JCT Releases Summary of Report on Tax Compliance Proposals

The lack of a withholding mechanism on non-wage payments leads to substantial underpayments of tax each year and has long been identified as contributing to the tax gap. According to the most recent IRS report on the tax gap and consistent with earlier reports, the underreporting of "non-farm proprietor net income" -- in general, compensation income of sole proprietors not subject to wage withholding -- is the single largest contributor to the tax gap. Payments made by Federal, State, and local governments represent a significant amount of those annual payments that are not subject to withholding. Imposing withholding on non-wage payments made by Federal, State, and local governments would improve taxpayer compliance, reduce the tax gap, and promote fairness.

The proposal requires withholding at a three-percent rate on payments for goods and services² made by all branches of the Federal government and its agencies and all units of State and local governments. Local governments with less than $100 million of annual expenditures are excluded from the withholding requirement. The proposal also imposes information reporting requirements on payments that are subject to withholding under the proposal but are not subject to information reporting under present law.

In general, submission of an offer indicates that the taxpayer is willing and able to make a partial payment of the taxpayer's liability. Because of the lengthy review process that the IRS undertakes prior to accepting an offer, there may be a substantial period of time before the IRS actually collects the amounts the taxpayer is willing to pay. Moreover, experience under present law has shown that in some cases taxpayers do not make offers in good faith (e.g., by concealing information from the IRS). Requiring partial payment with the submission of an offer-incompromise will preserve the offer program for those cases in which it is appropriate, and will increase fairness for those taxpayers who pay their taxes in full. Thus, the proposal requires that a taxpayer make partial payments while the taxpayer's offer is being considered by the IRS. These payments are retained and applied to the taxpayer's outstanding balance, even if the taxpayer's offer is ultimately rejected as inadequate.

The proposal provides a uniform standard for applying the economic substance doctrine to transactions having any of six characteristics present in many tax shelters.³ Under the uniform standard, for a transaction to have economic substance, a taxpayer must demonstrate that the transaction had a substantial non- tax purpose and changed the taxpayer's economic position in a meaningful way (apart from Federal tax consequences). The fact that financial accounting benefits would result from the desired tax treatment is not itself an allowable non-tax purpose. For transactions other than those with any of the six characteristics, the proposal retains present law.

The two different provisions for similar expenses create inequity in the operation of the tax laws because the same benefit is not available to all taxpayers. The differing benefits also add to complexity as taxpayers may need to determine which provision produces the best tax result for them.

Under the proposal, the dependent care tax credit is the sole means of providing a tax benefit for dependent care expenses. The proposal is designed to provide greater equity among similarly situated taxpayers and simplify the treatment of dependent care expenses.

The credit equals 25 percent of the first $10,000 of qualified expenses per student. The otherwise allowable aggregate credit per tax return is phased out by $50 for each $1,000 that adjusted gross income exceeds $70,000 ($140,000 if married filing a joint return).⁵ The credit is allowed against the alternative minimum tax.

The exclusion for qualified tuition reductions raises fairness concerns because it is available only to a limited group of taxpayers, as compared to other present-law provisions which provide tax benefits relating to education much more broadly. The exclusion also adds complexity and a source of noncompliance due to the need to make factual determinations in some cases, for example, determining if the tuition reduction is compensation for services.

The proposal repeals the exclusion for qualified tuition reductions. Under the proposal, such benefits are included in gross income and are treated as wages for employment tax purposes. Tuition reductions that are includible in income under the proposal would be eligible for the generally available benefits for education expenses, provided the requirements for such benefits are otherwise satisfied.

The present-law 15-day rule inaccurately measures economic income by excluding rental income earned by the taxpayer. The amount of the untaxed income can be significant even for fewer than 15 days' rental. A dollar limitation in conjunction with the 15-day rule would more accurately function as a de minimis threshold than a rule based exclusively on the rental period.

The proposal limits the total exclusion for the rental value of a residence rented fewer than 15 days to $2,000. Under the proposal, a taxpayer may claim the otherwise allowable deductions attributable to such rental use (e.g., depreciation) reduced in proportion to the ratio of excludable rental income to total rental income from the property.

The proposal extends to all part-gift, part-sale transfers the present law pro rata basis allocation rule applicable to bargain sales to charities. Consequently, for determining gain from any bargain sale, the proposal requires a taxpayer to allocate to the sale portion of property an amount of basis equal to that portion's pro rata share, based on respective fair market values, of the entire property's adjusted basis.

The present-law kiddie tax provisions are complex and lead to uncertainty about the tax rate that will apply to a child's unearned income. A main source of complexity is that present law requires a linkage between the child's return, the parent's return, and if applicable, the returns of the child's siblings. This linkage increases complexity in the initial filing of the child's return, and in subsequent filings or proceedings if the return of the child, the parent, or a sibling is amended or adjusted under audit. The rules are further complicated depending on whether the child's parents file jointly, separately, are married, unmarried, or remarried.

The proposal generally increases the age of children to which the kiddie tax provisions apply from under 14 to under 18. The proposal also eliminates the parental election and subjects a child's unearned income in excess of an exemption amount to the highest individual income tax rate applicable to income of that character, rather than to his or her parents' marginal rate. Thus, under the proposal, a child's income tax liability would no longer be determined by reference to parental income or filing status.

Legislative history indicates that the treatment of contributions made to tax-favored retirement plans by salary reduction as FICA wages is intended to assure that salary reduction amounts are included in the FICA base. Otherwise, individuals could, in effect, control which portion of their compensation is included in wages for Social Security purposes. This rationale applies equally to salary reduction amounts used to provide benefits under a cafeteria plan or qualified transportation fringe benefits.

