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

III. Revenue Effects of the Bill

IV. Explanation of the Bill

VI. Regulatory Impact of the Bill and Other Matters to be Discussed Under Senate Rules

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

VIII. Additional Views

The amendment is shown in the text of the resolution in italic.

The principal provisions of the bill are the following:

• An across-the-board individual income tax rate reduction of approximately 1 percent in 1981, 10 percent in 1982, 19 percent in 1983, and 23 percent in 1934 and subsequent years. This reduction in tax liabilities will be reflected in reductions of taxes withheld from workers' paychecks of 5 percent on October 1, 1981, a further 10 percent on July 1, 1982, and a final 10 percent on July 1, 1983.

• A new deduction for two-earner married couples of 10 percent of the first $30,000 of earnings of the spouse with the lesser amount of earnings (5 percent in 1982).

• A reduction in the maximum tax rate on all income to 50 percent, effective January 1, 1982.

• A maximum tax rate on individuals' long-term capital gains of 20 percent for sales or exchanges after June 10, 1981.

• A complete revision of rules for recovering the cost of depreciable assets, called the Accelerated Cost Recovery System (ACRS), under which equipment will be written off over either 3, 5, 10, or 15 years and most structures will be written off over 15 years.

• Replacement of the existing 10-percent investment credit for rehabilitating industrial and commercial buildings with a credit of 15 percent for 30 to 39 year old commercial or industrial buildings, 20 percent for such buildings at least 40 years old, and 25 percent for certified historic structures.

• Optional expensing of up to $10,000 of investment in tangible personal property, phased in over a 5-year period.

• Elimination of the $100,000 limit on the amount of used property eligible for the investment tax credit and changes in the recapture rules for that credit.

• Various other tax changes to aid small businesses, including an increase in the number of shareholders for subchapter S corporations and an increase in the minimum accumulated earnings tax credit.

• An increase in the limit on deductible contributions for individual retirement accounts (IRAs) from $1,500 to $2,000 (from $1,750 to $2,250 when a nonearning spouse is a beneficiary).

• Extension of eligibility for IRAs to active participants in employer sponsored pension plans with a $1,500 limit on deductible contributions ($1,625 when a nonearning spouse is a beneficiary).

• An increase in the annual limit on deductions for contributions to self-employed retirement plans from $7,500 to $15,000.

• Tax exemption of up to $1,000 ($2,000 for a married couple) of interest income on certain 1-year savings certificates issued by depository institutions.

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

• A restructuring of the tax credit for employer contributions to employee stock ownership plans (ESOPs).

• A permanent $2,500 credit for royalty owners against the windfall profit tax.

• A reduction from 30 percent to 15 percent in the windfall profit tax rate on newly discovered oil, phased in over a 4-year period.

• A 25-percent tax credit for incremental expenditures for wages paid for services performed in conducting research and experimentation.

• An increase in the unified credit against the estate and gift taxes, phased in over a 5-year period, so that no tax will be imposed on transfers of $600,000 or less.

• Repeal of the existing limits on the material deduction in the estate and gift taxes.

• An increase in the gift tax exclusion for gifts in any single year to any individual person from $3,000 to $10,000.

• Technical changes in the rules relating to current use valuation of farms and small businesses.

• An expansion of the exclusion for income earned abroad to the first $50,000 of earned income plus one-half of the next $50,000, plus an exclusion for excess housing costs.

• A significant tightening of the rules to prevent the use of commodity tax straddles and similar devices to defer taxes and convert ordinary income and short-term capital gains into long-term capital gains.

• Restoration of capital gains treatment for incentive stock options.

• Sixty-month amortization for motor carriers for the adjusted basis of their operating rights.

• Incentives for corporate contributions of research equipment to colleges.

The bill includes a multi-stage, across-the-board reduction in individual income tax rates. The reduction in tax rates is approximately 1 percent in 1981, 10 percent in 1982, 19 percent in 1983 and 23 percent in 1984 and future years.

These reductions in tax liability will be accompanied by a series of reductions in taxes withheld from workers' paychecks. The withholding reductions will be at a rate of 5 percent on October 1, 1981, a further 10 percent on July 1, 1982 and a final 10 percent on July 1, 1983.

The revenue loss from these tax rate reductions will be $24.6 billion in fiscal year 1982, $63.1 billion in 1983, and $103.0 billion in 1984.

50-percent maximum rate on investment income

The bill reduces the top tax rate on all income to 50 percent for 1982 and subsequent years. This establishes a maximum rate on long-term capital gains of 20 percent because 40 percent of long-term capital gains is included in income and will be taxed at no more than the 50-percent rate. The top rate under the alternative minimum tax also will be reduced to 20 percent, starting in 1982. In addition, there will be a special 20-percent alternative tax rate on long-term capital gains, under both the regular income tax and the alternative minimum tax, for sales and exchanges between June 10, 1981, and January 1, 1982.

The revenue loss, on a static basis, is expected to be $1.5 billion in fiscal year 1982 and $2.6 billion in 1983; however, the committee expects that the expansion of the tax base resulting from these changes will offset much, and possibly all, of this static revenue effect.

Deduction for two-earner married couples

In order to reduce the marriage tax penalty and to provide an additional work incentive, the bill provides a new deduction for married couples equal to a percentage of the first $30,000 of the earnings of the spouse with the lesser earnings. This deduction will be available both to itemizers and nonitemizers. For 1982, the deduction will be 5 percent (a maximum deduction of $1,500). For 1983 and subsequent years, the deduction will be 10 percent (a maximum deduction of $3,000).

Together with the across-the-board rate cuts, the deduction will reduce marriage tax penalties for most taxpayers subject to the marriage penalty by at least 50 percent.

The marriage penalty deduction will reduce revenue by $0.4 billion in fiscal year 1982, $4.4 billion in 1983, and $9.1 billion in 1984.

The bill provides an exclusion for interest on savings certificates which meet certain conditions. There is a lifetime limit on the amount of interest which can qualify for the exclusion of $1,000 for single returns and $2,000 for joint returns. For a certificate to qualify for the exemption, it must have a 1-year maturity, have a yield of 70 percent of the 1-year Treasury bill rate, and be issued by a depository institution between September 30, 1981, and October 1, 1982.

This exemption will reduce revenue by $0.4 billion in fiscal year 1982, $1.7 billion in 1983, and $1.0 billion in 1984.

Interest and dividend exclusion

Under present law, there is an exclusion for the first $200 of interest and dividends ($400 for joint returns) for the years 1981 and 1982. Under present law, the provision reverts, in 1983, to the prior law dividend exclusion for the first $100 of dividends received by any taxpayer. The bill provides that the reversion to prior law will occur in 1982, instead of 1983.

This change will increase revenues by $0.6 billion in fiscal year 1982 and $1.9 billion in 1983.

Individual retirement accounts

The bill increases the limits on deductible contributions to individual retirement accounts (IRAs). The current limit of 15 percent of compensation or $1,500, whichever is less, will be replaced by a new limit equal to the lesser of 100 percent of compensation or $2,000. The limits on spousal IRAs (IRAs where a nonearning spouse is a beneficiary) will be raised from $1,750 to $2,250.

In addition, active participants in employer-provided retirement plans, who are now ineligible for the tax incentives from IRAs will be able to make deductible contributions to IRAs. However, the limit on deductible contributions for these active participants will be $1,500 for a regular IRA and $1,625 for a spousal IRA. Voluntary contributions to employer sponsored plans will be eligible for this deduction. subject to the $1,500 and $1,625 limits.

These IRA provisions will reduce revenues by $0.2 billion in fiscal year 1982, $1.1 billion in 1983, and $1.5 billion in 1984.

Retirement savings for the self-employed

The bill increases the annual limit on deductible contributions to self-employed retirement plans (commonly called Keogh or H.R. 10 plans) from $7,500 to $15,000.

Employee stock ownership plans

The bill revises the provisions which provide a tax credit for contributions to employee stock ownership plans (commonly known as ESOPs). The existing investment tax credit for contributions to ESOPs will be repealed after 1982. Beginning January 1, 1983, a tax credit will be allowed based upon a percentage of the employer's payroll. This percentage will be one-half of one percent in 1983, three-fourths of one percent in 1984, and one percent in 1985 and future years. The bill also makes a number of other modifications designed to encourage the use of ESOPs.

These changes will reduce revenues by $0.8 billion in fiscal year 1984, $2.0 billion in 1985, and $2.8 billion in 1986.

The bill completely revises the Federal income tax treatment of depreciation and makes revisions in the investment tax credit. The committee's Accelerated Cost Recovery System (ACRS) generally provides much faster recovery of the costs of capital expenditures than occurs under existing law. The changes made by the bill will encourage investment, which will improve productivity, and will simplify the tax law and tax administration.

Personal property

Tangible personal property is assigned to one of four classes with recovery periods of 3, 5, 10 or 15 years. The 3-year class consists of autos, light trucks, equipment used in research and experimentation, and other assets with a current guideline life under the ADR system of 4 years or less. The 10-year class consists of public utility property with an ADR guideline life greater than 18 and less than 25.5 years and railroad tank cars. The 15-year class consists of public utility property with an ADR guideline life above 25 years. All other tangible personal property eligible for ACRS is included in the 5-year class. The 5-year class includes single purpose agricultural structures and petroleum product storage facilities.

An accelerated method of cost recovery is provided for each of the four classes. Before 1985, these methods provide benefits approximating the 150-percent declining balance method for the early years of the recovery period with a switch to the straight-line method for the remainder of the recovery period (adjusted to take account of a half year convention). In 1985, cost recovery is accelerated further and provides benefits approximating the 175-percent declining balance method for the first year of the recovery period with a switch to the sum-of-the-years-digits method for the remaining years. After 1985, the permanent cost recovery schedules take effect, and these provide benefits approximating the 200-percent declining balance method for the first year of the recovery period with a switch to the sum-of-the-years-digits method for the remaining years.

The investment tax credit is 6 percent for eligible property in the 3-year class and 10 percent for all other eligible property.

Businesses are allowed to expense (i.e., write off immediately) up to $5,000 of investment in 1982 and 1983, $7,500 in 1984 and 1985, and $10,000 after 1985. No regular investment credit is allowed for this expensed property.

Real property

Real property is generally written off over a 15-year period. Tax payers will use an accelerated method based on the use of the 200-percent declining balance method in the early years of the recovery period with a switch to the straight-line method in the remaining years. A taxpayer may, however, elect a straight-line method. Taxpayers will no longer be allowed to depreciate components separately but must use a composite method of cost recovery for the entire structure.

When a taxpayer disposes of nonresidential property for which the accelerated method of depreciation has been used, gain is treated as ordinary income to the extent of all prior cost recovery deductions. For residential real property, however, the gain is treated as ordinary income only to the extent of the excess of accelerated over straight-line cost recovery. There is no ordinary income recapture in the case of dispositions of real estate for which straight-line depreciation has been elected.

Other rules

As part of its complete restructuring of capital cost recovery, the bill provides a number of special rules. To provide flexibility in the use of depreciation deductions, taxpayers are allowed to make a number of elections to use longer recovery periods and straight-line methods of depreciation. Rules are also provided for the computation of earnings and profits, depreciation on assets used predominantly outside the United States and the minimum tax. Rules under which leasing transactions are recognized as such for tax purposes are considerably liberalized.

At-risk rules

The bill provides an "at-risk" rule for the investment tax credit. Under this rule, the credit cannot be claimed to the extent an asset is financed with debt for which the taxpayer is not personally liable. However, exceptions are provided for debt provided by certain kinds of third-party lenders, such as financial institutions.

Effective date

ACRS will be effective for property placed in service after December 31, 1980. However, rules are provided to prevent related parties from making used property eligible for ACRS through paper transactions.

Revenue effect

ACRS will reduce revenues by $9.8 billion in fiscal year 1982, $17.6 billion in 1983 and $27.0 billion in 1984.

The revenue loss is expected to be $0.1 billion in fiscal year 1982, $0.2 billion in 1983, and $0.2 billion in 1984.

The research and experimentation credit is effective for wages paid or incurred after June 30, 1981.

The revenue loss from the credit is expected to be $0.3 billion in fiscal year 1982, $0.6 billion in 1983, and $0.7 billion in 1984.

Increase in unified credit

The bill increases the amount of the tax credit against the estate and gift taxes from $47,000 to $192,800 over a 5-year period. Thus, the level of transfers at which the estate and gift taxes begin increases from the present $175,625 to $225,000 in 1982, $275,000 in 1983, $350,000 in 1984, $450,000 in 1985, and $600,000 in 1986 and subsequent years.

Unlimited marital deduction

The bill provides an unlimited marital deduction for both the estate and gift taxes. As a result, no transfer tax will be imposed on transfers between spouses regardless of how large those transfers are. Transfers of community property qualify for the unlimited marital deduction.

Annual gift tax exclusion

The bill increases from $3,000 to $10,000 the maximum amount which a taxpayer can give to any individual donee each year without paying gift tax. Thus, under the bill, a husband and wife may jointly transfer up to $20,000 per donee each year without being subject to gift tax.

Current use valuation

Present law provides a reduction in the value of farms and small businesses for estate tax purposes, called current use valuation. The bill provides a number of technical modifications to these provisions to make them simpler and easier to use.

The required period of physical presence in the foreign country which is needed to qualify for the exclusion is shortened to 11 out of 12 consecutive months, instead of the present 17 out of 18 consecutive months.

The new provisions are effective for 1982 and subsequent years and replace the present exclusion for employees of charities and employees in hardship areas, as well as the current deductions for certain identified expenses that relate to the excess cost of living overseas.

Revenue losses from these changes are $0.3 billion in fiscal year 1982, and $0.5 billion in 1983.

Mark-to-market

Under the bill, regulated futures contracts are marked to market at the earlier of disposition or the end of the tax year. Under this rule, gains and losses in a taxpayer's futures account are treated as recognized at the close of the year. Net gains on regulated futures contracts are treated as if 40 percent of the gain were short-term gain and 60 percent of the gain were long-term gain, thus providing a maximum tax rate of 32 percent on gains on regulated futures contracts after 1981. Furthermore, the bill provides a 3-year capital loss carryback for losses on regulated futures contracts. These losses can be deducted against gains from regulated futures contracts in the three prior years.

Loss deferral

In the case of straddles which do not involve positions in regulated futures contracts, losses are deferred to the extent there are unrealized gains in offsetting positions. However, in the case of straddles which consist of one or more positions in regulated futures contracts, the taxpayer may elect either to have all positions marked to market, or alternatively, have the leg that is a regulated futures contract exempted from the mark-to-market rule and treated, along with the other positions making up the straddle, under the general loss deferral rule. The bill also authorizes regulations extending present law wash-sale and short-sale principles to straddle positions.

Capitalization of interest and carrying charges

The bill requires the taxpayers to capitalize interest and carrying charges for certain "cash and carry" straddles.

Hedging exception

The bill exempts hedging transactions from the mark-to-market, loss deferral and capitalization rules.

Treasury bills

Treasury bills are treated as capital assets. The amount of ordinary interest income assumed to be earned in connection with the Treasury bill is based on a linear amortization of the difference between the taxpayer's basis and the price at which the bills are to be redeemed during the period which the taxpayer held the Treasury bill.

Dealer identification of securities

Broker-dealers are required to identify securities held for investment on the day the securities are acquired.

Sale or exchange

The bill provides that certain dispositions of capital assets which produce capital gain or loss on their sale or exchange are treated as resulting in capital gain or loss without regard to whether a disposition is a sale or exchange.

Effective date

The bill will generally be effective for property acquired and positions entered into after June 23, 1981.

Revenue effect

These provisions will increase revenues by $1.4 billion in fiscal year 1982.

The bill includes a permanent credit for the first $2,500 of windfall profit tax paid by qualified royalty owners each year. In addition, some technical amendments are made which will permit royalty owners to receive the benefit of these credits during the year instead of having to claim a tax refund after the close of the year.

The revenue loss is $0.8 billion in fiscal year 1982, $0.7 billion in fiscal year 1983 and $.06 billion in 1984.

Reduced tax on newly discovered oil

The bill reduces the tax rate on newly discovered oil from the present 30 percent to 25 percent in 1983 and 1984, 20 percent in 1985, and 15 percent in 1986 and subsequent years.

The revenue loss is $0.2 billion in fiscal year 1983, $0.4 billion in 1984 and $1.5 billion in 1986.

The bill creates a special class of stock options called "incentive stock options." Employers are denied a business deduction relating to the grant of these options. However, an employee receiving such an option is taxed only when he sells the stock, and the gain on the sale is taxed at capital gains rates.

Subchapter S corporations

The bill increases the maximum number of shareholders for a subchapter S corporation from 15 to 25 and permits certain trusts to be shareholders of such corporations.

Accumulated earnings credit

The bill increases the credit against the accumulated earnings tax from $150,000 to $250,000.

Investment credit for used property

The bill repeals the existing $100,000 limitation on the amount of used property eligible for the investment credit. There will, however, be recapture of previously claimed credits based on the proceeds from the sale or disposition of the asset, rather than the period of time the property was held by the taxpayer.

The bill allows motor carriers to amortize over a 60-month period the adjusted basis of all motor carrier operating rights held on July 1, 1980.

Corporate contributions of research equipment to colleges

Present law limits the amount deductible for charitable contributions of property if the sale of that property would generate ordinary income. The bill provides a limited exception to this rule for contributions by a corporation of new tangible personal property which is manufactured by the corporate donor and is to be used by the donee college or university for research purposes.

The committee is concerned that the performance of the economy has fallen far below its potential and that this condition will continue if there is no change in policy. The real growth of the economy, which had slowed in 1978 and again in 1979, came to a halt in 1980. Inflation and interest rates rose to exceptional levels and remain high. The unemployment rate rose sharply in 1980 and remains unacceptably high, while rates of productivity and savings have declined or stagnated. At the same time, Federal budget receipts have grown to be larger percentage of the income generated by the American economy than at any other time in the postwar period. Without significant tax cuts, Federal taxes would continue to rise to 22.8 percent of the gross national product by 1984. The committee believes that this level of taxation is a significant impediment to economic progress and that an extensive program of tax cuts is required at this time.

The committee believes that a program of multi-year tax cuts will help check the growth of Federal expenditures. Federal spending has grown from 19.5 percent of gross national product in fiscal year 1974 to 22.6 percent in fiscal year 1980. This trend must be reversed. Through increased expenditures, the Federal Government has too often intruded into decisions on the allocation of resources. Such intrusions have caused inefficiencies in the workings of the economy, misallocation of resources, uncertainty and instability. As a result, the free enterprise system has fallen short of its potential for economic growth. The committee believes that its program of tax reductions will increase the likelihood that Federal spending will be restrained over an extended period of time, and will speed economic recovery by reducing governmental interference in the workings of a free economy.

A second reason for individual tax reductions is to mitigate the adverse effects of high marginal tax rates on productivity and savings. A high marginal tax rate--that is, the tax rate applicable to the last dollar of income--discourages additional work effort and encourages tax avoidance by diverting people from more productive activities that are fully taxable to less productive activities that are not fully taxable or that generate tax losses which can be used to shelter other income from tax. Marginal income tax rates are now higher than they have been at any other time during the last two decades. Today, more than half of all income is received by taxpayers whose marginal income tax rate exceeds 30 percent. Moreover, without a change in policy, inflation would cause marginal tax rates to increase automatically in future years. The committee believes that these marginal income tax rates should be lowered for all taxpayers by multi-year cuts in tax rates.

Third, tax changes are needed to reduce the tax penalty which results when two persons with relatively equal incomes marry each other. Imposing-substantial tax penalties on marriage is undesirable because such penalties imply a lack of concern on the part of the government for the family. These penalties also discourage work effort by second-earners and undermine respect for the tax system itself as an even-handed way to raise revenue. Accordingly, the bill is designed to achieve significant reductions in this marriage penalty.

The committee concludes that the appropriate size of the income tax reduction for individuals is $4.0 billion for calendar year 1981, $41.4 billion for calendar year 1982, $84.8 billion for calendar year 1983 and $119.3 billion for calendar year 1984. These amounts represent significant progress toward the goals of tax reduction, yet are consistent with controlling the budget and eliminating the deficit in 1984.

In its hearings on tax reduction, the committee heard numerous witnesses testify that a restructuring of depreciation allowances for tax purposes would be an effective way of stimulating capital formation. Inflation reduces the tax savings from depreciation deductions because the value of the dollar is less when these deductions are claimed than it was when the investment was originally made. As a result, the current system of depreciation reduces the incentive to invest. The committee agrees that a new system of capital cost recovery is required and the bill, therefore, provides for more accelerated depreciation of plant, equipment, and rental housing. This will provide incentives for investment spending and will contribute immediately to cash flow for the financing of such spending. In addition, the new system is designed to simplify compliance by taxpayers and administration by the Internal Revenue Service.

The committee is concerned that the nation's lead in research and development has been diminished in recent years. From research and development come technological advances that are essential to increased productivity and competitiveness. The committee believes that a major new tax incentive is needed to encourage additional research and development.

The committee believes that the tax system should be modified to promote greater personal savings, so that the rebuilding of the economy can occur with less risk of inflation and so that individuals can more easily accumulate their own resources for retirement. The bill, therefore, provides incentives for individuals to make greater contributions to private retirement accounts and to a new type of savings account. It extends tax incentives for individual retirement accounts to a much broader class of taxpayers. The bill also contains incentives for the wider use of employee stock ownership plans, which encourage employees to invest in the stock of their employer and to increase their productivity. The reduction in the top income tax rate to 50 percent in 1982 will also encourage saving and direct saving away from tax shelter investments.

The committee believes that additional incentives are needed to maintain and increase the viability of small businesses. Small businesses are important sources of employment, innovation and competition, but are especially vulnerable during periods of high inflation, high interest rates and economic stagnation. The committee bill therefore provides for significant reductions in estate and gift taxes, the expensing of relatively small amounts of investment and other measures targeted to small businesses.

A substantial percentage of the tax reductions in the committee bill are specifically targeted toward improving capital formation. The committee believes these tax cuts, in combination with individual income tax reductions, constitute a redirection of the Federal tax system that will restore the vitality of the national economy.

As shown in Table 1, the committee bill provides a tax reduction of $1.5 billion in fiscal year 1981, $37.0 billion in fiscal year 1982, $93.1 billion in fiscal year 1983, and $224.2 in fiscal year 1986.

On the calendar year basis, the tax reduction is $9.1 billion in 1981. $56.8 billion in 1982, $115.8 billion in 1983, and $243.3 billion in 1986.

In many cases the revenue estimates do not include assumptions about the extent to which taxpayers change their behavior in response to tax changes. However, responses by taxpayers often can be expected to increase the tax base and offset some or all of the revenue loss from the reduction in taxes. For example, the reduction in the top individual income tax rate from 70 percent to 50 percent is expected to encourage additional sales of capital assets, reduce use of tax shelters and a number of other changes in behavior which will expand the amount of taxable income, i.e., the tax base. The committee believes that there is a good chance that these "feedback effects" will expand the tax base enough to offset the revenue loss from the reduction in the top rate. However, because it is very difficult to make precise scientific estimates of these feedback effects, the revenue estimates of this provision of the bill do not take feedback effects into account.

[Estimate Tables not reproduced.]

(secs. 101 and 102 of the bill and secs. 1, 55, 541, 1348, and 6428 of the Code)

Under present law, individual income tax rates begin at 14 percent on taxable income in excess of $3,400 on a joint return and $2,300 on a single return. There is no tax on taxable income below these amounts. Individual income tax rates range up to 70 percent on taxable income in excess of $215,400 for joint returns and $108,300 for single returns. The existing marginal tax rates applying to married couples filing joint returns are shown in table 5.

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

Maximum tax

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

Alternative minimum tax (capital gains)

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

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

The committee believes that these marginal rate reductions will accomplish two important goals of the economic recovery program. First, they provide equitable across-the-board relief from the excessive and steadily growing tax burden that is imposed under current law. Second, they reduce the distortions, inefficiencies and disincentives that result from the current high level of marginal tax rates.

The average income tax burden, as a percentage of income, is now higher than at any time during the last twenty years. A cornerstone of the economic recovery program is the reduction of the role the Federal government plays in the lives of American citizens. Other legislative action, such as the reconciliation bill, will provide substantial reductions in government spending programs; the committee bill returns to taxpayers the substantial resources that otherwise would have been absorbed by these programs. The tax rate reductions are provided in an across-the-board manner, in order to assure that all taxpayers share the relief in proportion to what their tax liability would have been had the shrinkage in the government's role not taken place. (See Table 4 for figures on the distribution of the tax cut by income class.)² The 23-percent reduction will be phased in over three years, in a manner that will have a steady, predictable impact on the economy and that is consistent with the goal of a balanced budget in fiscal year 1984.

