JCT Compiles Reports on Camp Tax Reform Discussion Draft

This document compiles and republishes with minor typographical and content corrections the following 11 documents which were originally published on February 26, 2014:

• Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title I -- Tax Reform for Individuals (JCX-12-14);

• Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title II -- Alternative Minimum Tax Repeal (JCX-13-14);

• Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title III -- Business Tax Reform (JCX-14-14);

• Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title IV -- Participation Exemption System for the Taxation of Foreign Income (JCX-15-14);

• Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title V -- Tax Exempt Entities (JCX-16-14);

• Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title VI -- Tax Administration and Compliance (JCX-17-14);

• Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title VII -- Excise Taxes (JCX-18-14);

• Technical Explanation of the Tax Reform Act of 2014, a Discussion Draft of the Chairman of the House Committee on Ways and Means to Reform the Internal Revenue Code: Title VIII -- Deadwood and Technical Provisions (JCX-19-14);

• Estimated Revenue Effects of the "Tax Reform Act of 2014" (JCX-20-14);³

• Distributional Effects of the "Tax Reform Act of 2014" (JCX-21-14);⁴ and

• Macroeconomic Analysis of the "Tax Reform Act of 2014" (JCX-22-14).⁵

Page 27 corrects an error in the description of the proposal that is on page 25 of JCX-12-14, relating to the American opportunity tax credit. The original stated that the inflation adjustment was for tax years beginning in 2018. The correction states that the adjustment is for taxable years beginning after 2018.

Page 271 corrects an error in the description of the proposal that is on page 132 of JCX-14-14, relating to the modification of rules for capitalization and inclusion in inventory costs of certain expenses. The original stated that the proposal repeals the exception to section 263A for farming businesses. The correction deletes this statement.

Page 480 corrects an error in the description of present law that is in footnote 1246 on page 341 of JCX-14-14, relating to the increased section 179 expensing limitation for an enterprise zone business. The original stated that for 2012 the limit is $500,000, and for taxable years beginning after 2012, the limit is $200,000. The correction states that for 2010 - 2013 the limit is $2,000,000, and for taxable years beginning after 2013, the limit is $200,000.

Pages 529 and 530 correct two errors in the description of the proposal, on pages 38 and 39 of JCX-15-14, relating to the extension and modification of the active financing exception. The description of the proposal mistakenly states that the proposal extends the exception for taxable years beginning before January 1, 2020. In fact, the proposal extends the exception for taxable years beginning before January 1, 2019. The description of the proposal mistakenly states that for an item of income subject to an effective foreign income tax rate of at least 50 percent of the maximum U.S. corporate tax rate under section 11, the proposal limits the exclusion to 50 percent. In fact, the 50-percent exclusion is for an item of income subject to an effective foreign income tax rate of less than 50 percent of the maximum U.S. corporate tax rate under section 11.

To determine regular tax liability, an individual taxpayer generally must apply the tax rate schedules (or the tax tables) to his or her regular taxable income. The rate schedules are broken into several ranges of income, known as income brackets, and the marginal tax rate increases as a taxpayer's income increases.

Tax rate schedules

Separate rate schedules apply based on an individual's filing status. For 2014, the regular individual income tax rate schedules are as follows:

           Table 1. -- Federal Individual Income Tax Rates for 2014⁶

Special rules (generally referred to as the "kiddie tax") apply to the net unearned income of certain children.⁷ Generally, the kiddie tax applies to a child if: (1) the child has not reached the age of 19 by the close of the taxable year, or the child is a full-time student under the age of 24, and either of the child's parents is alive at such time; (2) the child's unearned income exceeds $2,000 (for 2014); and (3) the child does not file a joint return.⁸ The kiddie tax applies regardless of whether the child may be claimed as a dependent by either or both parents. For children above age 17, the kiddie tax applies only to children whose earned income does not exceed one-half of the amount of their support.