The proposal provides consistent treatment of salary reduction amounts for FICA purposes. Specifically, salary reduction amounts used to provide benefits under a cafeteria plan or to provide qualified transportation fringe benefits are included in FICA wages in a manner similar to salary reduction contributions to employer- sponsored retirement plans.

The scope of the exception has been the subject of uncertainty in recent years. It appears that the student exception may be viewed by certain taxpayers as applying more broadly to include situations that are similar to full-time employment. In addition, questions (and court cases) have arisen with respect to the application of the student exception to medical residents performing services at a university hospital or other medical facility. Although regulations issued by the IRS in December 2004 help to clarify the scope of the student exception, clear statutory standards would make the exception more administrable. In addition, the original intent of the exception can be implemented more effectively through a dollar limit.

The proposal codifies the IRS regulations relating to: (1) the definition of school, college, or university; and (2) student status. In addition, the proposal amends the student exception so that it applies only to individuals whose earnings from the school, college, or university are less than the amount needed to receive a quarter of social security coverage for the year ($920 for 2005).

Under the proposal, sales incentives payments made by manufacturers or distributors to sales people employed by dealers are wages for employment tax purposes. Thus, sales incentive payments are subject to FICA taxes (and income tax withholding).

It has become increasingly common for individuals who perform services in businesses that they own to choose the S corporation form to seek to reduce their FICA taxes. These S corporation shareholders pay themselves wages below the wage cap, while treating the rest of their compensation as a distribution by the S corporation in their capacity as shareholders.

More broadly, the discontinuities in the present-law employment tax treatment of general partners, limited partners, LLC members, and S corporation shareholders cause taxpayers' choice-of-business form decisions to be motivated by a desire to avoid or reduce employment tax, rather than by non-tax considerations.

Under the proposal, all partners -- including general partners, limited partners, and LLC members taxed as partners -- are subject to self-employment tax on their distributive share (whether or not distributed) of partnership income or loss. As under present law, specified types of income or loss are excluded from net earnings from self-employment of a partner, such as certain rental income, dividends and interest, certain gains, and other items. However, under the proposal, in the case of a service partnership, all of the partner's net income from the partnership is treated as net earnings from self-employment. If, however, any partner does not materially participate in the trade or business of the partnership, a special rule provides that only the partner's reasonable compensation from the partnership is treated as net earnings from self-employment.

Under the proposal, for purposes of employment tax, an S corporation is treated as a partnership and any shareholders of the S corporation are treated as general partners. Thus, S corporation shareholders are subject to self-employment tax under the same rules described above for partners.

In the context of an employer providing an aircraft to employees for nonbusiness (e.g., vacation) flights, the exception for expenses treated as compensation was interpreted by the Tax Court in Sutherland Lumber-Southwest, Inc. v. Commissioner ("Sutherland Lumber") as not limiting the company's deduction for operation of the aircraft to the amount of compensation reportable to its employees. This can result in a deduction many times larger than the amount required to be included in income. The American Jobs Creation Act of 2004 overturned Sutherland Lumber, but only with respect to covered employees.⁶

Permitting a business to deduct entertainment benefits provided to its employees in an amount greater than the compensation reportable to such employees effectively allows taxpayers to deduct personal expenses, contrary to general income tax principles. Congress curbed this practice in the American Jobs Creation Act of 2004, but only with respect to covered employees. The same rule applicable to all individuals would prevent the outcome more broadly and would simplify the law, thereby removing a potential source of noncompliance.

Under the proposal, in the case of all individuals, the exceptions to the general entertainment expense disallowance rule for expenses treated as compensation or includible in income apply only to the extent of the amount of expenses treated as compensation or includible in income. The proposal overturns Sutherland Lumber for all individuals.

In Robinson v. United States, the U.S. Court of Appeals for the Federal Circuit rejected the IRS interpretation that "included" means actual inclusion on the service provider's tax return. The court instead interpreted "included" to mean the amount included in gross income as a matter of law (that is, the amount legally required to be included in the service provider's gross income under section 83), without regard to the amount, if any, actually included on the service provider's return or timely reported as compensation for services.

The amount of the deduction to which a service recipient is entitled as a result of a transfer of property in connection with the performance of services should be the amount actually included in the service provider's income. This link helps to avoid mismatches in the amount of income and deductions attributable to such transfers. The elimination of this link under the Robinson decision increases the potential for such mismatches, thus creating tax administration and compliance issues.

The proposal overrides the Robinson decision and reaffirms that the amount of the deduction allowed with respect to a transfer of property in connection with the performance of services is determined by reference to the amount actually included in income by the service provider under section 83. The proposal also retains the safe harbor provided in Treasury regulations for an amount that is properly reported by the service recipient.

Some taxpayers have taken the position that payments in redemption of stock allocated to participants' accounts under an ESOP and paid to a terminating or retiring participant in partial or full satisfaction of the plan's obligations to pay benefits are deductible as dividends under section 404(k). The IRS issued a ruling on this issue in 2001, and held that such payments are not applicable dividends under section 404(k). However, the Court of Appeals for the Ninth Circuit in Boise Cascade v. United States held that such payments in redemption of the stock were deductible dividends under section 404(k).

Redemption payments like those involved in Boise Cascade are not the economic equivalent of a dividend. To allow a deduction for such payments would allow an employer a deduction for a transaction which is not a dividend and therefore was not intended to qualify for deduction. Further, allowing a deduction for these types of redemption payments would circumvent the deduction limitations applicable to ESOPs and could have an adverse impact on plan participants because they would lose substantial rights, such as the ability to make a tax-free rollover.

Under the proposal, redemption payments that are not economically equivalent to a dividend are not deductible under section 404(k). This result is accomplished by providing that, for purposes of determining whether an amount is deductible as a dividend under section 404(k), each ESOP participant is treated as the direct owner of any shares allocated to his or her account.