       Table 4--Distribution of Aggregate Revenue Loss Relative

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

The committee also believes that the increase, resulting from marginal rate reductions, in the after-tax return to saving will significantly increase personal saving, thus insuring adequate financing for the additional investment encouraged by other provisions of this bill. The urgency with which the committee views this need is reflected in its decision to reduce the highest marginal rate by 20 percentage points on January 1, 1982, rather than to phase in this change, as is the case with other rate reductions. Because the law already provides a special maximum tax rate on earned income, this change is intended to eliminate a substantial disincentive to investment. In addition to providing a stimulus for additional saving, the marginal rate reductions will encourage the expansion of many small business activities by increasing the after-tax return to those activities. Moreover, by increasing the after-tax cost of borrowing, marginal rate reductions will reduce the incentive for borrowing (or dissaving) that results from the present law deduction for interest. Further, individuals will be less inclined to shift their investments from highly taxed, productive activities, to lightly taxed, less productive investments such as tax shelters and precious metals. Finally, lower marginal rates will reduce the "lock-in" effect of the present treatment of capital gains, thus increasing the likelihood that capital assets always will be employed in their most efficient uses.

The committee bill reduces individual income tax rates in every tax bracket. By 1984, all tax rates in current tax rate schedules are reduced by approximately 23 percent. Moreover, the highest marginal tax rate is reduced from 70 percent to 50 percent as of January 1, 1982; this 50-percent maximum rate is applied in all years to the rate schedules which would have resulted from the across-the-board reductions by themselves. Thus, when the committee's tax rate cuts are phased in fully, tax rates will range from 11 percent to 50 percent instead of the present law range of 14 percent to 70 percent. The committee bill implements the "5-10-10" proposal put forward by the President.

The committee bill reduces individual income tax liability in four stages. For calendar year 1981, there is a tax credit against regular tax equal to 1-1/4 percent of regular tax liability before other credits. This credit corresponds to a 5-percent reduction in withholding, effective on October 1, 1981. The Secretary is required to incorporate this credit in the section 3 tax tables for 1981 and has the authority to modify the applicable rate schedules of section 1 to reflect the credit or to prescribe other tables which reflect the amount of credit for different levels of tax or taxable income. In calendar year 1982, there are across-the-board rate reductions averaging about 10 percent below present law. For 1983, there are additional across-the-board rate reductions of 10 percent, resulting in rates about 19 percent below present law. (The two 10-percent rate reductions lead to a 19-percent, rather than a 20-percent reduction because the second 10-percent reduction is applied to the rates in effect after the first 10-percent reduction.) Finally, in 1984, the permanent rate schedules, incorporating further reductions of 5 percent and total across-the-board reductions of about 23 percent below present law, take effect. The marginal tax rates proposed under the committee bill for married couples filing joint returns are shown in table 5, below.

To conform the tax on undistributed personal holding company income to the reduction in the maximum individual income tax rate from 70 percent to 50 percent, the bill reduces the tax rate on such income to 50 percent.

 Table 5. -- Tax Rate Schedules Under Present Law and the Committee

As a result of reducing the maximum regular tax rate from 70 percent to 50 percent, the committee bill reduces the maximum rate of tax on net capital gains from 28 percent to 20 percent, even though the deduction for net capital gains is not increased. This 20-percent capital gain rate results from applying the highest tax rate under the bill (50 percent) to the 40 percent of net capital gain that is includible in gross income.

In order to conform the alternative minimum tax to the reduction in the maximum regular tax on net capital gains, the bill reduces the top alternative minimum tax rate from 25 percent to 20 percent. Thus, under the committee bill, the alternative minimum tax rate is 10 percent for amounts from $20,000 to $60,000 and 20 percent for amounts in excess of $60,000.

c. Special rules for net capital gains in 1981

Because the committee does not want to encourage individuals to postpone the disposition of capital assets until 1982 in order to take advantage of the effect that the 50-percent maximum tax rate will have on the taxation of net capital gains, the committee bill provides a special alternative tax so that a maximum 20-percent rate on net capital gains will apply to sales or exchanges occurring after June 10, 1981.

Specifically, an individual who has net capital gains in 1981 will pay a tax equal to the lesser of: (1) the sum of the regular tax on all taxable income other than 40 percent of the qualified net capital gain, and a tax at the rate of 20 percent on the qualified net capital gain, or (2) the regular tax on all taxable income (including 40 percent of qualified net capital gain). Qualified net capital gain is the lesser of the net capital gain for the taxable year or the net capital gain for the taxable year taking into account only gain or loss from sales or exchanges occurring after June 10, 1981. Thus, qualified net capital gain does not take account of taxable receipts after June 10, 1981, of proceeds of transactions which occurred prior to that date. Likewise, with respect to the alternative minimum tax, an individual's tax is limited to the sum of the alternative minimum tax on alternative minimum taxable income other than qualified net capital gain, and a 20-percent tax on qualified net capital gain. Credits other than the foreign tax credit are not allowed against the qualified net capital gain portion of the minimum tax.

d. Withholding changes

Under the committee bill, three changes in income tax withholding rates are scheduled. An initial 5-percent reduction in income tax withholding rates takes effect on October 1, 1981. There is a further 10-percent reduction on July 1, 1982, amounting to a cumulative reduction of 14-1/2 percent. (The cumulative reduction is less than 15 percent because the 10-percent reduction applies to the withholding rates in effect after the initial 5-percent reduction.) There is a final 10-percent reduction on July 1, 1983, for a total cumulative reduction of 23 percent.

In addition to the withholding changes made to reflect the tax reductions provided by the committee bill, the bill makes several other with holding changes to give the Secretary authority to issue regulations which would permit workers to adjust their withholding to more closely match their tax liability. The bill makes clear that the maximum number of withholding exemptions to be claimed by an individual will be determined pursuant to Treasury regulations. The bill also allows the Secretary to prescribe that more than one additional withholding exemption may be allowed to taxpayers who may claim a zero bracket (special withholding) allowance because they are neither married with a spouse receiving wages nor working for more than one employer (present law allows only one additional exemption to such taxpayers). Moreover, the Secretary is authorized to provide by regulations that employees may have withholding either increased or reduced at their request (present law provides only for increases) and that an employee could achieve such increased or decreased withholding without the employer's consent. (Present law requires both the employer and employee to agree to increased withholding). Finally, the bill makes it clear that additional withholding allowances for anticipated excess itemized deductions and tax credits can be claimed only in accordance with Treasury regulations and gives the Treasury statutory authority to provide additional withholding allowances for any additional items specified in Treasury regulations.

e. Elimination of maximum tax

Under the committee bill, the highest marginal tax rate on all types of income is reduced to 50 percent, as of January 1, 1982. Therefore, the maximum tax rate on personal service income, which would become redundant, is repealed by the bill, as of January 1, 1982.

For fiscal year taxpayers, the rate changes would be effective for the portion of the taxable year after December 31 of the year (sec. 21).

2. Deduction for two-earner married couples

(sec. 103 of the bill and secs. 62, 85, 105, 3402 and new sec. 221 of the Code)

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

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

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

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

The substantial reductions in the marriage penalty resulting from both this new deduction and the overall reductions in marginal rates provided by the committee bill are shown in table 6. This new deduction is a major step towards the goal of eliminating the marriage penalty completely.

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

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

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

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

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

 Table 6--Marriage Tax Penalty for Two-Earner Couples Under

The marriage bonus or penalty is the difference between the tax liability of a married couple and the sum of the tax liabilities of the two spouses had each been taxed as a single person. Marriage bonuses are negative in the table; marriage penalties are positive. It is assumed that all income is earned, that taxpayers have no dependents, and that deductible expenses are 23 percent of adjusted gross income and are allocated between spouses in proportion to income.

Committee bill computations assume the rate schedules and two-earner couple deduction in effect in 1984 and thereafter.

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

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

Finally, a married couple will be allowed to take this deduction into account in determining withholding allowances under section 3402(m).

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

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

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

Foreign Earned Income Act of 1978

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Finally, the provision of the Foreign Earned Income Act of 1978 requiring the Secretary to report biannually to the Congress on the operation and effects of sections 911 and 912 is changed to require the report after the close of calendar year 1983, and each fourth calendar year thereafter.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

                                                 Carryover

The at-risk loss limitation rules apply to most business activities, except real estate, engaged in by individuals, subchapter S corporations, and certain closely held corporations. Certain leasing activities engaged in by closely held corporations are not covered by the at-risk loss limitations.

Under present law, there is no at-risk limit on the investment credit.

The real value of depreciation deductions allowed under present rules has declined for several years due to successively higher rates of inflation. Reductions in the real value of depreciation deductions diminish the profitability of investment and discourage businesses from replacing old equipment and structures with more modern assets that reflect recent technology. The committee agrees with numerous witnesses who testified that a substantial restructuring of depreciation deductions and the investment tax credit will be an effective way of stimulating capital formation, increasing productivity and improving the nation's competitiveness in international trade. The committee therefore believes that a new capital cost recovery system is required which provides for the more rapid acceleration of cost recovery deductions and maintains or increases the investment tax credit.

The committee heard copious testimony that the present rules are too complex. These rules require determinations on matters, such as useful life and salvage value, which are inherently uncertain and, thus, too frequently result in unproductive disagreements between taxpayers and the Internal Revenue Service. Current regulations provide numerous elections and exceptions which taxpayers--especially, small businesses--find difficult to master and expensive to apply. The committee believes that a new capital cost recovery system should be structured which de-emphasizes the concept of useful life, minimizes the number of elections and exceptions, and so is easier to comply with and to administer.

Under the new system, the cost of eligible personal property is recovered over a 15-year, 10-year, 5-year, or 3-year period depending on the type of property. Most eligible personal property is in the 5-year class. Cars, light duty trucks, research and experimentation equipment, and certain other short-lived property are in the 3-year class. Theme park structures, railroad tank cars, and certain long-lived public utility property are in the 10-year class. Certain other long-lived public utility property has a 15-year recovery period. Eligible real property is placed in a separate 15-year real property class. To provide flexibility, certain longer optional recovery periods are provided.

Recovery of costs generally is determined by using a statutory accelerated method. As an option, the taxpayer may choose to recover costs using the straight-line method over either the regular recovery period or the longer recovery periods provided.

The entire cost or other basis of eligible property is recovered under the new system, eliminating the salvage value limitation under present law.

Eligible property includes depreciable property other than (1) property the taxpayer properly elects to amortize (e.g., leasehold improvements or low-income rehabilitation expenditures) and (2) most property the taxpayer properly elects to depreciate under a method not expressed in terms of years (e.g., unit-of-production or income forecast methods). However, railroad property currently depreciated under the retirement-replacement-betterment method is included in ACRS, subject to special transitional rules.

The committee bill provides a provision for the limited expensing of eligible property and special rules relating to cost recovery for foreign assets, normalization requirements for public utility property, and the computation of earnings and profits and of the minimum tax. Special rules also are provided to prevent the "churning" of used property between certain persons solely to obtain the benefits of increased investment incentives under ACRS. In addition, ACRS establishes new rules for determining if the nominal lessor is entitled to recovery deductions and investment credits for certain leased recovery property.

The committee bill also extends the carryover period for certain operating losses.

Under the committee bill, the capital cost of tangible personal property generally will be recovered over a 15-year, 10-year, 5-year, or 3-year recovery period, depending on the type of property. However, the taxpayer can elect to use either the extended recovery period used to calculate earnings and profits for the property or the extended earnings and profits recovery period for property in the next higher class. (Because there is no class higher than the 15-year class, an optional 45-year period is permitted for 15-year property.) Thus, a taxpayer can elect to use a 45-year or 35-year recovery period for 15-year property, a 35-year or 25-year recovery period for 10-year property, a 25-year or 12-year recovery period for 5-year property, and a 12-year or 5-year recovery period for 3-year property. Theme park structures are included in the 10-year class.

3-year class.--Automobiles, light-duty trucks, and machinery and equipment used in connection with research and experimentation are assigned to the 3-year class. For these purposes, research and experimentation has the same meaning as the term "research and experimental" has in Code section 174. In addition, all other machinery and equipment (such as special tools) with an ADR midpoint life of 4 years or less as of January 1, 1981, are placed in this class.

5-year class.--The 5-year class includes all tangible personal property, including public utility property with a present ADR midpoint of 18 years or less, that is not included in the 15-year, 10-year, or 3-year recovery classes. Single purpose agricultural and horticultural structures and facilities used for the storage of petroleum and its primary products are designated by the bill as section 1245 property and included in the 5-year class. Under regulations prescribed by the Secretary, petroleum and its primary products will have the same meaning as described in the DISC regulations (Treas. Reg. Sec. 1.993-3(g)(3)(i)). Petrochemicals are not considered to be primary products from petroleum. Single purpose agricultural and horticultural structures are the same structures which are eligible for the investment credit under Code section 48(a)(1)(D). The committee intends that no inference should be made as to the treatment under present law of these single purpose structures and petroleum products storage facilities.

The Department of Treasury has advised the committee that after ACRS is enacted, the class life of telephone central office equipment will be reduced, pursuant to a study by the Office of Industrial Economics, from 20 years to 18 years, effective January 1, 1981. Therefore, such equipment will be classified as 5-year property.

10-year class.--Public utility property with an ADR midpoint life, as of January 1, 1981, of 18.5 to 25 years (other than public utility property used in research and experimentation) and railroad tank cars are placed in the 10-year class. Theme park structures also are included in the 10-year class and, except for eligibility for the investment, are subject to the same rules that apply to 10-year personal property.

15-year class.--Public utility property with an ADR midpoint life, as of January 1, 1981, of more than 25 years (other than public utility property used in research and experimentation) is placed in the 15-year class. This class will include, for example, electric utility steam production plants, gas utility manufactured gas production plants, water utility property, and telephone distribution plants.

Method

Prescribed method.--The recovery deduction in each year of the recovery period will be determined by applying a statutory percentage to the unadjusted basis of the personal property. In determining the annual deduction, the applicable percentage to be applied to the unadjusted basis of the property will depend on the property's class and the number of years since the property was placed in service by the taxpayer ("recovery year"). No recovery deduction will be allowable in the year of an asset's disposition.

The bill delegates authority to the Secretary to promulgate regulations for determining the amount of a recovery deduction when, after property is placed in service, the basis must be redetermined as, for example, when there has been a reduction or an increase in the purchase price or a reduction in basis under Code section 1017.

For the years 1981-1984, the prescribed accelerated method will approximate the benefit of using the 150-percent declining balance method for the early years of the recovery period, including the use of a "half-year convention" for the year of acquisition. The recovery percentages for the prescribed accelerated method for 1981-1984 are set forth in the following table.

      FOR PROPERTY PLACED IN SERVICE, 1981-84

The recovery percentages for property placed in service in 1985 and for property placed in service in 1986 and subsequent years are shown in the tables below:

         FOR PROPERTY PLACED IN SERVICE IN 1985

A taxpayer electing to use an optional recovery must elect the same recovery for all property of that class placed in service for the year the election is made. The election will apply to all property in that class and is irrevocable. However, a different election may be made for property in other classes and for property in that class (and other classes) placed in service in a different taxable year.

If the straight-line method is elected, a half-year of cost recovery is allowable for the year the property is placed in service and, if the property is held for the entire recovery period, a half-year of depreciation is allowable for the year following the end of its recovery period. For example, for 5-year property for which the straight-line method and a 5-year recovery period is used, a half-year of cost recovery is allowable in the first year, a full year of cost recovery is allowable in each of the next 4 years and a half-year in the 6th year. However, if property is disposed of prior to the end of the recovery period elected by the taxpayer, no cost recovery will be allowable to the taxpayer with respect to the property for the year of disposition.

Disposition of assets and recapture

Gain or loss generally will be recognized on each disposition of an asset, including ordinary or normal retirements, unless other provisions of the Code provide for nonrecognition. However, a special rule is provided to avoid calculation of gain on the disposition of assets from mass asset accounts. In such case, gain is recognized to the extent of the proceeds realized from the disposition of the asset and the unadjusted basis of the property is left in the account until fully recovered in future years.

As under present law, gain recognized on the disposition of assets will be ordinary income to the extent of prior recovery deductions taken ("sec. 1245 recapture"). This section 1245 recapture applies to theme park structures, single purpose agricultural and horticultural structures, and facilities used for the storage of petroleum and its primary products.

All real property (other than theme park structures, which are included in the 10-year class, and certain real property designated as section 1245 property) has a 15-year recovery period. The taxpayer has the option under ACRS to use an extended recovery period of either 35 or 45 years. A substantial improvement is treated as a separate building for this election. (See "Component depreciation eliminated" below). The recovery period for a building, in general, will begin on the first day of the month in which the property is placed in service.

Method

A schedule of accelerated recovery percentages is to be provided by the Secretary for use in computing the annual recovery allowances for real property in the 15-year class. Generally, the recovery percentages will take into account the number of months the property is in service during the year of acquisition and the year of disposition of the property.

Taxpayers may elect to use the straight-line method over the regular recovery period or either of the optional longer recovery period. As with the schedules of accelerated recovery percentages, the straight-line recovery percentage for the first year will depend on the number of months the property is in service during the year of its acquisition and disposition. Unlike the election for personal property, the half-year convention will not apply to the election for the 15-year real property, and the real property election may be made on a property-by-property basis.

Gain on disposition and recapture

If the cost of nonresidential property in the 15-year class is recovered under the prescribed accelerated method, all gain will be ordinary income to the extent of all recovery allowances previously taken (sec. 1245). However, if the straight-line method is elected, all gain will be capital gain.

For all residential real property, gain will be ordinary income only to the extent the recovery allowed under the prescribed accelerated method exceeds the recovery that would have been allowable if the straight-line method over the 15-year period had been used (sec. 1250). Therefore, if the straight-line method is elected, all gain will be capital gain.

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

Component depreciation eliminated

Composite depreciation is required for the entire structure other than those components the taxpayer properly elects to amortize, (e.g., low-income rehabilitation expenditures). Thus, the same recovery period and method, in general, must be used for each component, such as plumbing, wiring, etc. The recovery period for any component part begins on the first day of the month in which the component is placed in service or, if later, when the building is placed in service.

For purposes of making the election to use an optional recovery period or method, a substantial improvement of a building is treated as a separate building. For example, the taxpayer may use a 15-year period for a substantial improvement even if the rest of the building is depreciable over a 35-year or 45-year period. Also, the taxpayer may use an accelerated method even if the straight-line method were used for the rest of the building. Under the committee bill, an improvement is a substantial improvement if (a) over a 2-year period the amounts added to the capital account for the building are at least 25 percent of the adjusted basis of the building (disregarding adjustments for depreciation or amortization) as of the first day of that period and (b) the improvement is made at least 3 years after the building was placed in service.

A special rule allows a new recovery period and method election for the first component placed in service after 1980 on a building owned before 1981, whether or not it is a substantial improvement.

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

For real property (excluding theme parks which are treated as section 1245 property for purposes of cost recovery under ACRS), the amount of the preference is the excess of the recovery deduction allowed over the deduction which would have been allowable if the deduction had been calculated using no salvage value and the straight-line method over the 15-year recovery period. This amount is a preference item for all taxpayers.

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

  EXTENDED RECOVERY PERIOD

For foreign real property, the recovery period will be 35 years. The applicable percentages for real property also will be determined under tables prescribed by the Secretary, which will be based on the 150-percent declining balance method for the early years of the recovery period and the straight-line method for the later years. There will be no salvage value limitation. Useful life determinations based on facts and circumstances will not be allowed.

To provide flexibility, the straight-line method can be used in lieu of the prescribed accelerated method. In the case of foreign personal property the taxpayer may elect to use the straight-line method over the ADR midpoints, the extended recovery period used to compute earnings and profits for property of the same class, or the earnings and profits period for property of the next higher class, but the period elected may not be shorter than the ADR midpoint. Thus, for a foreign asset that is 3-year property, the taxpayer may elect straight-line recovery over a recovery period of the midpoint life, or if longer, 5 years or 12 years. For all foreign personal property with the same ADR midpoint and same ACRS class, the taxpayer must make any election regarding recovery periods and recovery methods with respect to all such property placed in service in the same taxable year.

For real property, the taxpayer may elect to use the straight-line method over a recovery period of 35 or 45 years. This election may be made on a property-by-property basis.

If an optional straight-line recovery is elected for personal property, the "half-year" convention will apply in the same manner as for domestic property. For foreign real property, recovery in the years of acquisition and disposition will be based on the number of months the property is in service during the year.

Whether an asset is used predominantly outside the United States will be determined under regulations prescribed by the Secretary similar to the rules currently used to determine whether foreign assets are eligible for the investment credit (sec. 48(a)(2)), taking into account all the exceptions set forth in section 48(a)(2)(B).

Under the committee bill, the normalization rule for the benefits of using ACRS shortened recovery periods differs from present law. Under present law, the maximum benefit that must be normalized is the benefit of using the 20-percent ADR variance rather than the ADR midpoint life. The further benefit of using the ADR midpoint life instead of a longer rate-making useful life may be immediately flowed through to customers under present law. Under the committee bill, the total benefit of using the ACRS recovery period rather than the longer rate-making useful life must be normalized, and none of this benefit may be immediately flowed through to customers.

The committee bill also requires that the statutory "half-year" convention and salvage value rules of ACRS be normalized. Therefore, if for purposes of determining the rate-making allowance for depreciation, a salvage value limitation rule or a rule relating to first-year depreciation is used, those rules will be used in determining the amount of deferred taxes that result from using ACRS.

As under present law, the committee bill does not restrict the authority of regulatory bodies to treat the deferred taxes as zero-cost capital or as a reduction in rate base in setting rates. However, as under present law, the amount of capital treated as zero-cost capital and the amount of rate base reduction may not exceed the amount of deferred taxes that result from the taxpayer's use of the recovery periods and methods actually used to compute a recovery allowance.

The committee bill does not provide for any continuation of flow-through accounting for property placed in service after December 31, 1980. Thus, public utility property placed in service after December 31, 1980, that is the same type of property as property for which flow-through accounting is currently permitted is subject to the normalization requirement. This is in contrast to present law rules, which permit flow-through accounting for public utility property placed in service after 1969 if the same type of property was subject to flow-through accounting in 1969.

As a consequence of the mandatory normalization requirement for all property placed in service after 1980, flow-through treatment of the investment credit permitted under section 46(f)(3) will not be permitted for any property placed in service after 1980.

During a 4-year transition period (1981-1984), a special transition rule is provided for such property that would have been expensed under RRB (replacements). Costs of property that would have been capitalized under RRB (additions and betterments) are treated the same as other 5-year property under ACRS. Thus, such costs are subject to the same rules that apply for other eligible property placed in service after 1980.

Replacement property (which would be expensed under RRB) is phased in to ACRS over 5 years. Replacement property placed in service in 1981 will be expensed. Replacement property placed in service in 1982 through 1984 will be recovered over 2, 3, and 4 years, respectively, using a statutory accelerated method based on the 200-percent declining balance method with a switch to the sum of the years-digits method. The recovery percentage for such property during the 4-year transition period are as follows:

Replacement property placed in service in 1985 and later years is treated the same as other 5-year property under ACRS. (Therefore, replacement property placed in service in 1985 will be depreciated using a statutory method based on the 175-percent declining balance method with a switch to the sum of the years-digits method.)

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

 PERCENTAGE OF BASIS DEDUCTIBLE

Under the committee bill, beginning in 1981, expenditures that are not capitalized (such as repairs) will not be allowed the investment credit permitted for such expenditures under present law. During the transition year 1981, expenditures that would be capitalized if incurred in a later year are considered to have been capitalized, even though they are expensed under the transition recovery rule for 1981.

Special rules are provided to prevent the taxpayer from bringing its property used during 1980 (pre-1981 property) within the system by certain post-1980 transactions (i.e., "churning" transactions.) Similar rules are provided to prevent the taxpayer from taking advantage of the increased recovery percentages available after 1984 for its property used before that time (pre-1985 property).

Pre-1981 property

ACRS will not apply to personal property in use during 1980, unless the property is transferred after 1980 in a transaction in which both the owner and user (if different) change. This rule may not be avoided by selling the churned property more than once after December 31, 1980, unless the user of the property also changes in the same transaction. The requirement that the user must change is designed to prevent lessors of equipment from swapping properties to obtain the benefits of ACRS. Also, ACRS does not apply to personal property leased back to a person that owned or used the property during 1980 or to a person related to that person.

ACRS will not apply to real property if (a) the taxpayer or a person related to the taxpayer owned the property during 1980, (b) the property is leased back to a person that owned the property at any time during 1980 or to a person related to that person, or (c) the property is acquired in certain like-kind exchanges, "rollovers" of low-income housing, involuntary conversions, or repossessions, for property the taxpayer or a related person owned during 1980. The rule in (c) applies only to the extent of the substituted basis of the property received. Thus, ACRS will apply to the extent the taxpayer pays "boot". The taxpayer may not avoid the rule in (c) by transferring the churned property in another like-kind exchange, rollover, etc. Unlike the personal property anti-churning rules, the user need not change for ACRS to apply to real property.

In determining whether the owner or the user of the property has changed under these rules, a person will be considered related to the prior owner or user if the person is related within the meaning of section 267(b) or 707(b)(1) (substituting 10-percent for the 50-percent ownership test), or section 52(a) or (b). A subsidiary is not considered a related person if at least 80 percent of its stock was acquired by the taxpayer by purchase after December 31, 1980, in a transaction described in section 334(b)(2).

For pre-1981 property acquired in a churning transaction (described above), present law governs depreciation of the asset.