Under these rules, the net unearned income of a child (for 2014, unearned income over $2,000) is taxed at the parents' tax rates if the parents' tax rates are higher than the tax rates of the child.⁹ The remainder of a child's taxable income (i.e., earned income, plus unearned income up to $2,000 (for 2014), less the child's standard deduction) is taxed at the child's rates, regardless of whether the kiddie tax applies to the child. For these purposes, unearned income is income other than wages, salaries, professional fees, other amounts received as compensation for personal services actually rendered, and distributions from qualified disability trusts.¹⁰ In general, a child is eligible to use the preferential tax rates for qualified dividends and capital gains.¹¹

The kiddie tax is calculated by computing the "allocable parental tax." This involves adding the net unearned income of the child to the parent's income and then applying the parent's tax rate. A child's "net unearned income" is the child's unearned income less the sum of (1) the minimum standard deduction allowed to dependents ($1,000 for 2014¹²), and (2) the greater of (a) such minimum standard deduction amount or (b) the amount of allowable itemized deductions that are directly connected with the production of the unearned income.¹³

The allocable parental tax equals the hypothetical increase in tax to the parent that results from adding the child's net unearned income to the parent's taxable income.¹⁴ If the child has net capital gains or qualified dividends, these items are allocated to the parent's hypothetical taxable income according to the ratio of net unearned income to the child's total unearned income. If a parent has more than one child subject to the kiddie tax, the net unearned income of all children is combined, and a single kiddie tax is calculated. Each child is then allocated a proportionate share of the hypothetical increase, based upon the child's net unearned income relative to the aggregate net unearned income of all of the parent's children subject to the tax.

Generally, a child must file a separate return to report his or her income.¹⁵ In such case, items on the parents' return are not affected by the child's income, and the total tax due from the child is the greater of:

Indexing tax provisions for inflation

Under present law, many parameters of the tax system are adjusted for inflation to protect taxpayers from the effects of rising prices. Most of the adjustments are based on annual changes in the level of the Consumer Price Index for all Urban Consumers ("CPI-U") .¹⁸ The CPI-U is an index that measures prices paid by typical urban consumers on a broad range of products, and is developed and published by the Department of Labor.

Among the inflation-indexed tax parameters are the following individual income tax amounts: (1) the regular income tax brackets; (2) the basic standard deduction; (3) the additional standard deduction for aged and blind; (4) the personal exemption amount; (5) the thresholds for the overall limitation on itemized deductions and the personal exemption phase-out; (6) the phase-in and phase-out thresholds of the earned income credit; (7) IRA contribution limits and deductible amounts; and (8) the saver's credit.

The benefit of the 10-percent rate, as measured against the 25-percent rate on taxable income, is phased out if an individual's modified AGI exceeds a threshold of $300,000 for joint filers and surviving spouses ($250,000 for any other individual other than trusts and estates). For taxpayers whose modified AGI exceeds these thresholds, the benefit amounts to $10,680 for joint filers and $5,340 for all other filers. The benefit amount is phased out at a five-percent rate, and is thus fully phased out at modified AGI of $513,600 (in the case of joint filers) or $356,800 (in the case of other individual taxpayers) above the threshold amount.

The bracket thresholds, and the threshold at which the benefit of the 10-percent rate begins to be phased out, are all adjusted for inflation using a base year of 2013, and then rounded to the next lowest multiple of $100 in future years. Unlike present law (which uses a measure of the consumer price index for all-urban consumers), the new inflation adjustment uses the chained consumer price index for all-urban consumers.

For purposes of the 35-percent bracket and the phaseout of the benefit of the 10-percent bracket, modified AGI is defined as AGI increased by:

Domestic manufacturing gross receipts generally are gross receipts of a taxpayer that are derived from: (1) any lease, rental, license, sale, exchange, or other disposition of tangible personal property that was manufactured, produced, grown, or extracted by the taxpayer in whole or in significant part within the United States;²² or (2) in the case of a taxpayer engaged in the active conduct of a construction trade or business, construction of real property performed in the United States by a taxpayer in the ordinary course of such trade or business if such real property is placed in service after December 31, 2014.

