

present-law section 174 (described below) but also had to be undertaken for the purpose of

discovering information that is technological in nature, the application of which was intended to

be useful in the development of a new or improved business component of the taxpayer, and

substantially all of the activities of which had to constitute elements of a process of

experimentation for functional aspects, performance, reliability, or quality of a business

component.  Research did not qualify for the credit if substantially all of the activities related to

style, taste, cosmetic, or seasonal design factors (sec. 41(d)(3)).  In addition, research did not

qualify for the credit:  (1) if conducted after the beginning of commercial production of the

business component; (2) if related to the adaptation of an existing business component to a

particular customer's requirements; (3) if related to the duplication of an existing business

component from a physical examination of the component itself or certain other information; or

(4) if related to certain efficiency surveys, management function or technique, market research,

market testing, or market development, routine data collection or routine quality control (sec.

41(d)(4)).  Research did not qualify for the credit if it was conducted outside the United States,

Puerto Rico, or any U.S. possession.

Relation to deduction

Under section 174, taxpayers may elect to deduct currently the amount of certain research

or experimental expenditures paid or incurred in connection with a trade or business,

notwithstanding the general rule that business expenses to develop or create an asset that has a

useful life extending beyond the current year must be capitalized.   While the research credit

was in effect, however, deductions allowed to a taxpayer under section 174 (or any other section)

were reduced by an amount equal to 100 percent of the taxpayer's research tax credit determined

for the taxable year (Sec. 280C(c)).  Taxpayers could alternatively elect to claim a reduced

research tax credit amount (13 percent) under section 41 in lieu of reducing deductions otherwise

allowed (sec. 280C(c)(3)).

Description of Proposal

The research tax credit, excluding the energy research credit, is made permanent.

Effective date.–The proposal is effective for amounts paid or incurred after December 31,

2005.

Analysis

Overview

Technological development is an important component of economic growth.  However,

while an individual business may find it profitable to undertake some research, it may not find it

profitable to invest in research as much as it otherwise might because it is difficult to capture the

full benefits from the research and prevent such benefits from being used by competitors.  In

general, businesses acting in their own self-interest will not necessarily invest in research to the

extent that would be consistent with the best interests of the overall economy.  This is because

costly scientific and technological advances made by one firm are cheaply copied by its

competitors.  Research is one of the areas where there is a consensus among economists that

government intervention in the marketplace can improve overall economic efficiency.  

However, this does not mean that increased tax benefits or more government spending for

research always will improve economic efficiency.  It is possible to decrease economic

efficiency by spending too much on research.  However, there is evidence that the current level

of research undertaken in the United States, and worldwide, is too little to maximize society's

well-being.   Nevertheless, even if there were agreement that additional subsidies for research

are warranted as a general matter, misallocation of research dollars across competing sectors of

the economy could diminish economic efficiency. It is difficult to determine whether, at the

present levels and allocation of government subsidies for research, further government spending

on research or additional tax benefits for research would increase or decrease overall economic

efficiency.   

If it is believed that too little research is being undertaken, a tax subsidy is one method of

offsetting the private-market bias against research, so that research projects undertaken approach

the optimal level.  Among the other policies employed by the Federal Government to increase

the aggregate level of research activities are direct spending and grants, favorable anti-trust rules,

and patent protection.  The effect of tax policy on research activity is largely uncertain because

there is relatively little consensus regarding magnitude of the responsiveness of research to

changes in taxes and other factors affecting its price.  To the extent that research activities are

responsive to the price of research activities, the research and experimentation tax credit should

increase research activities beyond what they otherwise would be.  However, the pre-2006

research credit did create certain complexities and compliance costs.

Scope of research activities in the United States and abroad

In the United States, private for-profit enterprises and individuals, non-profit

organizations, and the public sector undertake research activities.  Total expenditures on research

and development in the United States are large, representing 2.6 percent of gross domestic

product in 2003.   This rate of expenditure on research and development exceeds that of the

European Union and the average of all countries that are members of the Organisation for

Economic Co-operation and Development ("OECD"), but is less than that of Japan.  See Figure

1, below.  In 2003, expenditures on research and development in the United States represented

42.1 percent of all expenditures on research and development undertaken by OECD countries,

were 37 percent greater than the total expenditures on research and development undertaken in

the European Union, and were more than two and one half times such expenditures in Japan.  

Expenditures on research and development in the United States have grown at an average real

rate of 2.7 percent over the period 1995-2003.  This rate of growth has exceeded that of France

(1.5 percent) and the United Kingdom (2.4 percent), and equaled that of Japan (2.7 percent), but

is less than that of Germany (2.9 percent), Italy (3.8 percent for the period 1995-2002), Canada

(5.0 percent), Ireland (6.7 percent for the period 1995-2002), and Spain (7.4 percent).  

 

 

Source: OECD, OECD Science, Technology and Industry Scoreboard, 2005.

Direct expenditures are not the only means by which governments subsidize research

activities.  A number of countries, in addition to the United States, provide tax benefits to

taxpayers who undertake research activities.  The OECD has attempted to quantify the relative

value of such tax benefits in different countries by creating an index that measures the total value

of tax benefits accorded research activities relative to simply permitting the expensing of all

qualifying research expenditures.  Table 2 below, reports the value of this index for selected

countries.  A value of zero would result if the only tax benefit a country offered to research

activities was the expensing of all qualifying research expenditures.  Negative values reflect tax

benefits less generous than expensing.  Positive values reflect tax benefits more generous than

expensing.  For example, in 2004 in the United States qualifying taxpayers could expense

research expenditures and, in certain circumstances claim the research and experimentation tax

credit.  The resulting index number for the United States is 0.066.

Table 2.-Index Number of Tax Benefits for Research Activities

in Selected Countries, 2005

Country

Index Number1

Italy

      -0.027

Germany

      -0.024

Ireland

      0.049

United States

      0.066

United Kingdom

      0.096

France

      0.134

Japan

      0.135

Canada

      0.173

Spain

      0.441

1  Index number reported is only that for "large firms."  Some countries have additional tax

benefits for research activities of "small" firms.

Source: OECD, OECD Science, Technology and Industry Scoreboard, 2005.

The scope of tax expenditures on research activities before the expiration of the research

credit

The tax expenditure related to the research and experimentation tax credit is estimated to

be $4.8 billion for 2005.  The related tax expenditure for expensing of research and development

expenditures was estimated to be $4.0 billion for 2005 growing to $6.3 billion for 2009.   As

noted above, the Federal Government also directly subsidizes research activities.  Direct

government outlays for research have substantially exceeded the annual estimated value of the

tax expenditure provided by either the research and experimentation tax credit or the expensing

of research and development expenditures.  For example, in fiscal 2005, the National Science

Foundation made $3.9 billion in grants, subsidies, and contributions to research activities, the

Department of Defense financed $11.8 billion  in basic research, applied research, and

advanced technology development, and the Department of Energy financed $0.7 billion in

research in high energy physics, $1.0 billion in basic research in the sciences, $0.6 billion in

biological and environmental research, and $226 million for research in advance scientific

computing.   However, such direct government outlays generally are for directed research on

projects selected by the government.  The research credit provides a subsidy to any qualified

project of an eligible taxpayer with no application to a grant-making agency required.  Projects

are chosen based on the taxpayer's assessment of future profit potential.

Table 3 and Table 4 present data for 2003 on those industries that utilized the research tax

credit and the distribution of the credit claimants by firm size.  In 2003, more than 15,500

taxpayers claimed more than $5.7 billion in research tax credits.   Taxpayers whose primary

activity is manufacturing claimed just over two-thirds of the research tax credits claimed.  Firms

with assets of $50 million or more claimed nearly 85 percent of the credits claimed. 

Nevertheless, as Table 3 documents, a large number of small firms are engaged in research and

were able to claim the research tax credit.

 

 

Table 3.–Percentage Distribution of Firms Claiming Research Tax Credit

and Percentage of Credit Claimed by Sector, 2003

Industry

Percent of

Corporations

Claiming Credit

Percent of

Total

R & E Credit

Manufacturing

47.65

68.92

Information

7.79

11.56

Professional, Scientific, and Technical

Services

30.61

10.21

Wholesale Trade

4.18

3.03

Finance and Insurance

2.05

1.73

Holding Companies

0.91

1.71

Retail Trade

1.26

0.66

Administrative and Support and Waste

Management and Remediation Services

0.57

0.55

Health Care and Social Services

0.43

0.52

Mining

0.15

0.32

Construction

0.20

0.20

Utilities

3.08

0.11

Agriculture, Forestry, Fishing and Hunting

0.43

0.09

Other Services

0.29

0.02

Arts, Entertainment, and Recreation

(1)

(1)

Accommodation and Food Services

(1)

(1)

Educational Services

(1)

(1)

Real Estate and Rental and Leasing

(1)

(1)

Transportation and Warehousing

(1)

(1)

Wholesale and Retail Trade not Allocable

(1)

(1)

Not Allocable

(1)

(1)

1  Data undisclosed to protect taxpayer confidentiality.

 

Source:  Joint Committee on Taxation calculations from Internal Revenue Service, Statistics of Income data.

Table 4.–Percentage Distribution of Firms Claiming Research Tax Credit

and of Amount of Credit Claimed by Firm Size, 2002

Asset Size ($)

Percent of Firms

Claiming Credit

Percent of

Credit Claimed

0

1.27

0.29

1 to 99,999

17.58

0.36

100,000 to 249,999

4.85

0.22

250,000 to 499,999

2.70

0.22

500,000 to 999,999

7.61

0.48

1,000,000 to 9,999,999

34.86

5.48

10,000,000 to 49,999,999

16.51

6.86

50,000,000 +

14.62

85.49

Note:  Totals may not add to 100 percent due to rounding.

Source:  Joint Committee on Taxation calculations from Internal Revenue Service, Statistics of Income data.

Flat or incremental tax credits?

For a tax credit to be effective in increasing a taxpayer's research expenditures it is not

necessary to provide that credit for all the taxpayer's research expenditures (i.e., a flat credit). 

By limiting the credit to expenditures above a base amount, incremental tax credits attempt to

target the tax incentives where they will have the most effect on taxpayer behavior.

Suppose, for example, a taxpayer is considering two potential research projects: Project A

will generate cash flow with a present value of $105 and Project B will generate cash flow with a

present value of $95.  Suppose that the research cost of investing in each of these projects is

$100.  Without any tax incentives, the taxpayer will find it profitable to invest in Project A and

will not invest in Project B.

Consider now the situation where a 10-percent flat credit applies to all research

expenditures incurred.  In the case of Project A, the credit effectively reduces the cost to $90. 

This increases profitability, but does not change behavior with respect to that project, since it

would have been undertaken in any event.  However, because the cost of Project B also is

reduced to $90, this previously neglected project (with a present value of $95) would now be

profitable.  Thus, the tax credit would affect behavior only with respect to this marginal project.

Incremental credits attempt not to reward projects that would have been undertaken in

any event but to target incentives to marginal projects.  To the extent this is possible, incremental

credits have the potential to be far more effective per dollar of revenue cost than flat credits in

inducing taxpayers to increase qualified expenditures.  In the example above, if an incremental

credit were properly targeted, the Government could spend the same $20 in credit dollars and

induce the taxpayer to undertake a marginal project so long as its expected cash flow exceeded

$80.  Unfortunately, it is nearly impossible as a practical matter to determine which particular

projects would be undertaken without a credit and to provide credits only to other projects.  In

practice, almost all incremental credit proposals rely on some measure of the taxpayer's previous

experience as a proxy for a taxpayer's total qualified expenditures in the absence of a credit. 

This is referred to as the credit's base amount.  Tax credits are provided only for amounts above

this base amount.

Since a taxpayer's calculated base amount is only an approximation of what would have

been spent in the absence of a credit, in practice, the credit may be less effective per dollar of

revenue cost than it otherwise might be in increasing expenditures.  If the calculated base amount

is too low, the credit is awarded to projects that would have been undertaken even in the absence

of a credit.  If, on the other hand, the calculated base amount is too high, then there is no

incentive for projects that actually are on the margin.

Nevertheless, the incentive effects of incremental credits per dollar of revenue loss can be

many times larger than those of a flat credit.  However, in comparing a flat credit to an

incremental credit, there are other factors that also deserve consideration.  A flat credit generally

has lower administrative and compliance costs than does an incremental credit.  Probably more

important, however, is the potential misallocation of resources and unfair competition that could

result as firms with qualified expenditures determined to be above their base amount receive

credit dollars, while other firms with qualified expenditures considered below their base amount

receive no credit.

The responsiveness of research expenditures to tax incentives

Like any other commodity, the amount of research expenditures that a firm wishes to

incur generally is expected to respond positively to a reduction in the price paid by the firm. 

Economists often refer to this responsiveness in terms of price elasticity, which is measured as

the ratio of the percentage change in quantity to a percentage change in price.  For example, if

demand for a product increases by five percent as a result of a 10-percent decline in price paid by

the purchaser, that commodity is said to have a price elasticity of demand of 0.5.   One way of

reducing the price paid by a buyer for a commodity is to grant a tax credit upon purchase.  A tax

credit of 10 percent (if it is refundable or immediately usable by the taxpayer against current tax

liability) is equivalent to a 10-percent price reduction.  If the commodity granted a 10-percent tax

credit has an elasticity of 0.5, the amount consumed will increase by five percent.  Thus, if a flat

research tax credit were provided at a 10-percent rate, and research expenditures had a price

elasticity of 0.5, the credit would increase aggregate research spending by five percent.  

Despite the central role of the measurement of the price elasticity of research activities,

the empirical evidence on this subject has yielded quantitative measures of the response of

research spending to tax incentives.  While all published studies report that the research credit

induced increases in research spending, early evidence generally indicated that the price

elasticity for research is substantially less than one.  For example, one early survey of the

literature reached the following conclusion:

In summary, most of the models have estimated long-run price elasticities of

demand for R&D on the order of -0.2 and -0.5. . . . However, all of the

measurements are prone to aggregation problems and measurement errors in

explanatory variables.  

If it took time for taxpayers to learn about the credit and what sort of expenditures

qualified, taxpayers may have only gradually adjusted their behavior.  Such a learning curve

might explain a modest measured behavioral effect.

A more recent survey of the literature on the effect of the tax credit suggests a stronger

behavioral response, although most analysts agree that there is substantial uncertainty in these

estimates.

[W]ork using US firm-level data all reaches the same conclusion:  the tax price

elasticity of total R&D spending during the 1980s is on the order of unity, maybe

higher. …  Thus there is little doubt about the story that the firm-level publicly

reported R&D data tell:  the R&D tax credit produces roughly a dollar-for-dollar

increase in reported R&D spending on the margin.  

However this survey notes that most of this evidence is not drawn directly from tax data. 

For example, effective marginal tax credit rates are inferred from publicly reported financial data

and may not reflect limitations imposed by operating losses or the alternative minimum tax.  The

study notes that because most studies rely on "reported research expenditures" that a "relabelling

problem" may exist whereby a preferential tax treatment for an activity gives firms an incentive

to classify expenditures as qualifying expenditures.  If this occurs, reported expenditures increase

in response to the tax incentive by more than the underlying real economic activity.  Thus,

reported estimates may overestimate the true response of research spending to the tax credit.

Apparently there have been no specific studies of the effectiveness of the university basic

research tax credit.

Other policy issues related to the research and experimentation credit

Perhaps the greatest criticism of the research and experimentation tax credit among

taxpayers regards its temporary nature.  Research projects frequently span years.  If a taxpayer

considers an incremental research project, the lack of certainty regarding the availability of

future credits increases the financial risk of the expenditure.  A credit of longer duration may

more successfully induce additional research than would a temporary credit, even if the

temporary credit is periodically renewed.

An incremental credit does not provide an incentive for all firms undertaking qualified

research expenditures.  Many firms have current-year qualified expenditures below the base

amount.  These firms receive no tax credit and have an effective rate of credit of zero.  Although

there is no revenue cost associated with firms with qualified expenditures below base, there may

be a distortion in the allocation of resources as a result of these uneven incentives.

If a firm has no current tax liability, or if the firm is subject to the alternative minimum

tax ("AMT") or the general business credit limitation, the research credit must be carried forward

for use against future-year tax liabilities.  The inability to use a tax credit immediately reduces its

present value according to the length of time between when it actually is earned and the time it

actually is used to reduce tax liability.

Under pre-2006 law, firms with research expenditures substantially in excess of their

base amount could be subject to the 50-percent base amount limitation.  In general, although

these firms received the largest amount of credit when measured as a percentage of their total

qualified research expenses, their marginal effective rate of credit was exactly one half of the

statutory credit rate of 20 percent (i.e., firms subject to the base limitation effectively are

governed by a 10-percent credit rate).

Although the statutory rate of the research credit was 20 percent, it is likely that the

average marginal effective rate may be substantially below 20 percent.  Reasonable assumptions

about the frequency that firms were subject to various limitations discussed above yield

estimates of an average effective rate of credit between 25 and 40 percent below the statutory

rate, i.e., between 12 and 15 percent.

Since sales growth over a long time frame will rarely track research growth, it can be

expected that over time each firm's base will drift from the firm's actual current qualified

research expenditures.  Therefore, if the research credit were made permanent, increasingly over

time there would be a larger number of firms either substantially above or below their calculated

base.  This could gradually create an undesirable situation where many firms would receive no

credit and have no reasonable prospect of ever receiving a credit, while other firms would

receive large credits (despite the 50-percent base amount limitation).  Thus, over time, it can be

expected that, for those firms eligible for the credit, the average marginal effective rate of credit

would decline while the revenue cost to the Federal Government increased.

As explained above, because costly scientific and technological advances made by one

firm may often be cheaply copied by its competitors, research is one of the areas where there is a

consensus among economists that government intervention in the marketplace, such as the

subsidy of the research tax credit, can improve overall economic efficiency.  This rationale

suggests that the problem of a socially inadequate amount of research is not more likely in some

industries than in other industries, but rather it is an economy-wide problem.  The basic

economic rationale argues that a subsidy to reduce the cost of research should be equally applied

across all sectors.  As described above, prior to the expiration of the research credit, the Energy

Tax Incentives Act of 2005 had provided that energy related research undertaken by certain

energy research consortia receive a greater tax subsidy than other research.  Some argue that it

makes the tax subsidy to research inefficient by biasing the choice of research projects.  They

argue that an energy related research project could be funded by the taxpayer in lieu of some

other project that would offer a higher rate of return absent the more favorable tax credit for the

energy related project.  In addition, taxpayers may have an incentive to enter into such research

consortia without the additional tax benefit because a research consortia potentially reduces the

cost of all participants by eliminating duplication of effort.  Proponents of the differential

treatment for energy related research argue that broader policy concerns such as promoting

energy independence justify creating a bias in favor of energy related research.  The President's

budget proposal would not extend the special energy credit.  It would provide that energy related

research be treated equivalently to any other proposed research under the tax credit.

Complexity and the research tax credit

Administrative and compliance burdens also resulted from the research tax credit.  The

General Accounting Office ("GAO") has testified that the research tax credit had been difficult

for the IRS to administer.  The GAO reported that the IRS states that it is required to make

difficult technical judgments in audits concerning whether research was directed to produce truly

innovative products or processes.  While the IRS employs engineers in such audits, the

companies engaged in the research typically employ personnel with greater technical expertise

and, as would be expected, personnel with greater expertise regarding the intended application of

the specific research conducted by the company under audit.  Such audits create a burden for

both the IRS and taxpayers.  The credit generally requires taxpayers to maintain records more

detailed than those necessary to support the deduction of research expenses under section 174.  

An executive in a large technology company has identified the research credit as one of the most

significant areas of complexity for his firm.  He summarizes the problem as follows.

Tax incentives such as the R&D tax credit … typically pose compliance

challenges, because they incorporate tax-only concepts that may be only

tenuously linked to financial accounting principles or to the classifications used

by the company's operational units. … [I]s what the company calls "research and

development" the same as the "qualified research" eligible for the R&D tax credit

under I.R.C. Section 41?  The extent of any deviation in those terms is in large

part the measure of the compliance costs associated with the tax credit.

Prior Action

The President's budget proposals for fiscal years 2003 through 2006 contained an

identical provision.

H.R. 4297, as passed by the House (the "Tax Relief Extension Reconciliation Act of

2005"), contains a one year extension of a modified research credit, effective retroactively to the

expiration of the research credit under present law.  H.R. 4297, as passed by the Senate ("the Tax

Relief Act of 2005"), also contains a two year extension of a modified research credit.

 

 

C.    Extend and Modify the Work Opportunity Tax Credit

and Welfare-to-Work Tax Credit

Present Law

Work opportunity tax credit

Targeted groups eligible for the credit

The work opportunity tax credit is available on an elective basis for employers hiring

individuals from one or more of eight targeted groups.  The eight targeted groups are: (1) certain

families eligible to receive benefits under the Temporary Assistance for Needy Families

Program; (2) high-risk youth; (3) qualified ex-felons; (4) vocational rehabilitation referrals;

(5) qualified summer youth employees; (6) qualified veterans; (7) families receiving food

stamps; and (8) persons receiving certain Supplemental Security Income (SSI) benefits.

A qualified ex-felon is an individual certified as: (1) having been convicted of a felony

under State or Federal law; (2) being a member of an economically disadvantaged family; and

(3) having a hiring date within one year of release from prison or conviction.

The Katrina Emergency Tax Relief Act of 2005 created a new category of Hurricane

Katrina employees and provided special rules for their eligibility.

Qualified wages

Generally, qualified wages are defined as cash wages paid by the employer to a member

of a targeted group.  The employer's deduction for wages is reduced by the amount of the credit.

Calculation of the credit

The credit equals 40 percent (25 percent for employment of 400 hours or less) of

qualified first-year wages. Generally, qualified first-year wages are qualified wages (not in

excess of $6,000) attributable to service rendered by a member of a targeted group during the

one-year period beginning with the day the individual began work for the employer.  Therefore,

the maximum credit per employee is $2,400 (40 percent of the first $6,000 of qualified first-year

wages).  With respect to qualified summer youth employees, the maximum credit is $1,200 (40

percent of the first $3,000 of qualified first-year wages).

Minimum employment period

No credit is allowed for qualified wages paid to employees who work less than 120 hours

in the first year of employment.

Coordination of the work opportunity tax credit and the welfare-to-work tax credit

An employer cannot claim the work opportunity tax credit with respect to wages of any

employee on which the employer claims the welfare-to-work tax credit.