For real or personal property used during 1980 and transferred in certain transfers to a corporation or partnership in which the basis is determined by reference to its basis to the transferor (transactions described in section 332, 351, 361, 371, 374, 721, or 731), ACRS will not apply. In that case the Secretary shall provide rules similar to those that apply under section 381(c)(6). Thus, the transferee, in general, must use the same recovery period and method used by the transferor (including use of any optional recovery period or method) the transferor used for the transferred property. This rule will continue to apply to successive transfers of such property to the extent the basis to the transferee includes an amount representing the basis of property used during 1980. Post-1980 additions to such basis, however, such as by the payment of boot, will not be subject to the anti-churning rules.

Finally, broad authority is granted to the Secretary to prescribe regulations to make ineligible for cost recovery under ACRS property transferred in a transaction the principal purpose of which is to make property eligible for more generous capital cost recovery.

Pre-1985 property

Similar antichurning rules are provided to prevent used property placed in service before 1985 or 1986 from taking advantage of the faster methods of depreciation made available under the committee bill after 1984. For this churned property, the transferee must use the same recovery period and method of depreciation as the transferor.

The committee bill provides that a taxpayer (other than a trust or estate) may elect to treat the cost of qualifying property as an expense that is not chargeable to capital account. The costs for which the election is made will be allowed as a deduction for the taxable year in which the qualifying property is placed in service. The optional expensing provision applies to qualified property placed in service in taxable years beginning after 1981. For taxable years beginning in 1982 and 1983, the dollar limitation on the amount that can be expensed is $5,000 a year ($2,500 in the case of a married individual filing a separate return). For taxable years beginning in 1984 and 1985, the dollar limitation is $7,500 ($3,750 for a married individual filing a separate return). For taxable years beginning in 1986 and later years, the dollar limitation is $10,000 ($5,000 for a married individual filing a separate return).

In general, the property for which an election may be made is personal property eligible to be treated as recovery property, if the property is acquired by purchase for use in a trade or business and is eligible for the investment credit. The trade or business limitation means that the election is not available for property held merely for the production of income (sec. 212). The requirement that the property be acquired by purchase is the same as the requirement in present section 179 for property eligible for additional first-year depreciation. Generally, this means that acquisitions do not qualify if (1) the property is acquired from a person whose relationship to the taxpayer would result in a disallowance of loss on a transaction between the taxpayers, (2) the property is acquired by one component member of a controlled group from another component member of the same group (using a 50-percent control test), or (3) the basis of the property in the hands of the person acquiring it is determined in whole or in part (a) by reference to the adjusted basis of the property in the hands of the person from whom it was acquired or (b) under the step-up basis rules for property acquired from a decedent.

Existing section 179 is repealed for property placed in service after December 31, 1980. Thus, neither additional first-year depreciation nor expensing is allowed for property placed in service in taxable years beginning in 1981.

Other limitations on eligibility

Under the bill, a controlled group of corporations is subject to limitations similar to those of present section 179. Thus, a controlled group of corporations (with a 50-percent control test) is treated as one taxpayer and must apportion the annual dollar limitation among the members of the group as provided in regulations.

Similarly, the same type of dollar limitations will apply in the case of partnerships as currently apply under section 179(d)(8). Under the committee bill, as under section 179, both the partnership and each partner are subject to the annual dollar limitation.

Dollar limitations where property is traded in

Present section 179 provides that the cost of property eligible for additional first-year depreciation does not include the portion of the basis of such property that is determined by reference to the basis of property traded in. The same rule is provided in the new expensing provision.

Elections

The bill provides that an election to expense property under this section for any taxable year must specify the items of property to which the election applies and the portion of the cost of each of these items to be deducted currently. The election must be made on an original return (including a late filed original return). In order to provide a degree of certainty, the provisions require that an election to expense property and any specification of items or amounts contained in such an election may not be revoked except with the consent of the Treasury Department.

Treatment of expensed property on disposition

If any portion of the basis of property is expensed under the new provision, the amount expensed is treated as depreciation taken for purposes of the recapture rules of section 1245. Thus, gain recognized on disposition of the property is treated as ordinary income to the extent of amounts expensed and depreciation taken.

In the case of a disposition that is given installment sales treatment under section 453, the committee bill provides that any amounts expensed with respect to the property are immediately recaptured as ordinary income to the extent of the gain realized on the disposition. An amount equal to the amount immediately recaptured under this rule is treated as an addition to the adjusted basis of the property for purposes of determining the amount of basis recovered and gain recognized from each installment.

Relationship with investment tax credit

To the extent that the cost of property is expensed pursuant to this new provision, no investment tax credit is allowable with respect to such cost.

Under present IRS guidelines, a transaction must meet the following requirements (among others) to qualify for an IRS ruling characterizing the transaction as a lease:

To come within the safe harbor, both the lessor and the lessee must affirmatively elect to treat the lessor as the owner of the property. The lessor must be a corporation other than a subchapter S corporation or a closely held corporation described in section 465(a)(1)(C) or a partnership of which all the partners are corporations other than the excepted corporations. At all times during the term of the lease and at the time that the property is first placed in service, the lessor must have a minimum "at risk" investment of not less than 10 percent of the adjusted basis of the property. Finally, the term of the lease (including all extensions thereof) cannot exceed a period equal to the ADR midpoint life of the property.

Only property that is new section 38 property may come within the safe harbor rules. The leased property must be leased within 3 months after its acquisition or, in the case of a sale-leaseback transaction, it must be purchased by the lessor within 3 months of the lessee's acquisition for a purchase price not to exceed the adjusted basis of the property in the hands of the lessee at the time of the lessor's purchase. For these purposes, the time that property is acquired will be the later of the time the property was acquired or the time the property was placed in service (so that, for example, if property takes a substantial period to construct and is not leased until after it has been completed and placed in service, the property would be required to be leased within 3 months after it was completed and placed in service).

If a transaction meets the above requirements, it will not be scrutinized to determine whether the transaction would be, absent this safe-harbor provision, a lease, a sale, a financing, or some other type of transaction. The transaction will be treated as a lease and the parties to the transaction will be treated as lessor and lessee as stipulated in their agreement. The following factors will therefore not be relevant to the characterization of a safe harbor transaction as a lease: whether or not the lessor's deriving a profit or cash flow from the transaction depends upon the tax benefits of owner ship; the fact that the lessee is the nominal owner of the property for state or local law purposes (e.g., has title to the property) and retains the burdens, benefits, and incidents of ownership (such as payment of taxes and maintenance charges with respect to the property); whether or not a person other than the lessee may be able to use the property after the lease term; the fact that the property may (or must) be bought or sold at the end of the lease term at a fixed or determinable price that is more or less than its fair market value at that time; and the fact that the lessee or a related party has provided financing or has guaranteed financing for the transaction (other than for the lessor's minimum 10 percent investment).

A lessor may lease a percentage of the property in a safe-harbor transaction, thereby transferring a parallel percentage of the tax benefits associated with the leased portion of the property. All new section 38 property may be leased, regardless of whether or not it is considered separate property under local law. However, the modified leasing rules will not apply to property which is used by the lessee for personal purposes.

If the lessee-user acquires the property and subsequently disposes of it, the lessee-user will be subject to the recapture rules under sections 47 and 1245, as if the lessee had been the owner of the property for the entire term of the lease, except that any credit or depreciation recaptured by the lessor will not be again recaptured by the lessee.

2. Investment tax credit revisions

To permit removal of the $100,000 limitation on used property, the present law recapture rules for the regular credit, which are based on the holding period of the property, are replaced with a recapture rule based on the amount realized on the disposition of the property. This rule applies to (1) property first placed in service by any taxpayer after December 31, 1980 and (2) other property disposed of (or ceasing to be qualified property) after December 31, 1980. For property disposed of after December 31, 1980 that is not subject to the proceeds-based recapture rule, the present law recapture rules will apply. Thus, all property in use before 1981 will continue to be subject to the present law recapture rules until 1991.

Under the system, analogous to the depreciation recapture system, the taxpayer will determine the recapture amount by multiplying the amount realized on a sale, exchange, or involuntary conversion (or, for other dispositions or cessations, the fair market value of the property) times the regular credit percentage that would apply to that property if it were placed in service in the year of disposition. However, the recapture amount is limited to an amount equal to the credit allowed to the taxpayer for that property for all prior years. In determining the applicable regular credit percentage for this recapture rule, all property will be treated as recovery property. Thus, the regular percentage applicable for property that would be 5-year recovery property in the year of disposition will be a full 10-percent. For property that would be 3-year recovery property, the applicable regular credit percentage will be 6-percent.

For example, assume a taxpayer acquired a $1,000 asset qualifying for a full 10-percent regular credit of $100. In a subsequent year, the taxpayer disposed of the asset for $500. If in the year of disposition, the property would be 5-year recovery property, the amount of recapture would be $50, which is 10-percent of the amount realized ($500). The taxpayer would retain a net credit of $50, equal to 10 percent of the taxpayer's net $500 ($1,000 less than $500) investment in the asset. In contrast, under present law the amount of the credit recapture would be more or less than $50, depending on how long the taxpayer held the asset; the amount received on the disposition of the asset would be immaterial.

Energy ESOP, and rehabilitation credits

Although the amount of the energy credit, rehabilitation credit, and ESOP credit initially allowable is determined under the same rules applicable to the regular credit, the proceeds-based recapture rule does not apply to those credits.

Unlike the proceeds-based recapture rule, the recapture amount for these credits will equal the amount of credit that would have been allowed to the taxpayer for that property for all prior years if the credit had been determined using the following percentage of the cost or basis of the property:

 If the taxpayer

A special rule applies for property that would be 3-year recovery property if it were recovery property in the year of disposition. Under this rule, the amount of recapture for property held 3 or 4 years would be one-half of the amount of recapture determined under the general rule above for energy, ESOP, and rehabilitation credits. If property were held 5 years or more, there would be no recapture.

In no case may the recapture amount exceed the credit allowed to the taxpayer for the property for all prior years.

Under a special rule for 3-year property held less than 5 years, the amount of recapture is one-half of the amount of recapture determined under the rule above for energy, ESOP, and rehabilitation credits. If 3-year property is held 5 years or more, there is no recapture.

Recapture tax and tax liability limitation

The bill repeals section 47(c) with respect to proceeds based recapture. Thus, under the bill, an increase in tax due to recapture of any investment credits may be taken into account in determining the tax liability limitation on the amount of credits allowed for the year of disposition.

The committee bill provides that an investment credit will not be allowed with respect to amounts invested in qualifying property to the extent the invested amounts are not "at risk." Generally, amounts are not considered at risk if (1) the taxpayer is protected against the loss of the invested amount, (2) the amount was borrowed and the taxpayer is not personally liable for repayment of the debt, (3) the lender has an interest other than as a creditor or (4) the lender is a related party to the borrower. These rules are the same as those used to determine whether amounts are at risk in an activity for purposes of the loss limitation rules of section 465.

Amounts at risk with respect to qualifying property are only those amounts considered at risk under section 465 that are directly attributable to investment in the property. Cash contributed to the operating expenses of a business is not considered at risk with respect to section 38 property used in the business. Similarly, a loan for the operation of a business, even if recourse, would not be considered at risk with respect to section 38 property.

The calculation of amounts at risk in the case of a partnership will be made by each partner to whom the at risk rules apply.

The committee bill provides an exception to the rules relating to amounts not at risk. Under the exception, amounts borrowed with respect to section 38 property no later than the taxable year the property is placed in service generally will be considered at risk if the amounts are owed to a bank, savings and loan association, credit union, or insurance company regulated under Federal, State, or local law, or are owed to a Federal, State, or local agency or instrumentality, or guaranteed by a Federal, State, or local agency. The exception does not apply where the Federal, State, or local government unit (or instrumentality) is merely acting as a conduit with respect to the loan.

[sic] not be a party related to the borrower. Under a special related party rule, any holder of greater than a 10 percent equity interest in the borrower will be a related party. In addition, the lender is considered related to the borrower if the lender is, for example, the seller or promoter of the taxpayer's interest in the property or is a person related to such seller or promoter. Furthermore, the debt advanced by the borrower cannot be convertible into equity.

In order for debt to qualify under this exception, the lending institution cannot transfer or have an agreement to transfer the debt, to a nonqualified lender during the 12-month period after the date on which the taxpayer borrowed the amount. A transfer of the debt to a nonqualified lender after such 12-month period will not decrease the taxpayer's amount at-risk with respect to the property. The debt may not be secured by property of a party other than the taxpayer.

Debt that falls within the exception will not be subject to the at risk rules and will generate basis for the investment credit as under the existing law. Thus, debt of a limited partnership (whether recourse or nonrecourse) to a qualifying institution will be allocated to the limited partners for these purposes, according to the rules applicable for allocating the investment credit to the limited partners (Treas. Reg. sec. 1.46-3(f)), even if the limited partners are not personally liable on the debt. Likewise, if a qualifying financial institution has a permissible 9 percent interest in the borrower that would otherwise be an interest other than as a creditor under section 465, the debt will still be taken into account in computing the credit.

A taxpayer's amount at risk with respect to property is increased only through increases in the actual investment in the property, such as by repayment of nonrecourse debt for the property. Repayment must be made with amounts for which the taxpayer is at risk within the meaning of section 465. Repayment of debt from a qualified lender, which is considered to be at risk, will not increase the taxpayer's amount at risk with respect to property. Unless operating profits of a business are used to repay debt with respect to section 38 property, such amounts would not increase at risk amounts for these purposes, even if there would be increases in amounts at risk under section 465. If the amount at risk with respect to property is increased, the credit for the property is redetermined as if the increased amount at risk had been taken into account when the property was first placed in service. Any increase in the credit attributable to the increased amount at risk is considered a credit earned in the taxable year the amount at risk was increased.

Amounts at risk with respect to property are reduced only if the taxpayer's investment in the property decreases. Cash distributions generally will not reduce a taxpayer's amount at risk with respect to property. Amounts at risk with respect to section 38 property will be reduced when recourse debt is converted into nonrecourse debt or when qualified debt is refinanced by the taxpayer and is replaced by debt for which the taxpayer is not at risk.

When an amount at risk with respect to property is reduced the credit for the property is redetermined as if only the reduced amount at risk had been taken into account when the property was first placed in service. Any credit previously earned in excess of the redetermined credit increases the taxpayer's tax liability for the taxable year the amount at risk is reduced. This rule applies to all taxable years following the taxable year the property is placed in service. The investment credit recapture rules will govern recapture upon the disposition (or cessation as qualifying property) of section 38 property.

The committee bill provides that the at-risk limitation on the investment credit will not apply to property placed in service before February 19, 1981, or property placed in service on or after such date property was acquired by the taxpayer under a binding contract entered into before February 19, 1981. For purposes of this rule, the Secretary shall prescribe regulations under which property will be considered to have been acquired under a binding contract if it was acquired in a manner that would have qualified the property as pre-termination property under section 49(b) (as in effect before its repeal by the Revenue Act of 1978).

3. Extension of carryover periods certain credits

The committee bill, in general, extends to 10 years the carryover period for the WIN, alcohol fuels, new employees, and investment credits.

The investment credit provisions generally apply to property placed in service after 1980.

The proceeds-based recapture rule and repeal of section 47(c) applies to (1) property the original use of which begins with the taxpayer after December 31, 1980, or (2) other property disposed of after December 31, 1990. The used property limitation is repealed for (1) property the original use of which begins after December 31, 1980, or (2) other property the taxpayer acquires after December 31, 1990.

The effective dates for extension of the carryover periods for various credits is as follows:

The provision in the bill removing the limit on investment credit for used property and changing the investment credit recapture rules would reduce budget receipts by $11 million in fiscal year 1981, $88 million in fiscal year 1982, $208 million in 1983, $303 million in 1984, $358 million in 1985, and $353 in 1986.

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

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

Depreciation

In addition to the investment credit, and in some cases in lieu of the credit, several special depreciation benefits are available to specified types of rehabilitated buildings. These special depreciation benefits and their relation to the investment credit are summarized by the following table [text]:

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

Under the committee bill, the 10-percent regular investment credit (and the additional energy credit) and certain special depreciation provisions for qualified rehabilitated buildings will be replaced by a three-tier investment credit. The credit is 15 percent for structures at least 30 years old, 20 percent credit for structures at least 40 years old, and 25 percent for certified historic structures. No credit is allowed for rehabilitation of a building less than 30 years old. However, a special rule allows a credit under present law rules for buildings that are more than 20 but less than 30 years old, if the rehabilitation began before January 1, 1982.

The 15- and 20-percent credits are limited, as under present law, to nonresidential buildings. However, the 25-percent credit for certified historic rehabilitation is available for both nonresidential and residential buildings. There credits are available only if the taxpayer elects to use the straight-line method of cost recovery with respect to the rehabilitation expenditures. In addition, there must be a substantial rehabilitation of the building to qualify for the credit.

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

The investment credit recapture rules applicable to the energy and ESOP credits will apply to the rehabilitation credit (see Subtitle A. "2. Investment Credit Revisions").

Qualified rehabilitated building

Expenditures qualify only if they are capitalized and are made for real property with a 15-year recovery period for depreciation under the bill. Expenditures qualify only in connection with a substantial rehabilitation of the building. A building has been substantially rehabilitated if either of two conditions are met.

First, there has been a substantial rehabilitation if the rehabilitation expenditures during the 24-month period ending on the last day of the taxable year exceed the greater of (a) the adjusted basis of the property as of the first day of the 24-month period, or (b) $5,000. This rule will apply in a manner similar to that provided under present law section 167(o)(2) (relating to accelerated methods of substantially rehabilitated certified historic structures).

Second, a rehabilitation is substantial if it meets the requirements under the first alternative by substituting 60 months for 24 months. However, under regulations prescribed by the Secretary, this 60-month alternative will be available only if there is a written set of architectural plans and specifications for all phases of the rehabilitation and a reasonable expectation that all phases of the rehabilitation will be completed. It is intended that the latter rule apply in a manner prescribed by the Secretary in regulations.

Certified historic structure

Under present law, expenditures for a certified historic structure are not eligibly for a credit unless the rehabilitation is a certified rehabilitation. Under the committee bill, this rule is extended to buildings located in a registered historic district unless the building is not a certified historic structure and the taxpayer obtains a certification from the Secretary of Interior that the building is not of historic significance to the district.

A certified historic structure is not subject to the rule in the committee bill requiring 30 years to elapse between the year the property was first placed in service and the year rehabilitation begins. However, as is the case for other qualified rehabilitated buildings, there must be a substantial rehabilitation of the building.

Repeal of other special benefits

The committee bill repeals the special 60-month amortization provisions for certified historic structures under section 191. In addition, the special rule permitting use of accelerated methods for substantially rehabilitated certified historic structures is repealed (sec. 167(o)).

Lessees

If a rehabilitation is undertaken by a lessee, the committee bill provides that the lessee is eligible for the investment credit for qualified rehabilitation expenditures incurred by the lessee but only if, on the date of completion of the rehabilitation, the remaining term of the lease is at least 15 years. This is similar to the rule under current law relating to the availability to lessees of the 5-year amortization of certified rehabilitation expenditures incurred in connection with a certified historic structure. The Secretary of the Treasury will prescribe by regulations rules for applying the substantial rehabilitation requirement to lessee.

Demolition costs

The present law rule (sec. 167(n)) that requires the use of straight-line cost recovery over the useful life of a building placed in service at the site of a demolished certified historic structure, is amended to require straight-line recovery over 15 years. The composite method of depreciation must be used. The rule in present law requiring demolition costs to be capitalized as part of the cost of the land is retained.

(sec. 221 of the bill and new Code sec. 44F)

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

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

Section 174 deduction elections

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

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

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

Definition of qualifying expenditures

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

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

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

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

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

Under the provision, a nonrefundable income tax credit is allowed for research and experimental³ wage expenditures paid or incurred by a taxpayer during the taxable year in carrying on a trade or business of the taxpayer, but only to the extent such expenditures exceed the average amount of the taxpayer's research wage expenditures in the specified base period. The rate of the credit (new Code sec. 44f) is 25 percent of the incremental research wage expenditure amount.

The credit is available for incremental research wage expenditures for the taxable year whether or not the taxpayer has elected under section 174 to expense or amortize research expenditures.

Trade or business requirement

Under the provision, the credit is to be available only with regard to research expenditures paid or incurred in carrying on a trade or business (within the meaning of Code sec. 162) of the taxpayer. The credit, therefore, is not available for research expenditures paid or incurred by a taxpayer merely in connection with, but not in carrying on, a trade or business. Similarly, the credit is not available with respect to expenditures paid or incurred by a taxpayer as part of a hobby or a financing arrangement.

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

For example, under the trade or business test of new section 44F, the credit generally is not available with regard to a taxpayer's expenditures for "outside" or contract research intended to be transferred by the taxpayer to another in return for license or royalty payments. (Receipt of royalties does not constitute a trade or business under present law, even though expenses attributable to those royalties are deductible from gross income (sec. 62(5)) in arriving at adjusted gross income.) In such a case, the nexus between the research and the transferee's activities generally would be insufficient to support a finding that the taxpayer had incurred the research expenditures, nevertheless, the nexus might be deemed adequate for purposes of the section 174 deduction elections). If, however, the taxpayer used the product of the research in the taxpayer's trade or business, as well as licensing use of the product by others, the relationship between the expenditures and the taxpayer's trade or business activities generally would be sufficient for credit purposes.

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

Definition of qualifying wages

Under the provision, the term "wages" has the same meaning as provided in section 3401(a) for purposes of employee wage withholding. Thus, amounts of compensation which are not subject to withholding, such as certain fringe benefits, do not enter into the credit computation even though paid for services in performing research. In the case of self-employed individuals and owner-employees, the term "wages" for purposes of the new credit includes earned income of such individuals as defined in section 401(c). These rules apply equally to research wages paid or incurred by the taxpayer to its employees and to wages reimbursed by the taxpayer for research performed by another person on behalf of the taxpayer.

The determination of whether and to what extent payments from a taxpayer to another person enter into the credit computation as reimbursement of wages for services performed in conducting research on behalf of the taxpayer depends on all the facts and circumstances of the particular research arrangement. If, therefore, the taxpayer enters into a research contract with a university under which substantial benefits of the research, if any, are to accrue to the taxpayer, such research generally will be considered to be performed on behalf of the taxpayer. For example, where a corporation contracts with a university medical school for basic research to be conducted by the medical school in genetic engineering and retains in the contract exclusive rights to make use of discoveries achieved through the research, such research is to be considered as conducted on behalf of the corporation, whether or not the corporation has the right under the contract to direct or control the research and whether or not the taxpayer, in entering into the contract, expects that a particular business item or other research product will result.

If a taxpayer makes qualifying reimbursements of research wage expenditures, the amounts paid by the taxpayer as such wage reimbursements enter into the credit computation in the taxable year of the taxpayer during which the research firm, etc. pays or incurs the wages being reimbursed, provided that the taxpayer has actually made the reimbursement payments in that taxable year or a prior taxable year. Thus, if any amounts paid by a taxpayer during a particular taxable year to the research entity as wage reimbursements are attributable to research to be conducted after the close of that taxable year, such reimbursements are treated as paid or incurred in the taxable year or years of the taxpayer during which the research services for which wages are reimbursed actually are performed. Reimbursements which are treated as wages paid by the taxpayer during a particular taxable year pursuant to these rules, and hence which count as expenditures for such year entering into the credit computation for such taxable year, also are treated as having been made during that same taxable year for purposes of determining average yearly base period expenditures in later year credit computations.

Amount of wages eligible for credit

As a general rule, wages enter into the credit computation only to the extent paid for that portion of the services performed by an individual for or on behalf of the taxpayer which is performed in conducting research (as described below). For example, if an individual spends part of his or her time during the year conducting research, part of the time engaged in production or marketing activities, and part of the time providing general or administrative services, only the amount of wages actually paid for services performed in conducting research enters into the credit computation. The allocation of wages between conducting research and other services is to be made in a consistent manner, in accordance with Treasury regulations, on the basis of time or other appropriate factors.

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

Definition of qualifying services

Definition of qualifying research

As described above, the term "research or experimental expenditures" as used in Code section 174 means "research and development costs in the experimental or laboratory sense" (Treas. Reg. Sec. 1.174-2(a)). This includes generally "all such costs incident to the development of an experimental or pilot model, a plant process, a product, a formula, an invention, or similar property, and the improvement of already existing property of the type mentioned," and the costs of obtaining a patent on such property.

The credit is not available for expenditures such as those for the ordinary testing or inspection of materials or products for quality control or those for efficiency surveys, management studies, consumer surveys, advertising, or promotions, or for the costs of acquiring another person's patent, model, production, or process. Other expenditures which are ineligible for the section 174 deduction elections also are not eligible for the new credit. These ineligible expenditures include expenditures for the acquisition or improvement of land or of certain depreciable or depletable property used in research (sec. 174(c)) and expenditures for the purpose of ascertaining the existence, location, extent, or quality of mineral deposits, including oil and gas (sec. 174(d)).

It is anticipated that the Treasury and the Internal Revenue Service, pursuant to authority to issue interpretive regulations and rulings (Code sec. 7805), will provide additional guidance, not inconsistent with existing regulations, defining qualifying research for purposes of new section 44F and section 174.