Under the proposal, tangible personal property does not include computer software²³ or any motion picture films, video tapes, or sound recordings.²⁴

However, domestic manufacturing gross receipts do not include any gross receipts of the taxpayer derived from property that is leased, licensed, or rented by the taxpayer for use by any related person. Further, domestic manufacturing gross receipts do not include any gross receipts of the taxpayer that are derived from the sale of food or beverages prepared by the taxpayer at a retail establishment; that are derived from the transmission or distribution of electricity, natural gas, or potable water; and that are derived from the lease, rental, license, sale, exchange, or other disposition of land. Domestic manufacturing gross receipts also do not include any gross receipts which are properly allocable to the taxpayer's net earnings from self employment,²⁵ or any amount attributable to a qualified change in method of accounting²⁶ and/or any other change in method of accounting required by the discussion draft.²⁷

A special rule for government contracts provides that property that is manufactured or produced by the taxpayer pursuant to a contract with the Federal Government is considered to be domestic manufacturing gross receipts even if title or risk of loss is transferred to the Federal Government before the manufacture or production of such property is complete to the extent required by the Federal Acquisition Regulation.

With respect to the domestic manufacturing income of a partnership or S corporation, each partner or shareholder generally will take into account such person's allocable share of the components of the calculation (including domestic manufacturing gross receipts; the cost of goods sold allocable to such receipts; and other expenses, losses, or deductions properly allocable to such receipts) from the partnership or S corporation. For a trust or estate, the components of the calculation are apportioned between (and among) the beneficiaries and the fiduciary under regulations prescribed by the Secretary. However, in the case of a publicly traded partnership described in section 7704(c), each partner shall not take into account any allocable share of the aforementioned components of the calculation.

A phase-in is provided for taxable years beginning before January 1, 2017: for any taxable year beginning in 2015, only 33 percent of a taxpayer's qualified domestic manufacturing income reduces AGI; and for any taxable year beginning in 2016, only 67 percent of a taxpayer's qualified domestic manufacturing income reduces AGI.

Simplification of tax on unearned income of children

The proposal simplifies the "kiddie tax" by effectively applying the rates applicable to trusts to the net unearned income of a child to whom the proposal applies. Specifically, the amount of taxable income taxed at a 10-percent rate may not exceed the amount of taxable income in excess of the net unearned income of the child. The amount of taxable income taxed at rates below 35 percent may not exceed sum of (1) the taxable income in excess of the net unearned income of the child plus (2) the amount of taxable income not in excess of the 35-percent bracket threshold in the case of a trust.

The following examples illustrate the application of the proposal:

Example 1. -- Assume a child to whom the "kiddie tax" applies has $60,000 taxable income (and modified AGI) of which $50,000 is net unearned income. Assume the 25-percent bracket threshold amount for the taxable year is $35,600 for an unmarried taxpayer (other than a child subject to the "kiddie tax"), and the 35-percent bracket threshold for a trust is $12,000.

The child's 25-percent bracket threshold is $10,000 ($60,000 less $50,000) and 35-percent bracket threshold is $22,000 ($10,000 plus $12,000). Thus, $10,000 is taxed at a 10-percent rate, $12,000 is taxed at a 25-percent rate, and $38,000 is taxed at a 35-percent rate.

Example 2. -- Assume the same facts as in Example 1 except that the amount of the child's net unearned income is $20,000 (rather than $50,000).

The child's 25-percent bracket threshold is $35,600 and 35-percent bracket threshold is $52,000 ($40,000 ($60,000 less $20,000) plus $12,000). Thus, $35,600 is taxed at a 10-percent rate, $16,400 is taxed at a 25-percent rate, and $8,000 is taxed at a 35-percent rate.

Replacing CPI-U with chained CPI-U

The proposal requires the use of the chained CPI-U ("C-CPI-U") to index tax parameters currently indexed by the CPI-U. The C-CPI-U is developed and published by the Department of Labor, and differs from the CPI-U in that it accounts for the ability of individuals to alter their consumption patterns in response to relative price changes.