Other rules

The work opportunity tax credit is not allowed for wages paid to a relative or dependent

of the taxpayer.  Similarly wages paid to replacement workers during a strike or lockout are not

eligible for the work opportunity tax credit.  Wages paid to any employee during any period for

which the employer received on-the-job training program payments with respect to that

employee are not eligible for the work opportunity tax credit.  The work opportunity tax credit

generally is not allowed for wages paid to individuals who had previously been employed by the

employer.  In addition, many other technical rules apply.

Expiration date

The work opportunity tax credit is effective for wages paid or incurred to a qualified

individual who begins work for an employer before January 1, 2006.

Welfare-to-work tax credit

Targeted group eligible for the credit

The welfare-to-work tax credit is available on an elective basis to employers of qualified

long-term family assistance recipients.  Qualified long-term family assistance recipients are:

(1) members of a family that has received family assistance for at least 18 consecutive months

ending on the hiring date; (2) members of a family that has received such family assistance for a

total of at least 18 months (whether or not consecutive) after August 5, 1997 (the date of

enactment of the welfare-to-work tax credit) if they are hired within 2 years after the date that the

18-month total is reached; and (3) members of a family that is no longer eligible for family

assistance because of either Federal or State time limits, if they are hired within 2 years after the

Federal or State time limits made the family ineligible for family assistance.

Qualified wages

Qualified wages for purposes of the welfare-to-work tax credit are defined more broadly

than for the work opportunity tax credit.  Unlike the definition of wages for the work opportunity

tax credit which includes simply cash wages, the definition of wages for the welfare-to-work tax

credit includes cash wages paid to an employee plus amounts paid by the employer for:

(1) educational assistance excludable under a section 127 program (or that would be excludable

but for the expiration of sec. 127); (2) health plan coverage for the employee, but not more than

the applicable premium defined under section 4980B(f)(4); and (3) dependent care assistance

excludable under section 129.  The employer's deduction for wages is reduced by the amount of

the credit.

Calculation of the credit

The welfare-to-work tax credit is available on an elective basis to employers of qualified

long-term family assistance recipients during the first two years of employment.   The maximum

credit is 35 percent of the first $10,000 of qualified first-year wages and 50 percent of the first

$10,000 of qualified second-year wages. Qualified first-year wages are defined as qualified

wages (not in excess of $10,000) attributable to service rendered by a member of the targeted

group during the one-year period beginning with the day the individual began work for the

employer.  Qualified second-year wages are defined as qualified wages (not in excess of

$10,000) attributable to service rendered by a member of the targeted group during the one-year

period beginning immediately after the first year of that individual's employment for the

employer.  The maximum credit is $8,500 per qualified employee.

Minimum employment period

No credit is allowed for qualified wages paid to a member of the targeted group unless

they work at least 400 hours or 180 days in the first year of employment.

Coordination of the work opportunity tax credit and the welfare-to-work tax credit

An employer cannot claim the work opportunity tax credit with respect to wages of any

employee on which the employer claims the welfare-to-work tax credit.

Other rules

The welfare-to-work tax credit incorporates directly or by reference many of these other

rules contained on the work opportunity tax credit.

Expiration date

The welfare-to-work tax credit is effective for wages paid or incurred to a qualified

individual who begins work for an employer before January 1, 2006.

Description of Proposal

Combined credit

The proposal combines the work opportunity and welfare-to-work tax credits and extends

the combined credit for one year.

Targeted groups eligible for the combined credit

The combined credit is available for employers hiring individuals from one or more of all

nine targeted groups.  The welfare-to-work credit/long-term family assistance recipient is the

ninth targeted group.  The special rules for Hurricane Katrina employees are unchanged by the

proposal.

The proposal repeals the requirement that a qualified ex-felon be an individual certified

as a member of an economically disadvantaged family.

Qualified wages

Qualified first-year wages for the eight WOTC categories remain capped at $6,000

($3,000 for qualified summer youth employees).  No credit is allowed for second-year wages.  In

the case of long-term family assistance recipients the cap is $10,000 for both qualified first-year

wages and qualified second-year wages.  For purposes of the combined credit, qualified wages

are defined as cash wages paid by the employer to a member of a targeted group (not the broader

WWTC definition of wages).  Also, for all targeted groups, the employer's deduction for wages

is reduced by the amount of the credit.

Calculation of the credit

First-year wages.–For the eight WOTC categories, the credit equals 40 percent (25

percent for employment of 400 hours or less) of qualified first-year wages.  Generally, qualified

first-year wages are qualified wages (not in excess of $6,000) attributable to service rendered by

a member of a targeted group during the one-year period beginning with the day the individual

began work for the employer.  Therefore, the maximum credit per employee for members of any

of the eight WOTC targeted groups generally is $2,400 (40 percent of the first $6,000 of

qualified first-year wages).  With respect to qualified summer youth employees, the maximum

credit remains $1,200 (40 percent of the first $3,000 of qualified first-year wages).  For the

welfare-to-work/long-term family assistance recipients, the maximum credit equals $4,000 per

employee (40 percent of $10,000 of wages).

Second-year wages.–In the case of long-term family assistance recipients the maximum

credit is $5,000 (50 percent of the first $10,000 of qualified second-year wages).

Minimum employment period

No credit is allowed for qualified wages paid to employees who work less than 120 hours

in the first year of employment.

Coordination of the work opportunity tax credit and the welfare-to-work tax credit

Coordination is no longer necessary once the two credits are combined

Effective date.–The proposal is effective for wages paid or incurred to a qualified

individual who begins work for an employer after December 31, 2005 and before January 1,

2007.

Analysis

Overview of policy issues

The WOTC and WWTC are intended to increase the employment and earnings of their

targeted group members, respectively.  The credits are made available to employers as an

incentive to hire members of the targeted groups.  To the extent the value of the credits is passed

on from employers to employees, the wages of target group employees will be higher than they

would be in the absence of the credit.

The rationale for the WOTC and WWTC is that employers will not hire certain

individuals without a subsidy, because either the individuals are stigmatized (e.g., convicted

felons) or the current productivity of the individuals is below the prevailing wage rate.  Where

particular groups of individuals suffer reduced evaluations of work potential due to membership

in one of the targeted groups, the credits may provide employers with a monetary offset for the

lower perceived work potential.  In these cases, employers may be encouraged to hire individuals

from the targeted groups, and then make an evaluation of the individual's work potential in the

context of the work environment, rather than from the job application.  Where the current

productivity of individuals is currently below the prevailing wage rate, on-the-job-training may

provide individuals with skills that will enhance their productivity.  In these situations, the

WOTC and WWTC provides employers with a monetary incentive to bear the costs of training

members of targeted groups and providing them with job-related skills which may increase the

chances of these individuals being hired in unsubsidized jobs.  Both situations encourage

employment of members of the targeted groups, and may act to increase wages for those hired as

a result of the credit.

As discussed below, the evidence is mixed on whether the rationales for the WOTC are

supported by economic data.  The information presented is intended to provide a structured way

to determine if employers and employees respond to the existence of the WOTC in the desired

manner.  A similar analysis may be appropriate for the WWTC.

Efficiency of the WOTC

The WOTC provides employers with a subsidy for hiring members of targeted groups. 

For example, assume that a worker eligible for the credit is paid an hourly wage of w and works

2,000 hours during the year.  The worker is eligible for the full credit (40 percent of the first

$6,000 of wages), and the firm will receive a $2,400 credit against its income taxes and reduce

its deduction for wages by $2,400.  Assuming the firm faces the full 35-percent corporate income

tax rate, the cost of hiring the credit-eligible worker is lower than the cost of hiring a credit-

ineligible worker for 2,000 hours at the same hourly wage w by 2,400 (1-.35) = $1,560.   This

$1,560 amount would be constant for all workers unless the wage (w) changed in response to

whether or not the individual was a member of a targeted group.  If the wage rate does not

change in response to credit eligibility, the WOTC subsidy is larger in percentage terms for

lower wage workers.  If w rises in response to the credit, it is uncertain how much of the subsidy

remains with the employer, and therefore the size of the WOTC subsidy to employers is

uncertain.

To the extent the WOTC subsidy flows through to the workers eligible for the credit in

the form of higher wages, the incentive for eligible individuals to enter the paid labor market

may increase.  Since many members of the targeted groups receive governmental assistance

(e.g., Temporary Assistance for Needy Families or food stamps), and these benefits are phased

out as income increases, these individuals potentially face a very high marginal tax rate on

additional earnings.  Increased wages resulting from the WOTC may be viewed as a partial offset

to these high marginal tax rates.  In addition, it may be the case that even if the credit has little

effect on observed wages, credit-eligible individuals may have increased earnings due to

increased employment.

The structure of the WOTC (the 40-percent credit rate for the first $6,000 of qualified

wages) appears to lend itself to the potential of employers churning employees who are eligible

for the credit.  This could be accomplished by firing employees after they earn $6,000 in wages

and replacing them with other WOTC-eligible employees.  If training costs are high relative to

the size of the credit, it may not be in the interest of an employer to churn such employees in

order to maximize the amount of credit claimed.  Empirical research in this area has not found an

explicit connection between employee turnover and utilization of WOTC's predecessor, the

Targeted Jobs Tax Credit ("TJTC").

Job creation

The number of jobs created by the WOTC is certainly less than the number of

certifications.  To the extent employers substitute WOTC-eligible individuals for other potential

workers, there is no net increase in jobs created.  This could be viewed as merely a shift in

employment opportunities from one group to another.  However, this substitution of credit-

eligible workers for others may not be socially undesirable.  For example, it might be considered

an acceptable trade-off for a targeted group member to displace a secondary earner from a well-

to-do family (e.g., a spouse or student working part-time).

In addition, windfall gains to employers or employees may accrue when the WOTC is

received for workers that the firm would have hired even in the absence of the credit.  When

windfall gains are received, no additional employment has been generated by the credit. 

Empirical research on the employment gains from the TJTC has indicated that only a small

portion of the TJTC-eligible population found employment because of the program.  One study

indicates that net new job creation was between five and 30 percent of the total certifications. 

This finding is consistent with some additional employment as a result of the TJTC program, but

with considerable uncertainty as to the exact magnitude.

A necessary condition for the credit to be an effective employment incentive is that firms

incorporate WOTC eligibility into their hiring decisions.  This could be done by determining

credit eligibility for each potential employee or by making a concerted effort to hire individuals

from segments of the population likely to include members of targeted groups.  Studies

examining this issue through the TJTC found that some employers made such efforts, while

other employers did little to determine eligibility for the TJTC prior to the decision to hire an

individual.   In these latter cases, the TJTC provided a cash benefit to the firm, without

affecting the decision to hire a particular worker.

Complexity issues

Extension of the provisions for one year even in a modified form provides some

continuity (especially in the case of the eight WOTC categories) and simplifies tax planning

during that period for taxpayers and practitioners.  Some argue that a permanent extension will

have a greater stabilizing effect on the tax law.  They point out that temporary expirations, like

the current one, not only complicate tax planning but also deter some taxpayers from

participating in the program.  Others who are skeptical of the efficacy of the WOTC and WWTC

programs argue that not extending the credits could eliminate a windfall benefit to certain

taxpayers and permanently reduce complexity in the Code.  

The partial combining of the WOTC and the WWTC will provide some simplification

benefits, particularly with respect to limiting the WWTC to the WOTC cash-only definition of

wages.  Allowing the WWTC to use the WOTC minimum employment periods is likely to

provide limited simplification since it expands the eligibility for the WWTC.  The failure to fully

combine the two credits (e.g., by maintaining the larger cap on eligible first year wages for the

WWTC, and maintaining the second-year benefit under the WWTC) essentially means that two

separate credits remain in effect which limits the simplification benefits under the proposal.

Prior Action

Separate proposals to extend the two credits without combining them were included in

the President's fiscal year 2002 and 2003 budget proposals.   A similar proposal was included

in the President's fiscal year 2004, 2005, and 2006 budget proposals.

Similar provisions are contained in H.R. 4297, "the Tax Relief Extension Reconciliation

Act of 2005" as passed by the House and H.R. 4297, the "Tax Relief Act of 2005," as amended

by the Senate.

The Tax Relief Extension Reconciliation Act of 2005 as passed by the House separately

extends the work opportunity credit and the welfare-to-work tax credits for one year (through

December 31, 2006).  Also, the House bill raises the maximum age limit for the WOTC food

stamp recipient category to include individuals who are at least age 18 but under age 35 on the

hiring date.

The "Tax Relief Act of 2005," as amended by the Senate combines the work opportunity

and welfare-to-work tax credits and extends the combined credit for one year.  The welfare-to-

work credit is repealed.  The combined credit is available on an elective basis for employers

hiring individuals from one or more of all nine targeted groups.  The nine targeted groups are the

present-law eight groups with the addition of the welfare-to-work credit/long-term family

assistance recipient as the ninth targeted group.  Also, the "Tax Relief Act of 2005," as amended

by the Senate on February 2, 2006: (1) raises the age limit for the high-risk youth category to

include individuals aged 18 but not aged 40 on the hiring date; (2) renames the high-risk youth

category to be the designated community resident category; (3) repeals the requirement that a

qualified ex-felon be an individual certified as a member of an economically disadvantaged

family; and (4) raises the age limit for the food stamp recipient category to include individuals

aged 18 but not aged 40 on the hiring date.

 

 

 

D.    Extend District of Columbia Homebuyer Tax Credit

Present Law

First-time homebuyers of a principal residence in the District of Columbia are eligible for

a nonrefundable tax credit of up to $5,000 of the amount of the purchase price.  The $5,000

maximum credit applies both to individuals and married couples.  Married individuals filing

separately can claim a maximum credit of $2,500 each.  The credit phases out for individual

taxpayers with adjusted gross income between $70,000 and $90,000 ($110,000-$130,000 for

joint filers).  For purposes of eligibility, "first-time homebuyer" means any individual if such

individual did not have a present ownership interest in a principal residence in the District of

Columbia in the one-year period ending on the date of the purchase of the residence to which the

credit applies.  The credit expired for residences purchased after December 31, 2005.

Description of Proposal

The proposal extends the first-time homebuyer credit for one year, through December 31,

2006. 

Effective date.–The proposal is effective for residences purchased after December 31,

2005.

Analysis

The D.C. first-time homebuyer credit is intended to encourage home ownership in the

District of Columbia in order to stabilize or increase its population and thus to improve its tax

base.  Recently, home sales in D.C. have reached record levels, and sales prices have increased. 

However, this has been equally true in surrounding communities.  It is difficult to know the

extent to which the D.C. homebuyer credit may have been a factor in the surge in home sales. 

According to the Treasury Department, the homeownership rate in the District of Columbia is

significantly below the rate for the neighboring States and the nation as a whole.  Arguably,

extending the credit would enhance the District of Columbia's ability to attract new homeowners

and establish a stable residential base.

A number of policy issues are raised with respect to whether the D.C. homebuyer credit

should be extended.  One issue is whether it is the proper role of the Federal Government to

distort local housing markets by favoring the choice of home ownership in one jurisdiction over

another.  Favoring home ownership in one area comes at the expense of home ownership in

adjacent areas.  Thus, if the credit stimulates demand in the District of Columbia, this comes at

the expense of demand in other portions of the relevant housing market, principally the nearby

suburbs of Virginia and Maryland.  

To the extent that local jurisdictions vary in their tax rates and services, individuals

purchasing a home may choose to buy in the jurisdiction that offers them the combination of tax

rates and services and other amenities that they desire.   If a jurisdiction has a low tax rate,

some might choose it on that basis.  If a jurisdiction has a high tax rate but offers a high level of

services, some will decide that the high tax rate is worth the services and will choose to buy in

that jurisdiction.  If tax rates are high but services are not correspondingly high, individuals may

avoid such jurisdictions.  It is in part this individual freedom to choose where to live that can

promote competition in the provision of local public services, helping to assure that such services

are provided at reasonable tax rates.  If a jurisdiction fails at providing reasonable services at

reasonable tax rates, individuals might choose to move to other jurisdictions.  This may cause

property values in the jurisdiction to fall and, together with taxpayer departures, may put

pressure on the local government to change its behavior and improve its services.  If the Federal

Government were to intervene in this market by encouraging the purchase of a home in one local

market over another, competition among local jurisdictions in the provision of public services

may be undermined.

In the above scenario, however, a dwindling tax base may make it financially difficult to

improve government services.  Some argue that the District of Columbia is in this position and

that it needs Federal assistance to improve the District's revenue base.  An alternative view is

that the tax credit could take some of the pressure off the local government to make necessary

improvements.  By improving the local government's tax base without a commensurate

improvement in government services, the Federal expenditure could encourage a slower

transition to better governance.

Some argue that the credit is appropriate because a number of factors distinguish the

District of Columbia from other cities or jurisdictions and that competition among the District

and neighboring jurisdictions is constrained by outside factors.  For example, some argue that the

credit is a means of compensating the District for an artificially restricted tax base.  While many

residents of the suburbs work in the District and benefit from certain of its services, the Federal

Government precludes the imposition of a "commuter tax," which is used by some other

jurisdictions to tax income earned within the jurisdiction by workers who reside elsewhere.  In

addition, some argue that the District has artificially reduced property, sales, and income tax

revenues because the Federal Government is headquartered in the District.  The Federal

Government makes a payment to the District to compensate for the forgone revenues, but some

argue that the payment is insufficient.  Some also argue that to the extent migration from the

District is a result of poor services, it is not entirely within the control of the District to fix such

problems, because the District government is not autonomous, but is subject to the control of

Congress.

Another issue regarding the D.C. homebuyer credit is how effectively it achieves its

objective.  Several factors might diminish its effectiveness.  First, the $5,000 will not reduce the

net cost of homes by $5,000.  Some of the $5,000 is likely to be captured by sellers, as eligible

buyers entering the market with effectively an additional $5,000 to spend will push prices to

levels higher than would otherwise attain.  If the supply of homes for sale is relatively fixed, and

potential buyers relatively plentiful, then the credit will largely evaporate into sellers' hands

through higher prices for homes. 

A second reason the credit might not be very effective at boosting the residential base of

the District is that it applies to existing homes as well as any new homes that are built. Thus, the

family that sells its D.C. home to a credit-eligible buyer must move elsewhere.  To the extent that

they sell in order to move outside of the District of Columbia, there is no gain in D.C. residences. 

And, to the extent that the credit caused home prices to rise, the credit can be seen as an

encouragement to sell a home in the District as much as an encouragement to buy.

Prior Action

A similar proposal was included in the President's fiscal year 2004, 2005, and 2006

budget proposals.

H.R. 4297, as passed by the House (the "Tax Relief Extension Reconciliation Act of

2005") and as amended by the Senate (the "Tax Relief Act of 2005"), contains a similar

proposal.

 

 

 

 

E.    Extend Authority to Issue Qualified Zone Academy Bonds

Present Law

Tax-exempt bonds

Interest on State and local governmental bonds generally is excluded from gross income

for Federal income tax purposes if the proceeds of the bonds are used to finance direct activities

of these governmental units or if the bonds are repaid with revenues of the governmental units. 

Activities that can be financed with these tax-exempt bonds include the financing of public

schools.   Issuers must file with the IRS certain information about the bonds issued by them in

order for interest on those bonds issues to be tax-exempt.   Generally, this information return is

required to be filed no later the 15th day of the second month after the close of the calendar

quarter in which the bonds were issued.

The tax exemption for State and local bonds does not apply to any arbitrage bond.   An

arbitrage bond is defined as any bond that is part of an issue if any proceeds of the issue are

reasonably expected to be used (or intentionally are used) to acquire higher yielding investments

or to replace funds that are used to acquire higher yielding investments.    In general, arbitrage

profits may be earned only during specified periods (e.g., defined "temporary periods") before

funds are needed for the purpose of the borrowing or on specified types of investments (e.g.,

"reasonably required reserve or replacement funds").  Subject to limited exceptions, investment

profits that are earned during these periods or on such investments must be rebated to the Federal

Government.

Qualified zone academy bonds

As an alternative to traditional tax-exempt bonds, States and local governments were

given the authority to issue "qualified zone academy bonds".   A total of $400 million of

qualified zone academy bonds was authorized to be issued annually in calendar years 1998

through 2005.  The $400 million aggregate bond cap was allocated each year to the States

according to their respective populations of individuals below the poverty line.  Each State, in

turn, allocated the credit authority to qualified zone academies within such State. 

Only certain financial institutions are eligible to hold qualified zone academy bonds.

Financial institutions that hold qualified zone academy bonds are entitled to a nonrefundable tax

credit in an amount equal to a credit rate multiplied by the face amount of the bond.  A taxpayer

holding a qualified zone academy bond on the credit allowance date is entitled to a credit.  The

credit is includable in gross income (as if it were a taxable interest payment on the bond), and

may be claimed against regular income tax and alternative minimum tax liability.

The Treasury Department set the credit rate at a rate estimated to allow issuance of

qualified zone academy bonds without discount and without interest cost to the issuer.  The

maximum term of the bond was determined by the Treasury Department, so that the present

value of the obligation to repay the bond was 50 percent of the face value of the bond.

"Qualified zone academy bonds" are defined as any bond issued by a State or local

government, provided that (1) at least 95 percent of the proceeds are used for the purpose of

renovating, providing equipment to, developing course materials for use at, or training teachers

and other school personnel in a "qualified zone academy" and (2) private entities have promised

to contribute to the qualified zone academy certain equipment, technical assistance or training,

employee services, or other property or services with a value equal to at least 10 percent of the

bond proceeds.

A school is a "qualified zone academy" if (1) the school is a public school that provides

education and training below the college level, (2) the school operates a special academic

program in cooperation with businesses to enhance the academic curriculum and increase

graduation and employment rates, and (3) either (a) the school is located in an empowerment

zone or enterprise community designated under the Code, or (b) it is reasonably expected that at

least 35 percent of the students at the school will be eligible for free or reduced-cost lunches

under the school lunch program established under the National School Lunch Act.

Description of Proposal

The proposal authorizes issuance of up to $400 million of qualified zone academy bonds

in calendar year 2006.   For qualified zone academy bonds issued after the date of enactment, the

proposal requires issuers to report issuance to the IRS in a manner similar to the information

returns required for tax-exempt bonds.

Effective date.–The provision is effective generally for bonds issued after the date of

enactment. 

Analysis

Policy issues

The proposal to extend qualified zone academy bonds would subsidize a portion of the

costs of new investment in public school infrastructure and, in certain qualified areas, equipment

and teacher training.  By subsidizing such costs, it is possible that additional investment will take

place relative to investment that would take place in the absence of the subsidy.  If no additional

investment takes place than would otherwise, the subsidy would merely represent a transfer of

funds from the Federal Government to States and local governments.  This would enable States

and local governments to spend the savings on other government functions or to reduce taxes.  