Although many of the rules for section 401(k) and 403(b) plans have been conformed over time, special rules for section 403(b) plans still exist under present law. Present law rules for section 403(b) plans relating to the definition of includible compensation, additional elective deferrals, and nondiscrimination requirements are inequitable and create complexity in many cases. The proposal provides greater conformity of the rules for section 401(k) and section 403(b) plans by eliminating these special rules and applying the rules relating to section 401(k) plans.⁷

Present law prohibits various self-dealing transactions between certain tax-preferred retirement plans, including IRAs, and disqualified persons. The proposal is designed to restrict the ability of IRAs to be used in shelter transactions by expanding the definition of disqualified persons. Under the proposal, all IRA owners and entities established by an IRA owner are disqualified persons.

Under a special rule, in the case of a plan maintained by a State or local government, if contributions are designated as employee contributions, but the State or local governmental employer "picks up" (i.e., pays) the contributions, contributions so picked up ("pick-up contributions") are treated as employer contributions. As a result of being treated as employer contributions, pick-up contributions are not includible in employees' income at the time of contribution. In addition, pick-up contributions are generally exempt from FICA taxes unless made pursuant to a salary reduction agreement.

The pick-up rules result in inconsistent tax treatment of employee contributions to qualified retirement plans. Employee contributions made to plans maintained by private employers or by the Federal government are includible in income. However, the pickup rules allow employee contributions to State and local governmental plans to be made on a pre-tax basis. In many cases, inconsistent treatment applies also for FICA tax purposes. These inconsistencies cause inequity in the tax system.

The proposal repeals the pick-up rules. Accordingly, contributions to a State or local government plan that are designated as employee contributions under the plan are treated as employee contributions for Federal tax purposes. Thus, such contributions are includible in income and are wages for FICA purposes.

Generally, among other requirements, a quarterly common stock dividend is an "extraordinary dividend" if it exceeds 10 percent of the taxpayer's adjusted basis for the stock (or, if greater, fair market value of the stock that can be proven to the satisfaction of the Treasury). The threshold for preferred stock dividends is five percent.

The proposal reduces the threshold for common stock extraordinary dividends from 10 percent to five percent of the taxpayer's adjusted basis (or, if greater, fair market value of the stock that can be proven to the satisfaction of the Treasury). The proposal addresses the fact that some very large dividends can still result in dividend stripping transactions under present law.

This basis reduction rule does not apply if a dividend payment is partly or entirely exempt from U.S. taxation for reasons other than the dividends received deduction. Consequently, in certain redemptions that are treated as dividends but are not subject to full U.S. taxation, tax basis is preserved and may under present law be shifted to a shareholder whose stock is not redeemed. This shifting of basis may be from a tax-indifferent shareholder -- a foreign person or tax-exempt organization -- to a taxable shareholder. If the shift is to a taxable shareholder, that shareholder can use the additional basis to generate a tax loss on a subsequent disposition of the stock to which the basis has been shifted. Thus, the combination of failing to reduce basis by the nontaxed portion of an extraordinary dividend and the shifting of tax basis to a taxable person creates a taxable loss without corresponding taxable income. This result is contrary to the outcome intended by the extraordinary dividend rules.

The proposal extends the basis reduction rule described above to transactions in which extraordinary dividends (including certain redemptions treated as extraordinary dividends) are received by shareholders not subject to full, current U.S. taxation.

The proposal confines section 355 more closely to this purpose by limiting its use in the case of transactions that give shareholders an interest in a separate corporation that has more than 50 percent cash or other assets that are not qualifying 5-year active business assets, and by requiring a higher standard of continuing participating equity ownership by the same shareholders.

Under the proposal, a tax-exempt entity (other than a qualified employee stock ownership plan) is a permissible shareholder of an S corporation only if it is subject to tax on its share of S corporation income.

The proposal modifies the present-law safe harbor requirement that allocations must be reasonably consistent with the allocation of some other significant item. Under the proposal, the 18 allocation of nonrecourse deductions must bear some relationship to the partners' overall economic arrangement rather than merely to one specific partnership item.⁸

In addition to the safe harbor modification, the proposal provides that nonrecourse liabilities of the partnership are excluded from a partner's outside basis. As a result, a partner's outside basis is increased only by contributions of money or property, distributive shares of income, gain, and tax-exempt income, and a portion of any recourse liability of the partnership.

The statutory distinction between guaranteed payments and nonpartner payments has little continuing purpose. Eliminating the distinction would conform the income and deduction timing rules applicable to all payments to partners that are not based on partnership net income to the more generally applicable timing rules applicable to other taxpayers, would eliminate opportunities for manipulation of the tax rules, and would provide simplification benefits.

Under the proposal, all compensation for services or use of capital that is not based on the net income (or an item of net income) of the partnership is treated as arising from a transaction between a partnership and a nonpartner. The income and deduction timing rule for guaranteed payments is repealed and such payments are subject to the income and deduction timing rules for nonpartner payments.

The proposal establishes an objective cap to determine "reasonable housing expenses." The Department of Housing and Urban Development ("HUD") considers maximum affordable housing to be 30 percent of an individual's annual income. The proposal also ties the employer-provided housing exclusion to the foreign earned income cap ($80,000) to bring the two exclusions into conformity. With these two modifications, the objective cap on employerprovided housing is set at 30 percent of $80,000.

Present law may also allow individuals working abroad to benefit from being subject to low income tax rates on their non-excludible income. The taxable income of section 911 beneficiaries is subject to rates that ordinarily are applicable to taxpayers with substantially less economic income.

The proposal imposes a stacking rule that requires individuals with section 911 benefits to stack their taxable income after their section 911 exclusion amounts, thereby subjecting such individuals to the same rates applicable to individuals living and working in the United States earning the same amount of economic income.