2. Deduction for capital gains and dividends of individuals (sec. 1002 of the discussion draft and sec. 169 of the Code)

In the case of an individual, estate, or trust, any adjusted net capital gain which otherwise would be taxed at the 10- or 15-percent rate is not taxed. Any adjusted net capital gain which otherwise would be taxed at rates over 15-percent and below 39.6 percent is taxed at a 15-percent rate. Any adjusted net capital gain which otherwise would be taxed at a 39.6-percent rate is taxed at a 20-percent rate.

The unrecaptured section 1250 gain is taxed at a maximum rate of 25 percent, and 28-percent rate gain is taxed at a maximum rate of 28 percent. Any amount of unrecaptured section 1250 gain or 28-percent rate gain otherwise taxed at a 10- or 15-percent rate is taxed at the otherwise applicable rate.

In addition, a tax is imposed on net investment income in the case of an individual, estate, or trust. In the case of an individual, the tax is 3.8 percent of the lesser of net investment income, which includes gains and dividends, or the excess of modified adjusted gross income over the threshold amount. The threshold amount is $250,000 in the case of a joint return or surviving spouse, $125,000 in the case of a married individual filing a separate return, and $200,000 in the case of any other individual.

Definitions

A capital asset generally means any property except (1) inventory, stock in trade, or property held primarily for sale to customers in the ordinary course of the taxpayer's trade or business, (2) depreciable or real property used in the taxpayer's trade or business, (3) specified literary or artistic property, (4) business accounts or notes receivable, (5) certain U.S. publications, (6) certain commodity derivative financial instruments, (7) hedging transactions, and (8) business supplies. In addition, the net gain from the disposition of certain property used in the taxpayer's trade or business is treated as long-term capital gain. Gain from the disposition of depreciable personal property is not treated as capital gain to the extent of all previous depreciation allowances. Gain from the disposition of depreciable real property is generally not treated as capital gain to the extent of the depreciation allowances in excess of the allowances available under the straight-line method of depreciation.

A dividend is the distribution of property made by a corporation to its shareholders out of its after-tax earnings and profits. Qualified dividends generally includes dividends received from domestic corporations and qualified foreign corporations. The term "qualified foreign corporation" includes a foreign corporation that is eligible for the benefits of a comprehensive income tax treaty with the United States which the Treasury Department determines to be satisfactory and which includes an exchange of information program. In addition, a foreign corporation is treated as a qualified foreign corporation for any dividend paid by the corporation with respect to stock that is readily tradable on an established securities market in the United States.

If a shareholder does not hold a share of stock for more than 60 days during the 121-day period beginning 60 days before the ex-dividend date (as measured under section 246(c)), dividends received on the stock are not eligible for the reduced rates. Also, the reduced rates are not available for dividends to the extent that the taxpayer is obligated to make related payments with respect to positions in substantially similar or related property.

Dividends received from a corporation that is a passive foreign investment company (as defined in section 1297) in either the taxable year of the distribution, or the preceding taxable year, are not qualified dividends.

A dividend is treated as investment income for purposes of determining the amount of deductible investment interest only if the taxpayer elects to treat the dividend as not eligible for the reduced rates.

The amount of dividends qualifying for reduced rates that may be paid by a regulated investment company ("RIC") for any taxable year in which the qualified dividend income received by the RIC is less than 95 percent of its gross income (as specially computed) may not exceed the sum of (1) the qualified dividend income of the RIC for the taxable year and (2) the amount of earnings and profits accumulated in a non-RIC taxable year that were distributed by the RIC during the taxable year.

The amount of qualified dividend income that may be paid by a real estate investment trust ("REIT") for any taxable year may not exceed the sum of (1) the qualified dividend income of the REIT for the taxable year, (2) an amount equal to the excess of the income subject to the taxes imposed by section 857(b)(1) and the regulations prescribed under section 337(d) for the preceding taxable year over the amount of these taxes for the preceding taxable year, and (3) the amount of earnings and profits accumulated in a non-REIT taxable year that were distributed by the REIT during the taxable year.