In this event, the stated objective of the proposal would not be achieved.

Though called a tax credit, the Federal subsidy for tax credit bonds is equivalent to the

Federal Government directly paying the interest on a taxable bond issue on behalf of the State or

local government that benefits from the bond proceeds.   To see this, consider any taxable bond

that bears an interest rate of 10 percent.  A thousand dollar bond would thus produce an interest

payment of $100 annually.  The owner of the bond that receives this payment would receive a

net payment of $100 less the taxes owed on that interest.  If the taxpayer were in the 28-percent

Federal tax bracket, such taxpayer would receive $72 after Federal taxes.  Regardless of whether

the State government or the Federal Government pays the interest, the taxpayer receives the

same net of tax return of $72.  In the case of tax credit bonds, no formal interest is paid by the

issuer or the Federal Government.  Rather, a tax credit of $100 is allowed to be taken by the

holder of the bond on its Federal income tax return.  In general, a $100 tax credit would be worth

$100 to a taxpayer, provided that the taxpayer had at least $100 in tax liability.  However, for tax

credit bonds, the $100 credit also has to be claimed as income.  Claiming an additional $100 in

income costs a taxpayer in the 28-percent tax bracket an additional $28 in income taxes, payable

to the Federal Government.  With the $100 tax credit that is ultimately claimed, the taxpayer nets

$72 on the bond, after taxes.  The Federal Government loses $100 on the credit, but recoups $28

of that by the requirement that it be included in income, for a net cost of $72, which is exactly

the net return to the taxpayer.  If the Federal Government had simply agreed to pay the interest

on behalf of the State or local government, both the Federal Government and the

bondholder/taxpayer would be in the same situation.  The Federal Government would make

outlays of $100 in interest payments, but would recoup $28 of that in tax receipts, for a net

budgetary cost of $72, as before.  Similarly, the bondholder/taxpayer would receive a taxable

$100 in interest, and would owe $28 in taxes, for a net gain of $72, as before.  The State or local

government also would be in the same situation in both cases.

Use of qualified zone academy bonds to subsidize public school investment raises some

questions of administrative efficiencies and tax complexity (see below).  Because potential

purchasers of the qualified zone academy bonds must educate themselves as to whether the

bonds qualify for the credit, certain "information costs" are imposed on the buyer.  Additionally,

since the determination as to whether the bond is qualified for the credit ultimately rests with the

Federal Government, further risk is imposed on the investor.  These information costs and other

risks serve to increase the credit rate and hence the costs to the Federal Government for a given

level of support to the zone academies.  For these reasons, and the fact that tax credit bonds will

be less liquid than Treasury securities, the bonds would bear a credit rate that is equal to a

measure of the yield on outstanding corporate bonds.

Qualified zone academy bonds, unlike interest-bearing State and local bonds, are not

subject to the arbitrage or rebate requirements of the Code.  The ability to earn and retain

arbitrage profits provides an incentive for issuers to issue more bonds and to issue them earlier

than necessary.  As a result, there may be increased delays in the expenditure of bond proceeds

for approved purposes in order to earn greater arbitrage profits.    Further, there are transaction

costs, such as brokers and investment advisor fees, associated with investing to earn arbitrage,

which diverts funds away from the rehabilitation or repair of a school facility.  

On the other hand, the ability of issuers to invest proceeds at unrestricted yields and

retain the earnings from such investments, increases the subsidy available for qualified

expenditures, as well as the repayment of principal on such bonds, beyond the savings achieved

through having the issuer's interest costs paid by Federal tax credit.  Opponents of imposition of

arbitrage or rebate requirements argue that such restrictions will decrease the amount of subsidy

available to assist schools with significant needs, but limited means through which to satisfy

those needs.  Increasing the subsidy through permitted arbitrage, however, results in costs to the

Federal Government beyond the revenue loss associated with providing Federal tax credits.  The

lack of arbitrage restrictions and rebate also results in foregone tax revenues on the arbitrage

profits because the issuing entity is tax-exempt.

The direct payment of interest by the Federal Government on behalf of States or

localities, which was discussed above as being economically the equivalent of the credit

proposal, would involve less complexity in administering the income tax, as the interest could

simply be reported as any other taxable interest.  Additionally, the tax credit approach implies

that non-taxable entities would only be able to invest in the bonds to assist school investment

through repurchase agreements or by acquiring rights to repayment of principal if a tax credit

bond is stripped.  In the case of a direct payment of interest, by contrast, tax-exempt

organizations would be able to enjoy such benefits.

Complexity issues

A temporary extension provides some stability in the qualified zone academy bonds

program.  Certainty that the program would continue at least temporarily, without further

interruption or modification, arguably would facilitate financial planning by taxpayers during

that period.  The uncertainty that results from expiring provisions may adversely affect the

administration of and perhaps the level of participation in such provisions.  For example, a

taxpayer may not be willing to devote the time and effort necessary to satisfy the complex

requirements of a provision that expires shortly.  Similarly, the Internal Revenue Service must

make difficult decisions about the allocation of its limited resources between permanent and

expiring tax provisions.

Some argue that a permanent or long-term extension is necessary to encourage optimal

participation among potential qualified zone academy bond issuers.  Others respond that the

permanent repeal of expiring provisions such as the qualified zone academy bond rules that are

inherently complex would provide the same level of certainty for tax planning purposes as a

long-term or permanent extension, and would further reduce the overall level of complexity in

the Code.  A related argument is that programs such as qualified zone academy bonds would be

more efficient if administered as direct expenditure programs rather than as a part of the tax law.

The proposal's reporting requirements may assist in the monitoring of the use of these

bonds.  On the other hand, it will add to complexity in that it imposes a requirement not

previously applied to qualified zone academy bonds.  In addition, the proposal increases the

paperwork burden on issuers in that forms must be completed and filed with the IRS.

Prior Action

Similar proposals were included in the President's fiscal year 2003, 2004, 2005, and 2006

budget proposals.

H.R. 4297, as passed by the House (the "Tax Relief Extension Reconciliation Act of

2005"), authorizes up to $400 million of qualified zone academy bonds for calendar year 2006.  

H.R. 4297, as amended by the Senate (the "Tax Relief Act of 2005"), authorizes up to

$400 million of qualified zone academy bonds for each of calendar years 2006 and 2007.  The

Tax Relief Act of 2005 also imposes information reporting requirements for qualified zone

academy bonds, limits acceptable private business contributions to cash or cash equivalents,

requires ratable principal amortization, imposes a five-year expenditure period in which to spend

bond proceeds, and applies the arbitrage rules of section 148 to these bonds.

 

 

 

 

F.    Extend Provisions Permitting Disclosure of Tax Return

Information Relating to Terrorist Activity

Present Law

In general

Section 6103 provides that returns and return information are confidential may not be

disclosed by the IRS, other Federal employees, State employees, and certain others having access

to the information except as provided in the Internal Revenue Code.   A "return" is any tax or

information return, declaration of estimated tax, or claim for refund required by, or permitted

under, the Internal Revenue Code, that is filed with the Secretary by, on behalf of, or with

respect to any person.   Return also includes any amendment or supplement thereto, including

supporting schedules, attachments, or lists which are supplemental to, or part of, the return so

filed.

The definition of "return information" is very broad and includes any information

gathered by the IRS with respect to a person's liability or possible liability under the Internal

Revenue Code.   "Taxpayer return information" is a subset of return information. Taxpayer

return information is return information filed with or furnished to the IRS by, or on behalf of, the

taxpayer to whom the information relates.  For example, information submitted to the IRS by a

taxpayer's accountant on behalf of the taxpayer is "taxpayer return information." 

Section 6103 contains a number of exceptions to the general rule of confidentiality,

which permit disclosure in specifically identified circumstances  when certain conditions are

satisfied.   One of those exceptions is for the disclosure of return and return information

regarding terrorist activity.

The Code permits the disclosure of returns and return information for purposes of

investigating terrorist incidents, threats, or activities, and for analyzing intelligence concerning

terrorist incidents, threats, or activities.  The term "terrorist incident, threat, or activity" is

statutorily defined to mean an incident, threat, or activity involving an act of domestic terrorism

or international terrorism, as both of those terms are defined in the USA PATRIOT Act.

Return information generally is available Federal law enforcement and Federal

intelligence agencies upon a written request meeting specific requirements. However, a return or

information submitted to the IRS by the taxpayer or on his behalf may only be obtained pursuant

to an ex parte court order.  No disclosures may be made under this provision after December 31,

2006.

Disclosure of return information other than taxpayer return information

Disclosure by the IRS without a request

The Code permits the IRS to disclose return information, other than taxpayer return

information, related to a terrorist incident, threat, or activity to the extent necessary to apprise the

head of the appropriate Federal law enforcement agency responsible for investigating or

responding to such terrorist incident, threat, or activity.    The IRS on its own initiative and

without a written request may make this disclosure.  The head of the Federal law enforcement

agency may disclose information to officers and employees of such agency to the extent

necessary to investigate or respond to such terrorist incident, threat, or activity.  A taxpayer's

identity is not treated as taxpayer return information for this purpose, and may be disclosed under

this authority.

Disclosure upon written request of a Federal law enforcement agency

The Code permits the IRS to disclose return information, other than taxpayer return

information, to officers and employees of Federal law enforcement upon a written request

satisfying certain requirements.   A taxpayer's identity is not treated as taxpayer return

information for this purpose and may be disclosed under this authority.   The request must:  (1)

be made by the head of the Federal law enforcement agency (or his delegate) involved in the

response to or investigation of terrorist incidents, threats, or activities, and (2) set forth the

specific reason or reasons why such disclosure may be relevant to a terrorist incident, threat, or

activity.  The information is to be disclosed to officers and employees of the Federal law

enforcement agency who would be personally and directly involved in the response to or

investigation of terrorist incidents, threats, or activities.  The information is to be used by such

officers and employees solely for such response or investigation.

The Code permits the head of a Federal law enforcement agency to redisclose return

information received, in response to the written request described above, to officers and

employees of State and local law enforcement personally and directly engaged in the response to

or investigation of the terrorist incident, threat, or activity.  The State or local law enforcement

agency must be part of an investigative or response team with the Federal law enforcement

agency for these disclosures to be made.

Disclosure upon request from the Departments of Justice or Treasury for intelligence

analysis of terrorist activity

Upon written request satisfying certain requirements discussed below, the IRS is to

disclose return information (other than taxpayer return information) to officers and employees of

the Department of Justice, Department of Treasury, and other Federal intelligence agencies, who

are personally and directly engaged in the collection or analysis of intelligence and

counterintelligence or investigation concerning terrorist incidents, threats, or activities.   Use of

the information is limited to use by such officers and employees in such investigation, collection,

or analysis.  A taxpayer's identity is not treated as taxpayer return information for this purpose

and may be disclosed under this authority.

The written request is to set forth the specific reasons why the information to be disclosed

is relevant to a terrorist incident, threat, or activity.  The request is to be made by an individual

who is:  (1) an officer or employee of the Department of Justice or the Department of Treasury,

(2) appointed by the President with the advice and consent of the Senate, and (3) responsible for

the collection, and analysis of intelligence and counterintelligence information concerning

terrorist incidents, threats, or activities.  The Director of the United States Secret Service also is

an authorized requester.

Disclosure of returns and return information by ex parte court order

Ex parte court orders sought by Federal law enforcement and Federal intelligence

agencies

In order to obtain a return or information submitted to the IRS by the taxpayer or his

representative, court approval must be obtained.   The Code permits, pursuant to an ex parte

court order, the disclosure of returns and return information (including taxpayer return

information) to certain officers and employees of a Federal law enforcement agency or Federal

intelligence agency.  These officers and employees are required to be personally and directly

engaged in any investigation of, response to, or analysis of intelligence and counterintelligence

information concerning any terrorist incident, threat, or activity.  These officers and employees

are permitted to use this information solely for their use in the investigation, response, or

analysis, and in any judicial, administrative, or grand jury proceeding, pertaining to any such

terrorist incident, threat, or activity.

The Attorney General, Deputy Attorney General, Associate Attorney General, an

Assistant Attorney General, or a United States attorney, may authorize the application for the ex

parte court order to be submitted to a Federal district court judge or magistrate.  The Federal

district court judge or magistrate would grant the order if based on the facts submitted he or she

determines that:  (1) there is reasonable cause to believe, based upon information believed to be

reliable, that the return or return information may be relevant to a matter relating to such terrorist

incident, threat, or activity; and (2) the return or return information is sought exclusively for the

use in a Federal investigation, analysis, or proceeding concerning any terrorist incident, threat, or

activity.

Special rule for ex parte court ordered disclosure initiated by the IRS

If the Secretary of Treasury possesses returns or return information that may be related to

a terrorist incident, threat, or activity, the Secretary of the Treasury (or his delegate), may on his

own initiative, authorize an application for an ex parte court order to permit disclosure to Federal

law enforcement.   In order to grant the order, the Federal district court judge or magistrate

must determine that there is reasonable cause to believe, based upon information believed to be

reliable, that the return or return information may be relevant to a matter relating to such terrorist

incident, threat, or activity.  The information may be disclosed only to the extent necessary to

apprise the appropriate Federal law enforcement agency responsible for investigating or

responding to a terrorist incident, threat, or activity and for officers and employees of that agency

to investigate or respond to such terrorist incident, threat, or activity.  Further, use of the

information is limited to use in a Federal investigation, analysis, or proceeding concerning a

terrorist incident, threat, or activity.  Because the Department of Justice represents the Secretary

of the Treasury in Federal district court, the Secretary is permitted to disclose returns and return

information to the Department of Justice as necessary and solely for the purpose of obtaining the

special IRS ex parte court order.

Description of Proposal

The proposal extends for one year the disclosure authority relating to terrorist activities

(through December 31, 2007).

Effective date.–The proposal is effective for disclosures on or after the date of enactment.

Analysis

The temporary nature of the present-law provision introduces a degree of uncertainty

regarding the disclosure of return information relating to terrorist activities, i.e., whether the

provision will be the subject of further extensions.   There has been no study of the effectiveness

of the provisions. 

According to IRS accountings of disclosures made under the authority of the provisions

in calendar year 2002, the IRS reported 39 disclosures to the Federal Bureau of Investigation

under the terrorist activity provisions governing IRS-initiated disclosures to Federal law

enforcement.   However, the IRS used its authority to make disclosures in emergency

circumstances to make an additional 12,236 disclosures to the FBI.  The IRS made 25

disclosures to the Department of Justice for purposes of preparing an application for an ex parte

court order to permit the IRS to initiate an affirmative disclosure of returns and return

information.  Pursuant to the ex parte court order authority, 2,215 disclosures were made to U.S.

Attorneys in calendar year 2002.  The IRS did not report any terrorist activity disclosures to

Federal intelligence agencies, nor did it report any disclosures in response to requests from

Federal law enforcement agencies for calendar year 2002.

 For calendar year 2003, 1,626 disclosures were made under the terrorist activity

provisions governing IRS disclosures to Federal law enforcement.  Under the ex parte court

order authority, 1,724 disclosures were made to U.S. Attorneys in calendar year 2003.  The IRS

did not report any disclosures to Federal intelligence agencies or in response to requests from

Federal law enforcement agencies for calendar year 2003.  

For calendar year 2004, the IRS made 883 disclosures to under the provisions permitting

disclosure to Federal law enforcement.  Under the ex parte court order authority, 3,992

disclosures were made to U.S. Attorneys in calendar year 2004. Again, for calendar year 2004,

the IRS did not report any disclosures to Federal intelligence agencies or in response to request

from Federal law enforcement agencies.  

The fact that the IRS has not reported any responses in connection with requests by

Federal intelligence agencies and Federal law enforcement, may be an indication that further

extension of those provision is not warranted.  However, the data does indicate that the IRS is

using its self-initiated disclosure authority and that U.S. Attorneys are taking advantage of the ex

parte court order provision to obtain returns and return information.  

Some argue that the terrorist activity disclosure provisions are duplicative provisions that

were already in place for emergency disclosures and for use in criminal investigations.  As noted

above, the IRS used its emergency disclosure authorization to make disclosures to the Federal

Bureau of Investigation concerning terrorist activity.   However, the emergency disclosure

authorization is to be used under circumstances involving an imminent danger of death or

physical injury.  In the case of terrorist activity, it may not be clear whether the danger is

"imminent", which could lead to the misapplication of the emergency authority and uncertainty

as to whether a particular disclosure is authorized.  Thus, the existence of a specific disclosure

provision for terrorist activity information provides clear authority and direction for making

disclosures to combat terrorism.

The requirements for disclosure of terrorist activity information are not as stringent as

those required for criminal investigations.  For example, the granting of an ex parte order relating

to terrorist activities does not require a finding that there is reasonable cause to believe that a

specific criminal act has been committed.  In cases involving terrorist activity the judge or

magistrate needs to determine that there is reasonable cause to believe that the return or return

information may be relevant to a matter relating to such terrorist incident, threat or activity.  In

addition, unlike the requirements for criminal investigations, the judge or magistrate does not

need to find that the information cannot be reasonably obtained from another source before

granting the request for an ex parte order for disclosure relating to terrorist activity.  Some argue

that the less stringent requirements facilitate a proactive approach to combating terrorism.

Prior Action

A similar proposal was included in the President's fiscal years 2004, 2005, and 2006

budget proposals.

 

 

G.      Permanently Extend and Expand Disclosure of Tax Return Information

for Administration of Student Loans

Present Law

Income-contingent loan verification program

Present law prohibits the disclosure of returns and return information, except to the extent

specifically authorized by the Code.   An exception is provided for disclosure to the

Department of Education (but not to contractors thereof) of a taxpayer's filing status, adjusted

gross income and identity information (i.e., name, mailing address, taxpayer identifying number)

to establish an appropriate repayment amount for an applicable student loan.   The Department

of Education disclosure authority is scheduled to expire after December 31, 2006.  

An exception to the general rule prohibiting disclosure is also provided for the disclosure

of returns and return information to a designee of the taxpayer.   Because the Department of

Education utilizes contractors for the income-contingent loan verification program, the

Department of Education obtains taxpayer information by consent under section 6103(c), rather

than under the specific exception.   The Department of Treasury has reported that the Internal

Revenue Service processes approximately 100,000 consents per year for this purpose.  

Verifying financial aid applications

The Higher Education Act of 1998 ("Higher Education Act") authorized the Department

of Education to confirm with the Internal Revenue Service four discrete items of return

information for the purposes of verifying of student aid applications.   The Higher Education

Act, however, did not amend the Code to permit disclosure for this purpose.  Therefore, the

disclosure provided by the Higher Education Act may not be made unless the taxpayer consents

to the disclosure pursuant to section 6103(c).

The financial aid application is submitted to the Department of Education and is then

given to a contractor for processing.  Based on the information given, the contractor calculates an

expected family contribution that determines the amount of aid a student will receive.  All

Department of Education financial aid is disbursed directly through schools or various lenders.

The Department of Education requires schools to verify the financial aid information of

30 percent of the applicants.  The applicants must furnish a copy of their tax returns.  The

applicants are not required to obtain copies of tax returns from the IRS or to produce certified

copies.  If the information reflected on the student's copy of the tax return does not match the

information on the financial aid application, the school requires corrective action to be taken

before a student receives the appropriate aid. 

The Office of Inspector General of the Department of Education has reported that,

because many applicants are reporting incorrect information on their financial aid applications,

erroneous overpayments of Federal Pell grants have resulted. 

Overpayments of Pell grants and defaulted student loans

For purposes of locating a taxpayer to collect an overpayment of a Federal Pell grant or to

collect payments on a defaulted loan, the Internal Revenue Service may disclose the taxpayer's

mailing address to the Department of Education.   To assist in locating the defaulting taxpayer,

the Department of Education may redisclose the mailing address to the officers, employees and

agents of certain lenders, States, nonprofit agencies, and educational institutions whose duties

relate to the collection of student loans.

Safeguard procedures and recordkeeping

Federal and State agencies that receive returns and return information are required to

maintain a standardized system of permanent records on the use and disclosure of that

information.   Maintaining such records is a prerequisite to obtaining and continuing to obtain

returns and return information.  Such agencies must also establish procedures satisfactory to the

IRS for safeguarding the information it receives.  The IRS must also file annual reports with the

House Committee on Ways and Means, the Senate Committee on Finance, and the Joint

Committee on Taxation regarding procedures and safeguards followed by recipients of return

and return information.

Description of Proposal

The proposal allows the disclosure to the Department of Education and its contractors of

the adjusted gross income, filing status, total earnings from employment, Federal income tax

liability, type of return filed and taxpayer identity information for the financial aid applicant or of

the applicant's parents (if the applicant is a dependent) or spouse (if married).  Pursuant to the

proposal, the Department of Education could use the information not only for establishing a loan

repayment amount but also for verifying items reported by student financial aid applicants and

their parents. 

The proposal allows the Department of Education to use contractors to process the

information disclosed to the Department of Education, eliminating the need for consents.  It is

understood that the proposal imposes the present-law safeguards applicable to disclosures to

Federal and State agencies on disclosures to the Department of Education and its contractors. 

Effective date.–The proposal is effective with respect to disclosures made after the date

of enactment.

Analysis

Contractors

The proposal permits the disclosure of a taxpayer's return information to contractors and

agents of the Department of Education, not just to Department of Education employees.  Some

might argue that the use of contractors significantly expands the risk of unauthorized disclosure,

particularly when return information is used by a contractor outside of the recipient agency.  The

volume of taxpayer information involved under this proposal and the disclosure of millions of

taxpayer records, significantly contributes to the risk of unauthorized disclosure.  On the other

hand, some might argue that it is appropriate to permit the disclosure of otherwise confidential

tax information to contractors to ensure the correctness of Federal student aid.   

Opponents of the proposal may argue that it is not clear that the Internal Revenue Service

has the resources and computer specialists to implement and enforce the safeguards that the

proposal imposes.  However, proponents of the proposal argue that the proposal alleviates some

of the burden on the Internal Revenue Service by requiring the Department of Education to

monitor its contractors as a supplement to the safeguard reviews conducted by the Internal

Revenue Service.