For publicly traded foreign-incorporated entities, the proposal adds new rules that look to a corporation's primary place of management and control. A corporation's primary place of management and control is where the executive officers and senior management of the corporation exercise day-to-day responsibility for the strategic, financial and operational policy decision making for the company (including direct and indirect subsidiaries). If a company is incorporated in the United States, it is still considered a domestic corporation and does not have to look any further to determine its residence.

The proposal strikes a balance between the goal of simplification and the policies reflected in the substantive provisions of the Code by generally retaining the elective approach of the current entity classification regulations, but providing that single-member business entities organized under foreign law must be treated as corporations for Federal tax purposes. This approach will not prevent every arrangement that might be thought to be abusive, as not all abuses require the use of a separate disregarded entity, but the approach will render it considerably more difficult in many cases for taxpayers to use the entity classification rules to frustrate the intent of the international tax provisions of the Code. A wide range of potentially abusive transactions that are currently disregarded for purposes of the substantive rules of the Code would be "regarded" under the proposal, thereby providing a greater opportunity to apply and adjust those rules in an appropriate manner, whether that be to allow or to disallow a particular tax result.

At the same time, basing the system on repatriation renders the payment of U.S. tax on foreign-source business income substantially elective in many cases, because repatriation itself is elective. By maintaining deferral indefinitely, a taxpayer may achieve a result that is economically equivalent to 100-percent exemption of income, with no corresponding disallowance of expenses allocable to the exempt income, provided that the taxpayer does not repatriate the earnings or run afoul of subpart F or other anti-deferral rules. In addition, taxpayers that repatriate high-tax earnings may be able to use excess foreign tax credits arising from these repatriations to offset the U.S. tax on lower-tax items of foreign-source income, such as royalties received for the use of intangible property in a low-tax country. For these reasons, in many cases, the present-law "worldwide" system actually may yield results that are more favorable to the taxpayer than the results available in similar circumstances under the "territorial" exemption systems used by many U.S. trading partners. These systems generally fully tax foreign-source royalties and portfolio-type income, and often exempt less than 100 percent of a dividend received from a subsidiary, as a proxy for disallowing expenses allocable to the exempt income. At the same time, however, the potential for taxation under the U.S. system by reason of either repatriation or application of the highly complex U.S. anti-deferral rules arguably forces U.S.-based multinationals to contend with a greater degree of complexity, and to engage in a greater degree of tax-distorted business planning, than many of their foreignbased counterparts resident in countries with exemption systems. The proposal would replace the current worldwide, deferral-based system with a dividend exemption system to mitigate many of these remaining problems, while generally moving the system further in the direction charted by the Congress in 2004.

Unlike the pro rata rule, the tracing rule requires an inquiry into a taxpayer's intent in borrowing. A taxpayer's deduction for the interest expense of borrowing is subject to the tracing rule only if the taxpayer intends to use the proceeds of the borrowing to buy or hold tax-exempt obligations. Because intent is difficult to determine, and because a firm's funds are fungible, the tracing rule has proven difficult to administer and easy to avoid. In particular, related corporations have avoided the tracing rule by engaging in borrowing through one corporation and the holding of exempt obligations by another corporation. Moreover, the two-percent safe harbor permits a certain amount of tax arbitrage.

The proposal extends to all corporations (other than insurance companies) the pro rata rule applicable to financial institutions under present law. Accordingly, the proposal generally repeals the tracing rule, and it repeals the two-percent safe harbor. Moreover, to restrict taxpayers' ability to avoid interest disallowance through the use of related parties, the proposal treats all members of the same affiliated group as one taxpayer and treats any interest in a partnership held by a taxpayer as that taxpayer's direct ownership interest in its allocable share of partnership assets and liabilities.

Under the proposal, if multiple section 197 intangibles are sold (or otherwise disposed of) in a single transaction or series of transactions, the seller must calculate recapture as if all of the section 197 intangibles were a single asset. Thus, any gain on the sale (or other disposition) of the intangibles is recaptured as ordinary income to the extent of ordinary depreciation deductions previously claimed on any of the section 197 intangibles. The proposal applies regardless of whether the intangibles were acquired as part of the same acquisition. If the sale transaction includes an intangible asset whose adjusted basis exceeds its fair market value, such intangible is not subject to recapture and is excluded from this aggregate calculation. The loss on such intangible continues to be permitted to the extent it is permitted under present law.

Taxpayers should not be permitted to deduct costs prior to the time such costs are paid or incurred, under principles that are generally applicable in determining the timing of deductions. Under the proposal, depreciation deductions under the income forecast method would be disallowed to the extent that they would cause the adjusted basis for purposes of determining gain or loss on sale to become negative. Any disallowed deductions will effectively be carried over by operation of the income forecast formula in subsequent years.

When the luxury automobile limits were enacted, new car sales included far fewer trucks and vans than today, and those vehicles were more likely to be used in the operation of a business. Now, nearly half of all new vehicle sales are not automobiles, and many more of the larger vehicles are purchased as personal-use vehicles than they were previously. For these reasons, it is no longer appropriate to assume that the purchase of these larger vehicles is a likely indicator of 100 percent business use. Thus, an extension of the luxury automobile limits to these larger vehicles is appropriate.

Under the proposal, all vehicles subject to either the present- law luxury automobile depreciation limitation or to the present-law section 179 expensing limitation for certain sport utility vehicles are made subject to the luxury automobile limitation.

The 15-percent proration rule applicable to untaxed income of property and casualty insurance companies does not effectively limit the companies' ability to engage in tax arbitrage. Applying a rule similar to the rule for other types of financial intermediaries would improve neutrality of the tax law by treating more financial intermediaries similarly, and would more effectively limit tax arbitrage.