Computation of allowable credit

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

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

Rules of aggregation of expenditures

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

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

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

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

Rules for changes in business ownership

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

Limitation and carryover

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

In the case of an individual who owns an interest in an unincorporated trade or business, who is a beneficiary of a trust or estate, who is a partner in a partnership, or who is a shareholder in a subchapter S corporation, the amount of credit which can be used in a particular year also cannot exceed an amount (separately computed with respect to the person's interest in such trade or business or entity) equal to the amount of tax attributable to that portion of the person's taxable income which is allocable or apportionable to such interest. Accordingly, if in a particular year an individual taxpayer derives no taxable income from a specific partnership, subchapter S corporation, unincorporated business, or trust or estate, the taxpayer would not be able to utilize in that year any tax credit for incremental research wage expenditures of such entity or business.

If the amount of allowable credit exceeds the applicable limitation, the excess credit can be carried back three years (including carrybacks to years before enactment of the credit) and carried forward seven years, beginning with the earliest year.7

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

(sec. 222 of the bill and Code sec. 170(e))

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

General reduction rule

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

Exception

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

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

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

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

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

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

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

Requirements for favorable treatment

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

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

(sec. 231 of the bill and sec. 535 of the Code)

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

2. Subchapter S corporations

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

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

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

In addition, under the bill, if the individual beneficiary of a "qualified subchapter S trust" elects to be treated as the owner (under section 678) of stock in any subchapter S corporation held by the trust, then the trust will be an eligible shareholder of such corporation.

The election must be made by the beneficiary (or his legal representative) separately with respect to each subchapter S corporation whose stock is held by the trust. An election may be made retroactive for a period of up to 60 days.

A qualified subchapter S trust is a trust (1) holding stock of a subchapter S corporation; (2) which has as its sole income beneficiary an individual resident or citizen of the United States; (3) under the terms of which, all of its income is required to be distributed currently and the corpus of which may not be distributed during the term of the trust to any person other than the income beneficiary; and (4) under the terms of which, the trust terminates not later than the death of the beneficiary. If the trust terminates before the beneficiary's death, the trust assets must be distributed to the income beneficiary.

Where the first income beneficiary is the spouse of the grantor, the trust may provide that a lineal descendant of the grantor may be a successor income beneficiary. In this case, the trust termination rules must apply with respect to the successor income beneficiary.

The election to be treated a "qualified subchapter S trust" is in addition to the election by the shareholders of the corporation to have the corporation treated as an electing small business corporation. When the trust is a shareholder at the time of making the subchapter S election, the income beneficiary must consent.

(sec. 241 of the bill and sec. 6429 of the Code)

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

The committee bill provides that royalty owners need not wait until year-end to receive the benefits of the credit. Rules also are provided to prevent a proliferation of royalty interests eligible for the credit.

The committee bill provides for early utilization of the credit by most royalty owners through two sets of related changes in the administrative rules of present law. First, the definition of estimated income tax, the penalties for failure to pay estimated income tax, and the rules relating to wage withholding allowances are amended to permit a royalty owner's credit to be taken into account to the extent provided in the regulations. Second, the Secretary is directed to provide qualified royalty owners with a procedure for claiming an exemption from windfall profit tax withholding. Generally, a royalty owner who (1) had no windfall profit tax liability (or reasonably expects no tax liability) for the prior year in excess of the amount of the credit allowed under the new provision and (2) reasonably expects that no tax will be owed in excess of the current year's credit will be able to claim exemption from windfall profit tax withholding.¹ However, the Secretary may limit the availability of withholding exemption certificates when necessary for the effective administration of the windfall profit tax. The committee gives the Secretary broad discretion in determining how to permit royalty owners to claim the credit's benefits in a timely fashion. For example, the Secretary may prohibit certification for the withholding exemption by persons able to make adjustments in estimated income tax payments or vice versa. Regulations must be issued before December 15, 1981, and will take effect in 1982.

To assure that information adequate for royalty owners to determine whether their oil is properly exempt from withholding is available, the committee bill directs the Secretary to issue regulations that require first purchasers to supply royalty owners with information regarding the amount of the windfall profit tax imposed.

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

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

2. Reduction of windfall profit tax on newly discovered oil

(sec. 242 of the bill and sec. 4987 of the Code)

The definition of newly discovered oil is the same as that in present law.

(sec. 251 of the bill and sec. 422A of the Code)

An employer who grants a stock option generally is allowed a business expense deduction equal to the amount includible in the employee's income in its corresponding taxable year (sec. 83(h)).

Background of Tax Treatment of Stock Options

If the option price was at least 95 percent of the market price of the stock at the time the option was granted, the entire amount of any gain realized by the employee at the time the stock was sold was treated as capital gain. If the option price was between 85 and 95 percent of the market price at the time the option was granted, the difference between the market value of stock at the time of the option grant and the option price was treated as ordinary income when the stock was sold, and any additional gain at the time the stock was sold was treated as capital gain.

For a stock option to be classified as "restricted," the option price had to have been at least 85 percent of the market price of the stock at the time the option was granted; the stock or the option had to have been held by the employee for at least two years after the date of the granting of the option, and the stock held for at least six months after it was transferred to the employee; the option could not have been transferable other than at death; the individual could not have held ten percent or more of the stock of the corporation (unless the option price was at least 110 percent of the fair market value); and the option could not have been for a period of more than ten years.

Qualified options had to be granted with an option price of at least the stock's market price when the option was granted (subject to a 150-percent inclusion in income if a good faith attempt to meet this requirement failed). In addition, qualified stock options were subject to the requirements that the stock had to be held three years or more; the option could not be held more than five years; stockholder approval had to be obtained; the options had to be exercised in the order granted; and no option could be granted to shareholders owning more than five percent of the stock (increased up to ten percent for corporations with less than $2 million equity capital).

In addition, a 50-percent maximum marginal tax rate on income from personal services was added by the 1969 Act. Income eligible for this rate was reduced generally by the sum of the items of tax preference in excess of $30,000.

The bill provides for "incentive stock options," which will be taxed in a manner similar to the tax treatment previously applied to restricted and qualified stock options. That is, there will be no tax consequences when an incentive stock option is granted or when the option is exercised, and the employee will be taxed at capital gains rates when the stock received on exercise of the option is sold. Similarly, no business expense deduction will be allowed to the employer with respect to an incentive stock option.

The term "incentive stock option" means an option granted to an individual, for any reason connected with his or her employment, by the employer corporation or by a parent or subsidiary corporation of the employer corporation, to purchase stock of any of such corporations.

Requirements (holding period, etc.)

To receive incentive stock option treatment, the bill provides that the employee must not dispose of the stock within two years after the option is granted, and must hold the stock itself for at least one year. If all requirements other than these holding period rules are met, the tax will be imposed on sale of the stock, but gain will be treated as ordinary income rather than capital gain, and the employer will be allowed a deduction at that time.¹

In addition, for the entire time from the date of granting the option until three months before the date of exercise, the option holder must be an employee either of the company granting the option, a parent or subsidiary of that corporation, or a corporation (or parent or subsidiary of that corporation) which has assumed the option of another corporation as a result of a corporate reorganization, liquidation, etc. This requirement and the holding period requirements are waived in the case of the death of the employee.²

Terms of option

For an option to qualify as an "incentive stock option," terms of the option itself must meet the following conditions:

The bill provides that stock acquired on exercise of the option may be paid for with stock of the corporation granting the option.

The difference between the option price and the fair market value of the stock at the exercise of the option will not be an item of tax preference.

Also, under the bill, any option which was a qualified stock option or restricted stock option under prior law will become an incentive stock option, if it was not exercised before January 1, 1981, and if it otherwise satisfies requirements for incentive stock options. Such an option will not be subject to the minimum tax.

An option will not be disqualified because of the inclusion of any condition not inconsistent with the qualification requirements,⁴ nor because the corporation may make a cash payment to the employee at the time of exercise.

In the case of an option granted before 1982, the modification or deletion of any stock appreciation right or right to receive cash payments to permit the option to qualify as an incentive stock option can be made within one year of the enactment of the bill without the modification being treated as the grant of a new option.

In addition, the terms of a stock option plan or an option issued before 1982 can be modified to conform to the incentive stock option rules within one year of the date of enactment of the bill, without the modification being considered as giving rise to a new option requiring a new option price.

2. Deduction for diminution in value of motor carrier operating authorities

(sec. 252 of the bill)

Enacted in 1935, Part II of the Interstate Commerce Act (the "1935 Act") provided the basic framework for regulation of the motor carrier industry until enactment of the Motor Carrier Act of 1980. Under the 1935 Act, carriers were obligated to provide nondiscriminatory service at regulated rates for the public convenience and necessity, and further industry regulation was effected by issuing or withholding certificates of operating authority.

During the period 1935 to 1980, the Interstate Commerce Commission ("ICC") granted a limited number of permits and certificates of operating authority to motor carriers and freight forwarders. The basis for the grant of an authority from the ICC was a showing that additional services of the type for which authority was sought was, or would be, required by the public convenience and necessity. Businesses with existing operating rights could intervene in a proceeding for a request of operating authority to show that the proposed service was not, or would not be, required by the public convenience and necessity.

The right of existing operators to intervene (based on ICC procedural rules) and the applicant's burden of showing that the proposed service was required by the public convenience and necessity (based on the 1935 Act) gave existing operators protection against competition. Persons wishing either to enter the motor carrier business or expand an existing business, therefore, often would purchase an existing business with its operating authority.

Substantial amounts were paid for these operating authorities, reflecting, in part, the protection against competition afforded authority owners under ICC administration of the 1935 Act. The value of the operating authorities provided owners with an asset that constituted a substantial part of a carrier's asset structure and a source of loan collateral. In 1975, the ICC began to grant a higher percentage of requests for operating authorities under the standard of "required by the public convenience and necessity." On July 1, 1980, the Motor Carrier Act of 1980 was enacted (P.L. 96-296). Under the 1980 Act, applicants need not show that the proposed service is required by the public convenience and necessity. Existing operators protesting the grant of an authority bear the burden of showing the proposed service is inconsistent with the public convenience and necessity. Thus, the 1980 statute further lessened restrictions on entry into the interstate motor carrier business. However, an operating authority still must be obtained to conduct interstate motor carrier business. As a result of the increased ease of gaining entry into the interstate motor carrier business, the value of motor carrier operating authorities has been diminished substantially.

The ICC, following an opinion of the Financial Accounting Standards Board, has required that the value assigned to certificates of authority in the regulated books of motor carriers be written off in one year.

Deduction for realized loss of property

Code section 165 allows a deduction for certain losses, including any loss incurred in a trade or business which is sustained during the taxable year and not compensated for by insurance or otherwise. In general, the amount of the deduction equals the adjusted basis of the property involved (sec. 165(b)).

Treasury regulations provide that, to be allowable as a deduction, the loss must be realized, i.e., "evidenced by closed and completed transactions, fixed by identifiable events" (Treas. Reg. Sec. 1.165-1(b)). As a general rule, no deduction is allowed for a decline in value of property absent a sale, abandonment, or other disposition of the property¹ nor for loss of anticipated income or profits.² Thus, for a loss to be allowed under present law, generally either the business must be discontinued or the property must be abandoned or permanently discarded from use in the business (Treas. Reg. Sec. 1.165-2). Generally, if a capital asset declines in value and is sold or exchanged at a loss, the loss is a capital loss, the deduction of which is subject to the limitations of sections 1211 and 1212 (sec. 165(f)).

The courts, in several decisions,³ have denied a loss deduction when the value of an operating permit or license decreased as a result of legislation expanding the number of licenses or permits that could be issued. These decisions held that the diminution in the value of a license or permit did not constitute an event giving rise to a loss deduction under section 165 if the license or permit continued to have value as a right to carry on a business.

In the Consolidated Freight Lines case,⁴ the Ninth Circuit denied deductions for lost "monopoly rights" when the State of Washington deregulated the intrastate motor carrier industry by eliminating restrictions on entry. The court reasoned that the taxpayer had not lost any rights conferred by the certificate of operating authority because the taxpayer still was permitted to do business and the operating authority had not given any further rights. Any "monopoly rights," the court stated, resulted from legislation and State administration restricting the availability of operating authorities. Since the taxpayer could not own (or purchase) property rights in legislation or regulations, repeal or modification of legislation or regulations did not give rise to a deductible loss, even if such action had the result of making the taxpayer's business property less valuable.

The committee concluded that the unique circumstances of the deregulation of the interstate motor carrier industry requires some form of relief that is not available under the present tax laws.

Therefore, the committee bill provides that an ordinary deduction is allowed (over a 5-year period) equal to the adjusted bases of operating rights held by the taxpayer on July 1, 1980.

Under the committee bill, adjustments are to be made to the bases of operating authorities held on July 1, 1980 (or acquired thereafter under a binding contract in effect on July 1, 1980) to reflect amounts allowable as deductions.

Under regulations to be prescribed by the Secretary, a taxpayer may elect to allocate to the basis of an operating authority a portion of his cost basis in the stock of a corporation that held the operating authority when such stock was acquired, but only if such stock was acquired before July 2, 1980, or was acquired after July 1, 1980, under a binding contract in effect on July 1, 1980. The portion of the cost basis in the stock to be allocated to the operating authority is the amount that would have been properly allocable under section 334(b)(2) if the taxpayer had liquidated the corporation under a plan of liquidation described in section 334(b)(2)(A).

Similar rules shall be prescribed for situations in which the operating rights were transferred to the parent in a transaction in which the parents basis is determined with reference to the basis of the rights to the subsidiary, but only if the subsidiary could have been liquidated under section 334(b)(2). In all cases, the regulations shall provide for an appropriate adjustment to the basis of other assets.

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

Although the committee considered a variety of proposals to provide incentives for savings and investment in addition to the across-the-board tax reductions, no single, long-term solution recommended itself as clearly superior. Therefore, the committee decided to repeal the present partial exclusion for interest income and to provide for a temporary, one-year program of depository institution tax-exempt savings certificates (see section III B., below) and for increases in, and liberalizations of, the retirement savings provisions (see section III. C., below).

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

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

Qualified certificates

In general, depository institution tax-exempt savings certificates are one-year certificates issued after September 30, 1981, and before October 1, 1982, by a qualified depository institution with a yield equal to 70 percent of the yield on one-year Treasury bills.3 A qualified depository institution is a bank defined in section 581, a mutual savings bank, cooperative bank, domestic building and loan association, industrial loan association or bank, credit union, or any other savings or thrift institution chartered and supervised under Federal or State law, if the deposits or accounts of the depository institution are insured under Federal or State law or protected and guaranteed by State law.

For interest to qualify for the exclusion, a certificate issued by a qualified institution must meet several requirements. First, such certificates may be issued only during the one-year period beginning on October 1, 1981, and ending on September 30, 1982. Interest paid after September 30, 1982, with respect to certificates properly issued before that date will be entitled to the exemption. Second, the certificates must have a maturity period of one year. Thus, all of the interest excludable by virtue of the new provision will be earned by October 1, 1983. Third, the certificate must have a yield equal to 70 percent of the yield on 52-week Treasury bills. Whether a certificate meets this 70-percent requirement is determined by comparing the yield to maturity on the certificates (including the effect of any compounding of interest) to the yield to maturity on 52-week Treasury bills sold at the last Treasury auction to have occurred in a calendar week preceding the week the certificate is issued. Thus, an auction of 52-week Treasury bills will determine the interest limitation on depository tax-exempt savings certificates issued from the Monday following such auction until the Monday following the next auction of 52-week Treasury bills.

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

Limitations

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

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

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

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

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

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

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

Treasury study

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

Coordination with interest and dividends exclusion

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

(sec. 311 of the bill and secs. 62, 72, 219, 220, 401, 408, 409, 415, 2039, 2503, 2517, 3401, 4973, 6047, and 6652 of the Code)

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

Simplified employee pensions

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

Employee contributions

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

Tax-sheltered annuities

In the case of tax-sheltered annuities (including custodial accounts investing in shares of a regulated investment company) purchased for employees by certain tax-exempt organizations or by public educational organizations, the employees are entitled to an exclusion from gross income for amounts paid by the employer on a salary reduction basis (within limits). Amounts invested in a tax-sheltered annuity purchased by a tax-exempt organization can qualify for exclusions under the estate tax and gift tax rules.

The committee has found that the present rules providing tax-favored treatment for individual retirement savings have become too restrictive in view of recent rates of inflation and because they do not sufficiently promote individual savings by employees who participate in employer-sponsored plans

The committee bill is designed to promote greater retirement security by increasing the amount which individuals can set aside for retirement in an IRA and by extending IRA eligibility to individuals who participate in employer-sponsored plans. The bill also extends additional tax-favored treatment to voluntary employee contributions to employer-sponsored plans so that plan participants can take advantage of systematic payroll deductions to accumulate tax-favored retirement savings.

In the case of an employee who is an active participant in a plan (i.e., one who is not currently eligible for an IRA deduction), a deduction is allowed to an individual for retirement savings limited to the lesser of $1,500 ($1,625 for a spousal IRA) or 100 percent of compensation. In the case of a plan participant, a deduction is allowed for contributions to an IRA or for qualified voluntary contributions by (or on behalf of) the employee to the plan. An employee can allocate deductible contributions to all plans in which he participates, so long as the total amount deducted does not exceed the lesser of $1,500 or 100 percent of compensation. An employee for whom an employer contributes under a SEP is considered an active plan participant and is allowed a deduction for his own IRA contributions (under the limits applicable to active plan participants) as well as a deduction for employer contributions to the SEP (limited under the SEP rules on the basis of contributions by, and compensation from, each separate employer). (For applicable limits under a SEP, see 2. Retirement plan deduction for self-employed individuals, Explanation of Provisions, Increased contribution limit.)

The requirement that contributions to a spousal IRA be equally divided between spouses is deleted, but annual contributions for either spouse cannot exceed $2,000 ($1,500 for an active participant) for a year.

A participant's contributions to a qualified plan, a tax-sheltered annuity program, or a government plan are qualified voluntary contributions if (1) the contributions are not mandatory, (2) deductible employee contributions are accepted under the plan, and (3) the participant does not designate the contribution as nondeductible. An employee is allowed the deduction for qualified voluntary contributions only if the plan has made provision for the acceptance of deductible employee contributions. Rules are provided under which (1) a plan may permit participants to make or revise their designations for a year retroactively and (2) a plan may permit certain contributions made after the close of a calendar year to be treated as if made on the last day of the year. The bill continues the present law requirement that the opportunity to make voluntary contributions must be reasonably available to a nondiscriminatory group of employees. This availability standard will apply to the aggregate of deductible and nondeductible voluntary contributions and to the deductible voluntary contributions alone. If the eligibility standard is satisfied, the committee intends that the limit on the amount of voluntary contributions permitted under qualified plans of an employer is not to be less than the deductible limit provided by the bill for qualified voluntary employee contributions.

Accumulated deductible employee contributions (i.e., net qualified voluntary contributions adjusted for income, gain, loss, and expense) are subject to the same tax treatment accorded amounts held in an IRA, with certain exceptions. All distributions of accumulated deductible employee contributions are includible in gross income, except for tax-free rollovers to an IRA or to another plan where the rollover amount will be held as accumulated deductible employee contributions. Distributions of accumulated deductible employee contributions may be made without penalty after age 59-1/2 or in the event of disability or death. Other distributions of accumulated deductible employee contributions are subject to the same 10-percent additional income tax that applies to early withdrawals from an IRA.

A distribution of accumulated deductible employee contributions from a qualified plan may be transferred under the rollover rules to an IRA or to another qualified plan if the plan administrator of the other plan (1) treats the amount transferred as accumulated deductible employee contributions, and (2) permits such transfers on a nondiscriminatory basis. Of course, the amount transferred would not be taken into account under the limits on the amount of voluntary employee contributions under qualified plans. Such a rollover may be made without regard to whether the distribution is included in a lump-sum distribution or a distribution on account of termination of the plan, and without regard to whether the distribution constitutes a total distribution of the accumulated deductible employee contributions under the distributing plan. In addition, if a distribution of accumulated deductible employee contributions from a qualified plan is rolled over tax-free to an IRA, a total distribution from the IRA which is attributable only to a rollover from a qualified plan may be rolled over to a plan under which the distribution will be treated as accumulated deductible employee contributions, etc. Similar rules are provided for tax-sheltered annuities.

The IRA rules requiring that distributions commence not later than the taxable year in which the individual attains age 70-1/2 and that distributions be made within a prescribed time after the individual's death do not apply to accumulated deductible employee contributions unless rolled over to an IRA. If accumulated deductible employee contributions are applied toward the purchase of life insurance, the amount so applied is treated as a distribution to which the usual tax rules for distributions apply. In addition, if an employee borrows from or against such accumulated contributions, the amount of the loan or security interest is treated as distributed.

A plan which accepts deductible employee contributions is not required to hold assets purchased with such contributions (or income and gain therefrom) apart from the plan's other assets. Where these assets are not segregated from other plan assets, the committee expects that an employee's accumulated deductible contributions will be adjusted for income, etc. under the plan at least annually. In applying certain IRA rules to deductible employee contributions, the committee does not intend to imply that it would be appropriate to apply such rules to other plan contributions or benefits.

The bill does not change the usual vesting rules for qualified plans, under which a participant's accrued benefit derived from accumulated deductible employee contributions is nonforfeitable at all times. Under the bill, deductible employee contributions and deductible IRA contributions (other than employer contributions to a SEP) are not taken into account for purposes of the limitations on contributions and benefits for qualified plans and tax-sheltered annuities.

Accumulated deductible employee contributions do not qualify under the bill for 10-year forward income averaging, long-term capital gain treatment, deferred recognition of gain on employer securities, or the income tax death benefit exclusion for certain benefits under qualified plans. For purposes of the estate tax and gift tax exclusions for qualified plans and certain tax-sheltered annuities, as well as for purposes of the income tax treatment of annuities, accumulated deductible employee contributions are treated as a benefit derived from employer contributions.

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

Treasury regulations are to provide rules under which the plan administrator of a plan accepting deductible employee contributions is to provide reports to the Treasury and to plan participants.

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

2. Retirement plan deduction for self-employed individuals

(sec. 312 of the bill and secs. 72, 219, 401, 404, 408, 1379, and 4972 of the Code)

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

Limitation on contributions and benefits for self-employed individuals

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

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

Subchapter S corporations

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

Simplified employee pensions

If an individual retirement account or individual retirement annuity (IRA) qualifies as a simplified employee pension (SEP), both the employee and the employer may make contributions to the employee's IRA. Generally, employer contributions for an employee under a SEP are includible in the gross income of the employee and the employee is allowed a deduction for the employer contribution for a year limited to the lesser of 15 percent of compensation or $7,500. With respect to employee contributions, the limit is $1,500 (or 15 percent of compensation, if less) reduced (but not below zero) by the amount of deductible employer contributions for the year.

Limit on includible compensation

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

Employee borrowing from qualified plans

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

The committee also believes that current provisions permitting partners who are not owner-employees to borrow against their interest in an H.R. 10 plan diminish retirement savings. Accordingly, to promote long-term savings for retirement, the committee believes the current treatment of loans and pledges should be applied to all partners.

In general, the bill increases the deduction limit for employer contributions to defined contribution H.R. 10 plans, defined contribution plans maintained by subchapter S corporations, and simplified employee pensions, to $15,000. The 15-percent limit on contributions is not changed.

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

Increase in includible compensation

Under the bill, the maximum amount of compensation which may be used to determine contributions or benefits in a defined contribution H.R. 10 plan, or subchapter S plan, or a SEP is increased from $100,000 to $150,000. However, if annual compensation in excess of $100,000 is taken into account under the plan, the rate of employer contributions for any plan participant cannot be less than 7-1/2 percent of that participant's compensation (before the application of the rules permitting the integration of the plan with social security).

Employee borrowing

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

An employee stock ownership plan (ESOP) is a tax-qualified plan under which employer stock is held for the benefit of employees. The stock, which is held by a tax-exempt trust under the plan, may be acquired through direct employer contributions or with the proceeds of a loan to the trust.

Under the usual rules applicable to tax-qualified plans, an employee's benefits under an ESOP are generally not taxed until they are distributed or made available. Also, the Code provides special 10-year income averaging or tax-free rollover treatment for lump sum distribution, deferral of tax on appreciation in employer securities, and estate tax and gift tax exclusions.

Tax credit ESOPs

An employee stock ownership plan under which an employer contributes stock or cash in order to qualify for a credit against income tax liability is referred to as a tax credit ESOP. Under present law, an employer is entitled to an additional percentage point of investment tax credit (i.e., 11 percent rather than 10 percent) if it contributes an amount equal to the full additional credit to a tax credit ESOP. The employer's contribution to the ESOP may be made for the taxable year for which the investment tax credit is earned or as late as the taxable year for which the credit is claimed. In addition to the one-percent credit, up to one-half percent of extra investment tax credit is allowed where an employer contributes the extra amount to the tax credit ESOP, if the employer's extra contribution is matched by employee contributions.

The rules allowing an employer the additional investment tax credit for ESOP contributions expire with respect to qualifying investments made after December 31, 1983.