Burdens on IRS

In general, the proposal eases the burden on the financial aid applicant because the

applicant will not be required to produce copies of their tax returns for verification of their

financial aid applications.  The proposal arguably provides simplification for the schools as well,

because the schools will no longer be required to match the information of 30 percent of its

applicants.  On the other hand, the proposal tends to increase complexity for the Internal

Revenue Service by requiring it to resolve discrepancies between tax information and income

data on the financial aid application if the applicant is unable to resolve the discrepancy with the

school. 

Income contingent loan verification program

Currently the Department of Education uses consents to obtain tax information for

purposes of its income contingent loan verification program, and does not rely on the statutory

authority to receive that information without consent.  The IRS processes over 100,000 consents

for this program.  Some might argue that since the specific statutory authority is not being used,

it should not be extended. 

Verifying financial aid applications

Congress has expressed a concern about the increasing number of requests for the

disclosure of confidential tax information for nontax purposes and the effect of such disclosures

on voluntary taxpayer compliance.   Some might argue that consensual disclosure of return

information, in which the taxpayer knowingly consents to the disclosure of his or her return

information ("consents"), is less likely to adversely impact taxpayer compliance than adding a

nonconsensual provision for the disclosure of taxpayer information.  Since the Internal Revenue

Service is already processing consents for the Department of Education, some would argue that

the current practice simply could be extended to financial aid applications.   On the other hand,

some might argue that because present law does not impose restrictions on redisclosure of return

information obtained by consent, the proposal, which imposes such restrictions, would be

preferable.

Critics might argue that the disclosure of sensitive return information of millions  of

taxpayers to identify the abuse of a few does not strike the appropriate balance between the need

to know and the right to privacy.  On the other hand, some might argue that since this financial

information is already required to be submitted as part of the financial aid form, the infringement

on taxpayer privacy is minimal.

Prior Action

Similar proposals were contained in the President's fiscal year 2003, 2004, 2005, and

2006 budget proposals.

 

 

H.    Extend Excise Tax on Coal at Current Rates

Present Law

A $1.10 per ton excise tax is imposed on coal sold by the producer from underground

mines in the United States.  The rate is 55 cents per ton on coal sold by the producer from

surface mining operations.  In either case, the tax cannot exceed 4.4 percent of the coal

producer's selling price.  No tax is imposed on lignite.

Gross receipts from the excise tax are dedicated to the Black Lung Disability Trust Fund

to finance benefits under the Federal Black Lung Benefits Act.  Currently, the Black Lung

Disability Trust Fund is in a deficit position because previous spending was financed with

interest-bearing advances from the General Fund. 

The coal excise tax rates are scheduled to decline to 50 cents per ton for underground-

mined coal and 25 cents per ton for surface-mined coal (and the cap is scheduled to decline to

two percent of the selling price) for sales after January 1, 2014, or after any earlier January 1 on

which there is no balance of repayable advances from the Black Lung Disability Trust Fund to

the General Fund and no unpaid interest on such advances.

Description of Proposal

The proposal retains the excise tax on coal at the current rates until the date on which the

Black Lung Disability Trust Fund has repaid, with interest, all amounts borrowed from the

General Fund.  After repayment of the Trust Fund's debt, the reduced rates of $.50 per ton for

coal from underground mines and $.25 per ton for coal from surface mines would apply and the

tax per ton of coal would be capped at two percent of the amount for which it is sold by the

producer.

Effective date.–The proposal is effective for coal sales after December 31, 2005.

Analysis

Trust fund financing of benefits was established in 1977 to reduce reliance on the

Treasury and to recover costs from the mining industry.  Claims were much more numerous than

expected and it was difficult to find responsible operators, litigate their challenges and collect

from them.  Therefore, deficits were financed with interest-bearing advances from the General

Fund.  During each year of the period 1992-2002, the expenses of the program covered by the

trust fund (benefits, administration and interest) have exceeded revenues, with an advance from

the General Fund making up the difference and accumulating as a debt.   Direct costs (benefits

and administration), however, have been less than revenues.  According to the Congressional

Research Service, if it were not for the interest on the accumulated deficit, the trust fund would

be self-supporting:  "In effect, the annual advances from the Treasury are being used to pay back

interest to the Treasury, while the debt has been growing as if with compound interest."

Miners and survivors qualify for benefits from the Fund only if the miner's mine

employment terminated before 1970 or no mine operator is liable for the payment of benefits. 

Some might argue that since the Federal Government has essentially made a loan to itself with a

transfer between funds, the interest component should be forgiven.  Because the class of

beneficiaries is dwindling and revenues currently cover benefits and administrative costs, coal

tax revenues could eventually pay off the bonds if extended at their current rates.  

Based on historical trends, it appears that the trust fund will not be able to pay off its debt

by December 31, 2013.  Therefore, it could be argued that it is appropriate to continue the tax on

coal at the increased rates beyond that expiration date until the debt is repaid, rather than require

that the General Fund provide even larger advances to the trust fund.  On the other hand, since

the tax is not scheduled to be reduced until December 31, 2013, it could be argued that this

proposal to further extend the rates is premature.

Prior Action

Identical proposals (except for effective date) were included in the President's fiscal year

2005 and 2006 budget proposals.

 

 

I.      Election to Treat Combat Pay as Earned Income

for Purposes of the Earned Income Credit

Present Law

In General

Subject to certain limitations, military compensation earned by members of the Armed

Forces while serving in a combat zone may be excluded from gross income.  In addition, for up

to two years following service in a combat zone, military personnel may also exclude

compensation earned while hospitalized from wounds, disease, or injuries incurred while serving

in the zone.

Child Credit

Combat pay that is otherwise excluded from gross income under section 112 is treated as

earned income which is taken into account in computing taxable income for purposes of

calculating the refundable portion of the child credit.

Earned Income Credit

Any taxpayer may elect to treat combat pay that is otherwise excluded from gross income

under section 112 as earned income for purposes of the earned income credit.  This election is

available with respect to any taxable year ending after the date of enactment and before

January 1, 2007.

Description of Proposal

The proposal extends the elections to treat combat pay as earned income for purposes of

the earned income credit for one year (through December 31, 2007).

Effective date.–Generally, the proposal would be effective after December 31, 2006.

Analysis

The exclusion of combat pay from gross income is intended to benefit military personnel

serving in combat. However, to the extent that certain tax benefits, such as the child credit and

the earned income credit, may vary based on taxable or earned income, the exclusion has the

potential to limit the availability of certain refundable tax credits (i.e. the child credit and the

earned income credit).  Including combat pay in gross income for purposes of the refundable

child credit is always advantageous to the taxpayer.  However, including combat pay for

purposes of calculating the earned income credit may either help or hurt the taxpayer, because

the credit both phases in and phases out based on earned income.

If the objective of the present-law rules is to ensure that the exclusion of combat pay from

gross income does not result in a net economic detriment through the elimination of otherwise

available refundable credits, an election to include combat pay in income for all Code purposes

would be sufficient to achieve that objective.  Present law, however, takes a more taxpayer

favorable approach by allowing the tax treatment of combat pay to vary across Code provisions

when such variation is favorable, and thus present law (1) always treats combat pay as earned

income for purposes of the refundable portion of the child credit, as that is always the most

favorable result because the refundable child credit can only rise as income rises, and (2) allows

the taxpayer to elect to include combat pay as earned income for purposes of the EIC

(advantageous to the taxpayer depending on the amount of earned income that would result).

The election to include or exclude combat pay for purposes of the earned income credit

creates complexity.  In general, elections always add complexity, because taxpayers need to

calculate their tax liability in more than one way in order to determine which result is best for

them.

The present-law rules with respect to combat pay treat such pay differently than other

nontaxable compensation for purposes of the definition of earned income in the refundable child

credit and the earned income credit.  For example, under present law, other nontaxable employee

compensation (e.g., elective deferrals such as salary reduction contributions to 401(k) plans) is

not includible in earned income for these purposes.  Allowing combat pay to be included in

earned income creates an inconsistent treatment between it and other nontaxable employee

compensation and arguably creates inequities between taxpayers who receive combat pay

compared to other types of nontaxable compensation.

Prior Action

A similar proposal was included in the President's 2006 budget.  That proposal extended

the earned income credit combat pay election through December 31, 2006, and was enacted as

part of the Gulf Opportunity Zone Act of 2005 (Pub. Law 109-135).

 

 

IX.   OTHER PROVISIONS MODIFYING THE INTERNAL REVENUE CODE

A.      Extension of the Rate of Rum Excise Tax Cover Over

to Puerto Rico and Virgin Islands

Present Law

A $13.50 per proof gallon  excise tax is imposed on distilled spirits produced in or

imported (or brought) into the United States.   The excise tax does not apply to distilled spirits

that are exported from the United States, including exports to U.S. possessions (e.g., Puerto Rico

and the Virgin Islands).

The Code provides for cover over (payment) to Puerto Rico and the Virgin Islands of the

excise tax imposed on rum imported (or brought) into the United States, without regard to the

country of origin.   The amount of the cover over is limited under Code section 7652(f) to

$10.50 per proof gallon ($13.25 per proof gallon during the period July 1, 1999 through

December 31, 2005).

Tax amounts attributable to shipments to the United States of rum produced in Puerto

Rico are covered over to Puerto Rico.  Tax amounts attributable to shipments to the United

States of rum produced in the Virgin Islands are covered over to the Virgin Islands.  Tax

amounts attributable to shipments to the United States of rum produced in neither Puerto Rico

nor the Virgin Islands are divided and covered over to the two possessions under a formula.  

Amounts covered over to Puerto Rico and the Virgin Islands are deposited into the treasuries of

the two possessions for use as those possessions determine.   All of the amounts covered over

are subject to the limitation.

Description of Proposal

The proposal extends the $13.25-per-proof-gallon cover over rate for two additional

years, through December 31, 2007.

Effective date.–The proposal is effective for articles brought into the United States after

December 31, 2005.

Analysis

The fiscal needs of Puerto Rico and the Virgin Islands were the impetus to extend the

increased cover over rate to bolster the Treasuries in those possessions.  Rather than rely on rum

consumption in the United States, increased revenue could be achieved by intergovernmental

support through a direct appropriation.  The advantage of a direct appropriation is that it provides

for annual oversight.  Some argue that a cover over is akin to an entitlement in terms of the

annual budget process and making it permanent ensures a steady flow of revenue.  Although the

cover over may provide a more stable revenue stream, it may be more difficult to administer than

a direct appropriation. 

Prior Action

The $13.25 per-proof-gallon cover over rate had been scheduled to expire after

December 31, 2003.  The President's fiscal year 2004 and 2005 budget proposals included a

proposal that extended the $13.25 per-proof-gallon cover over rate for two additional years,

through December 31, 2005.  The Working Families Tax Relief Act of 2004 enacted that

proposal into law.   The President's fiscal year 2006 budget proposal included a proposal that

extended the $13.25 per-proof-gallon cover over rate for one additional year, through December

31, 2006.  H.R. 4388, as passed by the House (the "Tax Revision Act of 2005"), would extend

the $13.25 cover over rate through December 31, 2006.

 

 

B.      Establish Program of User Fees for Certain Services Provided to the

Alcohol Industry by the Alcohol and Tobacco Tax and Trade Bureau

Present Law

The Alcohol and Tobacco Tax and Trade Bureau ("TTB"), under the Secretary of the

Treasury, is responsible for the collection of alcohol, tobacco, firearms, and ammunition excise

taxes, for ensuring that such products are labeled, advertised, and marketed in accordance with

the law, and for administering certain laws and regulations concerning these products. 

TTB issues permits to members of the alcohol industry engaged in the business of

producing distilled spirits or wine, or importing or wholesaling distilled spirits, wine, or malt

beverages.   In addition, bottlers and importers of these alcoholic beverages must obtain a

certificate of label approval from TTB prior to bottling or selling its product in interstate

commerce or removing the bottled product from customs custody.   TTB also reviews formulas

and statements of process, and performs laboratory tests pursuant to the Federal Alcohol

Administration Act.   For example, formulas are required for distilled spirits operations that

change the character, composition, class, or type of the spirits.  These formulas must be approved

by TTB.   TTB does not currently charge fees for these services.

Under the Code, manufacturers may claim a drawback of most of the tax for the use of

tax-paid distilled spirits in nonbeverage products.  Currently TTB imposes a fee of one dollar per

proof gallon to process such claims.

The Code authorizes the Secretary to establish a user fee program for requests to the

Internal Revenue Service for ruling letters, opinion letters, determination letters, and other

similar requests.   The user fees charged under the IRS program must (1) vary according to

categories (or subcategories) established by the Secretary, (2) be determined after taking into

account the average time for (and difficulty of) complying with requests in each category (and

subcategory), and (3) be payable in advance.

Description of Proposal

The proposal directs the Secretary to establish a program requiring the payment of certain

user fees to TTB.  User fees would be required for the following categories of services, in no less

than the following minimum amounts:

Category

Minimum

Fee

Applications for basic permits

$500

Applications for certificates of label approval -- electronic filing

 $50

Applications for certificates of label approval -- paper filing

$100

Petitions for the establishment of new American viticultural areas or adjustment

of established viticultural areas

     $3,000

Formula review -- with no laboratory analysis

$200

Formula review -- with laboratory analysis

$600

Laboratory analysis -- other than for formula review

$150

Other similar filings or requests

 

The proposal provides that the amount of fees charged may vary according to categories

(or subcategories) established by the Secretary, after taking into account the average time for,

and difficulty of, processing such requests in each category (and subcategory).  The fees are

required to be payable in advance.  However, the foregoing rules do not limit the Secretary's

authority to use any other measures or standards in setting fees as the Secretary deems

appropriate and necessary.  The proposal also provides that, except for the minimum fees stated

in the fee schedule, the Secretary may provide for reduced or increased program fees as the

Secretary determines to be appropriate.

In exercising the authority under this proposal, the normal regulatory process of notice,

comment, and hearing would not be required.  Instead, the Secretary is required only to publish a

notice of the new fees or adjustment to such fees not less than 60 days prior to the effective date

of such new fees or adjustment.

In addition to the regulatory fees described above, the proposal increases the fee for

processing tax drawback claims of manufacturers of nonbeverage products from one dollar to

two dollars per proof gallon.

The fees in excess of one dollar per proof gallon for processing the drawback claims and

all of the other fees imposed under the proposal are to be deposited in an Alcohol and Tobacco

Regulatory Fund within the Treasury Department.  Amounts in such Fund are authorized to be

appropriated for activities of TTB, and remain available until expended.  However, such amounts

must be appropriated to be spent.

Effective date.–The proposal is effective on date of enactment.  The increased fee for

processing drawback claims is effective on date of enactment.  The other fees become effective

no sooner than 60 days after publication of a notice of such fees in the Federal Register.

Analysis

Some argue that TTB's regulatory services provide value to the industry by providing

information and assurance to the public that enhances the applicant's value, and, therefore, the

applicant should pay for these benefits, in the same manner as users of IRS ruling services. 

Others argue that the primary beneficiary of TTB's regulatory services is the public, and that

Congress should take these expenses into account when appropriating general funds for the TTB

budget.  Proponents of these arguments stress that it is unfair to require taxpayers to pay to apply

for government-mandated approvals, and that it is burdensome on small business taxpayers.

TTB employs a high percentage of highly educated and technically trained staff; more

than half are analysts, chemists, investigators, and auditors.  Accordingly, some argue that the

cost to TTB of regulatory approval may be greater than that of some other government agencies. 

On the other hand, it is not clear that the current TTB budget is inadequate for TTB to provide

these services.

The proposal gives the Secretary wide latitude to set the fees without providing the public

an opportunity for notice and comment on whether the fee is justified in light of the related

expense or its effect on the industry.  While the IRS has changed the amounts of user fees

without formal notice, comment, and hearing procedures,  the IRS user fees are constrained by

the statutory requirements that they shall vary by category and shall be determined after taking

into account the average time and difficulty of complying with the requests.  The proposal states

these same requirements with respect to TTB program fees, but only as nonbinding permissive

guidelines.  Some argue that the lack of binding statutory standards for these TTB fees

(particularly when compared with the statutory requirements applicable to the IRS), combined

with lack of notice, comment, and hearing rulemaking procedures vests too much discretion in

the Secretary.

The drawback fee under section 5134(a) has not been increased in over 50 years, and

some argue that the fee should keep up with the agency's increase in costs over that time span. 

On the other hand, some argue that two dollars per proof gallon is an unreasonably large

proportion of the entire tax on distilled spirits, i.e., $13.50 per proof gallon.

Prior Action

An identical proposal was included in the President's fiscal year 2006 budget proposal.

 

   This document may be cited as follows:  Joint Committee on Taxation, Description of Revenue

Provisions Contained in the President's Fiscal Year 2007 Budget Proposal (JCS-1-06), March 2006.

   See Office of Management and Budget, Budget of the United States Government, Fiscal Year

2007: Analytical Perspectives (H. Doc. 109-79, Vol. III), at 285-328.

   See Department of the Treasury, General Explanations of the Administration's Fiscal Year

2007Revenue Proposals, February 2006.

   However, certain provisions expire separately under the Act before the end of 2010.  For

example, the increased AMT exemption amounts expire after 2005, and thus is unaffected by the

proposal.

   The President's fiscal 2007 budget proposal includes a separate proposal to increase the

$100,000 and $400,000 amounts under section 179 to $200,000 and $800,000, respectively.  That

proposal is described in section II. B. of this document.

   Sec. 408.

   Sec. 219.

   Sec. 408A.

   Under the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA"), the

dollar limit on IRA contributions increases to $5,000 in 2008, with indexing for inflation thereafter, and

the catch-up limit is indexed for inflation for years after 2006. The provisions of EGTRRA generally do

not apply for years beginning after December 31, 2010.  As a result, the dollar limit on annual IRA

contributions is $2,000 for years after 2010, and catch-ups contributions are not permitted.  A proposal to

make the EGTRRA provisions that expire on December 31, 2010, permanent is discussed in Part I of this

document.

   Sec. 72(t).

   Sec. 25B.  The Saver's credit does not apply to taxable year beginning after December 31,

2006.

   Sec. 530.

   The present-law contribution limit and the adjusted gross income levels are subject to the

general sunset provision of EGTRRA.  Thus, for example, the limit on annual contributions to a

Coverdell education savings account is $500 after 2010.

   A proposal relating to qualified tuition programs is discussed in Part V.F. of this document.

   Sec. 529.  The general sunset provision of EGTRRA applies to certain aspects of the rules for

qualified tuition programs, including tuition programs maintained by one or more eligible educational

institutions (which may be private institutions).  Thus, for example, after 2010 a qualified tuition program

may be established and maintained only by a State or agency or instrumentality thereof.

   Sec. 223.

   Sec. 220.

   The contribution limit is indexed for inflation.

   The proposal relating to ERSAs is discussed in Part II.A.2. of this document.

   Total contributions to an LSA for a year may not exceed $5,000, regardless of whether any

distributions are taken from the LSA during the year.  The contribution limit is indexed for inflation.

   State tax law and qualified tuition program investment options may provide incentives for

savings used for educational purposes.

   The Treasury Department expects that, beginning with the 2007 filing season for individual

income tax returns, taxpayers will be able to direct that a portion of their refunds be deposited into an

LSA or RSA.

   Unlike present-law IRAs, an LSA does not require that contributions be no greater than

compensation.  Under the proposal, regardless of income, an individual may make nondeductible annual

contributions to an LSA of up to $5,000.  To the extent an individual makes contributions to his or her

own LSA that exceed his or her income, then the amounts transferred in excess of income must represent

a transfer of assets from existing savings and not new savings from forgoing current consumption. 

Additionally, individuals other than the LSA owner may make contributions to an LSA.

   Some argue that contributions to deductible IRAs declined substantially after 1986 for

taxpayers whose eligibility to contribute to deductible IRAs was not affected by the income-related limits

introduced in 1986 because financial institutions cut back on promoting contributions as a result of the

general limits on deductibility.  Thus, they would argue, universally available tax-preferred accounts such

as LSAs and RSAs will increase saving at all income levels.

   Whether an RSA and a traditional IRA to which deductible contributions are made are in fact

economically equivalent depends on the difference between the taxpayer's marginal tax rate in the year

contributions are made and the marginal tax rate in the year IRA funds are withdrawn.  When marginal

rates decrease over time (because tax rates change generally or taxpayers fall into lower tax brackets), a

traditional IRA to which deductible contributions are made is more advantageous than an RSA because

the traditional IRA permits taxpayer to defer payment of tax until rates are lower.  When marginal tax

rates increase over time, an RSA is more advantageous.

   Sec. 403(b).

   Sec. 457.

   Sec. 408(p).

   Sec. 408(k).

   Elective deferrals are treated as employer contributions for this purpose.

   For purposes of the nondiscrimination requirements, an employee is treated as highly

compensated if the employee (1) was a five-percent owner of the employer at any time during the year or

the preceding year, or (2) either (a) had compensation for the preceding year in excess of $100,000 (for

2006) or (b) at the election of the employer had compensation for the preceding year in excess of

$100,000 (for 2006) and was in the top 20 percent of employees by compensation for such year

(sec. 414(q)).   A nonhighly compensated employee is an employee other than a highly compensated

employee.

   Sec. 401(a)(4).  A qualified retirement plan of a State or local governmental employer is not

subject to the nondiscrimination requirements.

   See Treas. Reg. sec. 1.401(a)(4)-1.

   See Treas. Reg. sec. 1.401(a)(4)-2(b) and (c) and sec. 1.401(a)(4)-8(b).

   Except for certain grandfathered plans, a State or local governmental employer may not

maintain a section 401(k) plan.

   The Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA") increased

many of the limits applicable to employer-sponsored retirement plans and provided for catch-up

contributions, generally effective for years beginning after December 31, 2001.  The provisions of

EGTRRA generally do not apply for years beginning after December 31, 2010.

   Sec. 401(k)(3).

   Sec. 401(k)(12).

   Sec. 401(m).

   For proposals to provide greater conformity between section 403(b) and section 401(k) plans,

see Joint Committee on Taxation, Options to Improve Tax Compliance and Reform Tax Expenditures

(JCS-02-05), January 27, 2005, Part IV.E, at 122-129.

   The EGTRRA sunset applies to the contribution limits applicable to section 403(b) plans.

   As in the case of a qualified retirement plan, a section 403(b) plan of a State or local

governmental employer is not subject to the nondiscrimination rules.

   Section 457 applies also to deferred compensation plans of tax-exempt entities.  Those plans

are not affected by the proposal; only the rules for governmental section 457 plans are relevant for

purposes of this discussion.

   The EGTRRA sunset applies to the contribution limits applicable to section 457 plans.

   The EGTRRA sunset applies to the contribution limits applicable to SIMPLE plans.