The proposal extends to property and casualty insurers the pro rata interest disallowance rule that applies to financial institutions under present law section 265(b). As under the presentlaw rules for insurers, however, the proposal applies not only with respect to tax-exempt interest, but also with respect to the untaxed portion of dividends received and insurance inside buildup. The proposal does not change the tax treatment of life insurers.

The proposal requires that every five years, charitable organizations (other than churches) file with the IRS information that would enable the IRS to determine whether the organization continues to be organized and operated exclusively for exempt purposes. The proposal applies to new organizations and organizations receiving charitable status within ten years of enactment of the proposal. The filing would be done electronically, perhaps as a schedule to the current information return, and be made publicly available to encourage improved oversight of the sector by both the public and by State officials. The IRS would not be required to take action or make any determination with respect to a five-year review filing, but would have the discretion to review any filing and could revoke tax-exempt status retroactively or prospectively, as warranted by the facts and circumstances.

Part of this proposal also requires small charitable organizations that are exempt from the information return filing requirements to file with the IRS a short form each year to enable the IRS to maintain a record of the continuing existence of such organizations and provide the public with the ability to obtain basic information about the organization.

In order to provide the Federal government with a means to enforce the "dedication to charity" requirement, the proposal imposes a termination tax on liquidations or conversions of a public charity. The tax would also apply to private foundation terminations, and differs from the present law termination tax principally in that the tax would be based on the net asset value of the charity and not on the aggregate tax benefit. The tax could not be recovered against assets held by the charity for charitable purposes. The proposal also would impose the present-law excess benefit transaction rules to conversions of a public charity if, after the conversion, insiders of the public charity are also insiders of the newly converted entity. This is intended to ensure that when insiders are involved in the acquisition of a charitable organization, the acquisition is subject to the present law rules that tax abusive insider transactions.

The proposal imposes an excise tax on the participation by any exempt organization (not just charitable organizations) in a transaction that the Treasury Department determines is a listed transaction, or a reportable transaction that is a confidential transaction or one with contractual protection. Under the proposal, if an exempt organization participates in such a transaction, knowing or with reason to know that the transaction is "prohibited," the entity is subject to a tax of 100 percent of the entity's net income attributable to the transaction. If the exempt entity is eligible to receive deductible contributions, the Treasury Department may suspend eligibility for one year. The entity-level tax does not apply to certain pension plans and similar tax-favored accounts. An excise tax would also apply to the entity managers that approved the entity's participation in the transaction.

The proposal also addresses the case in which an exempt organization participates in a transaction that is later determined by the Treasury Department to be a prohibited tax shelter transaction. Because the exempt entity did not know at the time it entered into the transaction that it would later be prohibited, taxing all of the entity's net income attributable to the transaction may not be appropriate. However, the proposal would impose an excise tax at the UBIT rate on the exempt organization's net income from the transaction after it has learned that the transaction is prohibited. There also are obligations to disclose involvement in such transactions.

The proposal eliminates the rebuttable presumption of reasonableness contained in the intermediate sanctions regulations. The rebuttable presumption of reasonableness was intended to be an incentive for organizations to adopt procedures that, if followed, will protect against the occurrence of an excess benefit transaction. However, there appear to be no reasons to depart from normal tax rules by providing special treatment for organization managers and disqualified persons. Further, the rebuttable presumption of reasonableness may undermine the effectiveness of the intermediate sanctions regime by emphasizing process instead of substance, with the result that organization managers and insiders can use the process to reach a desired result with impunity. Under the proposal, the procedures that presently provide an organization with a presumption of reasonableness (i.e., advance approval by an authorized body, reliance upon data as to comparability, and adequate and concurrent documentation) generally will establish instead that an organization has performed the minimum standards of due diligence with respect to an arrangement or transfer involving a disqualified person. The proposal extends such minimum standards to transactions between private foundations and disqualified persons for purposes of the private foundation self-dealing rules, and imposes a tax on the organization (whether public charity, private foundation, or social welfare organization) unless it establishes that it operated consistent with the minimum standards of due diligence with respect to the transaction.

The proposal eliminates the special rule that provides that an organization manager's or foundation manager's participation ordinarily is not "knowing" for purposes of the intermediate sanctions and self-dealing excise taxes if the manager relied on professional advice. Instead of providing a special rule, reliance on professional advice that a transaction is not an excess benefit transaction generally would be a favorable factor showing that the organization manager did not know the transaction provided an excess benefit. The proposal also provides that an initial contract between an organization and a person who was not a disqualified person immediately prior to entering into the initial contract is subject to the intermediate sanctions rules if such person would become a disqualified person upon (a) entering into the contract, or (b) under the terms of the initial contract, at any time within two years of the time the contract is entered into. Allowing initial contracts to escape the scrutiny of the intermediate sanction provisions permits an organization to provide a substantial excess benefit to a third party without any real threat of a sanction to a party to the transaction or to the organization managers.

In general, the proposal doubles the amount of initial excise taxes with respect to certain activities by private foundations (self-dealing, failure to distribute income, excess business holdings, jeopardizing investments, and taxable expenditures), doubles the dollar limitation that applies to the tax on foundation managers with respect to certain of these actions, and doubles the dollar limitation on the organization managers tax for excess benefit transactions between public charities or social welfare organizations and organization insiders.

Because these valuation difficulties present the greatest challenge in the case of conservation easements placed on property used by the taxpayer as a personal residence, the proposal denies a deduction for such contributions. For gifts of easements placed on other historic structures, the proposal permits a deduction equal to the lesser of 5 percent of the fair market value of the structure or 33 percent of the value of the easement. For all other gifts of conservation easements or other similar partial interests, the deduction would be limited to 33 percent of the value of the easement or interest. Moreover, the gift must be pursuant to some clearly articulated Federal, State, or local government policy in favor of the conservation objective. The proposal also imposes heightened appraisal standards and requirements in the case of these contributions.