Dividends received from an organization that was exempt from tax under section 501 or was a tax-exempt farmers' cooperative in either the taxable year of the distribution or the preceding taxable year; dividends received from a mutual savings bank that received a deduction under section 591; or deductible dividends paid on employer securities are not qualified dividend income.

Adjusted net capital gain means net capital gain reduced (but not below zero) by the net collectibles gain and increased by the qualified dividend income.

The 3.8 percent tax on net investment income is not affected by the proposal.

In lieu of taking the applicable standard deduction, an individual may elect to itemize deductions. The deductions that may be itemized include State and local income taxes (or, in lieu of income, sales taxes), real property and certain personal property taxes, home mortgage interest, charitable contributions, certain investment interest, medical expenses (in excess of 10 percent of AGI (7.5 percent for certain taxpayers over age 65)), casualty and theft losses (in excess of $100 per loss and in excess of 10 percent of AGI), and certain miscellaneous expenses (in excess of two percent of AGI).

The proposal also provides that the amount of the standard deduction is phased out by 20 percent of every dollar that a taxpayer's modified AGI exceeds $513,600³⁰ for joint filers ($356,800 for all other filers).³¹ Thus, using the nominal values, the standard deduction will be completely phased out when a taxpayer's modified AGI reaches $623,600 in the case of a joint return (and $411,800 in any other case). The threshold amount at which the phaseout begins is indexed for inflation.³²

To provide parity with those who itemize their deductions, the proposal also provides for a phaseout of $22,000 of itemized deductions, in the case of joint filers ($11,000 for all other filers) over the same modified AGI range. Thus, if a joint filer had $40,000 in itemized deductions, this amount would be reduced to $18,000 (i.e., the $22,000 value of the standard deduction would be phased out) as the taxpayer's modified AGI went from $513,600 to $623,600.

The proposal eliminates the additional standard deduction for the aged and the blind.

The proposal provides for an additional above-the-line deduction for unmarried individuals with at least one qualifying child. These individuals are entitled to an additional deduction of $5,500 (indexed for inflation).³³ This additional deduction is phased out for every dollar by which a taxpayer's AGI exceeds $30,000 (this threshold is adjusted for inflation).

2. Increase and expansion of child tax credit (sec. 1102 of the discussion draft and sec. 24 of the Code)

The aggregate amount of child credits that may be claimed is phased out for individuals with income over certain threshold amounts. Specifically, the otherwise allowable child tax credit is reduced by $50 for each $1,000 (or fraction thereof) of modified adjusted gross income ("AGI") over $75,000 for single individuals or heads of households, $110,000 for married individuals filing joint returns, and $55,000 for married individuals filing separate returns. For purposes of this limitation, modified AGI includes certain otherwise excludable income earned by U.S. citizens or residents living abroad or in certain U.S. territories.

The credit is allowable against both the regular tax and the alternative minimum tax ("AMT"). To the extent the child credit exceeds the taxpayer's tax liability, the taxpayer is eligible for a refundable credit³⁴ (the "additional child tax credit") equal to 15 percent of earned income in excess of a threshold dollar amount (the "earned income" formula). Prior to the enactment of the American Recovery and Reinvestment Act of 2009 ("ARRA"), the threshold dollar amount was $10,000 and was indexed for inflation. Under the ARRA, the threshold amount was lowered to $3,000 (the $3,000 amount is not indexed). The $3,000 threshold is currently scheduled to expire for taxable years beginning after December 31, 2017, after which the threshold reverts to the indexed $10,000 amount ($13,600 for 2014).

Families with three or more children may determine the additional child tax credit using the "alternative formula," if this results in a larger credit than determined under the earned income formula. Under the alternative formula, the additional child tax credit equals the amount by which the taxpayer's Social Security taxes exceed the taxpayer's earned income credit ("EIC").

Earned income is defined as the sum of wages, salaries, tips, and other taxable employee compensation plus net self-employment earnings. At the taxpayer's election, combat pay may be treated as earned income for these purposes. Unlike the EIC, which also includes the preceding items in its definition of earned income, the additional child tax credit is based only on earned income to the extent it is included in computing taxable income. For example, some ministers' parsonage allowances are considered self-employment income, and thus are considered earned income for purposes of computing the EIC, but the allowances are excluded from gross income for individual income tax purposes, and thus are not considered earned income for purposes of the additional child tax credit since the income is not included in taxable income.