   The EGTRRA sunset applies to the contribution limits applicable to SARSEPs.

   The EGTRRA sunset applies to the ability to make designated Roth contributions to a section

401(k) or 403(b) plan.

   Special transition rules are to be provided for plans maintained pursuant to collective

bargaining agreements and for plans sponsored by State and local governments.

   For a detailed discussion of complexity issues related to retirement savings, see, Joint

Committee on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for

Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986 (JCS-3-01),

April 2001.

   This issue is discussed in Joint Committee on Taxation, Study of the Overall State of the

Federal Tax System and Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the

Internal Revenue Code of 1986 (JCS-3-01), April 2001, at Vol. II, Part III.A.1 (General simplification

issues, at 149-150) and Part III.C.5 (Sources of Complexity, at 186), and in Joint Committee on Taxation,

Options to Improve Tax Compliance and Reform Tax Expenditures (JCS-02-05), Jan. 2005, Part IV.E, at

122-129.

   The proposals relating to Lifetime Savings Accounts and Retirement Savings Accounts are

discussed in Part II.A.1. of this document.

   Rev. Rul. 99-44, 1999-2 C.B. 549.

   If the qualified entity is tax-exempt, other persons may claim the credit as provided for in

Treasury regulations.

   Married taxpayers filing separate returns are not eligible to open an IDA or to receive

matching funds for an IDA that is already open.

   See section I.A. of this document for the description of the President's fiscal 2007 budget

proposal permanently to extend those rules of section 179 that are currently in effect for taxable years

beginning before 2008.

   To see this, consider an investment of $100 that yields the normal return in the following year,

assumed to be 10-percent pre-tax return, resulting in $110 (this example assumes no remaining basis for

simplicity).  If the tax rate is 50 percent, expensing of the $100 investment yields a $50 reduction in tax

liability, meaning the after-tax cost to the taxpayer for the $100 investment is $50.  The $110 return in the

following year results in a $55 tax, and thus a $55 after-tax return.  Thus, the after-tax rate if return on the

investment is 10 percent ($55-$50, divided by $50), the same as the pre-tax rate of return, and the present

value of tax liability, discounted at the normal rate of return, is zero.  While an investment that realized a

return in excess of the normal return would also have the same pre-tax rate of return as after-tax rate of

return, the return in excess of the normal return would bear the statutory rate of tax and the present value

of tax liability would be greater than zero.  It should be noted that when a deduction for interest on debt-

financed investment is taken along with expensing, the effective rate of tax on the normal return to such

investment turns negative.

   Secs. 106, 3121(a)(2), and 3306(b)(2).

   Sec. 105.  In the case of a self-insured medical reimbursement arrangement, the exclusion

applies to highly compensated employees only if certain nondiscrimination rules are satisfied. Sec.

105(h).  Medical care is defined as under section 213(d) and generally includes amounts paid for qualified

long-term care insurance and services.

   Secs. 125, 3121(a)(5)(G), and 3306(b)(5)(G).  Long-term care insurance and services may not

be provided through a cafeteria plan.

   Notice 2002-45, 2002-28 I.R.B. 93 (July 15, 2002); Rev. Rul. 2002-41, 2002-28 I.R.B. 75

(July 15, 2002).

   Sec. 125(d)(2).

   Self-employed individuals include more than two-percent shareholders of S corporations who

are treated as partners for purposes of fringe benefit rules pursuant to section 1372.

   Sec. 162(l).  The deduction does not apply for self-employment tax (SECA) purposes.

   Sec. 213.  The adjusted gross income percentage is 10 percent for purposes of the alternative

minimum tax. Sec. 56(b)(1)(B).

   Pub. L. No. 107-210, secs. 201(a), 202 and 203 (2002).

   Pub. L. No. 108-173 (2003).

   Sec. 223.

   Permitted insurance is: (1) insurance if substantially all of the coverage provided under such

insurance relates to (a) liabilities incurred under worker's compensation law, (b) tort liabilities, (c)

liabilities relating to ownership or use of property (e.g., auto insurance), or (d) such other similar

liabilities as the Secretary may prescribe by regulations; (2) insurance for a specified disease or illness;

and (3) insurance that provides a fixed payment for hospitalization.  Permitted coverage is coverage

(whether provided through insurance or otherwise) for accidents, disability, dental care, vision care, or

long-term care.

   The limits are indexed for inflation.

   Sec. 220.

   The deductible and out-of-pocket expenses dollar amounts are for 2006.  These amounts are

indexed for inflation in $50 increments.

   While the proposal provides that the deduction (and the credit, described below) is not allowed

for individuals covered by employer plans, it is unclear what specifically constitutes an employer plan. 

For example, an employee could have a high deductible health plan purchased in the individual market, a

portion of the cost of which is paid by the employer.  It is unclear whether such plan would qualify for the

deduction.

   For Federal fiscal years 2005-2009, the tax expenditure for the exclusion of employer

contributions for health care, health insurance premiums, and long-term care insurance premiums is

estimated to be $493.7 billion.  Joint Committee on Taxation, Estimates of Federal Tax Expenditures for

Fiscal Years 2005-2009 (JCS-1-05), January 12, 2005. 

   The policy may cover more than one individual, e.g., the policyholder and his or her family.

   The refundable HCTC provides a greater tax benefit than the exclusion.  However, the credit is

available to only limited classes of taxpayers.  Less than one-half million taxpayers per year are estimated

to be eligible for the credit.  For a comparison of the value of health tax benefits for individuals covered

under a plan that is not a high deduction plan and for individuals covered under a high deductible plan,

see Joint Committee on Taxation, Present Law and Analysis Relating to the Tax Treatment of Health

Care Expenses (JCX-12-06) March 6, 2006, tables 2 and 3, at p. 13-14.

   With an HSA, both self-employed individuals and those with employer-provided coverage

receive a tax benefit for the purchase of the health insurance as well as a tax benefit for out-of-pocket

expenses (through the HSA).  However, in some circumstances, an employee could, in addition, have an

FSA or HRA that provides coverage for additional expenses on a tax-free basis.  Thus, for example, an

employer plan could provide that the cost of a high deductible plan is paid by the employer and could also

allow an FSA that provides certain limited coverage, e.g., for dental or vision benefits.  In addition, under

Treasury guidance, the individual could also have an FSA or HRA in certain other situations, such as an

FSA or HRA that pays expenses in excess of the deductible under the high deductible plan.  In such cases,

the individual could also have an HSA to which deductible contributions could be made.  A self-

employed individual, in contrast, would not have the opportunity to have an FSA or HRA.  Individuals

(other than self-employed individuals) who purchase a high deductible plan may make deductible

contributions to an HSA, but would not receive a subsidy for the purchase of the insurance unless

aggregate medical expenses exceed the adjusted gross income threshold.  There is not always a clear

distinction between out-of-pocket expenses and expenses covered by insurance, because insurance

policies differ.  That is, some insurance policies will cover expenses that are out-of-pocket expenses other

policies.

   Specifically, because of the income tax exclusion, a dollar of consumption of tax favored

health care actually costs the taxpayer only $(1-t), where t is the tax rate of the individual.  In other words,

the taxpayer is able to convert $(1-t) dollars of after-tax income into $1 of health consumption.  The last

column of Tables 2 and 3 reports the value of the tax subsidy as a percentage of the total health costs.

   Discussions relating to inequities of the present-law rules typically do not include the itemized

deduction for medical expenses in excess of 7.5 percent of adjusted gross income.  This is because that

deduction is generally viewed as having a different policy rationale than the other present-law provisions. 

While the other provisions are generally intended to provide subsidies in various ways of the purchase of

health care, the policy behind the itemized deduction is that medical expenses in excess of a certain

amount generally are not discretionary and that high levels of such expenses adversely impact an

individual's ability to pay taxes.

   The definition of what insurance qualifies under the proposal is not clear in all cases. For

example, it is not clear whether an employee who participates in a high deductible plan of the employer

(so that premiums are calculated on a group basis) and who pays for 100 percent of the premium is

eligible for the tax benefits provided by the proposal.

   The issue of adverse selection is discussed in greater detail in Joint Committee on Taxation,

Present Law and Analysis Relating to the Tax Treatment of Health Care Expenses (JCX-12-06) March 6,

2006, tables 2 and 3, at p. 16-17 and 20-21.

   This issue may also arise under the proposed refundable credits designed to offset FICA taxes.

   For a discussion of issues relating to income phase-outs, see Joint Committee on Taxation,

Study of the Overall State of the Federal Tax System and Recommendations for Simplification, Pursuant

to Section 8022(3)(B) of the Internal Revenue Code of 1986 (JCS-3-01), April 2001, Volume II at 79.

   Pub. L. No. 107-210 (2002).

   This date is 90 days after the date of enactment of the Trade Act of 2002, which was August 6,

2002.

   Part I of subchapter B, or subchapter D, of chapter 2 of title II of the Trade Act of 1974.

   Excepted benefits are:  (1) coverage only for accident or disability income or any combination

thereof; (2) coverage issued as a supplement to liability insurance; (3) liability insurance, including

general liability insurance and automobile liability insurance; (4) worker's compensation or similar

insurance; (5) automobile medical payment insurance; (6) credit-only insurance; (7) coverage for on-site

medical clinics; (8) other insurance coverage similar to the coverages in (1)-(7) specified in regulations

under which benefits for medical care are secondary or incidental to other insurance benefits; (9) limited

scope dental or vision benefits; (10) benefits for long-term care, nursing home care, home health care,

community-based care, or any combination thereof; and (11) other benefits similar to those in (9) and (10)

as specified in regulations; (12) coverage only for a specified disease or illness; (13) hospital indemnity or

other fixed indemnity insurance; and (14) Medicare supplemental insurance.

   An amount is considered paid by the employer if it is excludable from income.  Thus, for

example, amounts paid for health coverage on a salary reduction basis under an employer plan are

considered paid by the employer.

   Specifically, an individual is not eligible for the credit if, as of the first day of the month, the

individual is (1) entitled to benefits under Medicare Part A, enrolled in Medicare Part B, or enrolled in

Medicaid or SCHIP, (2) enrolled in a health benefits plan under the Federal Employees Health Benefit

Plan, or (3) entitled to receive benefits under chapter 55 of title 10 of the United States Code (relating to

military personnel).  An individual is not considered to be enrolled in Medicaid solely by reason of

receiving immunizations.

   For this purpose, "individual health insurance" means any insurance which constitutes medical

care offered to individuals other than in connection with a group health plan.  Such term does not include

Federal- or State-based health insurance coverage.

   For guidance on how a State elects a health program to be qualified health insurance for

purposes of the credit, see Rev. Proc. 2004-12, 2004-9 I.R.B. 1.

   Creditable coverage is determined under the Health Insurance Portability and Accountability

Act (Code sec. 9801(c)).

   There is an exception for those on American Samoa who are U.S. nationals.

   The refundable child tax credit is available to residents of the possessions if the individual has

three or more qualifying children and pays FICA or SECA taxes.

   Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and

Recommendations for Simplification, Pursuant to Section 8022(3)(b) of the Internal Revenue Code of

1986, Vol. II (JCS-3-01), April 2001, p. 310.

   Secs. 170(b) and (e).

   Sec. 170(a).

   Sec. 170(f)(8).

   Sec. 6115.

   Secs. 170(f), 2055(e)(2), and 2522(c)(2).

   Sec. 170(f)(2).

    Minimum distribution rules also apply to the case of distributions after the death of a

traditional or Roth ITA owner.

   Conversion contributions refer to conversions of amounts in a traditional IRA to a Roth IRA.

   Lucky Stores Inc. v. Commissioner, 105 T.C. 420 (1995) (holding that the value of surplus

bread inventory donated to charity was the full retail price of the bread rather than half the retail price, as

the IRS asserted).

   The Katrina Emergency Tax Relief Act of 2005 defines "apparently wholesome food" as that

term is defined under the Bill Emerson Good Samaritan Food Donation Act.  42 U.S.C.A. sec. 1791.

   See generally Louis Alan Talley, "Charitable Contributions of Food Inventory: Proposals for

Change Under the 'Community Solutions Act of 2001,'" Congressional Research Service Report for

Congress (August 23, 2001).

   In general, it is never more profitable to donate food than to sell food unless the taxpayer is

permitted to deduct a value greater than the current fair market value of the food.  To see this:

?     let Y denote the taxpayer's pre-tax income from all other business activity;

?     let B denote the taxpayer's acquisition cost (basis) of the item to be donated;

?     let a represent the percentage by which the permitted deduction exceeds the taxpayer's

basis, that is aB equals the value of the deduction permitted;

?     let ß equal the current market value as a percentage of the taxpayer's basis in the item,

that is the revenue that could be attained from sale is ßB;

and let t denote the taxpayer's marginal tax rate.

Further assume that ß < 1 < a, that is, at the current market value the taxpayer would be selling at

a loss, but previously the taxpayer could sell at a profit.

The taxpayer's after-tax income from sale of the item is (Y + ßB – B)(1-t).

Under the proposal, the taxpayer's after-tax income from contribution of the item is

Y – B – t(Y – aB).  For the case in which the permitted deduction would exceed twice the taxpayer's

basis, the taxpayer's after-tax income from contribution of the item is

Y – B – t(Y – 2B).

It is more profitable to donate the item than to sell it when the following inequality is satisfied.

(1)    (Y + ßB – B)(1-t) < Y – B – t(Y – aB).

This inequality reduces to:

(2)    ß/(ß + (a-1)) < t.

Whether it is more profitable to donate food than to sell food depends upon the extent to which

the food would be sold at a loss (ß) relative to the extent of the loss plus the extent to which the permitted

deduction exceeds the taxpayer's basis (a-1), compared to the taxpayer's marginal tax rate.  Because

under present law, the marginal tax rate is 0.35, equation (2) identifies conditions on the extent of loss and

the permitted deduction that could create a situation where a charitable contribution produces a smaller

loss than would a market sale, such as the example in the text.  In the case where the taxpayer's deduction

would be limited to twice basis, it is possible to show that for a marginal tax rate of 35 percent, the

current market value of the item to be donated must be less than 53.8 percent of the taxpayer's basis in the

item, that is, ß <0.538.

   See Martin A. Sullivan, "Economic Analysis: Can Bush Fight Hunger With a Tax Break?,"

Tax Notes, vol. 94, February 11, 2002, p. 671.

   Such taxpayers must remove the amount of the contribution deduction for the contributed

food inventory from opening inventory, and do not treat the removal as a part of cost of goods sold.  IRS

Publication 526, Charitable Contributions, pp. 7-8.

   Sec. 4942(g).

   Sec. 4940(e).

   Sec. 4942.

   Sec. 4940(d)(1).  Exempt operating foundations generally include organizations such as

museums or libraries that devote their assets to operating charitable programs but have difficulty meeting

the "public support" tests necessary not to be classified as a private foundation.  To be an exempt

operating foundation, an organization must: (1) be an operating foundation (as defined in section

4942(j)(3)); (2) be publicly supported for at least 10 taxable years; (3) have a governing body no more

than 25 percent of whom are disqualified persons and that is broadly representative of the general public;

and (4) have no officers who are disqualified persons.  Sec. 4940(d)(2).

   Sec. 4942(d)(2).

   Operating foundations are not subject to the minimum charitable payout rules.  Sec.

4942(a)(1).

   The proposal does not, however, increase the total amount required to be paid out for

charitable and tax purposes; rather, by reducing the rate of tax, the proposal decreases the amount of the

pay out that may be satisfied through payment of tax.

   In general, foundations that make only the minimum amount of charitable distributions and

seek to minimize total payouts have no incentive to decrease their rate of excise tax because such a

decrease would result in an increase in the required minimum amount of charitable distributions, thus

making no difference to the total payout of the private foundation.

   See C. Eugene Steuerle and Martin A. Sullivan, "Toward More Simple and Effective Giving:

Reforming the Tax Rules for Charitable Contributions and Charitable Organizations," American Journal

of Tax Policy, 12, Fall 1995, at 399-447.

   For example, if over a 10-year period the foundation increased its payout rate from the

minimum 5.00 percent to 5.01 percent, to 5.02 percent, up to 5.10 percent, the foundation generally would

qualify for the one-percent excise tax rate throughout the 10-year period.

   Whether a reduction in payout rate causes the foundation to pay the two-percent tax rate

depends upon the specific pattern of its payout rate in the preceding five years and the magnitude of the

decrease in the current year.

   In this example, after having paid out 8.0 percent, the five-year average payout for the first

year in which the foundation pays out 5.5 percent would be 5.6 percent.

   See Figure G in Melissa Ludlum, "Domestic Private Foundations and Charitable Trusts,

2001," Internal Revenue Service, Statistics of Income Bulletin, 24, Fall 2004 at 150.

   Steuerle and Sullivan, "Toward More Simple and Effective Giving: Reforming the Tax Rules

for Charitable Contributions and Charitable Organizations," at 438.

   See Figure I in Paul Arnsberger, "Private Foundations and Charitable Trusts, 1995," Internal

Revenue Service, Statistics of Income Bulletin, 18, Winter 1998-1999 at 73 and Figure I in Melissa

Ludlum, "Domestic Private Foundations and Charitable Trusts, 1999," Internal Revenue Service,

Statistics of Income Bulletin, 22, Fall 2002 at 148.

   See Figure J in Melissa Ludlum, "Domestic Private Foundations and Charitable Trusts,

2001," Internal Revenue Service, Statistics of Income Bulletin, 24, Fall 2004 at 153.

   See Figure I in Paul Arnsberger, "Private Foundations and Charitable Trusts, 1995," Internal

Revenue Service, Statistics of Income Bulletin, 18, Winter 1998-1999 at 73 and Figure I in Melissa

Ludlum, "Domestic Private Foundations and Charitable Trusts, 1999," Internal Revenue Service,

Statistics of Income Bulletin, 22, Fall 2002 at 148.

   See Figure J in Melissa Ludlum, "Domestic Private Foundations and Charitable Trusts,

2001," Internal Revenue Service, Statistics of Income Bulletin, 24, Fall 2004 at 153.

   Sec. 664(d).

   Sec. 664(b).

   Treas. Reg. sec. 1.664-1(d)(4).

   Sec. 1366(a)(1)(A).

   Sec. 1367(a)(2)(B).

   See Rev. Rul. 96-11 (1996-1 C.B. 140) for a similar rule applicable to contributions made by

a partnership.

   S. Rep. 105-33 (June 20, 1997), at 24-25.

   H. Rep. 105-220 (July 30, 1997), at 372-373.

   Section 142(a)(7) describes an exempt facility bond as any bond issued as part of an issue of

bonds if 95 percent or more of the net proceeds of the issue are to be used to provide qualified residential

rental projects.

   H.R. Rep. No. 100-795 at 585 (1988).  The report also noted:  "The press has reported

housing industry representatives stating publicly that a primary attraction of some housing financed with

governmental and qualified 501(c)(3) bonds is that the low-income tenant requirements and State volume

caps applicable to for-profit developers do not apply."  Id.

   H.R. Conf. Rep. 100-1104, vol. II at 126 (1988).

   Treas. Reg. sec. 1.162-5.

   Sec. 222.

   A separate proposal contained in the President's fiscal year 2007 budget permanently extends

the elimination of the overall limitation on itemized deductions after 2010 (I.A.,above ).

   See Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and

Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of

1986, Volume II, 15, 88, at 118 (JCS-3-01), April 2001.

   Section 179 provides that, in place of depreciation, certain taxpayers, typically small

businesses, may elect to deduct up to $100,000 of the cost of section 179 property placed in service each

year. In general, section 179 property is defined as depreciable tangible personal property that is

purchased for use in the active conduct of a trade or business.

   For a discussion of the economic effects of targeting economic activity to specific geographic

areas, see Leslie E. Papke, "What Do We Know About Enterprise Zones," in James M. Poterba, ed., Tax

Policy and the Economy, vol. 7 (Cambridge, MA: The MIT Press), 1993.

   Commissioner v. Idaho Power Co., 418 U.S. 1 (1974) (holding that equipment depreciation

allocable to the taxpayer's construction of capital facilities must be capitalized under section 263(a)(1)).

   For a discussion of the economic effects of targeting economic activity to specific geographic

areas, see Leslie E. Papke, "What Do We Know About Enterprise Zones," in James M. Poterba, ed., Tax

Policy and the Economy, vol. 7 (Cambridge, MA: The MIT Press), 1993.

   In addition to the NYLZ provisions described above, other NYLZ incentives are provided: 

(1) $8 billion of tax-exempt private activity bond financing for certain nonresidential real property,

residential rental property and public utility property is authorized to be issued after March 9, 2002, and

before January 1, 2010; and (2) $9 billion of additional tax-exempt advance refunding bonds is available

after March 9, 2002, and before January 1, 2006, with respect to certain State or local bonds outstanding

on September 11, 2001.

   The amount of the additional first-year depreciation deduction is not affected by a short

taxable year.

   A special rule precludes the additional first-year depreciation deduction for property that is

required to be depreciated under the alternative depreciation system of MACRS.

   Qualified NYLZ leasehold improvement property is defined in another provision.  Leasehold

improvements that do not satisfy the requirements to be treated as "qualified NYLZ leasehold

improvement property" maybe eligible for the 30 percent additional first-year depreciation deduction

(assuming all other conditions are met).

   For purposes of this provision, purchase is defined as under section 179(d).

   Property is not precluded from qualifying for the additional first-year depreciation merely

because a binding written contract to acquire a component of the property is in effect prior to

September 11, 2001.

   December 31, 2009 with respect to qualified nonresidential real property and residential rental

property.

   Sec. 168(i)(8).  The Tax Reform Act of 1986 modified the Accelerated Cost Recovery System

("ACRS") to institute MACRS.  Prior to the adoption of ACRS by the Economic Recovery Tax Act of

1981, taxpayers were allowed to depreciate the various components of a building as separate assets with

separate useful lives.  The use of component depreciation was repealed upon the adoption of ACRS.  The

Tax Reform Act of 1986 also denied the use of component depreciation under MACRS.

   Former sections 168(f)(6) and 178 provided that, in certain circumstances, a lessee could

recover the cost of leasehold improvements made over the remaining term of the lease.  The Tax Reform

Act of 1986 repealed these provisions.