In general, for contributions of appreciated property (not including publicly traded securities, certain other property, and property that has depreciated in value, such as clothing and household items), the proposal requires that the charitable deduction be equal to the taxpayer's basis in the property. This is the present-law rule for contributions to most private foundations as well as contributions of certain property to public charities. In most cases, basis is a more certain amount than fair market value and subject to easier proof by the taxpayer and verification by the IRS. Thus, this option could be expected to improve compliance, reduce burdens and disputes, and lessen the amount of IRS enforcement effort. It would also eliminate the greater tax preference under current law provided to these types of property gifts than to contributions of cash. As an alternative, the proposal suggests that a basis deduction might apply only to taxpayers contributing property unrelated to the charity's exempt function. Under this alternative, for example, a taxpayer could still deduct the fair market value of an appreciated gemstone given to a natural history museum, but could deduct only the basis of appreciated closely held company stock or real estate contributed to the museum.

The proposal extends the present-law public inspection and disclosure requirements and penalties applicable to the information return to an organization's unrelated business income tax return. The proposal provides that certain information may be withheld by the organization from public disclosure and inspection if public availability would adversely affect the organization. In addition, the proposal requires that organizations that normally have annual total gross revenues or gross assets of at least $10 million must include with its information and unrelated business income return filings a certification by an independent auditor or by independent counsel that the organization's filings accurately reflect the unrelated business income tax liability of the organization for the taxable year. The certifying auditor or counsel must also attest to whether it has knowledge regarding whether the organization has participated in or derived income from certain tax shelter transactions.

Under the proposal, a fraternal beneficiary society, order, or association is exempt from tax as an organization described in section 501(c)(8) only if no substantial part of its activities consists of providing commercial-type insurance. For this purpose, no substantial part has the same meaning as under the present-law rule, and commercial-type insurance generally is any insurance of a type provided by insurance companies (including annuities). An organization that is treated as not exempt from tax under the proposal is subject to tax as if it were an insurance company, including with respect to its fraternal and other activities. In the case of an organization that is exempt from tax under the proposal, the activity of providing commercialtype insurance is treated as an unrelated trade or business, but is taxed under the rules relating to insurance companies with respect to such activity, rather than under the unrelated business income tax rules generally applicable to exempt organizations.

Under the proposal, a nonprofit credit counseling agency or other nonprofit organization that provides credit counseling, debt management, and similar services, is eligible for exemption from income tax only as a charitable or educational organization under section 501(c)(3), or as a social welfare organization under section 501(c)(4), and only if certain requirements are satisfied. In general, such requirements relate to an organization's primary activities, loan practices, fee arrangements, level and type of debt management plan activity, board of directors, referral policies, affiliations, and the solicitation of voluntary contributions.

A number of pooled financing bonds have been issued recently under which few or no loans were made to conduit borrowers from bond proceeds. A common feature of these transactions is the use of non- binding demand surveys that fail to adequately identify potential borrowers or evaluate current financing needs. Many of these transactions involve large issuances by small local governments that receive a fee to act as the issuer of the pooled financing. These transactions result in greater issuance of tax-exempt bonds than necessary to finance current governmental activities, diminishing the utility and value of the tax subsidy.

The proposal imposes new requirements on pooled financing bonds as a condition of taxexemption. First, the proposal imposes a written loan commitment requirement to restrict the issuance of pooled bonds where potential borrowers have not been identified ("blind pools"). Second, in addition to the current three-year expectations requirement, the issuer must reasonably expect that at least 50 percent of the net proceeds of the pooled bond will be lent to borrowers one year after the date of issue. Third, the proposal requires the redemption of outstanding bonds with proceeds that are not loaned to borrowers within the expected loan origination periods. Finally, the proposal eliminates a special rule allowing an issuer of pooled financing bonds to disregard the pooled bonds for purposes of determining whether the issuer qualifies for the small issuer exception to arbitrage rebate.

Under the proposal, issuers of tax-exempt bonds are required to file information returns identifying the amount of interest payments in a calendar year and the name, address, and TIN of the person to whom interest is paid. The recordkeeping requirement imposed on issuers as persons required to file information returns may be satisfied by contracting with a third party to maintain the necessary information at the time bonds are issued.

Despite the limitations on bonds issued by Tribal governments, there have been reports of transactions in which State or local governments issued tax-exempt bonds and loaned the proceeds to Indian tribes to finance the construction of casino-related facilities. It has been argued that bonds issued in connection with these transactions are tax-exempt because the restrictions on bonds financing the activities of tribal governments do not apply where the tribe is the borrower of bond proceeds rather than the direct issuer.

Under the proposal, section 7871, which allows Indian tribes to finance projects with tax-exempt bonds subject to certain limitations, is amended to clarify that it applies whether an Indian tribal government is a conduit borrower or an issuer of tax-exempt bonds. The proposal has no impact on the ability of Indian tribes to enter into legitimate borrowing transactions with States or local governments. Rather, the proposal clarifies the intent of Congress and provides that Indian tribes must use the proceeds of tax-exempt bonds in the same manner whether they are direct issuers of such bonds or conduit borrowers.

In 1986, Congress eliminated a provision expressly allowing tax-exempt financing for sports facilities. Nevertheless, professional sports facilities continue to be financed with tax-exempt bonds despite the fact that privately owned sports teams are the primary (if not exclusive) users of such facilities. This is because present law permits the use of tax-exempt bond proceeds for private activities if either part of the two-part private business test is not met. In the case of bond-financed professional sports facilities, issuers have intentionally structured the tax-exempt bond issuance and related transactions to fail the private payment test. In most of these transactions, the professional sports team is not required to pay for more than a small portion of its use of the sports facility. As a result, the private payment test is not met and the bonds financing the facility are not treated as private activity bonds, despite the existence of substantial private business use.