Any credit or refund allowed or made to an individual under this provision (including to any resident of a U.S. possession) is not taken into account as income and is not be taken into account as resources for the month of receipt and the following two months for purposes of determining eligibility of such individual or any other individual for benefits or assistance, or the amount or extent of benefits or assistance, under any Federal program or under any State or local program financed in whole or in part with Federal funds.

The credit is phased out for higher-income individuals. Specifically, a taxpayer's child tax credit is reduced at a rate of five percent of the taxpayer's modified AGI as exceeds $623,600³⁷ for joint filers ($411,800 for other filers).³⁸ These thresholds are indexed for inflation.³⁹

The child tax credit is partially refundable against the individual's income tax liability. The refundable portion is limited to the lesser of: (1) the child tax credit otherwise allowed, or (2) 25 percent of the taxpayer's earned income. Earned income is defined as a taxpayer's wages, salaries, tips and other employee compensation includible in gross income for the taxable year, plus the taxpayer's net earnings from self-employment income for the taxable year (determined with regard to the deduction allowed to the taxpayer by section 164(f)). For purposes of calculating a taxpayer's refundable child credit, for taxable years beginning prior to 2018, a taxpayer must reduce earned income by $3,000 (but not below zero). Additionally, the proposal provides that a taxpayer is not allowed the refundable child tax credit for a taxable year in which the taxpayer excludes any amount from gross income under section 911 (relating to the exclusion of foreign earned income).

The proposal requires that the taxpayer include the name and taxpayer identification number of each qualifying child and dependent on the tax return for each taxable year. In the case of a refundable child tax credit the taxpayer must include the taxpayer's Social Security number on the tax return for the taxable year (in the case of a joint return either spouse's Social Security number will suffice). The Internal Revenue Service may assess a deficiency in tax arising from the failure to include the Social Security number on the tax return as a mathematical or clerical error.

3. Modification of earned income tax credit (sec. 1103 of the discussion draft and sec. 32 of the Code)

The EIC generally equals a specified percentage of earned income up to a maximum dollar amount. The maximum amount applies over a certain income range and then diminishes to zero over a specified phaseout range. For taxpayers with earned income (or AGI, if greater) in excess of the beginning of the phaseout range, the maximum EIC amount is reduced by the phaseout rate multiplied by the amount of earned income (or AGI, if greater) in excess of the beginning of the phaseout range. For taxpayers with earned income (or AGI, if greater) in excess of the end of the phaseout range, no credit is allowed.

An individual is not eligible for the EIC if the aggregate amount of disqualified income of the taxpayer for the taxable year exceeds $3,350 (for 2014). This threshold is indexed for inflation. Disqualified income is the sum of: (1) interest (both taxable and tax exempt); (2) dividends; (3) net rent and royalty income (if greater than zero); (4) capital gains net income; and (5) net passive income that is not self-employment income (if greater than zero).

The EIC is a refundable credit, meaning that if the amount of the credit exceeds the taxpayer's Federal income tax liability, the excess is payable to the taxpayer as a direct transfer payment.

Taxpayers with no qualifying children may claim a credit if they are over age 24 and below age 65. The credit is 7.65 percent of earnings up to $6,480, resulting in a maximum credit of $496. The maximum is available for those with incomes between $6,480 and $8,110 ($13,540 if married filing jointly). At that point, the credit begins to phase out at a rate of 7.65 percent of earnings above that threshold, resulting in a $0 credit at $14,590 of earnings ($20,020 if married filing jointly).

Taxpayers with one qualifying child may claim a credit of 34 percent of their earnings up to $9,720, resulting in a maximum credit of $3,305. The maximum credit is available for those with earnings between $9,720 and $17,830 ($23,260 if married filing jointly). At that point, the credit begins to phase out at a rate of 15.98 percent of earnings above this threshold, phasing out completely at $38,511 of earnings ($43,941 if married filing jointly).