   Secs. 168(b)(3), (c), (d)(2), and (i)(6).  If the improvement is characterized as tangible

personal property, ACRS or MACRS depreciation is calculated using the shorter recovery periods,

accelerated methods, and conventions applicable to such property. The determination of whether

improvements are characterized as tangible personal property or as nonresidential real property often

depends on whether or not the improvements constitute a "structural component" of a building (as defined

by Treas. Reg. sec. 1.48-1(e)(1)).  See, e.g., Metro National Corp v. Commissioner, 52 TCM (CCH) 1440

(1987); King Radio Corp Inc. v. U.S., 486 F.2d 1091 (10th Cir. 1973); Mallinckrodt, Inc. v.

Commissioner, 778 F.2d 402 (8th Cir. 1985) (with respect to various leasehold improvements).

   As defined in sec. 179(d)(1).

   See Rev. Proc. 2002-33, 2002-20 I.R.B. 963 (May 20, 2002), for procedures on claiming the

increased section 179 expensing deduction by taxpayers who filed their tax returns before June 1, 2002.

   Section 1033(a)(2)(B).

   Section 1033(g)(4).

   The proposal does not change the present-law rules relating to certain NYLZ private activity

bond financing and additional advance refunding bonds.

   Pub. Law No. 107-147, sec. 301 (2002).

   A foster child must reside with the taxpayer for the entire taxable year.

   All income thresholds are indexed for inflation annually.

   Secs. 32(d) and 7703(b).

   The proposal adopts the qualifying child test for this purpose, rather than the "dependent

child" test that applies under present law.

   Both under the proposal and present law, unmarried parents who reside together with multiple

qualifying children who are their sons, daughters, stepchildren, adopted children, or foster children, may

allocate the qualifying children between them for earned income credit purposes. 

   The proposal does not require that qualifying children have Social Security numbers

authorizing them to work in the United States.

   Under pension equity plans (often called "PEPs"), benefits are generally described as a

percentage of final average pay, with the percentage determined on the basis of points received for each

year of service, which are often weighted for older or longer service employees.  Pension equity plans

commonly provide interest credits for the period between a participant's termination of employment and

commencement of benefits.

   The assets of the cash balance plan may or may not include the assets or investments on

which interest credits are based.  As in the case of other defined benefit pension plans, a plan fiduciary is

responsible for making investment decisions with respect to cash balance plan assets.

   The conversion of a defined benefit pension plan to a cash balance plan generally means that

the plan is amended to change the formula for accruing benefits from a traditional defined benefit formula

to a cash balance formula.  In such cases, the plan with the old formula and the plan as amended with the

new formula are sometimes referred to as different plans, even though legally there is not a separate new

plan.

   Sec. 411(d)(6); ERISA sec. 204(g).

   Sec. 417(e); ERISA sec. 205(g).

   Sec. 411(b)(1)(G) and (H); ERISA sec. 204(b)(1)(G) and (H); Age Discrimination in

Employment Act ("ADEA"), 29 U.S.C. 623(i).

   Sec. 411(b); ERISA sec. 204(b).

   Announcement 2003-1, 2003-2 I.R.B. 281.

   Id.

   Sec. 411(b); ERISA sec. 204(b).

   Sec. 411(a)(7).  If a plan does not provide an accrued benefit in the form of an annuity

commencing at normal retirement age, the accrued benefit is an annuity commencing at normal retirement

age that is the actuarial equivalent of the accrued benefit determined under the plan.  Treas. Reg. sec.

1.411(a)-7(a)(1)(ii).

   Notice 96-8, 1996-1 C.B. 359.

   Sec. 411(d)(6); ERISA sec. 204(g).  The provisions do not, however, protect benefits that

have not yet accrued but would accrue in the future if the plan's benefit formula were not changed.

   Sec. 411(d)(6)(B); ERISA sec. 204(g)(2).

   This description applies to normal retirement benefits.  Other issues may arise with respect to

early retirement benefits.  For example, a plan might have provided a subsidized early retirement benefit

before the conversion.  After the conversion, the subsidized early retirement benefit must still be provided

with respect to the preconversion accrued benefit.  However, the plan is not required to provide a

subsidized early retirement benefit with respect to benefits that accrue after the conversion.

   This is sometimes the reduction in benefits that is referred to in connection with cash balance

conversions, i.e., a reduction in expected benefits, not accrued benefits.

   Code sec. 411(b)(1)(H); ERISA sec. 204(b)(1)(H).  Similarly, a defined contribution plan is

prohibited from reducing the rate at which amounts are allocated to a participant's account (or ceasing

allocations) because of the attainment of any age.

   29 U.S.C. Code sec. 623(i).

   Sec. 411(b)(1)(H)(ii); ERISA sec. 204(b)(1)(H)(ii).

   Other age discrimination issues may also arise in connection with cash balance plan

conversions, depending in part on how the conversion is made, such as whether the plan has a

"wearaway."  However, the recent focus of age discrimination has related to the basic cash balance plan

design.

   67 Fed. Reg. 76123 (December 11, 2002).  Prop. Treas. Reg. sec. 1.411(b)-2.  (The proposed

regulations were issued after consideration of comments on regulations proposed in 1988.  53 Fed. Reg.

11876 (April 11, 1988).)  Treasury had previously discussed the cash balance age discrimination issue in

the preamble to regulations issued in 1991 under section 401(a)(4), which provided a safe harbor for cash

balance plans that provide frontloaded interest credits and meet certain other requirements.  The preamble

to these regulations stated "[t]he fact that interest adjustments through normal retirement age are accrued

in the year of the related hypothetical allocation will not cause a cash balance plan to fail to satisfy the

requirements of section 411(b)(1)(H), relating to age-based reductions in the rate at which benefits accrue

under a plan."  56 Fed. Reg. 47528 (Sept. 19, 1991).

   The proposed regulations also addressed a number of other issues, including

nondiscrimination testing for cash balance plans under section 401(a)(4).  In April 2003, the Treasury

Department announced it would withdraw the portion of proposed regulations relating to

nondiscrimination testing because the regulations might make it difficult for employers to provide

transition relief to participants upon conversions.  Announcement 2003-22, 2002-17 I.R.B. 846 (April 28,

2003).

   Pub. L. No. 108-199 (2004).

   The Treasury Department complied with this requirement by including its cash balance

proposal in the President's fiscal year 2005 budget proposal.

   Announcement 2004-57, 2004-27 I.R.B. 15.

   Id.

   Other decisions discussing the age discrimination issue do not directly address the issue, but

are based on procedural errors or only discuss the issue as dicta.  In Campbell v. BankBoston, 327 F.3d 1

(1st Cir. 2003), the plaintiff argued for the first time only on appeal that the cash balance plan at issue

violated the age discrimination rules.  The court therefore held that the issue had been waived and did not

resolve the issue.  However, the court briefly described the various arguments involved and the

disagreement as to how rate of benefit accrual should be determined.  While the BankBoston decision is

often cited for the position that cash balance plans are not age discriminatory, the appeals court did not

actually resolve the age discrimination issue.  In Engers v. AT&T, 2000 U.S. Dist. LEXIS 10937 (D.N.J.

June 29, 2000), the court dismissed an age discrimination claim based on disparate impact, but ruled that

a claim that AT&T's cash balance plan reduced the rate of benefit accrual on account of age in violation

of ERISA and the ADEA could proceed to trial.

   117 F. Supp. 2d 812 (S.D. Ind. 2000).

   274 F. Supp. 2d 1010 (S.D. Ill. 2003).

   222 F.R.D. 88 (D. Md. 2004).

   No. 04-CV-6097, 2005 WL 3120268 (E.D. Pa. Nov. 21, 2005).

   Sec. 401(a)(11); ERISA sec. 205(a).

   Secs. III.B. and C of Notice 96-8.

   Berger v. Xerox Corp. Retirement Income Guarantee Plan, 338 F.3d 755 (7th Cir. 2003);

Esden v. Bank of Boston, 229 F.3d 154 (2d Cir. 2000), cert. dismissed, 531 U.S. 1061 (2001); and Lyons

v. Georgia Pacific Salaried Employees Retirement Plan, 221 F.3d 1235 (11th Cir. 2000), cert. denied,

532 U.S. 967 (2001).  See also, West v. AK Steel Corp. Retirement Accumulation Plan, 2004 U.S. Dist.

LEXIS 9224 (S.D. Ohio April 8, 2004).  Additionally, under Esden, if participants accrue interest credits

under a cash balance plan at an interest rate that is higher than the interest assumptions prescribed by the

Code for determining the present value of the annuity, the interest credits must be reflected in the

projection of the participant's hypothetical account balance to normal retirement age in order to avoid

violating the Code's prohibition against forfeitures.

   A proposal to change the interest rate used to determine minimum lump-sum values is

discussed in Part IV.C.

   These concerns led to the enactment of the present-law notice requirements regarding future

reductions in benefit accruals.  Sec. 4980F and ERISA sec. 204(h).

   Joint Committee on Taxation, Report of Investigation of Enron Corporation and Related

Entities Regarding Federal Tax and Compensation Issues, and Policy Recommendations (JCS-3-03),

February 2003, at Vol. I, 487.

   Additional information about the Administration's proposals relating to funding and the

Pension Benefit Guaranty Corporation is available on the Department of Labor's website at

www.dol.gov/ebsa/pensionreform.html.

   Many believe that resolution of the uncertainty surrounding cash balance plans is also

essential to the long-term viability of the defined benefit pension system, as discussed more fully in

connection with the Administration's proposal relating to cash balance plans in Part IV.A.

   A variety of estimates and assumptions are used by the PBGC in evaluating the present value

of its liability for future benefits, including assumptions about future plan terminations.  According to the

PBGC, this present value is particularly sensitive to changes in the underlying estimates and assumptions;

changes in estimates and assumptions could materially change the present value of its liability for future

benefits.

   Sec. 412; ERISA secs. 301-308.  The minimum funding rules do not apply to governmental

plans or to church plans, except church plans with respect to which an election has been made to have

various requirements, including the funding requirements, apply to the plan.  In some respects, the

funding rules applicable to multiemployer plans differ from the rules applicable to single-employer plans. 

In addition, special rules apply to certain plans funded exclusively by the purchase of individual insurance

contracts (referred to as "insurance contract" plans).

   Present law also provides for the use of an "alternative" funding standard account, which has

rarely been used.

   The deficit reduction contribution rules apply to single-employer plans, other than single-

employer plans with no more than 100 participants on any day in the preceding plan year.  Single-

employer plans with more than 100 but not more than 150 participants are generally subject to lower

contribution requirements under these rules.

   Under an alternative test, a plan is not subject to the deficit reduction contribution rules for a

plan year if (1) the plan's funded current liability percentage for the plan year is at least 80 percent, and

(2) the plan's funded current liability percentage was at least 90 percent for each of the two immediately

preceding plan years or each of the second and third immediately preceding plan years.

   In determining a plan's funded current liability percentage for a plan year, the value of the

plan's assets is generally reduced by the amount of any credit balance under the plan's funding standard

account.  However, this reduction does not apply in determining the plan's funded current liability

percentage for purposes of whether an additional charge is required under the deficit reduction

contribution rules.

   If the Secretary of the Treasury prescribes a new mortality table to be used in determining

current liability, as described below, the deficit reduction contribution may include an additional amount.

   In making these computations, the value of the plan's assets is reduced by the amount of any

credit balance under the plan's funding standard account.

   The weighting used for this purpose is 40 percent, 30 percent, 20 percent and 10 percent,

starting with the most recent year in the four-year period.  Notice 88-73, 1988-2 C.B. 383.

   If the Secretary of the Treasury determines that the lowest permissible interest rate in this

range is unreasonably high, the Secretary may prescribe a lower rate, but not less than 80 percent of the

weighted average of the 30-year Treasury rate.

   Sec. 412(b)(5)(B)(iii)(II); ERISA sec. 302(b)(5)(B)(iii)(II).  Under Notice 90-11, 1990-1 C.B.

319, the interest rates in the permissible range are deemed to be consistent with the assumptions reflecting

the purchase rates that would be used by insurance companies to satisfy the liabilities under the plan.

   Pub. L. No. 108-218 (2004).

   In addition, under PFEA 2004, if certain requirements are met, reduced contributions under

the deficit reduction contribution rules apply for plan years beginning after December 27, 2003, and

before December 28, 2005, in the case of plans maintained by commercial passenger airlines, employers

primarily engaged in the production or manufacture of a steel mill product or in the processing of iron ore

pellets, or a certain labor organization.

   Sec. 412(l)(7)(C)(ii); ERISA sec. 302(d)(7)(C)(ii).

   Rev. Rul. 95-28, 1995-1 C.B. 74.  Under Prop. Treas. Reg. 1.412(l)(7)-1, beginning in 2007,

RP-2000 Mortality Tables are used with improvements in mortality (including future improvements)

projected to the current year and with separate tables for annuitants and nonannuitants. 

   For plan years beginning before 2004, the full funding limitation was generally defined as the

excess, if any, of (1) the lesser of (a) the accrued liability under the plan (including normal cost) or (b) a

percentage (170 percent for 2003) of the plan's current liability (including the current liability normal

cost), over (2) the lesser of (a) the market value of plan assets or (b) the actuarial value of plan assets, but

in no case less than the excess, if any, of 90 percent of the plan's current liability over the actuarial value

of plan assets.  Under the Economic Growth and Tax Relief Reconciliation Act of 2001 ("EGTRRA"), the

full funding limitation based on 170 percent of current liability is repealed for plan years beginning in

2004 and thereafter.  The provisions of EGTRRA generally do not apply for years beginning after

December 31, 2010.

   Sec. 412(m); ERISA sec. 302(e).

   Sec. 412(d); ERISA sec. 303.  Under similar rules, the amortization period applicable to an

unfunded past service liability or loss may also be extended.

   Sec. 4971.  An excise tax applies also if a quarterly installment is less than the amount

required to cover the plan's liquidity shortfall.

   Sec. 4980.

   Sec. 420.

   The value of plan assets for this purpose is the lesser of fair market value or actuarial value.

   Sec. 404(a)(1).

   Sec. 404(a)(1)(D).  In the case of a plan that terminates during the year, the maximum

deductible amount is generally not less than the amount needed to make the plan assets sufficient to fund

benefit liabilities as defined for purposes of the PBGC termination insurance program (sometimes

referred to as "termination liability").

   Sec. 4972.

   The proposal does not change the funding rules applicable to multiemployer plans or

insurance contract plans.  Governmental plans and church plans continue to be exempt from the funding

rules to the extent provided under present law.

   As discussed below, different payments may be required with respect to amortization bases

established for different years.

   A proposal to use interest rates drawn from a corporate bond yield curve in determining

benefits subject to the minimum value rules, such as lump sums, is discussed in Part IV.C.

   These additional assumptions are intended to reflect behavior that may occur when the

financial health of the plan sponsor deteriorates.

   The loading factor is intended to reflect the cost of purchasing group annuity contracts in the

case of termination of the plan.

   At-risk normal cost does not include a loading factor of $700 per plan participant.

   Typically, higher interest rates apply to bonds of longer durations, and lower interest rates

apply to bonds of shorter durations.  It is therefore expected that higher interest rates will generally apply

in determining the present value of payments expected to be made further in the future, and lower interest

rates will generally apply in determining the present value of payments expected to be made in the nearer

future.

   Such benefits are taken into account in determining the plan's normal cost for the plan year.

   The present-law rules permitting the waiver of the minimum funding requirements continue to

apply.

   Under the proposal, the present-law rules permitting the extension of amortization periods are

repealed with respect to single-employer plans.

   Some employers may also wish to make additional contributions to improve the funding

status of their plans for financial reporting purposes.

   A proposal to use a corporate bond yield curve in determining minimum lump-sum benefits is

discussed in Part IV.C.

   In practice, the price of an annuity contact encompasses not only an interest rate factor but

also other factors, such as the costs of servicing the contract and recordkeeping.  Under present law, the

interest rate used for determining current liability is intended to embody all of these factors.  See H.R.

Rpt. No. 100-495, at 868 (1987).

   As discussed above, temporary increases in the permissible interest rate for purposes of

determining current liability were enacted in 2002 and 2004.

   Some also argue that the interest rate used for funding purposes should be based on the

expected return on plan investments, rather than on annuity purchase rates.

   Code secs. 6058 and 6059; ERISA secs. 103 and 4065.

   Code sec. 6059; ERISA sec. 103(d).

   ERISA sec. 104(b).  A participant must also be provided with a copy of the full annual report

on written request.

   ERISA sec. 4011.

   ERISA sec. 4010.

   ERISA sec. 4071.

   ERISA sec. 4010(c).

   As discussed  connection with the proposal relating to funding rules for single-employer

defined benefit pension plans in Part IV.B.2, for a plan sponsor that is not financially weak, the funding

target is the plan's ongoing liability.  For a plan sponsor that is financially weak, the funding target

generally is the plan's at-risk liability.  In general, a plan's ongoing liability for a plan year is the present

value of future payments expected to be made from the plan to provide benefits earned as of the

beginning of the plan year.  At-risk liability is based on the same benefits and assumptions as ongoing

liability, except that the valuation of those benefits would require the use of certain actuarial assumptions

to reflect the concept that a plan maintained by a financially weak plan sponsor may be more likely to pay

benefits on an accelerated basis or to terminate its plan.

   ERISA sec. 4011.

   The exception for trade secrets and commercial or financial information also applies for

purposes of the Code rule allowing public inspection of written determinations. Sec. 6110(c)(4).

   ERISA sec. 407.

   ERISA uses the term "individual account plan" to refer to defined contribution plans.  Money

purchase pension plans (a type of defined contribution plan) are subject to the 10-percent limitation unless

the plan was established before ERISA.  Special rules apply with respect to certain plans to which elective

deferrals are made.

   Enron's floor-offset plan and related issues are discussed in Joint Committee on Taxation,

Report of Investigation of Enron Corporation and Related Entities Regarding Federal Tax and

Compensation Issues, and Policy Recommendations (JCS-3-03), February 2003, at 458-75.

   Code sec. 412(d); ERISA sec. 303.

   Code sec. 412(f); ERISA sec. 304(b)(1).

   Code sec. 401(a)(29); ERISA sec. 307.

   Code sec. 401(a)(33); ERISA sec. 204(i).

   Code sec. 401(a)(32); ERISA sec. 206(e).

   Rules governing nonqualified deferred compensation arrangements are contained in Code

section 409A.

   Sec. 409A.

   Treas. Reg. sec. 1.401-1(b)(1)(i).

   Treas. Reg. secs. 1.401(a)(4)-3(f)(4) and 1.411(a)-7(c).

   Sec. 411(d)(6).  Section 204(g) of ERISA provides similar rules for ERISA-covered plans.

   Treas. Reg. sec. 1.411(d)-3(b).

   ERISA sec. 4022(a).

   ERISA sec. 4022(b) and (c).

   The PBGC termination insurance program does not cover plans of professional service

employers that have fewer than 25 participants.

   ERISA sec. 4006(a).

   Pub. L. No. 109-171, enacted February 8, 2006.  The Deficit Reduction Act of 2005 was

enacted after the issuance of the President's fiscal year 2007 budget proposal.

   If variable rate premiums are required to be paid, the plan administrator generally must

provide notice to plan participants of the plan's funding status and the limits on the PBGC benefit

guarantee if the plan terminates while underfunded.

   Sec. 6601.

   ERISA sec. 4007(b).

   For a plan sponsor that is not financially weak, the funding target is the plan's ongoing

liability.  For a plan sponsor that is financially weak, the funding target generally is the plan's at-risk

liability.  Ongoing liability and at-risk liability are discussed in the proposal relating to the funding and

deduction rules in Part IV.B.2.  In general, a plan's ongoing liability for a plan year is the present value of

future payments expected to be made from the plan to provide benefits earned as of the beginning of the

plan year.  At-risk liability is based on the same benefits and assumptions as ongoing liability, except that

the valuation of those benefits would require the use of certain actuarial assumptions to reflect the concept

that a plan maintained by a financially weak plan sponsor may be more likely to pay benefits on an

accelerated basis or to terminate its plan.

   Testimony of Bradley D. Belt, Executive Director, Pension Benefit Guarantee Corporation,

before the Committee on Finance, United States Senate (March 1, 2005) at 15.

   ERISA sec. 4041.

   Id.

   ERISA sec. 4001(a)(16).

   ERISA sec. 4041.

   ERISA sec. 4044(a).

   Id.

   The asset allocation rules also apply in standard terminations.

   ERISA sec. 4022(b) and (c).

   The PBGC generally pays the greater of the guaranteed benefit amount and the amount that

was covered by plan assets when it terminated.  Thus, depending on the amount of assets in the

terminating plan, participants may receive more than the amount guaranteed by PBGC.

   GAO, High-risk Series: An Update, GAO-05-207 (Washington, D.C.: January 2005).

   Code sec. 412; ERISA sec. 302.

   Code sec. 412(n); ERISA sec. 302(f).

   The term "controlled group" means any group treated as a single employer under subsections

(b), (c), (m) or (o) of Code section 414.

   When a creditor has taken the required steps to perfect a lien, that lien is senior to any liens

that arise subsequent to the perfection.  An unperfected lien is valid between the debtor and the creditor,

but in the context of a bankruptcy proceeding, an unperfected lien may be treated as behind liens created

later in time, but perfected earlier.  In addition, an unperfected lien can be avoided in bankruptcy.  State

law generally applies to perfection of liens.  A lien generally may be perfected in various ways, including

by filing or recording with various government offices. 

   11 U.S.C. sec. 362 (2005).

   11 U.S.C. sec. 101(53) (2005).

   The bankruptcy trustee is the representative of the debtor's estate.  The estate is generally is

comprised of the legal or equitable interests of the debtor as of the filing of the petition for bankruptcy. 

See 11 U.S.C. secs. 323 and 541 (2005).

   11 U.S.C. sec. 545(2) (2005).  Statutory liens may also be avoided to the extent that the lien

first becomes effective against the debtor: (1) when a bankruptcy case is commenced; (2) when an

insolvency proceeding other than under bankruptcy law is commenced; (3) when a custodian is appointed

or authorized to take or takes possession; (4) when the debtor becomes insolvent; (5) when the debtor's

financial condition fails to meet a specified standard; or (6) at the time of an execution against property of

the debtor levied at the instance of an entity other than the holder of such statutory lien.  11 U.S.C. sec.

545(1) (2005).

   Code sec. 417(e)(3); ERISA sec. 205(g)(3).

   Code sec. 415(b).

   The President's proposal relating to the interest rate to be used to value a plan's liabilities for

funding purposes is discussed in Part IV.B.2.

   Under the proposal relating to changes in the funding rules, discussed in Part IV.B.2, lump-

sum benefits expected to be paid from a plan are required to be reflected in valuing plan liabilities.