Leveraged ESOPs

An employee stock ownership plan which borrows to acquire employer stock is referred to as a leveraged ESOP. Under a leveraged ESOP, the employer is allowed a deduction, within limits, for contributions to the plan. These contributions may be applied by the plan to service the loan. Under present law, the deduction allowed an employer for contributions to a profit-sharing or stock bonus plan (including a leveraged ESOP) generally is limited to 15 percent of the compensation of all employees under the plan. In addition, present law provides that the annual contributions and other additions (including forfeitures) credited to a participant's account under a qualified defined contribution plan (including a leveraged ESOP) generally cannot exceed the lesser of $41,500 for 1981 ($25,000 adjusted for inflation since 1974) or 25 percent of the participant's compensation. In the case of certain ESOPs, the dollar limit is doubled.

Distributions from ESOPs

Under present law, employer securities allocated to an employee's account under a tax credit ESOP generally may not be distributed from the account before the end of the 84th month after the month in which the securities are allocated. This limitation does not apply to distributions of securities in the case of the employee's separation from service, death, or becoming disabled. In addition, a participant in a leveraged ESOP or a tax credit ESOP who is entitled to a distribution under the plan is required to be provided the right to demand that the distribution be made in the form of employer securities rather than in cash. Subject to a participant's right to demand a distribution of employer securities, the plan may elect to distribute the participant's interest in cash, in employer securities, or partially in cash and partially in employer securities.

A participant who receives a distribution of employer securities from a tax credit ESOP or a leveraged ESOP must be given a put option on the distributed employer securities if the employer securities are not readily tradable. Under the put option, the distributee must be given up to six months after receipt of the securities to require the employer to repurchase the securities at their fair market value. If the distributee does not exercise the initial put option within the six-month period, the option will temporarily lapse. After the close of the employer's taxable year in which the temporary lapse of a distributee's option occurs and following a determination of the value of the employer securities (determined in accordance with Treasury regulations) as of the end of that taxable year, the employer is required to notify each distributee who did not exercise the initial put option in the preceding year of the value of the employer securities as of the close of the taxable year. Each such distributee must then be given up to three months to require that the employer repurchase the employer securities. If the distributee does not exercise this put option, the option permanently lapses. Because a participant might wish to contribute a distribution from a tax credit ESOP or leveraged ESOP to an IRA in a tax-free rollover, and because the contribution would have to be made before the expiration of the first six-month put option, an IRA trustee or custodian must be able to exercise the same put option as the participant.

The additional investment tax credit allowed an employer for contributions to a tax credit ESOP is terminated with respect to qualifying investments made after December 31, 1982. With respect to qualifying investments made after December 31, 1981, and before January 1, 1983, an employer is allowed a partial additional investment tax credit (i.e., an additional credit not in excess of one percent), if it contributes an amount equal to the partial additional credit to a tax credit ESOP. For taxable years ending after that date, in lieu of the additional investment tax credit, an electing employer is allowed an income tax credit for contributions to a tax credit ESOP limited to a prescribed percentage of the compensation of all employees under the plan. For an employer's taxable year beginning or ending in 1983, the tax credit is limited to one-half of one percent of such aggregate compensation paid or accrued after 1982. For an employer's taxable year beginning in 1984, the limit is three-quarters of one percent, and for taxable years beginning after December 31, 1984, the tax credit allowed the employer is limited to one percent of the compensation of all employees under the ESOP.

For compensation paid or accrued in calendar year 1983, the tax credit is limited to one-half of one percent. For compensation paid or accrued in 1984, the limit is three-quarters of one percent, and for calendar year 1985 and thereafter the credit is limited to one percent of the compensation paid or accrued in that year to all employers under the ESOP. Under the bill, no payroll-based credit is allowed for contributions to a plan if more than one-third of the employer's contributions for the year are allocated to the group of employees consisting of officers, shareholders directly or indirectly owning more than 10 percent of the employer's stock (other than stock held by qualified plans), or individuals whose compensation exceeds a specified limit (for 1981, $83,000).

The amount of the employer's income tax liability that can be offset by the tax credit allowed for contributions to a tax credit ESOP generally is limited to the first $25,000 of tax liability, plus 90 percent of the excess over $25,000. If the employer is a member of a controlled group of corporations, the $25,000 amount against which the tax credit may be fully applied is reduced by apportioning such amount (pursuant to Treasury regulations) among the member corporations. If the tax credit otherwise allowed an employer for ESOP contributions exceeds the amount of tax liability against which the credit may be applied for a taxable year, the unused tax credit may be carried back to each of the three preceding taxable years and carried forward to each of the ten succeeding taxable years. The amount of any unused credit which expires at the close of the last taxable year to which it may be carried is allowed as a deduction to the employer for such taxable year without regard to the usual limits on deductions for contributions to qualified plans.

An employer is allowed a tax credit for ESOP contributions only if it establishes a plan which meets the Codes requirements for tax credit ESOPs and transfers employer securities to the plan having a total value not in excess of the applicable percentage of the compensation of all employees under the plan. In addition, the employer must agree to transfer the securities not later than 30 days after the due date (including extensions) for filing the return for the taxable year for which the credit is earned (without regard to whether the credit is allowed for such taxable year). For purposes of the tax credit ESOP rules, a contribution of cash to an ESOP is treated as a transfer of employer securities if the plan uses the cash within 30 days to purchase employer securities.

2. Deductible contributions to leveraged ESOPs

Amounts contributed by an employer to a leveraged ESOP and applied by the plan to the payment of principal or interest on a loan incurred to purchase employer securities are allowed separately as deductions to the employer. The deduction allowed the employer for contributions applied to the payment of loan principal (but not interest) is limited to 25 percent of the compensation of all employees under the plan. In addition, the employer's deductible ESOP contributions which are applied by the plan to the payment of interest on a loan to acquire employer securities, as well as any forfeitures of employer securities purchased with loan proceeds, generally are not taken into account under the qualified plan rules which limit contributions and benefits under qualified plans. However, the rule allowing the employer contributions for loan interest and the employee forfeitures to be disregarded for purposes of the annual limitation will apply only if no more than one-third of the employer's contributions for the year are allocated to the group of employees consisting of officers, shareholders directly or indirectly owning more than 10 percent of the employer's stock (other than stock held by qualified plans), or individuals whose compensation exceeds a specified limit (for 1981, $83,000). In addition, a forfeiture of an employer security is disregarded for purposes of the limitations on contributions and benefits only if the security's entire purchase price was paid with the proceeds of a loan to the ESOP. For this purpose, if a unit of employer securities is purchased by an ESOP partly with the proceeds of a loan and partly with other amounts, those securities having an aggregate value not in excess of the applied loan proceeds are treated as having been purchased only with the loan proceeds.

3. Distributions from ESOPs.

An additional exception is made to the rule in present law which provides that employer securities allocated to an employee's account under a tax credit ESOP generally may not be distributed before the end of the 84th month in which the securities are so allocated. Under the bill, the 84-month rule does not apply in the case of the direct or indirect transfer of a participant to the employment of an acquiring employer where all (or substantially all) of the assets used by the selling corporation in a trade or business are sold to the acquiring employer. The 84-month rule is also waived for an employee of a subsidiary of the selling corporation, with respect to securities of the selling corporation, where the selling corporation disposes of its interest in the subsidiary and the employee continues in the employ of the subsidiary. In addition, a tax credit ESOP or a leveraged ESOP may preclude a participant from demanding a distribution in the form of employer securities if the employer's corporate charter (or bylaws) restricts the ownership of substantially all outstanding employer securities to employees or to a trust under a qualified plan. The ESOP must, however, provide that participants entitled to a distribution have a right to receive the distribution in cash.

In the case of a tax credit ESOP or a leveraged ESOP established and maintained by a bank or similar financial institution which is prohibited by law from redeeming or purchasing its own securities, an exception is made to the rule generally requiring that a participant who receives a distribution of employer securities must be given a put option if the securities are not readily tradable. No put option is required if the ESOP provides that participants entitled to a distribution from the plan have a right to receive the distribution in cash. In addition, where a put option on distributed employer securities is required under present law, the employer may provide the option for a period of at least 60 days (rather than six months) following the date of the distribution and for an additional period of at least 60 days (rather than three months) in the following plan year.

A qualified stock bonus plan which is not a tax credit ESOP or a leveraged ESOP is permitted to provide a cash distribution option to participants if (1) a participant has a right to demand that plan benefits be distributed in the form of employer securities, and (2) a participant who receives a distribution of employer securities which are not readily tradable is given a put option on the securities (under the rules applicable to tax credit ESOPs and leveraged ESOPs).

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

With the existing level of unified credit (which permits cumulative tax-free transfers of $175,625), the estate tax is imposed on estates of a relatively small size, including those containing family farms or closely held businesses. Imposing the tax on these smaller, illiquid estates often results in forced sales of family enterprises.

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

The bill also revises the estate tax filing requirements to reflect the increased unified credit amount. When the credit is phased in fully, the bill requires that an estate tax return be filed only if the decedent's gross estate exceeds $600,000. During the five-year phase-in period, the filing requirements are to be $225,000, $275,000, $350,000, and $450,000 in 1982, 1983, 1984, and 1985, respectively. As under present law, the threshold filing requirement will be reduced (but not below zero) by the sum of the adjusted taxable gifts made by the decedent after December 31, 1976, and the amount of the specific gift tax exemption under prior law which may have been used by the decedent with respect to gifts made after September 8, 1976, and before 1977.

The bill makes no changes to the unified credit for nonresident aliens.

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

Under these provisions, transfers of community property or terminable interests generally do not qualify for either the gift or estate tax marital deductions.

Jointly held property

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

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

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

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

Moreover, the committee believes that the taxation of jointly held property between spouses is complicated unnecessarily. Often such assets are purchased with joint funds making it difficult to trace individual contributions. In light of the unlimited marital deduction adopted by the committee bill, the taxation of jointly held property between spouses is only relevant for determining the basis of property to the survivor (under sec. 1014) and the qualification for certain provisions (such as current use valuation under sec. 2032A, deferred payment of estate taxes under secs. 6166 or 6166A,¹ and for income taxation of redemptions to pay death taxes and administration expenses under sec. 303). Accordingly, the committee believes it appropriate to adopt an easily administered rule under which each spouse would be considered to own one-half of jointly held property regardless of which spouse furnished the consideration for the property.

Because an unlimited marital deduction is permitted for interspousal transfers, the bill exempts all such transfers from gift tax filing requirements. Under section 2035, gifts made within 3 years of death for which a gift tax return is not required are not includible in the gross estate. However, the bill provides that this rule does not apply to interspousal gifts for which a return is not required because of the marital deduction. Thus, all interspousal transfers made within three years of death (other than transfers which are less than the section 2503(b) annual exclusion) will be included in a decedent's gross estate pursuant to section 2035 (without reduction for the amount of the annual exclusion). Accordingly, the exemption for filing on interspousal transfers does not permit decedents to make deathbed transfers to insure that their estate qualifies for certain provisions depending on the size and composition of the gross estate (e.g., secs. 303, 2032A and 6166).

In addition, the bill provides special rules for determining ownership of property held by spouses in joint tenancy with a right of survivorship. Under the bill, each spouse will be deemed to own one-half of the value of the property regardless of which spouse furnished the consideration. The bill repeals certain of the special rules applicable to treatment of jointly held property between spouses (secs. 2040(c) to 2040(e), 2515, and 2515A).

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

A gift made by a husband and wife may, with the consent of both, be treated for gift tax purposes as made one-half by each. The full amount of exclusion is allowed with respect to each spouse's one-half share of gifts of present interests in property. Thus, where a couple agrees to split gifts, they may give up to $6,000 per donee per year without gift tax.

The committee believes that the annual gift tax exclusion should be increased to $10,000.

Many existing trusts provide powers of appointment specifically defined in terms of the section 2503(b) annual gift tax exclusion which, under present law, is limited to $3,000. The committee is concerned that many settlors, although limiting the power by reference to section 2503(b), may not have wanted to provide a power over property in excess of $3,000. For this reason, a two-year transitional rule provides that the increased annual gift exclusion, as provided by the bill, will not apply to powers granted under a trust created before 30 days after the date of enactment and not amended after that date provided that (1) the power is defined in terms of the section 2503(b) annual gift tax exclusion, and (2) there is not enacted a State law applicable to such instrument which construes the power of appointment as referring to the increased gift tax exclusion provided by the bill. This transitional rule will be effective only with respect to powers exercisable after December 31, 1981, and before January 1, 1984. This two-year period will provide sufficient time for trustees to obtain clarification of the settlor's intent through judicial construction of the trust governing instrument.

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

Qualification requirements

An estate may qualify for current use valuation if (1) the decedent was a citizen or resident of the United States at his death; (2) the adjusted value¹ of the farm or closely held business assets in the decedent's estate, including both real and personal property, is at least 50 percent of the adjusted value of the decedent's gross estate; (3) at least 25 percent of the adjusted value of the gross estate is qualified farm or closely held business real property:² (4) the real property qualifying for current use valuation passes to a qualified heir:³ (5) such real property has been owned by the decedent or a member of his family and used or held for use as a farm or closely held business ("a qualified use") for five of the last eight years prior to the decedent's death and on the date of the death; (6) there has been material participation in the operation of the farm or closely held business by the decedent or a member of his family for periods aggregating at least five years out of the eight years immediately preceding the decedent's death;⁴ (7) the executor elects the treatment within the time prescribed for filing the decedent's estate tax return; and (8) all parties with any interest in the property to be specially valued enter into an agreement consenting to the election.

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

Valuation methods

Under present law, the current use value of qualified real property⁵ can be determined under either of two methods: (1) the multiple factor method or (2) the formula method.

Recapture

If, within 15 years after the death of the decedent (and before the death of the qualified heir), the property is disposed of to non-family members or ceases to be used for farming or other closely held business purposes, all or a portion of the Federal estate tax benefits obtained by virtue of the reduced valuation are recaptured by means of a special "additional estate tax" imposed on the qualified heir.

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

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

The current use valuation provision has provided extensive relief to numerous family farms and businesses. However, a number of technical requirements of the current use valuation provision have resulted in incomplete relief being received by the owners of many family farms and other businesses for which the committee wished to provide. For these reasons, the committee has provided for a number of changes to the current use valuation provision to assist further in the preservation of family owned and operated farms and other businesses.

1. Changes to pre-death qualification requirements

For example, if a decedent has leased otherwise qualified real property to a son pursuant to a net cash lease,⁷ and the son conducts a farming operation on the property, the son's business use is attributed under the bill to the decedent for purposes of satisfying the qualified use requirement (sec. 2032A(b)(1)). On the other hand, during any period when the decedent leases the real property to a nonfamily member for use in a qualified use pursuant to a lease under which the rental is not substantially dependent upon production, the qualified use requirement is not satisfied.

The bill does not change the present requirement that the qualified heir owning the real property after the decedent's death use it in the qualified use throughout the recapture period. However, the bill creates a special one-year grace period immediately following the date of the decedent's death during which failure by the qualified heir to commence use of the property in its qualified use will not result in imposition of an additional estate tax. The 10-year recapture period is extended by a period equal to any part of the one-year grace period which expires before the qualified heir commences using the property in the qualified use. Failure by the heir to use the property in the qualified use after the one-year grace period would result in imposition of an additional estate tax.

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

The bill also provides an alternative to the material participation requirements for qualification of real property for current use valuation in the estates of certain surviving spouses who inherit the property from a decedent spouse in whose estate it was valued based on its current use. The bill provides that the spouse will be treated as having materially participated during periods when the spouse (but not a family member) engaged in active management of the farm or other business operation. In the case of spouses who survive a decedent spouse by not more than five years, the requirement of material participation during periods aggregating five years of an eight-year period is considered to be met if such spouse engaged in active management of the farm or other business operation at all times between the deaths of the spouses.

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

2. Changes to valuation methods

The amount of a net share rental is equal to the gross value of the produce received by the lessor of the comparable land minus the cash operating expenses (other than real property taxes) of growing the produce which are paid by the lessor. Where produce is disposed of in an arm's-length transaction within a period no longer than the period established by the U.S. Department of Agriculture for its price support program immediately following the date or dates on which the produce is received (or constructively received) by the lessor, the committee intends that the gross amount received in the disposition will be the gross value of the produce.8

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

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

Under the current use valuation provision, as amended by the bill, if specially valued standing timber is severed or otherwise disposed of by the qualified heir within 10 years after the decedent's death (or before the death of the qualified heir, if earlier), an additional estate tax would be imposed (sec. 2032A(c)). This additional estate tax is determined by treating the timber as an interest in the real property on which the timber stands or stood.

For purposes of the present rules governing imposition of the additional estate tax in the event of a partial disposition of qualified property (sec. 2032A(c)(2)(D)), the pro rata portion of the value of the property disposed of shall be determined by comparing the number of acres of land on which timber is severed or otherwise disposed of to the total number of acres of specially valued real property owned by the qualified heir. The bill provides a special rule for a severance or other disposition of a portion of the standing timber on an identifiable portion of the specially valued land. In such a case, the amount realized (or the fair market value on the date of severance or disposition in any case other than a sale or exchange at arm's length) on each such severance or disposition is payable as additional tax until the pro rata portion of additional tax attributable to an identifiable portion of the land (including all timber thereon) has been paid.

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

3. Changes to post-death recapture rules

The bill provides that an eligible qualified heir is treated as materially participating in the farm or other business operation during periods when the eligible heir (but not a member of the heir's family) engages in active management of the farm or other business operation. In the case of an eligible heir who has not attained the age of 21 or is disabled, the active management may be that of a fiduciary (e.g., a guardian or trustee, but not a general or special agent).

Eligible qualified heirs include the spouse of the decedent, a qualified heir who has not attained the age of 21, a qualified heir who is a full-time student (within the meaning of sec. 151(e)(4)(A) or (B)), and a qualified heir who is disabled (within the meaning of sec. 2032A(b)(4)(B), as added by the bill). Active management means the making of business decisions other than the daily operating decision of the trade or business.¹³

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

Generally, where an interest is brought back into the estate, the donee's basis in such interest is its date of death fair market value, reduced by amounts claimed by the donee as deductions in computing taxable income prior to the decedent's death.

The change does not modify the valuation rules with respect to transfers of property included in a decedent's gross estate because (1) the decedent retained the beneficial enjoyment of the property during life, or the power to alter, amend, or revoke a previous lifetime transfer; (2) the property was transferred previously by the decedent but the transfer takes effect at the decedent's death; (3) the decedent possessed a power of appointment over the property; or (4) with respect to the proceeds of life insurance, the decedent possessed an incident of ownership or the proceeds are receivable by the decedent's executor. Thus, such property would still be included in the decedent's gross estate at date of death fair market value. For example, if one year prior to death, a decedent transferred all incidents of ownership in a life insurance policy to a third party, the entire amount of the proceeds would be included in the decedent's gross estate pursuant to sections 2035 and 2042.

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

The committee believes that these provisions should be simplified and coordinated to provide a single set of rules to govern the estate tax treatment and qualified stock redemption of interests in a closely held business.

In addition, the committee believes that the rules regarding acceleration of deferred payments should be liberalized to permit dispositions of up to 50 percent of an interest in a closely held business.

The committee believes that the acceleration rules with respect to late payments should be expanded to cover all late payments of principal or interest. However, acceleration should not occur if any such payment is made within six months of the due date.

Under the bill, liberalizing changes are made to the acceleration rules in section 6166. First, an estate qualifying for deferral is permitted to dispose of up to 50 percent of the business before triggering acceleration. Second, if any payment of principal or interest is paid within six months of the due date, payments will not be accelerated. Rather, the payment loses eligibility for the special four-percent interest rate and a penalty is imposed, equal to five percent per month, based on the amount of the payment.

Under section 2518, however, because the disclaimer must be effective to divest the disclaimer of ownership, and pass the interest without direction on the part of the person making the disclaimer, the disclaimer must still satisfy local law. Because applicable law varies from State to State, there is still no uniformity.

The committee believes that a disclaimer should be able to perfect an otherwise valid disclaimer by directing that the interest pass to the person who would have received the property had the refusal been effective under local law.

Wash sales

The Internal Revenue Code includes a wash-sale rule providing for non-recognition of certain losses which do not constitute true economic losses where the taxpayer has not terminated his investment in the loss property. This provision disallows any loss from the disposition of stock or securities where substantially identical stock or securities (or an option or contract to acquire such stock or securities) are acquired by the taxpayer during the period beginning 30 days before the date of sale and ending 30 days after such date.² This provision prevents a taxpayer from selling stock which has declined in value in order to establish a loss for tax purposes and immediately reacquiring similar stock, because the sale and reacquisition together do not significantly alter the taxpayer's position with respect to that stock. No similar Code provision applies with respect to the disposition of property other than shares of stock or securities.³

Capital gains and losses

Generally, under present law, gain or loss from the sale or exchange of a capital asset⁴ receives special treatment. In the case of individuals, only 40 percent of the excess of the net long-term capital gain over net short-term capital loss for any taxable year is included in the taxpayer's adjusted gross income.⁵ In addition, capital losses of individuals are deductible in full against capital gains and against up to $3,000 of ordinary income each year.⁶ Only 50 percent of the net long-term capital losses in excess of net short-term capital gains may be deducted from ordinary income.⁷ Capital losses in excess of this limitation may be carried over to future years indefinitely, but may not be carried back to prior years.8

In the case of a corporation, the net capital gain is taxed at an alternative rate of 28 percent.⁹ Capital losses are allowed only against capital gains.¹⁰ Any excess loss may be carried back three years and forward five years.¹¹

Generally, in order for gains or losses on the sale or exchange of capital assets to be considered long-term capital gains or losses, the assets must be held for one year or more.¹² In the case of futures transactions in any commodity subject to the rules of a board of trade or commodity exchange, the required holding period is six months.¹³

Short sales

In the case of a "short sale" (i.e., where the taxpayer sells borrowed property and later closes the sale by repaying the lender with identical property), any gain or loss on the closing transaction is considered gain or loss from the sale or exchange of a capital asset if the property used to close the short sale is a capital asset in the hands of the taxpayer,¹⁴ but the gain ordinarily is treated as short-term gain.¹⁵ A contract to sell is treated as the short sale for purposes of these rules.16

The Code contains several rules which were enacted to eliminate specific devices in which short sales could be used to transform short-term gains into long-term gains. Under these rules, if a taxpayer holds property for less than the long-term holding period and sells short substantially identical property, any gain upon the closing of the short sale shall be considered short-term gain, and the holding period of the substantially identical property will generally be considered to begin on the date of the closing of the short sale.¹⁷ These rules prevent the conversion of short-term capital gain into long-term capital gain where the taxpayer is free of any significant risk. Also, if a taxpayer has held property for more than one year and sells substantially identical property short, any loss on the closing of the short sale shall be considered long-term capital loss.¹⁸ This rule prevents the conversion of long-term capital loss into short-term capital loss. For purposes of these rules, property includes stock, securities, and commodity futures,¹⁹ but commodity futures are not considered substantially identical if they call for delivery in different calendar months.²⁰ In addition, these rules do not apply in the case of hedging transactions in commodity futures.²¹

Straddles

Generally, the Internal Revenue Code does not contain any special rules dealing with straddles in commodities or commodity futures contracts.²² In the case of the typical straddle in commodities (i.e. the holding of a contract to buy a commodity in one month and the holding of a contract to sell the same commodity in a different month), neither the wash sale rule applicable to stocks or securities (sec. 1091), nor the special short sales rules preventing conversion of short-term gain to long-term gain or long-term losses to short-term losses (secs. 1233(b) and (d)) apply.

However, the Internal Revenue Service has ruled²³ that the loss from certain silver futures contracts constituting part of a straddle was not deductible because the taxpayer "had no reasonable expectation of deriving an economic profit from the transactions.²⁴ The ruling also stated that the loss claimed on the disposition of one leg of the straddle was not bona fide because the disposition represented no real economic change and was not a closed and completed transaction. This ruling has been the subject of much controversy, and the IRS is litigating the deductibility of certain losses claimed in straddle transactions.²⁵

Simple commodity tax straddles generally are used to defer tax on short-term capital gain from one tax year to the next tax year and, in many cases, to convert short-term capital gain realized in the first year into preferentially taxed long-term capital gain in a later year. However, in some cases straddles are used to defer tax on ordinary income and convert that income into short- or long-term capital gain. (See discussion of straddles in Treasury bill futures contracts at E, below.) A simple commodity straddle is constructed by taking equal long and short positions in futures contracts in the same commodity with different delivery dates. The two positions, called "legs," are expected to move in opposite directions but with approximately equal absolute changes. Thus, for example, if one leg of a straddle in futures contracts increases $500 in value, the other leg can be expected to decrease in value by about the same amount. By maintaining balanced positions, the risks of the transaction are minimized.

The committee believes that commodity futures markets play an important role in the economy. These markets provide a valuable means for farmers to reduce their risks in the production of crops and for bulk consumers to hedge their risks of price shifts. There has been explosive growth in the futures market over the past decade, and, there is good evidence that such growth will continue. Because of the importance of the commodities markets, particularly in the agricultural and commercial sectors, it is critical that the efficiency of these markets be preserved. The liquidity of these markets must be maintained. Thus, for example, the committee has included an exception to the rules for hedging transactions.

Four considerations dictate that legislative action be taken at this time. First, the use of tax straddles has received substantial public attention. The result is that a broad perception has arisen that it is possible, indeed, perhaps legitimate, to pay no tax at ordinary income rates. The committee recognizes the adverse effects of such a perception and believes that an immediate response to conversion and deferral through commodity transactions is necessary.