The proposal eliminates the private payment test for professional sports facilities. Under the proposal, bonds issued to finance a professional sports facility are taxable private activity bonds if more than 10 percent of the proceeds of the issue (including use of the bond-financed property) are to be used in the trade or business of any person other than a governmental unit, regardless of the amount of private payments received with respect to such use. A professional sports facility is defined as real property or related improvements used, in whole or in part, for professional sports. Use for professional sports includes any use by a nongovernmental person for sports exhibitions, games, or training which generates monetary benefit.

The exclusion from income for State and local bonds does not apply to private activity bonds, unless the bonds are issued for certain permitted purposes ("qualified private activity bonds").¹³ The definition of a qualified private activity bond includes a qualified mortgage bond.¹⁴ Qualified mortgage bonds are issued to make mortgage loans to qualified mortgagors for the purchase, improvement, or rehabilitation of owner- occupied residences. As with most qualified private activity bonds, the aggregate volume of qualified mortgage bonds which may be issued in a State is restricted by annual volume limits ("volume cap").

Qualified governmental units can elect to exchange all or a portion of their qualified mortgage bond authority for authority to issue mortgage credit certificates ("MCCs").¹⁵ MCCs entitle homebuyers to a nonrefundable income tax credit for a specified percentage of interest paid on mortgage loans on their principal residences.

MCCs provide a more efficient and stable mechanism for delivering the tax subsidy to potential homebuyers than qualified mortgage bonds. Despite this, the program is not widely used. For example, in 2002, $4.6 billion of qualified mortgage bonds were issued, representing about 15 percent of States' private activity bond volume, compared to $356.2 million of MCCs, representing about one percent of 2002 private activity bond capacity. The efficiencies that may be achieved through increased use of MCCs warrant requiring issuers to dedicate a portion of bond authority to the issuance of MCCs. Therefore, the proposal requires State and local issuing authorities to dedicate at least one dollar of volume cap to MCCs for every four dollars allocated to qualified mortgage bonds.

A refunding bond is defined as any bond used to pay principal, interest, or redemption price on a prior bond issue (the refunded bond). The Code contains different rules for "current" as opposed to advance refunding bonds. A current refunding occurs when the refunded bond is redeemed within 90 days of issuance of the refunding bonds. Conversely, a bond is classified as an advance refunding if it is issued more than 90 days before the redemption of the refunded bond.¹⁶ Proceeds of advance refunding bonds are generally invested in an escrow account and held until a future date when the refunded bond may be redeemed.

Although there is no statutory limitation on the number of times that tax-exempt bonds may be currently refunded, the Code limits advance refundings. Generally, governmental bonds and qualified 501(c)(3) bonds may be advance refunded one time.¹⁷ Private activity bonds, other than qualified 501(c)(3) bonds, may not be advance refunded at all.¹⁸ The Code limits advance refunding bonds because they represent an inefficient subsidy from the Federal government to State and local governments and section 501(c)(3) organizations because they result in two or more issues of tax-exempt bonds outstanding simultaneously for the financing of a single activity. For example, if tax-exempt bonds are issued to finance a building and a second issue of tax-exempt bonds is issued to advance refund the first bonds, the Federal government bears a revenue loss on both issues of bonds, resulting in a double subsidy for the same building.¹⁹ Thus, the proposal eliminates advance refundings of governmental bonds and 501(c)(3) bonds.

In addition, the proliferation of wireless communications technology and the Internet, and in particular broadband access, has blurred the lines between "data" and "voice" quality service and between the functions of transmission and application. Consequently, service providers have found it increasingly difficult to determine which services are taxable communications services and which are nontaxable information services, particularly when services are "bundled."

The proposal contains three options. Under Option 1, the communications excise tax is imposed upon both local and toll voice telephone services, regardless of whether the charges are fixed or vary with distance, elapsed transmission time, both, or some other criteria. It is also clarified that the tax is intended to apply to landline and wireless (including satellite) voice communications services. No view is expressed regarding whether Voice Over IP ("VOIP") is a taxable communications service or a nontaxable information service.

Option 2 incorporates the changes to the tax under Option 1. In addition, under Option 2, a voice communications service is taxable regardless of its technical form. For example, the tax applies to voice communications services using landlines, analog and digital wireless, satellite and VOIP, or any combination.

Option 3 incorporates the changes to the tax under Options 1 and 2. In addition, under Option 3, the communications excise tax base is expanded to include all data communications services to end-users. The taxable base includes local and long distance voice services, VOIP, analog and digital cellular and satellite telephone services, cable and satellite television services (to the extent the charge is for communications), broadband and dial-up Internet access services, paging services, and other data communications services.

The proposal imposes a uniform tax based on the alcohol content contained in the product. The rate of tax is based on proof gallon. Because the rate of tax would not depend on the source of the alcohol, the section 5010 credit is eliminated. The proposal taxes all alcohol at $8.40 per proof gallon.

Although international flights may include flight segments that consist of takeoffs and landings within the United States (utilizing the same airport flight control resources as a purely domestic flight) such segments are exempt from the domestic segment tax. The proposal imposes the domestic segment tax on these flight segments.

Under the proposal, the excise tax base on sport fishing equipment is narrowed to fishing rods, poles, and reels. This should minimize the complexity, administrative burdens, and base erosion. To maintain the current level of revenue generated by the tax, the rate of tax imposed on taxable articles is adjusted to 21 percent.

The proposal would not permit allocation of the generation skipping tax exemption to a "perpetual dynasty trust," except to the extent that the trust provides for distributions to beneficiaries in the same generation as the transferor's children or grandchildren. Under the proposal, the generation-skipping tax exemption effectively would be limited to an exemption of a skip of one-generation.