   For 2004 and 2005, 5.5 percent is used in lieu of the interest rate used in determining

minimum lump sums.  However, the proposal is not effective until after such years.

   Treas. Reg. sec. 1.901-2(f)(1).

   See, e.g., Notices 2004-19 and 2004-20, 2004-11 I.R.B. 1.

   Secs. 311(b) and 336.

   Secs. 301 and 302.

   Sec. 355(b).  Certain taxable acquisitions that are considered expansions of an existing active

trade or business are not treated as the taxable acquisition of a business for purposes of the rules.  Treas.

Reg. sec. 1.355-3(b)(3)(ii) and sec. 1.355-3(c), Examples (7) and (8).

   Sec. 355(b)(2)(A). The IRS takes the position for advance ruling purposes that the second

statutory test requires that at least 90 percent of the fair market value of the corporation's gross assets

consist of stock and securities of a controlled corporation that is engaged in the active conduct of a trade

or business.  Rev. Proc. 96-30, sec. 4.03(5), 1996-1 C.B. 696; Rev. Proc. 77-37, sec. 3.04, 1977-2 C.B.

568.

   The ruling guidelines also provided the possibility that the IRS might rule the active trade or

business test was satisfied if the trades or businesses relied upon were not "de minimis" compared with

the other assets or activities of the corporation and its subsidiaries. Rev. Proc. 2003-3, sec. 4.01(30),

2003-1 I.R.B. 113.

   Rev. Proc. 2003-48, 2003-29 I.R.B. 86.

   In one of the reported recent transactions, the Clorox Company distributed $2.1 billion cash

and a business worth $740 million to a U.S. subsidiary of the German company Henkel KGaA in

redemption of that subsidiary's 29 percent interest in Clorox.  Other reported transactions were

undertaken by Janus Capital Group and DST Systems, Inc. (with cash representing 89 percent of the value

of the distributed corporation); Houston Exploration Company and KeySpan Corp. (87 percent cash); and

Liberty Media Corporation and Comcast Corporation (53 percent cash).  See, e.g., Allan Sloan, "Leading

the Way in Loophole Efficiency," Washington Post, (October 26, 2004), at E.3;  Robert S. Bernstein,

"Janus Capital Group's Cash Rich Split-Off," Corporate Taxation, (November-December 2003) at 39;

Robert S. Bernstein, "KeySpan Corp.'s Cash-Rich Split Off," Corporate Taxation, (September-October

2004) at 38.  Robert Willens, "Split Ends," Daily Deal, (August 31, 2004); and Richard Morgan,

"Comcast Exits Liberty Media," Daily Deal, (July 22, 2004).  See also, The Clorox Company Form 8-K

SEC File No. 001-07151), (October 8, 2004); Janus Capital Group, Inc. Form 8-K (SEC File No. 001-

15253) (August 26, 2003); The Houston Exploration Company Form 8-K (SEC File No. 001-11899)

(June 4, 2004); Key Span Corp. Form 8-K (SEC File No. 001-14161 (June 2, 2004); and Liberty Media

Corporation Form 8-K (SEC File No. 001-16615) (July 21, 2004). 

   The proposal does not explicitly define the situations in which various types of assets could

qualify under the test as "used or held for use" in an active trade or business.  Thus, it is unclear whether,

or to what extent, the proposal categorically would preclude investment assets or cash from being

considered such assets. See additional discussion of these issues in the following text. 

   Secs. 1202(c)(2), 1202(e)(1)(A), and 1045(b). For purposes of this 80-percent test, the statute

expressly provides that assets are treated as used in the active conduct of a trade or business if they are

held as part of the reasonably required working capital needs of a qualified trade or business or if they are

held for investment or are reasonably expected to be used within two years to finance research and

experimentation in a qualified trade or business or increases in working capital needs of a qualified trade

or business. However, for periods after the corporation has been in existence for at least two years, no

more than 50 percent of the assets of the corporation can qualify as used in the active conduct of a trade

or business by reason of these provisions. Sec. 1202(e)(6).

   Tax free treatment under section 355 does not apply to a transaction that is used principally as

a "device" for the distribution of earnings and profits.  Sec. 355(a)(1)(B). The statute does not contain any

absolute percentage threshold of nonbusiness assets that is forbidden under this test.  It could be

undesirable and possibly suggestive of a more liberal rule in pro-rata cases to establish a specific

threshold for non-pro-rata transactions while allowing a continuing unspecified threshold in the pro-rata

situation.

   A similar proposal addressing the group to which the present law active business test is

applied was contained in the Joint Tax Committee Staff Simplification recommendations. Joint

Committee on Taxation, Study of the Overall State of the Federal Tax System and Recommendations for

Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986 (JCS-3-01), April

2001, Vol. II at 251-252. Such a proposal was also contained in section 304 of the Senate amendment to

H.R. 4250 (but was not adopted in the American Jobs Creation Act of 2004, which was the final enacted

version of that legislation).  See H.R. Rep. 108-755, 108th Cong. (2004) at 361-362.

   Section 467 of H.R. 4297 as passed by the Senate in 2006.  The provision is identical to

section 567 of S. 2020, passed by the Senate in 2005.

   Both the Senate and House tax reconciliation bills for Fiscal Year 2006 also modify the active

trade or business test to apply on a group basis to each of the affiliated chains of corporations of which the

distributing and controlled corporations are the respective parent corporations, immediately after the

distribution.  H.R, 4297, the Tax Relief Extension Reconciliation Act of 2005, as passed by the House of

Representatives, sec. 302; H.R. 4297, the Tax Relief Act of 2005, as passed by the Senate, sec. 467(a).

The House bill does not contain the restrictions on disqualified investment companies that the Senate bill

contains.  

   Charitable contributions of interests that constitute the taxpayer's entire interest in the

property are not regarded as qualified real property interests within the meaning of section 170(h), but

instead are subject to the general rules applicable to charitable contributions of entire interests of the

taxpayer (i.e., generally are deductible at fair market value, without regard to satisfaction of the

requirements of section 170(h)).  Priv. Ltr. Rul. 8626029 (March 25, 1986).

   Treas. Reg. sec. 1.170A-14(e)(2).

   Id.

   A person is related to another person if (1) such person bears a relationship to such other

person that is described in section 267(b) (determined without regard to paragraph (9)), or section

707(b)(1), determined by substituting 25 percent for 50 percent each place it appears therein; or (2) if

such other person is a nonprofit organization, if such person controls directly or indirectly more than 25

percent of the governing body of such organization. 

   In general, a person is potentially liable under section 107 of CERCLA if: (1) it is the owner

and operator of a vessel or a facility; (2) at the time of disposal of any hazardous substance it owned or

operated any facility at which such hazardous substances were disposed of; (3) by contract, agreement, or

otherwise it arranged for disposal or treatment, or arranged with a transporter for transport for disposal or

treatment, of hazardous substances owned or possessed by such person, by any other party or entity, at

any facility or incineration vessel owned or operated by another party or entity and containing such

hazardous substances; or (4) it accepts or accepted any hazardous substances for transport to disposal or

treatment facilities, incineration vessels or sites selected by such person, from which there is a release, or

a threatened release which causes the incurrence of response costs, of a hazardous substance.  42 U.S.C.

sec. 9607(a) (2004).

   For this purpose, use of the property as a landfill or other hazardous waste facility shall not be

considered more economically productive or environmentally beneficial.

   For these purposes, substantial completion means any necessary physical construction is

complete, all immediate threats have been eliminated, and all long-term threats are under control.

   Cleanup cost-cap or stop-loss coverage is coverage that places an upper limit on the costs of

cleanup that the insured may have to pay.  Re-opener or regulatory action coverage is coverage for costs

associated with any future government actions that require further site cleanup, including costs associated

with the loss of use of site improvements. 

   For this purpose, professional liability insurance is coverage for errors and omissions by

public and private parties dealing with or managing contaminated land issues, and includes coverage

under policies referred to as owner-controlled insurance.  Owner/operator liability coverage is coverage

for those parties that own the site or conduct business or engage in cleanup operations on the site.  Legal

defense coverage is coverage for lawsuits associated with liability claims against the insured made by

enforcement agencies or third parties, including by private parties.

   The Secretary of the Treasury is authorized to issue guidance regarding the treatment of

government-provided funds for purposes of determining eligible remediation expenditures.

   For example, rent income from leasing the property does not qualify under the proposal. 

   Depreciation or section 198 amounts that the taxpayer had not used to determine its unrelated

business taxable income are not treated as gain that is ordinary income under sections 1245 or 1250 (secs.

1.1245-2(a)(8) and 1.1250-2(d)(6)), and are not recognized as gain or ordinary income upon the sale,

exchange, or disposition of the property.  Thus, an exempt organization would not be entitled to a double

benefit resulting from a section 198 expense deduction and the proposed exclusion from gain with respect

to any amounts it deducts under section 198.

   The exclusions do not apply to a tax-exempt partner's gain or loss from the tax-exempt

partner's sale, exchange, or other disposition of its partnership interest.  Such transactions continue to be

governed by present-law. 

   A tax-exempt partner is subject to tax on gain previously excluded by the partner (plus

interest) if a property subsequently becomes ineligible for exclusion under the qualifying partnership's

multiple-property election.

   If the taxpayer fails to satisfy the averaging test for the properties subject to the election, then

the taxpayer may not apply the exclusion on a separate property basis with respect to any of such

properties.

   A taxpayer is subject to tax on gain previously excluded (plus interest) in the event a site

subsequently becomes ineligible for gain exclusion under the multiple-property election.

   For example, it appears that the U.S.-Barbados income tax treaty was often used to facilitate

earnings stripping arrangements.  That treaty was amended in 2004 to make it less amenable to such use. 

It is possible, however, that other treaties in the U.S. network might be used for similar purposes.  For a

discussion of this issue, see Joint Committee on Taxation, Explanation of Proposed Protocol to the

Income Tax Treaty Between the United States and Barbados (JCX-55-04), September 16, 2004, 12-20,

22.

   See, e.g., Department of the Treasury, General Explanations of the Administration's Fiscal

Year 2004 Revenue Proposals, February 2003, 104 ("Under current law, opportunities are available to

reduce inappropriately the U.S. tax on income earned from U.S. operations through the use of foreign

related-party debt.  Tightening the rules of section 163(j) is necessary to eliminate these inappropriate

income-reduction opportunities."); Department of the Treasury, Office of Tax Policy, Corporate

Inversion Transactions: Tax Policy Implications, May 17, 2002, Part VII.A ("Treasury study") ("The

prevalent use of foreign related-party debt in inversion transactions is evidence that [the rules of section

163(j)] should be revisited").

   See, e.g., Treasury study, Part VII.A; Joint Committee on Taxation, Background and

Description of Present-Law Rules and Proposals Relating to Corporate Inversion Transactions (JCX-52-

02), June 5, 2002, 3-4.

   For purposes of this description, the term "account" is used interchangeably to refer to a

prepaid tuition benefit contract or a tuition savings account established pursuant to a qualified tuition

program.

   Sec. 529(b)(1)(A).

   Sec. 529(b)(1)(A).

   Sec. 529(e)(3)(A).

   Sec. 529(e)(3)(B).

   Section 529 refers to contributors and designated beneficiaries, but does not define or

otherwise refer to the term account owner, which is a commonly used term among qualified tuition

programs. 

   Sec. 529(b)(6).

   For example, a qualified tuition program might provide that contributions to all accounts

established for the benefit of a particular designated beneficiary under that program may not exceed a

specified limit (e.g., $250,000), or that the maximum account balance for all accounts established for the

benefit of a particular designated beneficiary under that program may not exceed a specified limit.  In the

case of prepaid tuition contracts, the limit might be expressed in terms of a maximum number of

semesters.

   Sec. 529(b)(2).

   Sec. 529(b)(4).

   Sec. 529(b)(3).

   Sec. 529(b)(5).

   Sec. 529(c)(3)(B)(v) and (vi).

   Sec. 529(a).  An interest in a qualified tuition account is not treated as debt for purposes of the

debt-financed property rules.  Sec. 529(e)(4).

   Sec. 529(c)(3)(B).  Any benefit furnished to a designated beneficiary under a qualified tuition

account is treated as a distribution to the beneficiary for these purposes.  Sec. 529(c)(3)(B)(iv).

   Sec. 529(c)(3)(A) and (B)(ii).

   Sec. 529(c)(6).

   Sec. 529(c)(3)(C)(ii).  For this purpose,  "member of family" means, with respect to a

designated beneficiary: (1) the spouse of such beneficiary; (2) an individual who bears a relationship to

such beneficiary which is described in paragraphs (1) through (8) of section 152(a) (i.e., with respect to

the beneficiary, a son, daughter, or a descendant of either; a stepson or stepdaughter; a sibling or

stepsibling; a father, mother, or ancestor of either; a stepfather or stepmother; a son or daughter of a

brother or sister; a brother or sister of a father or mother; and a son-in-law, daughter-in-law, father-in-law,

mother-in-law, brother-in-law, or sister-in-law), or the spouse of any such individual; and (3) the first

cousin of such beneficiary.  Sec. 529(e)(2).

   Sec. 529(c)(2)(A).

   Sec. 529(c)(2)(B).

   Sec. 529(c)(5)(A).

   Sec. 529(c)(5)(B).

   Sec. 529(c)(4)(A).

   Sec. 529(c)(4)(B).

   Sec. 529(c)(4)(C).

   Sec. 20.2041-1(b)(1).  See also secs. 674, 2041, and 2514.

   Powers of appointment are often classified as "general powers of appointment" or as

"limited" or "special" powers of appointment.

   This change is proposed in order to be consistent with the objective of imposing no taxes on a

change of designated beneficiary so long as the new beneficiary is an eligible designated beneficiary and

the funds are not used for nonqualified purposes.

   In cases where an existing account or contract is subject to the new rules, the entire account or

contract is subject to the new rules, not just that portion of the account or contract that relates to

contributions made, or prepaid benefits acquired, after the date of enactment.

   Sec. 529(c)(2).

   Under otherwise applicable transfer tax principles, the designated beneficiary's lack of control

over the qualified tuition account generally would cause the beneficiary's interest in the account to be

regarded as a future interest, and any completed gift of a present interest would be regarded as having

been made from the contributor to the account owner (rather than to the designated beneficiary).  In cases

where the contributor and the account owner are the same person, no gift would take place under

generally applicable transfer tax principles.

   A change of account owner might be regarded as a completed gift of a present interest from

the old account owner to the new account owner, or as having no tax consequences because a completed

gift had been made to the designated beneficiary. 

   The refund claim must be filed prior to the expiration of the applicable statute of limitations

for the taxpayer to receive the refund.

   Sec. 6702.

   Because the Tax Court is the only pre-payment forum available to taxpayers, it handles the

majority of cases brought by individuals contesting their tax liability.  As a result, it also deals with most

of the frivolous, groundless, or dilatory arguments raised in tax cases.

   Sec. 6673(a).

   It is unclear how this portion of the proposal is intended to interact with the statutory

prohibition on the designation of taxpayers by the IRS as "illegal tax protesters (or any similar

designation)" (sec. 3707 of the Internal Revenue Service Restructuring and Reform Act of 1998; P.L.

105-206 (July 22, 1998)).

   The fiscal year 2004 and 2005 budget proposals applied to all types of tax returns, not just

income tax returns.

   Sec. 6159.

   Sec. 6159(b).

   Failure to timely make a required Federal tax deposit is not considered to be a failure to pay

any other tax liability at the time such liability is due under section 6159(b)(4)(B) because liability for tax

generally does not accrue until the end of the taxable period, and deposits are required to be made prior to

that date (sec. 6302).

   Sec. 6330(a).

   Sec. 6320.

  Sec. 6330(d).

  Sec. 7441.

   Sec. 7442.

   This reduction is attributable to the elimination of time periods built into the judicial review

process to permit the refiling of appeals that have been filed with the wrong court.

   Nestor v. Commissioner, 118 T.C. No. 10 (February 19, 2002), concurring opinion by Judge

Beghe.

   There was a slight difference in the effective dates of those proposals.

   Sec. 3401(b) of P.L. 105-206 (July 22, 1998).

   Sec. 7122.

   Sec. 6405.  The threshold for Joint Committee review is currently $2 million.

   Sec. 503 of the Taxpayer Bill of Rights 2 (P.L. 104-168; July 30, 1996).

   Sec. 6331.

   Sec. 6331(h).

   Sec. 6011(e).

   Partnerships with more than 100 partners are required to file electronically.

   Treasury General Explanations, p. 131.

   Sec. 7608(c).

   Sec. 7601(c) of Pub. L. 100-690 (Nov. 18, 1988).

   Sec. 3301 of Pub. L. 101-647 (Nov. 29, 1990).

   The Ways and Means Committee Report stated: "The committee believes that it is appropriate

to extend this provision for two additional years, to provide additional time to evaluate its effectiveness."

Rept. 101-681, Part 2, p. 5 (September 10, 1990).

   Sec. 1205 of Pub. L. 104-168 (July 30, 1996).

   The Ways and Means Committee Report stated: "Many other law enforcement agencies have

churning authority.  It is appropriate for IRS to have this authority as well." Rept. 104-506, p. 47

(March 28, 1996).  The Senate passed the House bill without alteration.

   Pub. L. 106-554.

   Pub. L. 109-135.

   Secs. 3101-3128 (FICA), 3301-3311 (FUTA), and 3401-3404 (income tax withholding).

   Secs. 6011 and 6051.

   Treas. Reg. secs. 31.3121(d)-1(c)(1), 31.3306(i)-1(a), and 31.3401(c)-1.

   Issues relating to the classification of workers as employees or independent contractors are

discussed in Joint Committee on Taxation, Study of the Overall State of the Federal Tax System and

Recommendations for Simplification, Pursuant to Section 8022(3)(B) of the Internal Revenue Code of

1986 (JCS-3-01), April 2001, at Vol. II, Part XV.A, at 539-550.

   Sec. 3401(d)(1) (for purposes of income tax withholding, if the employer does not have

control of the payment of wages, the person having control of the payment of such wages is treated as the

employer); Otte v. United States, 419 U.S. 43 (1974) (the person who has the control of the payment of

wages is treated as the employer for purposes of withholding the employee's share of FICA from wages);

In re Armadillo Corporation, 561 F.2d 1382 (10th Cir. 1977), and In re The Laub Baking Company v.

United States, 642 F.2d 196 (6th Cir. 1981) (the person who has control of the payment of wages is the

employer for purposes of the employer's share of FICA and FUTA).  The mere fact that wages are paid

by a person other than the employer does not necessarily mean that the payor has control of the payment

of the wages.  Rather, control depends on the facts and circumstances.  See, e.g., Consolidated Flooring

Services v. United States, 38 Fed. Cl. 450 (1997), and Winstead v. United States, 109 F. 2d 989 (4th Cir.

1997).

   The designated reporting agent rules do not apply for purposes of FUTA compliance.

   Sec. 3504.  Form 2678 is used to designate a reporting agent.

   For administrative convenience, an employer may also use a payroll service to handle payroll

and employment tax filings on its behalf, but the employer, not the payroll service, continues to be

responsible for employment tax compliance.

   Employee leasing companies are sometimes referred to as professional employer

organizations or "PEOs".

   The leasing company may also provide the leased employees with employee benefit coverage,

such as under a pension plan or a health plan.  In such a case, the fee paid by the client also covers

employee benefit costs.

   IRS news release IR-2006-28 and attachment (Feb. 14, 2006).  The tax gap is the amount of

tax that is imposed by law for a given tax year but is not paid voluntarily and timely. 

   As noted above, the designated payroll agent rules do not apply for FUTA purposes.

   Sec. 6041(a).

   The tax gap is the amount of tax that is imposed by law for a given tax year but is not paid

voluntarily and timely.

   Sec. 6041(a).

   Sec. 6051(a).

   Sec. 6041A.

   Sec. 6041A(d)(3)(A).

   Sec. 6050M.

   Sec. 6331(h).

   The tax gap is the amount of tax that is imposed by law for a given tax year but is not paid

voluntarily and timely.

   Sec. 6330(a).

   Sec. 6320.

   Secs. 3101-3128 (FICA), 3301-3311 (FUTA), and 3401-3404 (income tax withholding). 

FICA taxes consist of an employer share and an employee share, which the employer withholds from

employees' wages.

   Sec. 7701(a)(36)(A).

   Sec. 6695.

   Sec. 6694(a).

   Sec. 6694(b).

   1987-2 C.B. 674 (as clarified and modified by Rev. Proc. 88-22, 1988-1 C.B. 785).

   Sec. 168(e)(3)(E)(viii).

   See H.R. Rep. No. 108-67, at 51 (2003) and S. Rep. No. 108-54, at 58 (2003).  Sec.

168(e)(3)(E)(viii) was enacted as part of the Energy Policy Act of 2005 (Pub. L. No. 109-58).  While

neither tax committee filed a committee report with respect to the Energy Policy Act of 2005, a

substantially identical provision to sec. 168(e)(3)(E)(viii) was passed by both the House and the Senate in

2003.  The quoted text appears in each of the cited committee reports under the heading "Reasons for

Change." 

   While high voltage electric transmission lines are also assigned a 15-year recovery period, the

lower voltage lines which go into individual homes are recovered over 20 years.  No such distinction

exists with respect to the depreciable life of gas lines; thus, gas lines which serve individual homes and

businesses are eligible for the 15-year recovery period under present law.

   Division J of the Omnibus Consolidated and Emergency Supplemental Appropriations Act,

H.R. 4328, Pub. L. No. 105-206 (1999).

   The Congress also cited improper measurement of income and inefficient allocation of

investment capital as concerns.  See Joint Committee on Taxation, General Explanation of Tax

Legislation Enacted in 1998 (JCS-6-98), November 24, 1998, at 279.

   Department of the Treasury, Report to The Congress on Depreciation Recovery Methods and

Periods, July 2000, at 1.

   During the years 1989 through 1991 the now-defunct Depreciation Analysis Division of

Treasury's Office of Tax Analysis completed a number of property-specific reports which included the

results of such studies.  A summary of these reports can be found in the Treasury report. See id. at 123.

   The portion of these credits relating to personal use property is subject to the same tax

liability limitation as the nonrefundable personal tax credits (other than the adoption credit, child credit,

and saver's credit).

   The rule applicable to the adoption credit, child credit, and savers' credit is subject to the

EGTRRA sunset.