Second, the committee believes that the revenue loss, approximately $1 billion annually, may grow substantially because of the low transaction cost and significant leverage available in many commodity futures transactions. Thus, the revenue loss from a failure to act may be substantial. It is estimated that the committee bill will increase budget receipts by $1,351 million in fiscal year 1982.

Third, the widespread tax sheltering activity can cause substantial disruption in the commodity markets. The tax benefit allegedly available through commodity transactions will cause many taxpayers to engage in transactions that are otherwise uneconomic, with a resulting distortion of supply and demand curves. The percentage of tax-motivated transactions in certain markets may already be very substantial. The marked increase in the number of demands for delivery on Treasury bill futures contracts, noted in recent Decembers, has been linked to tax-motivated transactions and causes some distortion of the market.

Fourth, taxpayers currently confront unnecessary uncertainty in the area of futures and forward contracts. Greater simplicity in the rules governing such transactions and greater certainty about the results of common transactions is essential.

The committee believes that the changes which it is making affirm general principles of present law. Fundamentally, the new rules require that commodity futures transactions be taxed on their economic substance.

The committee bill provides rules to prevent deferral of income and to prevent conversion of ordinary income and short-term capital gain into long-term capital gain on straddle transactions. Generally, the deduction of losses on straddle positions involving property not on the market-to-market system (described below) is limited to the amount by which such losses exceed unrealized gains on any offsetting straddle positions. In addition, the bill authorizes the Secretary of the Treasury to prescribe regulations applying rules similar to those in subsections (a) and (d) of section 1091 (relating to wash-sales) and those in subsections (b) and (d) of section 1233 (relating to short sales) to straddle gains and losses.

Under the bill, a taxpayer's straddle losses are deferred to the extent the taxpayer has unrealized gains in offsetting straddle positions. If a taxpayer realizes a loss on the disposition of one or more positions in a straddle, the amount of loss which may be deducted is the excess of the loss over the unrealized gain (if any) in positions which offset the loss positions and which were acquired before the taxpayer disposed of the loss position. Losses on positions in straddles which the taxpayer identifies as such are not subject to this loss deferral rule, but gain and loss on such identified position must be netted. Losses on such identified straddles are treated as sustained no earlier than the day on which all positions in the identified straddle are closed.

Deferred losses are carried to the succeeding year and are subject to the application of the deferral rules in that succeeding year. Deferred losses are recognized in the first taxable year in which there is no unrealized appreciation in offsetting positions acquired before the disposition of the loss position. If there is more than one position with unrealized gain which was acquired prior to the loss disposition, which offsets the loss position and which does not belong to an identified straddle, the bill authorizes the Secretary of the Treasury to prescribe regulations for allocating the loss among the unrealized gain in such positions and for allocating unrealized gain among loss positions. The committee intends that allocation of unrealized gain positions to unrealized losses be done in a consistent manner that does not distort income. Regulations issued under this bill should provide that one dollar of unrealized appreciation at the end of any year defer at most only one dollar of realized loss.

A straddle composed entirely of futures contracts is not subject to this loss deferral rule. Such straddles will be taxed under the mark-to-market system. (See section C., below.) However, if a straddle is composed only partially of one futures contracts, it will be subject to this loss deferral treatment, unless the taxpayer elects to apply the mark-to-market rules to all positions in the straddle.

Under the bill, certain straddles are exempted from the loss deferral rule and taxed under special rules. The losses on the positions which make up an identified straddle are treated as sustained not earlier than the day on which the taxpayer disposes of all the positions comprising such a straddle. To be treated as an identified straddle, the bill requires that the straddle be clearly marked as an identified straddle on the taxpayer's records before the close of the day it is acquired. For a straddle to qualify as an identified straddle, all of its original positions must be acquired on the same day and either must have all of its positions closed on the same day during the taxable year or must have no positions closed by the end of the taxable year. In addition, an indentified straddle cannot constitute part of a larger straddle (for example, a butterfly).

In determining whether a taxpayer has deductible losses, the unrealized gain taken into account for a straddle position held by the taxpayer at the close of the taxable year shall be equal to the amount of gain which would be realized if the position were sold on the last business day of the taxable year at its fair market value in the case of futures contracts, fair market value is determined by the final settlement prices set by the futures exchanges for each contract on the final trading day of the year.

To verify the amount of loss deductible by the taxpayer, the taxpayer's unrealized gains must be disclosed. The bill requires taxpayers to disclose all their positions which have unrealized gain at the close of the taxable year and the amount of unrealized gain in each of the positions. Positions with unrealized gain must be disclosed whether or not the positions are part of a straddle. Taxpayers will not be required to file disclosure reports on unrealized gains if they have sustained no recognized loss on any position (including regulated futures contracts) during the taxable year. No disclosure report is required for positions which are part of an identified straddle. The exceptions available for identified straddles effectively will make such disclosure elective for most taxpayers. Additionally, a taxpayer is not required to report unrealized gain in inventory positions. The Secretary is authorized to issue regulations prescribing the time, manner and form required for disclosure of such unrealized gains on taxpayer's annual tax returns.

2. Wash sales; short sales

The committee bill requires that the Secretary issue regulations applying rules similar to certain provisions of the wash-sale rule (sec. 1091(a) and (d)) and of the short-sale rule sec. 1233(b) and (d)) to straddle positions. It is intended that the wash-sale rule be applied in appropriate cases to disallow losses in certain straddle transactions prior to the loss deferral rule of new section 1092. In the typical tax-shelter straddle transactions, for example, the taxpayer, after disposing of the loss leg immediately replaces it in order to remain in a balanced position and protect his unrealized gain. In this case, the modified wash-sale rule will prevent deduction of the loss. Thus, the loss deferral rule of section 1092 does not apply to this loss because section 1092 defers losses only if they are otherwise allowable. Any loss subsequently sustained on either leg of the reconstituted straddle may be deferred by application of new section 1092. Of course, an adjustment must be made to the replacement leg analogous to the basis adjustment made under section 1091(d). Thus, in most cases, the disallowance of losses under the section 1091 rule functions merely to defer the loss.

Under section 1233(b), gain on closing a short position generally results in short-term gain. In addition, the holding period of property held by the taxpayer which is substantially identical to the property sold short and not used to close the short sale, does not commence until the short position is closed (unless the long-term holding period requirement was already satisfied for such property when the short position was created). However, the holding periods of properties not satisfying the substantially identical standard of section 1233 are unaffected by its holding period rule, even if they are offsetting positions subject to the loss deferral rule of new section 1092. Section 1233(b) does not affect, for example, the typical tax-shelter commodity straddle because futures contracts calling for delivery in different calendar months are defined as not substantially identical (sec. 1233(e)(2)(B)). As a result, a short-term gain can be converted into a long-term gain by creating a straddle if the "long leg" increases in value and by holding the straddle for enough time to satisfy the long-term holding period requirement. To prevent this result, the bill authorizes the Secretary to prescribe regulations adopting rules comparable to section 1233(b), but applying such rules to suspend commencement of the holding period for any positions which are part of a straddle subject to new section 1092. For purposes of these rules, a futures contract to sell a commodity is equivalent to the short sale of a long futures contract for the same commodity or the short sale of the commodity itself. The regulations are also to adopt a rule comparable to section 1233(d), to prevent converting a long-term loss into a short-term loss.

Generally, the rules developed under the regulatory authority with respect to sections 1091 and 1233 will have broader application than the present law rules. In the new regulations, the concept of offsetting positions will be substituted for the present law concept of substantially identical property. The application of the new regulatory rules under sections 1091 and 1233 is to supercede any present law applications of those sections in situations where both the new regulations and present law appear to apply.

3. Definition of straddle

The bill defines straddles as offsetting positions with respect to personal property. A taxpayer is treated as holding a straddle if there is a substantial reduction in the taxpayer's risk of loss from holding any position in personal property because the taxpayer holds one or more other positions with respect to personal property. Although the concept of offsetting positions is not narrowly defined in the statute, certain cases fall outside its scope. For example, a mere diversification of positions usually would not substantially diminish risk for purposes of this bill where the positions are not balanced, and thus, would not be offsetting. Positions in personal property may be treated as offsetting whether or not the property is the same kind. Thus, a straddle can consist of two futures contracts for delivery of silver. A straddle also may consist of two positions which are not the same type of interest in property. A straddle may be made up of a cast position in silver, i.e., holding the physical commodity itself, and of a futures contract to sell the same amount of silver.

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

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

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

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

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

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

Any presumptions established under the bill's specific rules or under the regulatory authority provided by the bill can be rebutted.

4. Definitions and special rules

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

The term "position" includes options to buy or sell stock which is actively traded, provided either that the exercise period exceeds that required for long-term capital gain treatment or that the options are not traded on a domestic exchange. Thus, the bill's major rules apply to offsetting positions in stock options which can be held for more than 12 months. The definition of position excludes, and thus the major rules are inapplicable to, stock options traded on United States exchanges, if the options cannot produce a long-term capital gain or loss.

An attribution rule treats positions which are held by a person related to the taxpayer as positions held by the taxpayer. Persons related to the taxpayer are the taxpayer's spouse and a corporation which files a consolidated return with the taxpayer under section 1501. In addition, certain positions held by flow-through entities, such as trusts, partnerships, or subchapter S corporations, are treated as held by the taxpayer. If part or all of the gain or loss from a position held by a flow-through entity would be properly taken into account in determining the taxpayer's own Federal tax liability, the position is treated as held by the taxpayer, unless regulations provide otherwise.

New section 1092(a) providing for deferral of certain losses and the regulations to be issued under this bill to apply wash-sale (sec. 1091) and short-sale (sec. 1233) principles to straddle transactions do not apply to hedging transactions. The hedging transactions excepted from these rules also are excepted from the bill's mark-to-market and capitalization rules. (See sections B. and C., below.) Hedging is defined in the mark-to-market provisions (sec. 1256(e)) and refers to certain risk-limiting transactions conducted in the normal course of the taxpayer's trade or business which produce ordinary income or loss. A transaction qualifies for the exception only if it is clearly identified by the taxpayer as being a hedging transaction before the close of the day on which the transaction is executed. Taxpayers, such as banks or securities dealers, who may conduct thousands of hedging transactions to hedge property held or to be held in their accounts, may identify such accounts as hedged accounts without marking individual items as hedges or hedged property, provided such accounts deal only with ordinary income (or loss) items.

Taxpayers may elect to apply the new rules governing the taxation of straddles to positions which they held on June 23, 1981, for periods after that date, provided they make the election for all positions held on that date.

5. Penalty for failure to disclose gains

Taxpayers who without reasonable cause fail to report their unrealized gains are subject to a penalty, if they have a tax deficiency attributable to a denial of a loss deduction because they hold an off setting position with unrealized gain. The penalty for the failure to report unrealized gain is determined in the same way as the penalty for negligence or intentional disregard of rules and regulations (but without intent to defraud) in section 6653(a). The penalty assessed is the amount equal to 5 percent of the underpayment. Thus, for example, if a taxpayer who does not report all unrealized gain positions has an underpayment because the taxpayer is determined to have held an offsetting unrealized gain position, the taxpayer must pay the penalty, even if the taxpayer obtained a counsel's opinion that the unrealized gain did not offset the loss. To avoid the penalty, a taxpayer claiming a deduction for the loss may rely on the opinion, but the taxpayer also must disclose all unrealized gain positions and must indicate that none of the disclosed gain positions is considered an offsetting position.

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

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

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

When the 12-month holding period has passed, the taxpayer will deliver the silver on the futures contract and realize a gain on the silver. If the price of silver has increased, the taxpayer can sell the silver, producing long-term capital gain, while closing out the short futures position, creating a short-term capital loss. In either event, the net gain on the two positions will be about equal to the interest and carrying charges but will be treated as long-term capital gain. Thus, in 1981, investment income taxable at rates as high as 70 percent, would be deferred for a year and converted into capital gains taxable at maximum rates no higher than 28 percent. (The bill also reduces the maximum rate on investment income from 70 to 50 percent in 1982, which results in the reduction of the maximum long-term capital gains rate from 28 to 20 percent.)

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

Expenditures subject to this capitalization requirement are interest on indebtedness incurred or continued to purchase or carry the property, as well as amounts paid or incurred for insuring, storing or transporting the property. The amount of expenditures, called carrying charges, to be capitalized is reduced by any interest income from the property (including original issue discount), which is includible in gross income for the taxable year, and any amount of ordinary income acquisition discount (new sec. 1232(a)(4)(A)) includible in gross income for the taxable year.

The capitalization requirements do not apply to any identified hedging transactions (sec. 1256(e)) or to any position which is not part of a straddle. Thus, for example, a farmer still can deduct currently the costs of financing crops. Similarly, securities dealers' expenses for financing their inventory and trading accounts which generate ordinary income or loss remain deductible currently.

However, the Internal Revenue Service has ruled¹ that the loss from certain silver futures contracts was not deductible because the taxpayer "had no reasonable expectation of deriving an economic profit from the transactions."² This ruling has been the subject of controversy, and the IRS is litigating the deductibility of certain losses claimed in straddle transactions.3

Tax rules of general application which affect the taxation of transactions in commodity futures contracts are discussed in section A., Present Law, above.

In the case of the typical straddle in commodity futures tax-avoidance transactions.

A taxpayer using a simple futures straddle as a tax shelter will establish a position in contracts with contract prices of about, say, $10,000 each. The two contracts, one to buy, the other to sell, are identical in every respect, except for their delivery months. Because the taxpayer's position is a straddle, his margin deposit will be very low--as little as one percent of the value of the position ($200). The taxpayer will wait for the market to move, so that one leg of the straddle shows a loss, e.g., $500, and the other leg shows an almost identical gain. The taxpayer will liquidate the loss by entering into the opposite futures contract for the same month. (A contract to see December wheat, for example, is liquidated by executing a contract to buy December wheat). In order to maintain a balanced, minimal-risk position, the taxpayer will replace the liquidated leg with a contract which is identical, except for its delivery month. (The replacement contract will have a contract price of about $9,500, if the original long leg was liquidated at a loss, or a contract price about $10,500, if the original short leg was liquidated at a loss.)

The taxpayer will claim the decrease in value in the liquidated leg as a $500 short-term capital loss and deduct it from his income, thereby eliminating a $500 short-term gain for the tax year. At the same time, the taxpayer will continue to hold the other leg, which will have an unrealized gain approximately equal to his "realized loss," that is, about $500. However, the taxpayer will not have made any payment on the liquidated leg because no payment is due on a futures contract until its delivery date. In addition, because the taxpayer maintained balanced position, he ordinarily will not be required to deposit any additional margin into his margin account.

The taxpayer will hold the two legs into the following year. In the second year, the taxpayer will close out the two positions. Assuming the holdover contract has increased another $500 in value, the taxpayer will recognize a total gain of about $1,000 on the original leg and about a $500 loss on the replacement leg. If the gain is on the long (buy) position and that position was held for over six months, the taxpayer will report a $1,000 long-term capital gain on the long position and a $500 short-term capital loss on the short position. If he has no other capital transactions for the year, he will report the $500 difference between these legs as long-term capital gain. (His margin, less commission, will be returned.) Thus, he will have succeeded in deferring his short-term capital gain for one year and converting it to a long-term capital gain. If the gain is the short (sell) position, the gain will be short-term capital gain. In this case, the taxpayer gets a one-year deferral, but no conversion.

The committee believes that the enactment of tax rules, based on the actual operations of futures trading, will end this use of futures for tax avoidance purposes, establish an accurate method of determining a taxpayer's futures income (or loss), and ease tax administration and paperwork for both Government officials and taxpayers.

The United States commodity futures exchanges employ a unique system of accounting for every contracts gain or loss in cash on a daily basis. Even though a futures trader does not close out a position but continues to hold it, the trader receives any gain on the position in cash as a matter of right each trading day.

If a trader's position has increased in value during the day, the net increase in the position is computed and transferred to the trader's account before the beginning of trading the next day. The trader has the right to withdraw the full amount of such gains immediately every trading day. However, if a trader's position decreases in value, the trader will have to meet a margin call, that is, deposit additional funds before the next business day. Money paid on position losses is paid into the exchange clearing association which transfers such amounts to accounts which gained during the trading day. This daily accounting which includes the determination of contract settlement prices and margin adjustments to reflect gains and losses is called "marking-to-market."

Marking-to-market requires daily cash adjustments through the exchange clearing association to reconcile exchange members' net gains and losses on their positions. At the close of trading each day, every member must mark all customer accounts to the settlement prices (current market value) for the day. Gains and losses are immediately deposited into or withdrawn from the customer accounts. Customers in turn are entitled to withdraw their gains, or are required to deposit any margin required because of losses in their accounts at the close of every day under this marking-to-market system.

The committee bill adopts a mark-to-market system for the taxation of commodity futures contracts. This rule applies the doctrine of constructive receipt to gains in a futures trading account at year-end. The application of this rule in present law means, for example, that taxpayers must include in their income any interest which has accrued during the year, even though they may not have withdrawn the interest from their savings accounts. Because a taxpayer, who trades futures contracts receives profits as a matter of right or must pay losses in cash daily, the committee believes it appropriate to measure the taxpayer's futures' income on the same basis for tax purposes.

Under the committee bill, gain and loss from regulated commodity futures contracts must be reported on an annual basis under a mark-to-market rule which corresponds to the daily cash settlement, mark-to-market system employed by commodity futures exchanges in the United States for determining margin requirements. Futures contract subject to the new mark-to-market rules are expected from the loss deferral rule (new sec. 1092), the regulations authorized to adopt wash-sale and short-sale principles which apply to straddle positions, and the capitalization rule (sec. 263(g)).

All futures contracts must be marked-to-market at year end. Each regulated futures contract held by a taxpayer is treated as if it were sold for fair market value on the last business day of the year. Ordinarily, the settlement prices determined by an exchange for its futures contracts on the year's last business day are to be considered the contract's fair market value. Any gain or loss on the contract is taken into account for the taxable year, together with the gain or loss on other contracts which were held during the year but closed out before the last business day. Thus, taxpayers' net gain or loss is approximately equal to the aggregate net amount which is credited to their margin accounts, or which they had to pay into their accounts, during the year.

If a taxpayer holds futures contracts at the beginning of a taxable year, any gain or loss subsequently realized on these contracts must be adjusted to reflect any gain or loss taken into account with respect to these contracts in a prior year.

Any capital gain or loss on a regulated futures contract which is marked-to-market is treated as if 40 percent of the gain or loss is short-term gain or loss, and as if 60 percent of the gain or loss is long-term capital gain or loss. For 1982 and later years, this allocation of capital gain between short-term and long-term results in a top rate of tax of 32 percent. Any ordinary income or loss items on the mark-to-market system continue to be taxed at the regular tax rates applicable to such income.

The mark-to-market rules, including the allocation between long-term and short-term capital gain or loss, apply to a termination of a taxpayer's obligation with respect to a regulated futures contract whether the termination is executed by offsetting, by taking or making delivery, or in some other manner. Gain or loss upon termination is determined on the basis of the contract's fair market value at the time of termination, ordinarily the actual price received or paid.

Unless specifically excepted, all regulated futures contracts are subject to the mark-to-market rules.

A regulated futures contract means a contract (1) which requires delivery of personal property or an interest in personal property, as defined in new section 1092(d)(1); (2) which is marked-to-market under a daily cash flow system of the type used by United States futures exchanges to determine the amount which must be deposited, in case of losses, or the amount which may be withdrawn, in the case of gains, as a result of price changes with respect to the contract during the day; and (3) which is traded on or subject to the rules of a domestic board of trade designated as a contract market by the Commodity Futures Trading Commission, or of any board of trade or exchange which the Secretary determines operates under rules adequate to carry out the purpose of the mark-to-market provisions.

The bill provides special rules for the taxation of straddles composed of at least one position in regulated futures contracts and one or more positions in interests in property which are not regulated futures contracts. If the taxpayer clearly identifies each position in such a straddle as belonging to the straddle by the close of day of the positions' acquisition, the straddle is called a mixed straddle. The taxpayer may elect either to treat all the positions in mixed straddles, regulated futures contracts as well as other property, on a mark-to-market basis for tax purposes; or, to exclude all positions in the mixed straddle, including regulated futures contracts, from the mark-to-market rules, in which case, they will be subject to the loss deferral, wash sale, and short sale rules. The taxpayer's election is permanent and may be changed only with the consent of the Secretary.

If a taxpayer fails to identify the positions constituting a mixed straddle, or, if a taxpayer fails to make an election of a consistent tax treatment for all the positions in such a straddle, the amount of any gain or loss on futures contracts in the straddle is determined under the mark-to-market rules. Gain or loss on other positions in the straddle is determined under the regular tax rules. All positions in the straddle, both futures contracts and other property, are subject to the loss deferral rule in section 1092, the modifications of the wash sale and short sale rules applicable to straddles, and the capitalization rule in section 263(g). The application of section 1092 to such unidentified mixed straddles will result in the deferral of all losses with respect to which there is offsetting unrealized gain, so that losses realized on the mark-to-market system are deferred to the extent there are unrealized gains in other property. Similarly, losses on property outside the mark-to-market system are deductible to the extent of gains on futures contracts in the mark-to-market system (provided there are no unrealized gains in other offsetting positions.)

Hedging exemption

The mark-to-market rules do not apply to hedging transactions. For purposes of the mark-to-market rules, a hedging transaction means an identified transaction which the taxpayer executes in the normal course of his or her trade or business primarily to reduce certain risks and which results in only ordinary income or loss. Hedging transactions are varied and complex. They may be executed in a wide range of property and forms, including options, futures, forwards, and other contract rights and short sales.

A hedging transaction may be executed to reduce the risk of price change or of currency fluctuations with respect to property which is held or to be held by the taxpayer and which, if disposed of, whether by sale, exchange, lapse, cancellation, or otherwise, at a gain, produces ordinary income. Also, a hedging transaction may be executed to reduce risk of price or interest rate changes, or currency fluctuations with respect to borrowings made or to be made, or obligations incurred or to be incurred, by the taxpayer, provided all income or gain on such borrowings or obligations is treated as ordinary income. Transactions which result in capital gains or capital losses do not qualify for the hedging exemption. Speculation in commodity futures contracts, for example, does not qualify for this exemption whether a trader takes outright long or short positions, or whether a trader speculates in spreads, because futures speculation always produces only capital gains or capital losses.

For a transaction which would generate ordinary income or loss under normal tax principles to qualify as a hedging transaction, the transaction must be clearly identified in the taxpayer's records as being a hedging transaction before the close of the day on which the transaction was entered into. Regulations should allow taxpayers to minimize bookkeeping identification requirements in as many cases as practicable. In situations where hedging transactions are numerous and complex, but opportunities for manipulation of transactions to obtain deferral or conversion of income are minimal, it generally is unnecessary to require taxpayers to identify and match in their records hedging activities with hedged properties. In certain hedging transactions, for example, those conducted by banks, it may be extremely difficult to match a hedging contract with a specific hedged property. In such cases, it may be sufficient for this identification requirement to mark an entire account, such as the bank's securities trading account, as a hedged account. If the bank's securities trading account, which produces only ordinary income or loss, is managed and recorded independently and separately from the bank's investment account (and other capital asset account), there is little danger of manipulation for conversion. Moreover, because Federal regulatory agencies impose certain standard accounting practices on banks, their deferral opportunities too are limited. Thus, detailed identification or matching of such hedging activities ordinarily would serve no useful purpose.

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

Syndicate rule

In order to prevent possible manipulation of the hedging exemption by tax shelters structured as limited partnerships, the exemption for hedging transactions does not apply to transactions entered into by syndicates. Thus, unless excluded as mixed straddle, a syndicate's transactions in futures contracts are taxed under the mark-to-market rules, the loss deferral rule in section 1092, the modifications of the wash sale and short sale rules, and the capitalization rule in section 263(g).

A syndicate means any partnership or other entity (other than a regular, subchapter C corporation), if at any time interests in the entity have been offered for sale in an offering required to be registered with any Federal or State agency authorized to regulate security sales offerings; or, if more than 35 percent of the entity's losses during any period are allocable to limited partners or limited entrepreneurs within the meaning of section 464(e)(2). The Secretary may increase the percentage of losses allocable to limited partners or limited entrepreneurs by entities which are dealers in securities on a case-by-case basis. The Secretary may exercise this discretion to waive the 35-percent test with respect to dealers in securities when the facts and circumstances in a specific case indicate that a waiver is necessary for legitimate and demonstrated business reasons and that the waiver is not sought, nor could it be exploited, for tax-avoidance purposes. The waiver authority provides flexibility to deal with situations involving hardship or changed circumstances, such as the death or retirement of general partners. In some cases, it may be appropriate to grant the waiver from the effective date of the provision. An individual who actively participates in the management of an entity is not considered a limited partner or a limited entrepreneur with respect to the entity for the period of the individual's active management.

Election

Taxpayers may elect the new rules governing the taxation of straddles, including the mark-to-market rules, for positions which they held on June 23, 1981, for periods after that date. The election must cover all positions held by the taxpayer on that date.

The identification requirement for hedging transactions in section 1256(e)(2)(C) shall apply to property acquired by the taxpayers after December 31, 1981, in taxable years ending after that date.