Taxpayers with two qualifying children may claim a credit of 40 percent of earnings up to $13,650, resulting in a maximum credit of $5,460. The maximum credit is available for those with earnings between $13,650 and $17,830 ($23,260 if married filing jointly). The credit begins to phase out at a rate of 21.06 percent of earnings above that threshold, and is completely phased out at $43,756 of earnings ($49,186 if married filing jointly).

A temporary provision recently extended by the American Taxpayer Relief Act of 2012 ("ATRA")⁴¹ allows taxpayers with three or more qualifying children to claim the EIC at an increased rate of 45 percent for taxable years before 2018. Thus, in 2014 taxpayers with three or more qualifying children may claim a credit of 45 percent of earnings up to $13,650, resulting in a maximum credit of $6,143. The maximum credit is available for those with earnings between $13,650 and $17,830 ($23,260 if married filing jointly). The credit begins to phase out at a rate of 21.06 percent of earnings above that threshold, and is completely phased out at $46,997 of earnings ($52,427 if married filing jointly).

A temporary provision recently extended by the ATRA increases the phase-out thresholds for married couples to an amount $5,000 (indexed for inflation from 2009)⁴² above that for other filers. The increase is $5,430 for 2014. This increase expires for taxable years beginning after December 31, 2017.

For these purposes, employment-related taxes with respect to any taxpayer for any taxable year is the sum of: (1) the employee share and the employer share of FICA tax on the taxpayer's wages received during the calendar year in which the taxable year begins; (2) any RRTA tax imposed (i.e ., on employees, employers, and employee representatives) on compensation received by the taxpayer during the calendar year in which the taxable year begins; and (3) any Self-Employment Contributions Act ("SECA") tax imposed on the self-employment income of the taxpayer for the taxable year. For these purposes, the definition of wages is the same as used for FICA tax purposes in section 3121(a) and the definition of compensation is the same as used for Railroad Retirement Tax purposes in section 3231(e). In the case of taxpayers with no qualifying children, for purposes of the credit, employment-related taxes are defined as the employee share of FICA or RRTA taxes, or, in the case of any SECA tax imposed on the taxpayer, one-half of such amount.

In the case of taxpayers with qualifying children, the credit is phased-down by the sum of: (1) 19 percent of the taxpayer's AGI over $27,000 in the case of taxpayers filing a joint return ($20,000 for all other filers); and (2) 100 percent of the taxpayer's investment income as exceeds $3,300. The definition of investment income for these purposes is unchanged from present law.⁴⁵ For taxpayers with no qualifying children, the credit is phased down by the sum of (1) 19 percent of the taxpayer's AGI over $13,000 in the case of taxpayers filing a joint return ($8,000 for all other filers), and (2) 100 percent of the taxpayer's investment income as exceeds $3,300.

For tax years beginning prior to 2018, taxpayers with qualifying children are allowed an EIC for up to 200 percent of employment-related taxes, subject to the applicable maximum credit. For tax years beginning prior to 2018, the applicable maximum credit for taxpayers with two or more children is $4,000, regardless of filing status (that is, the maximum credit is increased by $1,000 for taxpayers with two or more children who do not file a joint return), and the maximum applicable credit for taxpayers with one child is increased by $600, to $3,000.

Both the maximum amount of the credit and income thresholds for the phaseout of the credit are indexed for inflation.⁴⁶

No credit is allowed unless the taxpayer includes on the tax return for the taxable year the taxpayer's Social Security number. In the case of taxpayers filing a joint return, this identification requirement will be satisfied if the Social Security number of either spouse is included on the tax return. Additionally, a child shall not be considered a qualifying child for purposes of the credit unless the return includes the name, age and Social Security number of that child. The Secretary of the Treasury or his designee may prescribe other methods for satisfying the second identification requirement.

The proposal also requires the Secretary of the Treasury (or the Secretary's designee) to submit a report to Congress within 180 days of the date of enactment, making recommendations regarding the best method for providing for advance payment of the EIC. The recommendations in the report shall seek to 1) provide for the payment of the EIC as promptly as is feasible, and 2) minimize any administrative burdens on employers and the IRS.