   For a recommendation that the repeal of the individual alternative minimum tax will result in

significant tax simplification, see Study of the Overall State of the Federal Tax System and

Recommendations Pursuant to Section 8022(3)(B) of the Internal Revenue Code of 1986, Volume II:

Recommendations of the Staff of the Joint Committee on Taxation to Simplify the Federal Tax System, p.

2.

   Sec. 41.

   The research tax credit initially was enacted in the Economic Recovery Tax Act of 1981 as a

credit equal to 25 percent of the excess of qualified research expenses incurred in the current taxable year

over the average of qualified research expenses incurred in the prior three taxable years.  The research tax

credit was modified in the Tax Reform Act of 1986, which (1) extended the credit through December 31,

1988, (2) reduced the credit rate to 20 percent, (3) tightened the definition of qualified research expenses

eligible for the credit, and (4) enacted the separate university basic research credit.

The Technical and Miscellaneous Revenue Act of 1988 ("1988 Act") extended the research tax

credit for one additional year, through December  31, 1989.  The 1988 Act also reduced the deduction

allowed under section 174 (or any other section) for qualified research expenses by an amount equal to 50

percent of the research tax credit determined for the year.

The Omnibus Budget Reconciliation Act of 1989 ("1989 Act") effectively extended the research

credit for nine months (by prorating qualified expenses incurred before January 1, 1991).  The 1989 Act

also modified the method for calculating a taxpayer's base amount (i.e., by substituting the present-law

method which uses a fixed-base percentage for the prior-law moving base which was calculated by

reference to the taxpayer's average research expenses incurred in the preceding three taxable years).  The

1989 Act further reduced the deduction allowed under section 174 (or any other section) for qualified

research expenses by an amount equal to 100 percent of the research tax credit determined for the year.

The Omnibus Budget Reconciliation Act of 1990 extended the research tax credit through

December 31, 1991 (and repealed the special rule to prorate qualified expenses incurred before January 1,

1991).

The Tax Extension Act of 1991 extended the research tax credit for six months (i.e., for qualified

expenses incurred through June 30, 1992).

The Omnibus Budget Reconciliation Act of 1993 ("1993 Act") extended the research tax credit

for three years-i.e., retroactively from July 1, 1992 through June 30, 1995.  The 1993 Act also provided a

special rule for start-up firms, so that the fixed-base ratio of such firms eventually will be computed by

reference to their actual research experience.

Although the research tax credit expired during the period July 1, 1995, through June 30, 1996,

the Small Business Job Protection Act of 1996 ("1996 Act") extended the credit for the period July 1,

1996, through May 31, 1997 (with a special 11-month extension for taxpayers that elect to be subject to

the alternative incremental research credit regime).  In addition, the 1996 Act expanded the definition of

start-up firms under section 41(c)(3)(B)(i), enacted a special rule for certain research consortia payments

under section 41(b)(3)(C), and provided that taxpayers may elect an alternative research credit regime

(under which the taxpayer is assigned a three-tiered fixed-base percentage that is lower than the fixed-

base percentage otherwise applicable and the credit rate likewise is reduced) for the taxpayer's first

taxable year beginning after June 30, 1996, and before July 1, 1997.

The Taxpayer Relief Act of 1997 ("1997 Act") extended the research credit for 13 months-i.e.,

generally for the period June 1, 1997, through June 30, 1998.  The 1997 Act also provided that taxpayers

are permitted to elect the alternative incremental research credit regime for any taxable year beginning

after June 30, 1996 (and such election will apply to that taxable year and all subsequent taxable years

unless revoked with the consent of the Secretary of the Treasury).  The Tax and Trade Relief Extension

Act of 1998 extended the research credit for 12 months, i.e., through June 30, 1999. 

The Ticket To Work and Work Incentive Improvement Act of 1999 extended the research credit

for five years, through June 30, 2004, increased the rates of credit under the alternative incremental

research credit regime, and expanded the definition of research to include research undertaken in Puerto

Rico and possessions of the United States.

The Working Families Tax Relief Act of 2004 extended the research credit through December 31,

2005.

The Energy Tax Incentives Act of 2005 added the energy research credit.

   The Small Business Job Protection Act of 1996 expanded the definition of start-up firms

under section 41(c)(3)(B)(i) to include any firm if the first taxable year in which such firm had both gross

receipts and qualified research expenses began after 1983.  A special rule (enacted in 1993) was designed

to gradually recompute a start-up firm's fixed-base percentage based on its actual research experience. 

Under this special rule, a start-up firm would be assigned a fixed-base percentage of three percent for

each of its first five taxable years after 1993 in which it incurs qualified research expenses.  In the event

that the research credit is extended beyond its expiration date, a start-up firm's fixed-base percentage for

its sixth through tenth taxable years after 1993 in which it incurs qualified research expenses will be a

phased-in ratio based on its actual research experience.  For all subsequent taxable years, the taxpayer's

fixed-base percentage will be its actual ratio of qualified research expenses to gross receipts for any five

years selected by the taxpayer from its fifth through tenth taxable years after 1993 (sec. 41(c)(3)(B)).

   Sec. 41(c)(4).

   Under a special rule enacted as part of the Small Business Job Protection Act of 1996, 75

percent of amounts paid to a research consortium for qualified research were treated as qualified research

expenses eligible for the research credit (rather than 65 percent under the general rule under section

41(b)(3) governing contract research expenses) if (1) such research consortium was a tax-exempt

organization that is described in section 501(c)(3) (other than a private foundation) or section 501(c)(6)

and was organized and operated primarily to conduct scientific research, and (2) such qualified research

was conducted by the consortium on behalf of the taxpayer and one or more persons not related to the

taxpayer.  Sec. 41(b)(3)(C).

   Taxpayers may elect 10-year amortization of certain research expenditures allowable as a

deduction under section 174(a).  Secs. 174(f)(2) and 59(e).

   This conclusion does not depend upon whether the basic tax regime is an income tax or a

consumption tax.

   See Zvi Griliches, "The Search for R&D Spillovers," Scandinavian Journal of Economics,

vol. XCIV, (1992), M. Ishaq Nadiri, "Innovations and Technological Spillovers," National Bureau of

Economic Research, Working Paper No. 4423, 1993, and Bronwyn Hall, "The Private and Social Returns

to Research and Development," in Bruce Smith and Claude Barfield, editors, Technology, R&D and the

Economy, (Washington, D.C.:  Brookings Institution Press), 1996, pp. 1-14.  These papers suggest that

the rate of return to privately funded research expenditures is high compared to that in physical capital

and the social rate of return exceeds the private rate of return.  Griliches concludes, "in spite of [many]

difficulties, there has been a significant number of reasonably well-done studies all pointing in the same

direction: R&D spillovers are present, their magnitude may be quite large, and social rates of return

remain significantly above private rates."  Griliches, p. S43.

   Organisation for Economic Co-operation and Development, OECD Science, Technology and

Industry Scoreboard, 2005, (Paris:  Organisation for Economic Co-operation and Development), 2005. 

These data represent outlays by private persons and by governments.  The figures reported in this

paragraph and Figure 1 do not include the value of tax expenditures, if any.  The OECD, measuring in

real 1995 dollars, calculates that the United States spent approximately $268 billion on research and

development in 2003.

   Ibid.  While the OECD attempts to present these data on a standardized basis the cross-

country comparisons are not perfect.  For example, the United States reporting for research spending

generally does not include capital expenditure outlays devoted to research while the reporting of some

other countries does include capital expenditures.

   Ibid.  The OECD calculates the annual real rate of growth of expenditures on research and

development for the period 1995-2003 in the European Union and in all OECD countries at 3.3 percent

and 3.7 percent, respectively.

   Organisation for Economic Co-operation and development, OECD Science, Technology and

Industry Scoreboard, 2005. (Paris: Organisation for Economic Co-operation and development), 2005. 

The index is calculated as one minus the so-called "B-index."  The B-index is equal to the after-tax cost

of an expenditure of one dollar on qualifying research, divided by one minus the taxpayer marginal tax

rate.  Alternatively, the B-index represents the present value of pre-tax income that is necessary to earn in

order to finance the research activity and earn a positive after-tax profit.  In practice, construction of the

B-index and the index number reported in Table 2 requires a number of simplifying assumptions.  As a

consequence, the relative position of the tax benefits of various countries reported in the table is only

suggestive.

   Joint Committee on Taxation, Estimates of Federal Tax Expenditures for Fiscal Years 2005-

2009 (JCS-1-05), January 12, 2005, p. 30. 

   Office of Management and Budget, Budget of the United States Government, Fiscal Year

2007, Appendix, pp. 294-299.  (Figures include military and non-military departments.)

   Office of Management and Budget, Budget of the United States Government, Fiscal Year

2007, Appendix, pp. 1073-1074, 294-299 and 387-388.

   The $5.7 billion figure reported for 2003 is not directly comparable to the $4.8 billion tax

expenditure estimate for 2005 reported in the preceding paragraph.  The tax expenditure estimate

accounts for the present-law requirement that deductions for research expenditures be reduced by research

credits claimed.  Also, the $5.7 billion figure does not reflect the actual tax reduction achieved by

taxpayers claiming research credits in 2003 as the actual tax reduction will depend upon whether the

taxpayer had operating losses, was subject to the alternative minimum tax, or other aspects specific to

each taxpayer's situation.

   For simplicity, this analysis assumes that the product in question can be supplied at the same

cost despite any increase in demand (i.e., the supply is perfectly elastic).  This assumption may not be

valid, particularly over short periods of time, and particularly when the commodity-such as research

scientists and engineers-is in short supply.

   It is important to note that not all research expenditures need be subject to a price reduction to

have this effect.  Only the expenditures that would not have been undertaken otherwise-so called

marginal research expenditures-need be subject to the credit to have a positive incentive effect.

   Charles River Associates, An Assessment of Options for Restructuring the R&D Tax Credit

to Reduce Dilution of its Marginal Incentive (final report prepared for the National Science Foundation),

February, 1985, p. G-14.  The negative coefficient in the text reflects that a decrease in price results in an

increase in research expenditures.  Often, such elasticities are reported without the negative coefficient, it

being understood that there is an inverse relationship between changes in the "price" of research and

changes in research expenditures.

In a 1983 study, the Treasury Department used an elasticity of 0.92 as its upper range estimate of

the price elasticity of R&D, but noted that the author of the unpublished study from which this estimate

was taken conceded that the estimate might be biased upward.  See, Department of the Treasury, "The

Impact of Section 861-8 Regulation on Research and Development," p. 23.  As stated in the text, although

there is uncertainty, most analysts believe the elasticity is considerable smaller.  For example, the General

Accounting Office (now called the Government Accountability Office) summarizes: "These studies, the

best available evidence, indicate that spending on R&E is not very responsive to price reductions.  Most

of the elasticity estimates fall in the range of 0.2 and 0.5. . . . Since it is commonly recognized that all of

the estimates are subject to error, we used a range of elasticity estimates to compute a range of estimates

of the credit's impact." See, The Research Tax Credit Has Stimulated Some Additional Research

Spending (GAO/GGD-89-114), September 1989, p. 23.  Similarly, Edwin Mansfield concludes: "While

our knowledge of the price elasticity of demand for R&D is far from adequate, the best available

estimates suggest that it is rather low, perhaps about 0.3." See, "The R&D Tax Credit and Other

Technology Policy Issues," American Economic Review, Vol. 76, no. 2, May 1986, p. 191.

   Bronwyn Hall and John Van Reenen, "How effective are fiscal incentives for R&D?  A

review of the evidence," Research Policy, vol.29, 2000, p. 462.  This survey reports that more recent

empirical analyses have estimated higher elasticity estimates.  One recent empirical analysis of the

research credit has estimated a short-run price elasticity of 0.8 and a long-run price elasticity of 2.0.  The

author of this study notes that the long-run estimate should be viewed with caution for several technical

reasons.  In addition, the data utilized for the study cover the period 1980 through 1991, containing only

two years under the revised credit structure.  This makes it empirically difficult to distinguish short-run

and long-run effects, particularly as it may take firms some time to fully appreciate the incentive structure

of the revised credit.  See, Bronwyn H. Hall, "R&D Tax Policy During the 1980s: Success or Failure?" in

James M. Poterba (ed.), Tax Policy and the Economy, vol. 7, (Cambridge: The MIT Press, 1993), pp. 1-

35.   Another recent study examined the post-1986 growth of research expenditures by 40 U.S.-based

multinationals and found price elasticities between 1.2 and 1.8.  However, including an additional 76

firms, that had initially been excluded because they had been involved in merger activity, the estimated

elasticities fell by half.  See, James R. Hines, Jr., "On the Sensitivity of R&D to Delicate Tax Changes:

The Behavior of U.S. Multinationals in the 1980s" in Alberto Giovannini, R. Glenn Hubbard, and Joel

Slemrod (eds.), Studies in International Taxation, (Chicago: University of Chicago Press 1993).  Also see

M. Ishaq Nadiri and Theofanis P. Mamuneas, "R&D Tax Incentives and Manufacturing-Sector R&D

Expenditures," in James M. Poterba, editor, Borderline Case: International Tax Policy, Corporate

Research and Development, and Investment, (Washington, D.C.: National Academy Press), 1997.  While

their study concludes that one dollar of research tax credit produces 95 cents of research, they note that

time series empirical work is clouded by poor measures of the price deflators used to convert nominal

research expenditures to real expenditures. 

Other research suggests that many of the elasticity studies may overstate the efficiency of

subsidies to research.  Most R&D spending is for wages and the supply of qualified scientists is small,

particularly in the short run.  Subsidies may raise the wages of scientists, and hence research spending,

without increasing actual research.  See Austan Goolsbee, "Does Government R&D Policy Mainly

Benefit Scientists and Engineers?"  American Economic Review, vol. 88, May, 1998, pp. 298-302.

   Hall and Van Reenen, "How effective are fiscal incentives for R&D?  A review of the

evidence," p. 463. 

   As with any tax credit that is carried forward, its full incentive effect could be restored, absent

other limitations, by allowing the credit to accumulate interest that is paid by the Treasury to the taxpayer

when the credit ultimately is utilized.

   For a more complete discussion of this point see Joint Committee on Taxation, Description

and Analysis of Tax Provisions Expiring in 1992 (JCS-2-92), January 27, 1992, pp. 65-66.

   Natwar M. Gandhi, Associate Director Tax Policy and Administration Issues, General

Government Division, U.S. General Accounting Office, "Testimony before the Subcommittee on

Taxation and Internal Revenue Service Oversight," Committee on Finance, United States Senate, April 3,

1995.

   David R. Seltzer, "Federal Income Tax Compliance Costs:  A Case Study of Hewlett-Packard

Company," National Tax Journal, vol. 50, September 1997, pp. 487-493.

   For individuals with productivity to employers lower than the minimum wage, the credit may

result in these individuals being hired and paid the minimum wage. For these cases, it would be clear that

the credit resulted in the worker receiving a higher wage than would have been received in the absence of

the credit (e.g., zero).

   The after-tax cost of hiring this credit eligible worker would be ((2,000)(w)-2,400)(1-.35)

dollars. This example does not include the costs to the employer for payroll taxes (e.g., Social security,

Medicare and unemployment taxes) and any applicable fringe benefits.

   See, for example, Macro Systems, Inc., Final Report of the Effect of the Targeted Jobs Tax

Credit Program on Employers, U.S. Department of Labor, 1986.

   Macro Systems, Inc., Impact Study of the Implementation and Use of the Targeted Jobs Tax

Credit: Overview and Summary, U.S. Department of Labor, 1986.

   For example, see U.S. General Accounting Office, Targeted Jobs Tax Credit: Employer

Actions to Recruit, Hire, and Retain Eligible Workers Vary (GAO-HRD 91-33), February 1991.

   Pub. L. No. 107-147, "The Job Creation and Worker Assistance Act of 2002," extended the

credits for two years.

   Sec. 1400C(i).  The District of Columbia first-time homebuyer credit was enacted as part of

the Taxpayer Relief Act of 1997, and was scheduled to expire on December 31, 2000.  The Tax Relief

Extension Act of 1999 extended the first-time homebuyer credit for one year, through December 31,

2000.  The Community Renewal Tax Relief Act of 2000 extended the first-time homebuyer credit for two

additional years, through December 31, 2003.  The Working Families Tax Relief Act of 2004 extended

the first-time homebuyer credit for two additional years, through December 31, 2005.

   Other factors may also affect the choice of where to live, such as closeness to work or family

members.

   Sec. 103.

   Sec. 149(e).

   Sec. 103(a) and (b)(2).

   Sec. 148.

   Sec. 1397E.

   Most economic studies have found that when additional funding is made available to localities

from outside sources, there is indeed an increase in public spending (this is known as the "fly-paper"

effect, as the funding tends to "stick" where it is applied).  The additional spending is not dollar for dollar,

however, implying that there is some reduction of local taxes to offset the outside funding.  See Harvey

Rosen, Public Finance, sixth ed., 2002, p. 502-503 for a discussion of this issue.

   This is true provided that the taxpayer faces tax liability of at least the amount of the credit. 

Without sufficient tax liability, the proposed tax credit arrangement would not be as advantageous. 

Presumably, only taxpayers who anticipate having sufficient tax liability to be offset by the proposed

credit would hold these bonds.

   The Treasury Department issued proposed regulations on March 26, 2004 that would require

issuers of qualified zone academy bonds to spend proceeds with due diligence.  REG 121475-03, 69 CFR

15747 (March 26, 2004).

   Sec. 6103(a).

   Sec. 6103(b)(1).

   Sec. 6103(b)(2).  Return information is 

?     a taxpayer's identity, the nature, source, or amount of his income, payments, receipts,

deductions, exemptions, credits, assets, liabilities, net worth, tax liability, tax withheld,

deficiencies, overassessments, or tax payments, whether the taxpayer's return was, is

being, or will be examined or subject to other investigation or processing, or any other

data, received by, recorded by, prepared by, furnished to, or collected by the Secretary

with respect to a return or with respect to the determination of the existence, or possible

existence, of liability (or the amount thereof) of any person under this title for any tax,

penalty, interest, fine, forfeiture, or other imposition, or offense,

?     any part of any written determination or any background file document relating to such

written determination (as such terms are defined in section 6110(b)) which is not open to

public inspection under section 6110,

?     any advance pricing agreement entered into by a taxpayer and the Secretary and any

background information related to such agreement or any application for an advance

pricing agreement, and

?      closing agreement under section 7121, and any similar agreement, and any background

information related to such an agreement or request for such an agreement,

Return information does not include data in a form which cannot be associated with, or otherwise

identify, directly or indirectly, a particular taxpayer. 

    Sec. 6103(c) - (o).

   18 U.S.C. 2331.

   Sec. 6103(i)(3)(C).

   Sec. 6103(i)(7)(A).

   Sec. 6103(i)(7)(B).

   Sec. 6103(i)(7)(C).

   As noted above, an ex parte court order is not necessary to obtain information gathered from a

source other than the taxpayer.

   Sec. 6103(i)(7)(D).

   Joint Committee on Taxation, Revised Disclosure Report for Public Inspection Pursuant to

Internal Revenue Code Section 6103(p)(3)(c) for Calendar Year 2002 (JCX-29-04), April 6, 2004.

   Joint Committee on Taxation, Disclosure Report for Public Inspection Pursuant to Internal

Revenue Code Section 6103(p)(3)(C) for Calendar Year 2003 (JCX-30-04), April 6, 2004.

   Joint Committee on Taxation, Disclosure Report for Public Inspection Pursuant to Internal

Revenue Code Section 6103(p)(3)(C) for Calendar Year 2004 (JCX-63-05), August 19, 2005.

   Sec. 6103.

   Sec. 6103(l)(13).

   Sec. 6103(l)(13)(D).

   Sec. 6103(c).

   Department of Treasury, Report to the Congress on Scope and Use of Taxpayer

Confidentiality and Disclosure Provisions, Volume I:  Study of General Provisions (October 2000) at 91.

   Department of Treasury, General Explanations of the Administration's Fiscal Year 2004

Revenue Proposals (February 2003), p. 133.

   Pub. L. No. 105-244, sec. 483 (1998).

   Sec. 6103(m)(4).

   Id.

   Sec. 6103(p)(4).

   Sec. 6103(p)(5).

   S. Prt. No. 103-37 at 54 (1993).

   In its study on the disclosure of return information, the Department of Treasury noted: "The

burden of processing this number of consents obviously would be reduced if the consents were executed

and transmitted electronically.  Accordingly, the Department of Education has asked to be included in the

TDS program."  Department of Treasury, Report to the Congress on Scope and Use of Taxpayer

Confidentiality and Disclosure Provisions, Volume I:  Study of General Provisions (2000) at 92.

   The Department of Education seeks access to the return information of approximately 15

million taxpayers each year.  The Department of Education receives approximately 10 million

applications for student financial assistance each year.  Because roughly half of the applicants are

dependents, income information is needed for both the student and his or her parents.  Thus, verification

under this provision could apply to over 15 million taxpayers each year.   It is not clear what percentage

of applicants submits fraudulent financial aid applications.  Id.

   Congressional Research Service, RS21239 The Black Lung Benefits Program (June 12, 2002)

at 6.

   Id.

   A similar issue would arise with respect to the child credit, because that credit also is phased

out based on adjusted gross income.  However, present law addresses this potential adverse effect by

including combat pay only for purposes of calculating the refundable portion of the credit.

   A proof gallon is a liquid gallon consisting of 50 percent alcohol.  See sec. 5002(a)(10) and

(11).

   Sec. 5001(a)(1).

   Secs. 5062(b), 7653(b) and (c).

   Secs. 7652(a)(3), (b)(3), and (e)(1).  One percent of the amount of excise tax collected from

imports into the United States of articles produced in the Virgin Islands is retained by the United States

under section 7652(b)(3).

   The amount covered over is limited to the amount of excise tax imposed under section

5001(a)(1), if lower than the limits stated above.  Sec. 7652(f)(2).

   Sec. 7652(e)(2).

   Secs. 7652(a)(3), (b)(3), and (e)(1).

   Pub. L. No. 108-311, sec. 305 (2004).

   27 U.S.C. sec. 204.

   27 U.S.C. sec. 205(e).

   27 CFR secs. 5.25-5.28.

   Sec. 5134(a).

   Sec. 7528(a).  See Rev. Proc. 2006-8, 2006-1 I.R.B. 245.

   Sec. 7528(b).

   Minimum fees would be in accordance with the minimum fees for the appropriate category of

services to which the relevant service is similar.

   See Rev. Proc. 93-23, 1993-1 CB 538.

 

 

 

 

 

 

 

           

 

 

 

 

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