The proposal restricts a taxpayer's ability to claim minority and marketability discounts in certain situations in which those discounts do not accurately reflect the value of the property interests transferred. It achieves this restriction by prescribing rules governing how property is valued for estate and gift tax purposes. One rule determines whether a minority discount is permitted by generally taking into account a transferor's entire ownership interest in property immediately before the transfer of an interest during life or at death. Another rule provides that if marketable assets such as publicly-traded stock account for at least one-third of the value of an entity, the value of an interest in that entity is determined in part by looking through the ownership interest to the marketable assets themselves. Where this rule applies, it has the effect of denying a marketability discount to the extent the entity holds marketable assets.

The proposal sets forth three options that the Congress may wish to consider for improving the tax treatment of Crummey powers. The first option is designed simply to prevent taxpayers from claiming multiple annual exclusions in connection with gifts that are intended and arranged to accrue to a single person. The other two options effectively eliminate Crummey powers altogether.

Providing an heir with fair market value information gives the heir records to improve reporting of income upon future realization of gain. Providing the IRS with the same information would better enable the IRS to challenge inappropriate attempts to underreport gain upon a subsequent realization of that gain. The proposal therefore requires that for any property acquired as a bequest from an estate which has a Federal estate tax liability, the executor is required to provide the heir and the IRS with a statement of the value of the asset reported for estate tax purposes. The value so reported is binding on the heir as his or her basis for the purpose of computing future gain or loss. The proposal does not apply to items of income in respect of a decedent or property that the executor of the decedent's estate sells.

The proposal clarifies the application of the transfer tax rules to section 529 accounts and modifies the rules applicable to such accounts so as to reduce the likelihood of inappropriate use. In general, under the proposal, a contribution to a qualified tuition account is not treated as a completed gift, and is includible in the estate of the contributor or the account owner, unless the terms governing the account satisfy certain requirements.

² Thus, the proposal does not apply, for example, to welfare and other types of public assistance payments. The proposal also does not apply to the following: payments of interest; payments for real property; payments to tax-exempt entities or foreign governments; intra-governmental payments; and payments made pursuant to a classified or confidential contract.

³ The six types of transactions to which the proposal applies are transactions: 1) in which the taxpayer holds offsetting positions which substantially reduce the risk of loss and tax benefits would result from differing tax treatment of the positions; 2) which are structured to result in a disparity between basis and fair market value which creates or increases a loss or reduces a gain; 3) which are structured to create or increase a gain in any asset any portion of which would not be recognized for Federal income tax purposes if the asset were sold at fair market value by the taxpayer (or a related person); 4) which are structured to result in income for Federal income tax purposes to a tax indifferent party for any period which is materially in excess of any economic income to such party with respect to the transaction for such period; 5) in which the taxpayer disposes of certain property which the taxpayer held at risk for a period of less than 45 days; or 6) which are structured to result in a deduction or loss which is otherwise allowable for Federal tax purposes but not for financial accounting purposes. The Treasury Department may by regulations add or subtract types of transactions from this list.

⁴ Unless otherwise noted, all section references are to the Internal Revenue Code of 1986, as amended.

⁵ The credit rate, expense limitation, and phaseout ranges were chosen to create an approximately revenue neutral proposal over the period 2006-2014 under the assumption that the baseline includes permanent extension of the above-the-line deduction and extension of provisions allowing nonrefundable personal credits against the alternative minimum tax. These assumptions were made for purposes of illustrating a possible credit and are based on the law in effect for 2005.

⁶ Covered employees are individuals who, with respect to an employer or other service recipient, are subject to the requirements of section 16(a) of the Securities and Exchange Act of 1934, or would be subject to such requirements if the employer or service recipient were an issuer of equity securities referred to in section 16(a). Such individuals generally include officers (as defined by section 16(a)), directors, and 10-percent-or-greater owners of private and publicly-held companies.

⁷ Under the proposal, the definition of compensation applicable to section 403(b) plans for purposes of the limit on annual additions is conformed to the definition of compensation applicable to defined contribution plans generally, including section 401(k) plans. The special rule permitting contributions to a section 403(b) plan for an employee for up to five years after termination of employment is eliminated. The proposal eliminates the special rule for section 403(b) plans which permits employees who have completed 15 years of service with certain employers to make additional elective deferrals. The proposal applies the actual deferral percentage test to elective deferrals under section 403(b) plans. As under present law, State and local government employers are not subject to the actual deferral percentage test under the proposal.

⁸ Specifically, under the new safe harbor, if the aggregate capital account balances and recourse liabilities of the partnership constitute at least 20 percent of the total capitalization of the partnership at the time the nonrecourse liability arises (using book values), then the partners may allocate nonrecourse deductions in accordance with the relative capital account balances of the partners. Alternatively, if there is a reasonable expectation of significant residual (or catchall) profits, then the partners may allocate the nonrecourse deductions in accordance with the residual profit sharing arrangement of the partners. In addition, any allocation arrangement which falls between relative capital account percentages and residual profit sharing percentages is acceptable if the required minimum capitalization and residual profit sharing expectation are both met.

⁹ Treas. Reg. sec. 1.150-1(b).

¹⁰ Sec. 6012(d).

¹¹ Sec. 7871.

¹² Sec. 7871(c).

¹³ Secs. 103(b)(1) and 141.

¹⁴ Sec. 143(a).

¹⁵ Sec. 25(c)(2).

¹⁶ Sec. 149(d)(5).

¹⁷ Sec. 149(d)(3).

¹⁸ Sec. 149(d)(2).

¹⁹ This is unlike refinancing a home mortgage loan where the original loan is retired at the time of the refinancing.

²⁰ Domestic segments also include portions of Canada or Mexico that are not more than 225 miles from the nearest point in the continental United States.