Individual taxpayers with significant increases in income may qualify to average their income over a five-year period which includes the four preceding taxable years (secs. 1301-1305). However, significant decreases in income do not entitle taxpayers to benefit from the provisions for income averaging.

The amount carried back may be applied only against net gains resulting from application of the marked-to-market rule of section 1256(a) in the carryback year. Such gains must be reduced by any net capital loss to which section 1256(a) did not apply in the carryback year, so that only to the extent the taxpayer had a net capital gain in the carryback year would any portion of the loss be allowed.

Amounts carried back under the election are to be treated as if 40 percent of the losses are short-term capital losses and 60 percent are long-term capital losses. Such losses must be absorbed in the earliest year to which they may be carried back and any remaining amount is then carried forward to the next year in the same proportions of 40 and 60 percent. Losses are not allowable to the extent they would create or increase a net operating loss for the carryback year. Amounts against which losses may be applied in the carryback year, i.e., "net commodities futures gain," are determined without regard to "net commodity futures loss" for the loss year or any year thereafter. Because the marked-to-market system begins in 1981 and no taxpayer has net marked-to-market capital gains for a prior year, 1981 is the earliest year to which net commodity futures capital losses can be carried back.

Losses absorbed in carryback years under the election are treated as capital gains for the loss year in the 40-percent short-term and 60-percent long-term proportions for the purpose of determining the amount of any net capital loss to be carried forward to a succeeding year under section 1212(b)(1). If capital losses are carried forward under section 1212(b), to the extent they were determined under a marked-to-market rule of section 1256(a), they continue to be treated as losses from regulated futures contracts in the year to which they are carried.

The carryback election does not apply to an estate or trust.

The capital loss carryback election for regulated futures contracts may be illustrated by the following example:

Assume that the taxpayers in 1985 has net losses of $100,000 from regulated futures contracts under the marked-to-market rule of section 1256(a). In addition, the taxpayer has a $3,000 short-term capital loss and a $50,000 long-term capital gain. Under section 1211, the taxpayer's capital losses are applied against the $50,000 of long-term capital gain and $3,000 of other income, leaving a $50,000 loss. If the carryback election under section 1212(c) is not made, the $50,000 loss may be carried to 1986 under section 1212(b). Initially, the $100,000 net loss from regulated futures contracts is treated as $40,000 of short-term loss and $60,000 of long-term loss under the marked-to-market rule. Since the taxpayer has $50,000 of long-term gain from other sources, only $10,000 of long-term loss remains, which, along with the $40,000 short-term loss, is carried to 1986 and treated as losses from regulated futures contracts in that year.

If the taxpayer makes the section 1212(c) election, his net losses from regulated futures contracts are carried back to 1982 but only to the extent of the net capital loss which would otherwise become a capital loss in 1986 under section 1212(b), i.e., $50,000. The amount carried back is treated as 40-percent short-term loss and 60-percent long-term loss in the carryback year. Thus, the $50,000 carried back will be treated as $20,000 of short-term loss and $30,000 of long-term loss from regulated futures contracts in 1982. The amount carried back may be applied only against gains from regulated futures contracts in the carryback year and only to the extent the taxpayer had a net capital gain in such year.

Assume that the taxpayer in 1982 had a net gain of $50,000 from regulated futures contracts and a long-term capital loss from other sources of $30,000. His gains subject to section 1256 were $20,000 short-term and $30,000 long-term which was absorbed by the $30,000 of unrelated long-term loss, leaving a net short-term gain of $20,000 to be offset by $20,000 of the $50,000 loss carried back from 1985. The unused portion of the loss, $30,000 may be carried to 1983 and treated as 40 percent short-term and 60 percent long-term in that year. The short-term and long-term amounts would be $12,000 and $18,000 in 1983.

If the taxpayer has no net gains or losses from regulated futures contracts in 1983 or 1984, the $30,000 of unused loss would be carried forward to 1986 under section 1212(b) and would be treated as losses from regulated futures contracts in that year. For this purpose, section 1212(b)(1) is applied by treating the amount of loss absorbed as a carryback loss, $20,000, as though it were additional capital gain in the 40-percent short-term, 60-percent long-term ratios in 1985. Thus, of the $20,000 of short-term loss and $30,000 of long-term loss carried back, $12,000 ($20,000 minus $8,000) and $18,000 ($30,000 minus $12,000) of short-term loss and long-term loss respectively remain to be carried forward as losses from regulated futures contracts in 1986.

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

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

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

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

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

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

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

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

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

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

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

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

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

As a result of these interpretations, losses from the termination, cancellation, lapse, abandonment and other dispositions of property, which are not sales or exchanges of the property, are reported as fully deductible ordinary losses instead of as capital losses, whose deductibility is restricted. However, if such property increases in value, it is sold or exchanged so that capital gains, long-term when the holding period requirements are met, are reported.

Some of the more common of these tax-oriented ordinary loss and capital gain transactions involve cancellations of forward contracts for currency or securities.

The committee considers this ordinary loss treatment inappropriate if the transaction, such as settlement of a contract to deliver a capital asset, is economically equivalent to a sale or exchange of the contract. For example, a taxpayer may simultaneously enter into a contract to buy German marks for future delivery and a contract to sell German marks for future delivery with very little risk. If the price of German marks thereafter declines, the taxpayer will assign his contract to sell marks to a bank or other institution for a gain equivalent to the excess of the contract price over the lower market price and cancel his obligation to buy marks by payment of an amount in settlement of his obligation to the other party to the contract. The taxpayer will treat the sale proceeds as capital gain and will treat the amount paid to terminate his obligation to buy as an ordinary loss.

The table below summarizes the estimates of decreases in budget receipts from the tax reduction provisions of the bill for fiscal years 1981--1986 and the increased receipts under the commodity tax straddles provisions. The estimates are present in greater detail in Part III, Revenue Effects, of this report.

[Estimate Table not reproduced.]

Under the administration's economic assumptions, the Treasury Department estimates of the net tax reductions made by this bill are as follows:

[Estimate Table not reproduced.]

Individuals who earn income abroad will have fewer calculations to make in determining the amount of their incomes subject to tax. Two-earner married couples will need to compute an additional deduction that will reduce their taxable income.

The depreciation and investment credit revisions will simplify substantially the depreciation computations of virtually all businesses. Businesses will make additional computations of readily available internal data to claim the tax credit for increased research and experimental expenditures. The estate tax and gift tax revisions will eliminate the need for preparing returns on behalf of the bulk of estates.

The explanations of the provisions in the bill (in Part IV of this report) describe in more detail how the tax revisions will affect individuals and businesses.

The views of the CBO with respect to the revenue estimates of the provisions in H.J. Res. 266 are expressed in the letter that follows.

U.S. CONGRESS, CONGRESSIONAL BUDGET OFFICE, Washington, D.C., July 6, 1981. Hon. ROBERT J. DOLE, Chairman, Committee on Finance, U.S. Senate, Washington, D.C.

DEAR MR. CHAIRMAN: In accordance with Section 403 of the Budget Act, the Congressional Budget Office has examined the Senate Finance Committee amendment to H.J. Res. 266 in the nature of a substitution, the Economic Recovery Act of 1981. This bill contains the following general tax provisions:

Sincerely, ALICE M. RIVLIN, Director.

The bill creates new tax expenditures in (1) the deduction for two earner married couples, (2) the partial expensing of business assets, (3) the tax incentives for research and experimental expenditures and contributions of equipment used in research and experimentation, (4) the payroll-based tax credit for contributions to an employee stock ownership plan, (5) the deduction for motor carrier operating rights, and (6) the exclusion for interest earned on certain savings certificates.

Increased tax expenditures include (1) the removal of the limit on the amount of used equipment eligible for the investment tax credit, (2) the incentive stock options, (3) the increased exclusions for contributions to individual retirement accounts, H.R. 10 plans, simplified employee pension plans and subchapter S corporations, (4) the revisions in the exclusion for income earned abroad, (5) the increased investment tax credit for rehabilitation expenditures, and (6) revisions in tax provisions affecting small business.

Reduced tax expenditures include (1) the repeal of the limited exclusion for interest income for 1982 and the return to the prior law limited exclusion for dividend income, (2) the revisions in the tax treatment of commodity tax straddles and (3) repealing the maximum tax on earned income because of the reduction in the highest marginal tax rate to 50 percent.

The depreciation reform and the associated revisions in the eligibility rules for the investment tax credit involve elements of both increased tax expenditures and restructuring of basic business income tax provisions to provide a desired economic objective. The characterization of these provisions as tax expenditures will be reanalyzed before the next tax expenditures pamphlet is published for the Committee on Finance in 1982.

The estimated effects on budget receipts of each new or increased tax expenditure is presented in Part III of this report, Revenue Effects.

In Finance Committee mark-up of H.J. Res. 266, we proposed to allow all taxpayers to deduct contributions to charitable organizations whether or not they itemize their deductions. Our amendment was structured to meet budget restrictions endorsed by the Finance Committee.

This proposal would help preserve the vitality of our nation's charitable and volunteer community. We are confident that volunteer groups, dollar for dollar, can equal or exceed the job done by government in delivering services. We believe that his proposal can help achieve this. Unfortunately, the proposal was defeated by a 10-10 tie vote.

We believe that the President and a majority in Congress favor extending the deduction for charitable contributions to non-itemizers. However, some believe that the budget cannot accommodate it, and that there is no particular need to approve it now. We respectfully disagree with these objections.

One purpose of proposal is to help reverse the decline in support for charitable groups. In 1970, we gave 1.99% of our personal income to charity. By 1980, this fell to 1.84%--a loss in contribution of more than $3 billion per year by 1980.

One important explanation for the loss of giving is that fewer people itemized deductions. This means fewer people have a tax incentive to give.

In 1970, 57.4% of taxpayers itemized deductions. By 1981, due to successive increases in the zero bracket amount (formerly called the standard deduction), the percent of taxpayers itemizing deductions is estimated to be 38.3%. Thus 61.7% of taxpayers, 43,000,000 households, no longer have a tax incentive to contribute.

There is growing evidence that the tax incentive for charitable contributions works. Survey research contained in a Gallup opinion poll in 1979 shows that itemizers contribute between two and three times as much to charity as non-itemizers.

The distinguished economist Martin Feldstein of Harvard University has also confirmed this conclusion. He testified before the Finance Committee's Subcommittee on Taxation that the revenue loss from this bill would be exceeded by new contributions to charitable groups. He said each $1 of revenue loss from this bill could produce from $1.30 to $2.00 in contributions.

We believe the incentive works. We also believe that this provision would be one of the most cost effective federal initiatives we could undertake. We can think of no way to get more money to solve human needs at less cost to the federal government.

Studies showing the effect of tax incentives on giving do not even attempt to measure the enormous importance of volunteer help. For example, the American Red Cross, in testimony before the Taxation Subcommittee of the Senate Finance Committee in January, 1980, indicated that it has 77 volunteers for each of its paid workers. Charitable organizers have often found that if a person gives financial support to an organization, soon after he or she often wishes to be personally involved by volunteering time. Reduced contributions can weaken this important volunteer resource.

As the incentive to give applies to fewer and fewer people, community organizations also lose their democratic base. They become more dependent on corporations and wealthy contributors.

The average income in 1981 for itemizers is estimated to be $31,533. In contrast, the average income for persons taking the standard deduction is estimated to be only $12,600. This legislation will encourage these 43,000,000 households to participate in giving.

Last September, the Senate Finance Committee approved a form of this bill as a Committee amendment to its tax cut bill. The vote was 16-4.

The 1980 National Republican Platform endorses this proposal:

"The American ethic of neighbor helping neighbor has been an essential factor in the building of our nation. Republicans are committed to the preservation of this great tradition." "To help non-government community programs aid in serving the needs of poor, disabled, or other disadvantaged, we support permitting taxpayers to deduct charitable contributions from their federal income tax whether they itemize or not.

On September 18, 1980, then-candidate Reagan sent a telegram to the National Conference of Catholic Charities citing the above language, and stating that he was strongly committed to it. Support for this proposal has been bipartisan from its inception.

In addition, the tax reductions in the Senate Finance Committee version of H.J. Res. 266 will further hamper our citizen's voluntary effort to meet community needs. The reduction in marginal rates will decrease tax incentives at each income level to contribute to charity. For example, the reduction in maximum rate from 70% to 50%, although fully meritorious to stimulate investment, will lead to less giving by persons in those higher brackets. Also, the reductions in estate and gift taxes will decrease the role of charitable giving in estate planning.

If the independent sector is to become more active in areas affected by budget cuts, we must give it the tools it needs to assume the broader responsibilities which it can handle so capably.

In September, 1980, the Senate Finance Committee approved a four year phase-in for this legislation. In the first year, non-itemizers would be permitted to deduct 1/4 of their contributions. In the second year they would be permitted to deduct 1/2; in the third, 3/4; and in the fourth year and thereafter, all contributions would be deductible. In light of budget restrictions, we think this concept is acceptable.

Delay in approving the bill will hamper non-profit volunteer efforts. But action now will send the word that America's tradition of reliance on volunteer organizations for alternative delivery systems will continue.

Our goal is to strengthen people's ability to solve problems for themselves in their own communities. Unintentionally, budget and tax cuts present a twin threat to this effort. We think it's vitally important that we signal to our fellow Americans that we wish their efforts to continue and we intend for them to succeed. Approval of this legislation now will send this message.

The problem is an inadequate appreciation for the likely side effects from rapidly increasing the rate of capital cost recovery through accelerating depreciation deductions and increasing the investment tax credit for certain short-lived property as proposed under the bill. Already many major industries cannot absorb the existing level of deductions and credits for a simple reason. They operate in the red or earn only a modest taxable income. Their problem will be shared by others in the future when the amount of depreciation and investment tax credits taken by businesses grows sharply. Yet, unless all American industries are in a position to benefit from tax incentives to purchase productivity-enhancing plant and equipment, we cannot expect them to do so faster than they would otherwise. Thus, under H.J. Res 266, certain industries and firms will move ahead at a faster rate than others depending, in part, on their ability to utilize additional deductions and credits.

While current tax law contains provisions to prevent this, the scope of the changes in the investment tax incentives proposed under the Committee bill means that adjustments in the old way of handling this problem are warranted. Under existing rules, corporate taxpayers may apply unused investment tax credits and current operating losses against their tax returns of the previous three years or the next seven. This practice provides reassurance to companies considering productive investments that they will benefit from the credit and depreciation deductions even if they are not profitable during the next 12 month period. By doing so, they encourage industries with substantial annual changes in profitability to make larger investments in plant and equipment by lowering the risk that the credits and deductions will be "crowded out" due to misestimates of profitability levels.

Nevertheless, even the existing rules have not been sufficient to prevent the buildup of $14 billion in unused investment tax credits that are being carried forward and are in jeopardy of being lost. For this reason, it is vital that the carryback and carryforward provisions be modified to accommodate the large increase in investment tax credits and depreciation deductions that will occur in the future. By 1986. for example, under the Committee bill it is anticipated that depreciation deductions will be over $90 billion larger than would otherwise be the case, compared to a total of $93 billion in total corporate depreciation deductions in 1976.

In Committee, therefore, we proposed the "banking rule". Under the banking rule, firms would have additional flexibility in determining the amount of depreciation they took in any taxable year. While the maximum amount in any year would depend on the classification of assets as 15, 10, 5, or 3 year property, the difference between the amount taken and the maximum would be banked. All or part of it would be used at sometime in the future. The effect of this would be to extend the carryforward term however long as would prove necessary, on a case-by-case basis, to eliminate "crowding out". This proposal failed on a tie vote, 10-10.

A more ambitious alternative that solves the "crowding out" problem would be to permit taxpayers to carry back investment tax credits over an extended period of time rather than just three years. This approach recognizes that the selection of an annual accounting period for measuring and taxing corporate income is arbitrary. (In fact, the amount of income earned by corporations annually varies by a wider percentage than that of individuals so corporate income averaging is justified.) Many currently unprofitable firms that now must carry forward unused investment tax credits paid substantial taxes in previous years. Had their historical pattern of losses and gains been reversed, by showing a profit now rather than previously, they could fully use new credits and deductions. By clearing away their backlog of credits through provision of extended carryback rules, such companies would be in a position to benefit fully from the modernization incentives contemplated under the Committee bill. Any new credits and deductions could be taken immediately.

Another alternative to flexibility under the banking rule or extended carryback terms is greater reliance on tax-motivated corporate leasing. In such transactions, one company which can take advantage of additional tax credits and depreciation deductions buys assets needed by a firm that cannot, due to a "crowding out" problem.

In return for the tax benefits created by ownership, the company purchasing the equipment agrees to lower its rental price. The Committee bill envisions a significant increase in such transactions by relaxing the rules deemed most to limit current growth of the corporate leasing industry. While there is nothing wrong with the leasing concept, we should recognize that up to 50% of the tax benefits may not be passed through by the leasing company and that certain expenditures, such as refurbishing an old factory, do not necessarily lend themselves well to the concept. However, leasing does allow some companies the opportunity to avoid a buildup of investment tax credits that must be carried forward, and perhaps, be lost one day.

These and other possible alternatives for assuring that investment tax incentives are neutral need continual evaluation, and we must expect to make adjustments in the future. In doing so, we improve the chances that the desirable and long overdue improvements in the rate of capital cost recovery have their intended effect, an across-the-board revival of all business enterprises and job opportunities, not just for those in favorable tax situations.

One class of investments that we especially need for national security reasons is coal conversion property to lower national petroleum consumption. Americans use petroleum products chiefly in three ways. We drive automobiles and trucks. We heat our homes and offices. And we generate energy for our utilities and industrial facilities. While important progress toward energy independence is being made as automotive fuel efficiency rises and insulation of new and old buildings accelerates, important steps should be taken to encourage greater use of coal as a replacement fuel for oil and gas when used by power plants and industrial concerns.

Perhaps the single most important step we can take is to place coal conversion property in the 3 year ACRS category. Depending on who makes the conversion, such property will receive a write-off of 5 to 15 years under the Committee bill. This is an unacceptably slow rate for assets central to any sound strategy for lowering national use of petroleum.

Similarily, other capital formation incentives that should be considered include extending the 10% energy tax credit to coal conversion property and permitting utilities to utilize the tax exempt industrial development bond mechanism to finance such conversions.

Together, these steps will save at least 500,000 barrels per day in petroleum. With a cost of less than $300 million, there may be no cheaper and efficient way to substantially lower our dependence on imported energy sources.

The principal public policy objective should be the attainment and preservation of equitable Federal tax provisions that reflect the long-term nature of forest investments and the unique risks involved. In addition, forest taxation policies should encourage forest conservation and stable land ownership patterns.

Presently, excessive Federal estate taxes now deter reforestation and force premature harvesting of our Nation's private forestlands. The provisions included in the Senate Finance Committee tax proposal, while attempting to address this problem, are in fact not much better than current law.

The current estate tax lowers productivity for two basic reasons. First, the estates of landowners are often forced to cut timber before its proper time in order to pay the estate tax. Cutting younger trees before they have reached optimal harvestable size is bad management. Depending on the region, tree species and forest management practices, timber crops take between 30 and 100 years to reach harvesting size. It is during the latter part of this lengthy growing period that timber increases in value most rapidly.

Rapid liquidation of timber just to meet tax liabilities is bad forestry in that it may not coincide with either optimal biologic or economic management considerations.

The second reason the estate tax lowers productivity is that it discourages reforestation. The present law reduces the rate of return on growing timber below the level required for continued investment. An owner usually will replant solely in order to benefit his heirs. Yet, before the trees grow to a size that will yield a fair return, the owner will die an 1 the trees will be cut in order to pay estate taxes. Neither the owner nor his heirs will ever see a fair return on their investment.

The result of this matter is simply economics. We have reached a point where the obvious adverse economics are redirecting investments away from forestry. Owners are discouraged from replanting after harvest, and intensive management is being curtailed.

Stable land ownership is also discouraged because an executor may be forced into a sale of all or part of the forestland to a large company or to a developer. Such action is detrimental to the established social premise of maintaining a balance of ownerships between the industrial and non-industrial sectors.

Congress was evidently concerned about such occurrences, and included special provisions for family farm and timberlands, and certain closely held businesses in the estate tax portion of the 1976 Tax Reform Act.

These provisions are twofold. First, a special rule permits certain managed woodlands to be valued for estate taxes on the basis of current use rather than at fair market (speculative) value. Second, payment over a ten-year period of that portion of the tax attributable to the forestland is now automatic in certain cases. In some situations, the first payment may be deferred for five years and the remainder made from the sixth through the 15th years.

In practice, a number of prerequisites and restrictions will severely limit use of these options. First, those assets used in the qualifying use must, at fair market value, comprise at least 50 percent of the total estate. Thus, the heirs of a forest owner who also had substantial other assets, such as life insurance, could very well be precluded from utilizing the use-value provision. In addition, even when timberland is the major asset of an estate, the IRS has interpreted the statute in such a way as to eliminate again the benefit of special use valuation. When land containing timber is valued, the value of the timber may not be counted as real property in the 25 percent test, although it is counted in valuing the whole estate. Timber, however, is often worth many times more than the land itself. Obviously, when the land by itself is worth less than 25 percent of the whole estate, the timberland estate will not qualify for the special use valuation. As a result, under current law, the only timberland that will ever qualify for special use valuation will be land that has been clear-cut or that contains a poorly stocked stand of timber.

Second, in order for a property to qualify for use-valuation, the decedent or a member of his family must have materially participated in the management of the property, and such material participation by a family member must continue after probate. Current law virtually excludes land managed by a forestry consultant or under lease to industry.

Third, in order to qualify for the 10-to-15 year tax payment extension, the forest property must have been a "closely held business" under the strict definition of the Internal Revenue Code for this purpose.

The Senate Finance Committee attempted to address some of these concerns by modifying the current use valuation test for timberland so that timber would be considered part of the qualified real property in the estate for purposes of Section 2032A of the Internal Revenue Code. However, if current use valuation is elected for timberland, the difference between the estate tax saved in the decedent's estate under current use valuation and the estate tax based upon the fair market value of the estate would be recaptured upon severance or disposition before severance of the timber.

In addition, the Senate Finance Committee provision does not address the problem in determining the value of the timberland for special use valuation. Current law under subparagraph (e)(7) permits farm property to be valued solely on the basis of the average annual gross cash rental for comparable property. This valuation method is virtually meaningless in the case of timberland. Often there is no comparable property for which cash rental figures can be obtained. In addition, comparable property is usually not rented for "cash." Finally, the formula in (e)(7) does not work well because timberland does not produce a recurring annual crop. Consequently, timberland property will still have to be valued for special use purposes under the highly subjective five factor method now used in (e)(8).

Current law and the Senate Finance Committee proposal are particularly troublesome given the fact that our country faces a significant shortage of timber in the decades to come. The Forest Service projects that domestic demand for paper and wood products will double in the next 50 years.

If our tax policies create a reduction in timber production, severe shortages may result. Historically, shortages exerted pressure on the price of wood products and the derivatives of those products. The effects would be felt throughout the entire economy.

Over 5,000 consumer products are derived from our forests--commodities which are essential to education, communication, sanitation and health, and many of which contribute in unique ways to the maintenance of the American standard of living.

A side benefit is that growing forests contribute significantly to the overall ecosystem. Unlike other basic resources, forests are renewable. Timber, a storehouse of solar energy, is most compatible with man's use in his present environment because of its strength, its versatility, its ease of production, and its biodegradability.

The greatest potential for increased production comes from the 283 million acres owned by 5 million private landowners. In general, these lands are not intensively managed for timber production, and produce wood at only about 63 percent of their potential.

In contrast, public lands are under constant pressure for uses other than commercial forestland. Harvest levels are nearly static and funds perennially have not been provided for adequate forest management. The industry lands comprise only 14 percent of the total and are producing at close to their full potential. It is, therefore, less feasible to achieve significant improvements in timber production from industrial or public lands than from nonindustrial private lands. However, if private timberland owners are further discouraged from continuing to manage and harvest timber, we will most likely be forced to attempt to meet our timber needs by harvesting more timber from our public lands.

The current estate tax law and the Senate Finance Committee proposal interferes with our attainment of an adequate supply of wood and fiber for the future.

In recent years, independent producers have drilled approximately 90 percent of all domestic wildcat wells, found 75 percent of the new fields, and discovered 54 percent of all new oil and gas. It has been demonstrated that independent producers reinvest 105 percent of their gross revenues in their production budgets. Because of their efforts to reinvest in new production, we see today a new level of domestic drilling. However, the figures plainly show that we will still need to double or triple our current drilling efforts if we are to substantially decrease our dependence on foreign crude. America's thirst for foreign crude drained our economy of about $80 billion last year. The amendment would have cut that deficit by over $2 billion in 1985.

Now, more than ever, independents need the extra incentives that my amendment will provide them. The cost of drilling an average well has increased over 350 percent since 1970. It is currently costing approximately $10 million to drill a 20,000 foot well in Oklahoma. At the same time, the cost of crude oil is leveling off or in some cases decreasing. In addition, the windfall tax has created a tidal wave of complex new crude oil regulations that have swamped thousands of smaller operators. Without the battalions of accountants and lawyers employed by the major oil companies, the windfall tax has diverted substantial drilling revenues into administrative overhead expenses, further reducing their competitive ability.

We believe the public interest is best served through government policies that promote diversity in the market place and that encourage vigorous competition among producers. In the domestic petroleum industry these goals can best be achieved through policies that foster a thriving segment of independent producers. For these reasons, when the full Senate considers the tax bill, we intend to offer an amendment which will provide for a 1,000 barrel a day exemption for independents and royalty owners from the windfall profits tax act.

It would be a mistake, however, to conclude that the All-Savers Certificate provides a comprehensive or even adequate response to the dilemma facing both the housing industry and our Savings and Loan Associations. Approval of the All-Savers Certificate is a first step in the right direction, but to be effective it must be followed by other initiatives to stimulate savings and investment in America.

The need for prompt and effective action to provide relief for the housing industry and the thrift institutions that serve it could not be more apparent:

Housing starts, the most widely accepted indicator of health in the industry, are down 43 percent since 1979. Unemployment in the construction industry exceeds 16 percent, more than double the national average. Over 1 million jobs in construction and housing have been lost since 1979. The supply of mortgage money has dried up as the traditional lenders, savings and loans and mutual savings associations, have suffered staggering losses that ran to $28 billion in 1980 alone. The cost of mortgage money has soared to 16 percent, pricing all but a handful of Americans out of the housing market. At many thrift institutions the cost of capital now exceeds earnings, and reserves are rapidly being eroded. As a result, over 260 savings and loan institutions are on the troubled list, twice the 1980 level. In April of this year the thrifts suffered a $6.6 billion deposit loss.

Less obvious but equally important is the need to generate new savings in our economy. The United States has one of the lowest rates of savings in the industrialized world, and that is a key factor in our general economic difficulties as well as in the area of housing. Cost-effective incentives for savings are an essential element in any formula for economic recovery.

The Committee and the Congress now has a unique opportunity to combine a temporary stimulus for the housing industry with a significant savings incentive. We are attempting to reduce the cost of loanable funds to mortgage lenders, thereby reducing mortgage rates. Lower mortgage rates should induce additional demand for housing, new economic activity in that industry, and new jobs. Those jobs will, in turn, create new income and savings.

We are concerned, however, that the All-Savers Certificate may fail to provide cost-effective incentives for either savings or housing. Our prolonged experience with six-month money market certificates suggests that about 40 percent of the All-Savers deposits will find their way into the housing sector. If that past pattern holds true, All Savers Certificates will not generate new savings but will merely shuffle funds from one form of savings to another and will do little to help the housing industry.

We believe that a savings incentive, to be fully effective, should be carefully and specifically targeted at housing. Targeting will insure maximum new economic activity in return for the tax revenue lost through the program. It will maximize new savings and help eliminate federal deficits in future years as the housing industry picks up, generates new tax revenues, new jobs, and a reduced requirement for unemployment compensation. We also believe that we should target the All-Savers proposal to housing for a period of at least three years. The Administration has spoken out forcefully and convincingly in favor of a three-year tax reduction in order to create stability and minimize uncertainty. The same rationale, in our opinion, should apply for savings incentives targeted at housing.

The Committee took a step in the right direction when it broke new ground and approved the All-Savers concept. We supported that effort because we believe it moves our policy in the direction of incentives. However, in an area as important as incentives for savings, we believe, we must strive for maximum effectiveness and minimal cost. We therefore plan to offer modifications to the All-Savers Certificate proposal when it is considered by the Senate. Our proposals will seek to insure that the savings incentives are targeted specifically at housing and our thrift institutions. We believe that the basic concept of incentives is sound; it will work. But it will work best if we focus it specifically on the sectors of our economy most in need of such support.

By no means will our proposal be limited to thrift institutions. Any financial institution which does mortgage lending can participate. If the institution does not presently hold mortgage, it can make them or purchase them in the Secondary market. This will insure that the maximum benefits of this proposal are targeted to those institutions which have or are willing to lend to that segment of the economy most in need.

Only five of the nine tax provisions we proposed, with the support of the small business community, were adopted by the Committee. Given the size, importance, and broad scope of this tax cut--$280 billion over the next four years--We consider that the legitimate needs of American small businesses are not adequately reflected in this legislation.

Sky-high interest costs, complicated tax laws, burdensome federal rules, regulations, and paperwork, and a slack economy have stretched the financial and managerial resources of many small businesses to the breaking point.

The provisions of this legislation targeted at small business are only a modest beginning in helping this important segment of our economy cope with its problems. The provision dealing with estate tax reform, investment expensing, an increase in the permissible amount of accumulated earnings, an increase in the number of permissible Subchapter S stockholders and retirement savings provisions will all encourage small business stability, investment, and modernization. That, in turn will mean greater productivity, more jobs, and an enhanced ability to compete and prosper.

But the job is only half done ...

Second, I am concerned that a three-year tax cut, in the context of these other Administration economic policies, is a recipe for higher inflation, higher interest rates, and much larger budget deficits. A more prudent and responsible fiscal policy would reduce inflation and interest rates.

Third, I believe that the distribution of the personal tax cuts is inequitable and that more relief should have been targeted toward middle and low-income taxpayers who are most heavily burdened by rising prices and payroll tax increases.

Finally, although I believe we need much more liberalized depreciation schedules, I am not persuaded that the bill's depreciation provisions will adequately stimulate our lagging productivity or improve the competitiveness of our industries in international markets. Rather than enhance the efficiency of capital allocation, 10-5-3 as written would worsen it by widening the gaps in effective tax rates for different assets and industries that exist under present tax law. The resulting inefficiency would dampen innovation and depress productivity. I prefer a depreciation change more similar to simple expensing or the 2-4-7-10 changes that the Senate Finance Committee passed last year.

Before the Finance Committee began its consideration of this bill, I introduced an alternative to the Administration's tax proposals. This legislation was designed to provide relief from inflation induced tax increases and rising payroll taxes and to accelerate economic recovery by reforming the depreciation allowance and increasing incentives for work, saving and productive investment.

During the Finance Committee's markup, I objected to the three-year nature of the personal tax out. My objection was based on the uncertainty over what the budget, interest rates and inflation will look like in 1983 and the potential that a large tax cut has for fueling inflationary expectations and generating a serious deficit in 1983 or 1984. I offered an amendment to address this problem by making the third year of the tax cut conditional on the success of the Administration's economic recovery program. I felt it was necessary to have a safety valve for this experimental plan since no one really knows if it will work. This amendment was defeated.

I also objected in markup to the across-the-board nature of the tax cuts. I argued that they would not provide enough tax relief for middle and low-income individuals and I offered an amendment to correct that. This amendment was also rejected.

Because I am committed to stimulating risk-taking and capital formation, I wholeheartedly supported cutting the top rate on investment income from 70 percent to 50 percent. For upper income individuals, that will be a significant tax education and it will increase investment and stimulate innovation. At the same time, I am concerned that the combination of the 70 to 50 change and the across the board tax cuts provides unnecessarily generous relief to upper-income taxpayers and risks eroding the broad consensus for economic recovery that is so critical to achieving and sustaining high rates of growth. I believe, therefore, that the Finance Committee bill could needlessly polarize the society around economic issues and jeopardize our prospects for restoring the economy to robust health.

Taken together, I believe these risks are too great to take with the only economy we have and I, therefore, cannot support the Finance Committee bill.

¹ The actual marginal tax rate on earned income may exceed 50 percent, under present law, even for those individuals whose tax liability is calculated using the maximum tax. This occurs because the tax liability on unearned income is calculated by "stacking" unearned after earned income, so that each additional dollar of earned income may push a taxpayer's unearned income into higher tax brackets. Moreover, because itemized deductions are, in effect, allocated on a pro rata basis between earned income and other income, each dollar of earned income causes an additional amount of itemized deductions to be allocated to earned income. Thus, an additional dollar of earned income causes a larger portion of itemized deductions to be deducted against income that would be taxed at a 50-percent rate rather than at the higher rates applicable to other income.

² The highest income group receives a 1984 tax reduction, as a percentage of current tax liability, which is lower than average because a large portion of the income received by this group--personal service income--is already subject to a maximum tax rate of 50 percent. The lowest income group receives a higher than average reduction because its tax liability has already been reduced substantially by the earned income credit: thus, a 23-percent reduction in tax liability before credits may lead to a substantially larger percentage reduction in tax liability after credits.

² Expanded income equals adjusted gross income plus excluded capital gains and various tax preference items less investment interest to the extent of investment income.

³ Includes outlay portion of the earned income credit.

⁴ Not meaningful because this income class does not have positive tax liability.

IV. Title II.A.

¹ Under the 200-percent declining balance method, depreciation is taken at twice the straight-line rate on the capital costs that have not yet been recovered through depreciation deductions. For example, for an asset with a 5-year life, the first year's deduction is 40 percent of the cost, the second year's deduction is 24 percent (40 percent of the remaining 60 percent of cost), and so forth. Taxpayers using the 200-percent declining balance method typically switch to straight-line or SYD at some point during the asset's useful life because the entire cost of an asset is not recovered using a declining balance method.

Using the sum of the years-digits (SYD) method, changing fractions are applied each year to the original cost (or other basis) of the property reduced by estimated salvage value. The numerator of the fraction for a given year is the number of years remaining in the asset's useful life, including the year for which the deduction is being computed and the denominator, which remains constant, is the sum of the numerals representing each of the years of the asset's estimated useful life.

² This minimum tax is sometimes called the 15-percent "add-on" minimum tax (sec. 56) and is different from the alternative minimum tax, although it has the same general purposes.

³ For this purpose, the term "personal property" means property which is subject to depreciation recapture under section 1245.

⁴ A controlled group of corporations (with a 50 percent control test) is treated as one taxpayer and thus is entitled to have only $10,000 of eligible property each year to be apportioned among the members of the group as provided by regulations (sec. 179(d)(6) and (7); Treas. Reg. Sec. 1.179-2(c)). Also, a partnership is limited to $10,000 of eligible property per year, and a member of a partnership must aggregate his distributive share of the partnership's eligible property with his distributive share of eligible property from other partnerships and from his direct interest in section 179 property in applying the $10,000 (or $20,000) eligible property limitation (sec. 179(d)(8)).

A trust is not eligible to elect additional first-year depreciation (sec. 179(d)(4)). However, an estate may elect to take an additional first-year depreciation allowance on up to $10,000 of qualifying property. Thus, the maximum deduction available to an estate is $2,000. The amount of the allowance under section 179 apportioned from an estate to an heir, legatee, or devisee shall not be taken to account by such heir, legatee, or devisee in determining the dollar limitations applicable to additional first-year depreciation on his own property (sec. 179(d)(5)).

^*[sic] Rev. Proc. 75-21, 1975-1 C.B. 715; Rev. Proc. 75-28, 1975-1 C.B. 752; Rev. Proc. 76-30, 1976-2 C.B. 647.

IV. Title II.B.

¹ Under present law, the investment tax credit is generally unavailable for residential property. (sec. 48(a)(3)).

IV. Title II.C.1.

¹ If the capitalized expenses relate to depreciable property, deductions may be taken in the form of depreciation allowances spread over the property's useful life. If the capitalized expenses relate to nondepreciable property, those costs cannot be recovered until disposition or abandonment of the property.

² However, expenses of developing new methods of extracting minerals from the ground may be eligible for sec. 174 elections (Rev. Rul 74-67, 1974-1 C.B. 63). Also, certain expenses for development of a mine or other natural deposit (other than an oil or gas well) may be deductible under Code sec. 616.

³ Hereinafter, this report uses the word "research" in place of the statutory terms "research and experimental" or "research and experimentation," as the case may be.

⁴ See Rev. Rul. 74-67, supra, note 2.

⁵ While the definition of research generally is the same for purposes both of the section 174 deduction elections and the new credit, research expenditures which qualify for the section 174 deduction elections may be ineligible for the credit. For example, research wage expenditures may be eligible under section 174 if paid or incurred in connection with the taxpayer's trade or business, but enter into the credit computation only if paid or incurred in carrying on a trade or business of the taxpayer (see discussion above). Also, wage expenditures for research conducted outside the United States may qualify for section 174 deduction elections but do not qualify for the credit.

⁶ In the case of government contracts, a research expenditure is considered to be funded from the grant, contract, or subcontract to the extent that the cost is required by, or allocable to, a particular contract or is incurred pursuant to a negotiated advance agreement for the payment of such costs (sec. e.g., 32 C.F.R. 15-205.35(a) (1980), relating to the establishment of a cost ceiling for availability of "independent research and development" costs under the Defense Acquisition Regulations). However, a government contractor's independent research generally would not be considered to be funded from a grant, contract, or subcontract. Nevertheless, the costs of such company-sponsored research generally would be treated as being funded from a government contract to the extent that those costs are reimbursed by a grant, contract, or subcontract in accordance with applicable government contracting accounting rules.

⁷ In conformity with these credit carryover rules, sec. 221(b) of the bill makes technical amendments to Code sec. 55(c)(4), relating to carryover and carryback of certain credits in connection with the alternative minimum tax; sec. 381(c), relating to carryover items of the distributor or transferor corporation in certain corporate acquisitions; sec. 383, relating to special limitations on carryovers of certain credits, etc.; the table of Code sections relating to carryovers; sec. 651i(d)(4)(C), defining credit carrybacks in connection with refund claims; and sec. 6411, relating to quick refunds in respect to tentative carryback adjustments.

Also, sec. 221(c) of the bill makes technical and clerical amendments to Code sec. 6096(b), defining income tax liability for purposes of rules on payments to the Presidential Election Campaign fund, and to the table of sections relating to allowable income tax credits.

IV. Title II.C.2.

¹ In the case of donation of capital-gain property, the amount taken into account as a charitable contribution must be reduced by a portion of the appreciation if the use of the donated item by the donee charity is unrelated to the charity's exempt functions, or if the property is given to certain types of private foundations.

² The bill provides that, under Treasury regulations, property is to be treated as constructed by the taxpayer only if the cost of parts (other than parts manufactured by the taxpayer or a related person) used in construction do not exceed 50 percent of the taxpayer's basis in the property.

³ For purposes of the fourth requirement listed above, the term "substantially all" means at least 80 percent. Donated inventory-type property will qualify under this use requirement if substantially all the use by the donee is for the conduct of research, if substantially all the use by the donee is for training to conduct research, or if substantially all the use by the donee is for a combination of such research and research training. For example, a charitable contribution of an electron microscope or a computer by the manufacturer will satisfy the use requirement if substantially all the use by the donee college or university consists of training undergraduate or graduate students (either in a laboratory or in a classroom) in how to use the microscope or computer in research, consists of research experiments conducted by such students, e.g., laboratory experiments as part of an undergraduate science course, or consists of a combination of such research and research training.

IV. Title II.E.

¹ The reasonable expectation standard for this purpose is similar to the present law rules for exemption from income tax withholding (sec. 3402(n)).

IV. Title II.F.1.

¹ In the case of a sale which does not meet the holding period requirements, the amount of ordinary income, and the amount of the employer's deduction, will be limited to the difference between the amount realized on the sale and the option price.

² For purposes of the holding period requirements, the bill also provides that certain transfers by an insolvent individual of stock received pursuant to exercise of an incentive stock option are not to be treated as dispositions of such stock. The transfers covered by this rule are transfers to a trustee, receiver, or similar fiduciary, or other transfers for the benefit of the individual's creditors, in a bankruptcy case or similar insolvency proceeding.

³ For this purpose, the individual is considered to own stock owned directly or indirectly by brothers and sisters, spouse, ancestors, and lineal descendants, and stock owned directly or indirectly by a corporation, partnership, estate, or trust is considered as being owned proportionately by shareholders, partners, or beneficiaries.

⁴ For example, the transfer of shares of stock for local law purposes will not disqualify a plan where the arrangement constitutes the grant of an option for Federal tax purposes. Treas. Reg. secs. 1.83-3(a) and 1.421-7(a) contain rules relating to the definition of "option" and rules setting forth when a "transfer" of property as compensation for services occurs.

IV. Title II.F.2.

¹ See, e.g., Reporter Publishing Co., Inc., v. Comm'r, 201 F.2d 743 (10th Cir.), cert. denied, 345 U.S. 993 (2953) (no deduction allowed to newspaper for decline in value of its membership in Associated Press after exclusivity feature held to violate antitrust laws) and, Monroe W. Beatty, 46 T.C. 835 (1966) (no deduction allowed for diminution in the value of liquor license resulting from amendment of State law limiting grant of such licenses).

² See, e.g., Alsop v. Comm'r, 290 F.2d 726 (2d Cir., 1961) and Marks v. Comm'r, 390 F.2d 598 (9th Cir.), cert. denied, 393 U.S. 883 (1968) (no loss deduction for difference between actual earnings and what taxpayer's earnings would have been absent revocation of her teaching credentials).

³Consolidated Freight Lines, Inc. v. Comm'r, 37 B.T.A. 576 (1938), affd, 101 F.2d 813 (9th Cir.), cert. denied, 308 U.S. 562 (1939) and Monroe W. Beatty, supra note 1.

⁴Note 3, supra.

⁵ See H.R. Rept. No. 96-1069. 96th Cong., 2d Sess. 4. 11 (1980).

IV. Title III.B.

¹ The bill repeals the $200/$400 exclusion for 1982 and allows section 116 to revert to the $100 dividend exclusion of prior law.

² One-year certificates of deposit, offered over a 1-year period, would be in existence over a 2-year period.

³ These certificates may be certificates of deposit or certificates that represent withdrawal or repurchasable shares.

IV. Title III.C.2.

¹ Defined contribution plans are plans under which each participant's benefit is based solely on the balance in the participant's account consisting out contributions, income, gain, expenses, losses, and forfeitures allocated from the accounts of other participants (e.g., a profit-sharing plan or a money purchase pension plan).

² A defined benefit plan specifies a participant's benefit independently of an account for contributions, etc. (e.g., an annual benefit of 2 percent of average pay for each year of employee service).

³ Generally, the loan must bear a reasonable rate of interest, be adequately secured, provide a reasonable repayment schedule, and be made available on a basis which does not discriminate in favor of employees who are officers, shareholders, or highly compensated.

IV. Title IV.A.

¹ However, the amount of the estate tax would be reduced further by other credits allowed to an estate.

IV. Title IV.B.

¹ The bill combines existing sections 6166 and 6166A. See F below.

IV. Title IV.C.

¹ S. Rep. No. 72-665, 72d Cong., 1st Sess. (1932)

IV. Title IV.D.

¹ The "adjusted value" of the gross estate or of specific property is its gross value less any mortgages or other indebtedness, payment of which are secured by an interest in the property included in the gross estate (or by the specific property).

² For purposes of the 50-percent and 25-percent tests, the value of property is determined without regard to its current use value.

³ The term "qualified heir" means a member of the decedent's family, including his spouse, lineal descendants, parents, and aunts or uncles of the decedent and their descendants. The term does not include members of a spouse's family.

⁴ In the case of qualifying real property where the ownership, use, and material participation requirements are satisfied, the real property which qualifies for current use valuation includes the farmhouse, or other residential buildings, and related improvements, located on qualifying real property if such buildings are occupied on a regular basis by the owner or lessee of the real property (or by employees of the owner or lessee) for the purpose of operating or maintaining the real property or the business conducted on the property. Qualified real property also includes roads, buildings, and other structures and improvements functionally related to the qualified use.

⁵ Growing crops, including standing timber in the case of timber farms, are not treated as part of the qualified real property.

⁶ Each average annual computation must be made on the basis of the five most recent calendar years ending before the decedent's death.

⁷ This result would not be affected by the fact that the property was rented for a lesser amount than would be charged in a lease between unrelated parties.

⁸ The committee understands that the present period established by the Department of Agriculture price support program is five months.

⁹ Specially valued standing timber will be subject to the special lien securing payment of the additional estate tax (sec. 6324B) to the same extent as the land on which the timber stands.

¹⁰ Leases for purposes other than growing timber to which the comparable land is subject are to be ignored in determining the value of qualified timber property in its current use.

¹¹ The required material participation must be that of the decedent or a member of the decedent's family during periods when the decedent owned the property.

¹² Section 2032(c)(7)(B) requires that material participation occur during periods aggregating more than five years of every eight-year period ending after the date of the decedent's death and before 15 years after that date (10 years under the bill).

¹³ The meaning of active management is more fully discussed in the discussion above of changes to the material participation requirement for qualification of property for current use valuation in the estates of certain surviving spouses.

¹⁴ The lien securing payment of the additional estate tax (sec. 6324B) would have to be transferred to the qualified replacement property before the original qualified property is discharged from that lien.

¹⁵ The lien securing payment of the additional estate tax (sec. 6324B) would have to be transferred to the qualified replacement property before the original qualified property is discharged from the lien.

IV. Title V.A.

¹ Sec. 1091.

² Sec. 1091.

³ For this purpose, commodity futures are not treated as stock or securities. Rev. Rul. 71-568, 1971-2 C.B. 312.

⁴ Sec. 1221. Capital assets generally include all property held by the taxpayer other than inventory, depreciable property or real property used in a trade or business, certain taxpayer-created property, certain receivables and certain short-term government obligations.

For this purpose, commodity futures contracts may not qualify as inventory. However, they are not allowed capital gains treatment if used as an integral part of the taxpayer's business, such as farming or food processing. Corn Products Refining Co. v. Comm'r., 350 U.S. 46 (1955).

⁵ Sec. 1202.

⁶ Sec. 1211(b).

⁷ Sec. 1211(b)(1)(C).

⁸ Sec. 1212(b).

⁹ Sec. 1201.

¹⁰ Sec. 1211(a).

¹¹ Sec. 1212(a).

¹² Generally, options held for investment are governed by the same provisions of the Internal Revenue Code as are other capital assets. However, section 1233(c) exempts certain options to sell property from the short sales rules if the option was acquired on the same day as the property and the option, if exercised, is exercised through the sale of the property. Section 1234 provides that gain or loss from the sale or exchange of an option has the same character as gain or loss from the sale or exchange of the property underlying the option, if the property were in the hands of the taxpayer. Gain or loss from closing transactions in options is treated as short-term capital gain or loss.

¹³ Sec. 1222.

¹⁴ Sec. 1233(a).

¹⁵ Sec. 1233(b)(1). However, if on the date of a short sale, the taxpayer has held substantially identical property for over a year, a loss on the closing of the short sale will be treated as a long-term capital loss. Sec. 1233(d).

¹⁶ Thus, in any commodity futures contract transaction, the person holding the obligation to sell may recognize only short-term capital gain or loss from that position.

¹⁷ Sec. 1233(b).

¹⁸ Sec. 1233(d).

¹⁹ Sec. 1233(e)(2)(A).

²⁰ Sec. 1233(e)(2)(B).

²¹ Sec. 1233(g).

²² Section 1222 provides a six-month holding period for regulated commodity futures contracts. Section 465 contains rules limiting losses from an activity to amounts which certain taxpayers have "at-risk" in that activity. These rules are generally applicable to all activities, other than real estate, in taxable years beginning after 1978. It is unclear whether these rules apply to straddles.

²³ Rev. Rul. 77-185, 1977-1 C.B. 48.

²⁴ In the transaction described in the Revenue Ruling, the taxpayer on August 1, 1975, simultaneously sold silver futures contracts for July delivery and purchased an identical number of silver futures contracts for March delivery. Three days later, the March contracts were sold for a loss and an identical number of May contracts were purchased. On February 18 of the following year, the taxpayer simultaneously sold the May contracts and purchased July contracts to cover the short position. The taxpayer reported a loss from the sale of the March silver contracts in 1975 which reduced its short term gain from the sale of real estate and reported a net long-term gain in the next year from the sale of the futures contracts.

²⁵ The Internal Revenue Service litigation in the area of straddles and the other shelter transactions discussed in this report, such as the cash and carry shelters explained in section B, below, is proceeding on the basis of several theories. If successful, this litigation would result in the disallowance of some or all of the claimed tax benefits.

IV. Title V.C.

¹ Rev. Rul. 77-185, 1977-1 C.B. 48.

² In the transaction described in the Revenue Ruling, the taxpayers on August 1, 1975, simultaneously sold silver futures contracts for July delivery and purchased an identical number of silver futures contracts for March delivery. Three days later, the March contracts were sold for a loss and an identical number of May contracts were purchased. On February 18 of the following year, the taxpayer simultaneously sold the May contracts and purchased July contracts to cover the short position. The taxpayer reported a loss from the sale of the March silver contracts in 1975 which reduced its short term gain from the sale of real estate and reported a net long-term gain in the next year from the sale of the futures contracts.

³Smith v. Comm'r, Docket No. 12709-77 and Jacobsen v. Comm'r, Docket No. 185-78.

IV. Title V.D.

¹ This bill amends 172(b) to allow a 10-year carryforward of net operating losses.

IV. Title V.E.

¹ S. Rep. 673 (77th Cong.), Part I, p. 30.

² Rev. Rul. 78 414, 1978 2 C.B. 213.

³ See e.g., U.S. v. Midland Ross Corporation, 381 U.S. 54 (1965).

IV. Title V.G.

¹ See Teh v. Comm'r, 260 F.2d 489 (9th Cir., 1952) and Comm'r v. Pittston Co., 252 F.2d 344 (2d Cir., 1958), cert. denied, 357 U.S. 919 (1958).