4. Repeal of deduction for personal exemptions (sec. 1104 of the discussion draft and sec. 151 of the Code)

Under the residency test , a child must have the same principal place of abode as the taxpayer for more than one half of the taxable year. Special rules apply in the case of divorced or separated parents. The relationship test requires that the individual is the taxpayer's son, daughter, stepchild, foster child, or a descendant of any of them (for example, the taxpayer's grandchild). Additionally, the child can be the taxpayer's brother, sister, half brother, half sister, stepbrother, stepsister, or a descendant of any of them (for example, the taxpayer's niece or nephew).⁴⁷

The age test varies depending upon the tax benefit involved. In general, a child must be under age 19 (or under age 24 in the case of a full-time student) in order to be a qualifying child. In general, no age limit applies with respect to individuals who are totally and permanently disabled at any time during the calendar year. There are exceptions to these general rules. Two notable exceptions are: (1) a child must be under age 13 (if he or she is not disabled) for purposes of the dependent care credit and (2) a child must be under age 17 (whether or not disabled) for purposes of the child credit.

The proposal modifies the requirements for those who are required to file a tax return. In the case of an individual who is not married, such individual is required to file a tax return if the taxpayer's gross income for the taxable year exceeds the applicable standard deduction. Married individuals are required to file a return if that individual's gross income, when combined with the individual's spouse's gross income for the taxable year, is more than the standard deduction applicable to a joint return, provided that: (i) such individual and his spouse, at the close of the taxable year, had the same household as their home; (ii) the individual's spouse does not make a separate return; and (iii) neither the individual nor his spouse is a dependent of another taxpayer and has income (other than earned income) in excess of $500.

The proposal modifies the age test for a qualifying child. Under the proposal, a child may only be a qualifying child if that child has not attained the age of 18 as of the close of the calendar year in which the taxable year of the taxpayer begins. Under the proposal, as under present law, there is no age test for an individual who is permanently and totally disabled.

The Hope credit that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified AGI between $55,000 and $65,000 ($110,000 and $130,000 for married taxpayers filing a joint return) for 2014, based on inflation adjustments determined by the staff of the Joint Committee on Taxation. The beginning points of the AGI phaseout ranges are indexed for inflation, with the amount rounded down to the next lowest multiple of $1,000. The size of the phaseout ranges for single and married taxpayers are always $10,000 and $20,000 respectively.

A taxpayer may not claim the Hope credit if the qualified tuition and related expenses for the enrollment or attendance of a student, if such student has been convicted of a Federal or State felony offense consisting of the possession or distribution of a controlled substance before the end of the taxable year.⁴⁹

For taxable years beginning after December 31, 2008, individual taxpayers are eligible to claim the American Opportunity credit, which refers to modifications to the Hope credit that apply for taxable years 2009 through 2017.⁵⁰ The maximum allowable modified credit is $2,500 per eligible student per year for qualified tuition and related expenses paid for each of the first four years of the student's post-secondary education in a degree or certificate program. The modified credit rate is 100 percent on the first $2,000 of qualified tuition and related expenses, and 25 percent on the next $2,000 of qualified tuition and related expenses. For purposes of the modified credit, the definition of qualified tuition and related expenses is expanded to include course materials. Forty percent of a taxpayer's otherwise allowable modified credit is refundable. The modified credit that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified AGI between $80,000 and $90,000 ($160,000 and $180,000 for married taxpayers filing a joint return). The modified credit may be claimed against a taxpayer's AMT liability.

In contrast to the Hope and American Opportunity tax credits, a taxpayer may claim the Lifetime Learning credit for an unlimited number of taxable years.⁵¹ Also in contrast to the Hope and American Opportunity tax credits, the maximum amount of the Lifetime Learning credit that may be claimed on a taxpayer's return does not vary based on the number of students in the taxpayer's family -- that is, the Hope credit is computed on a per student basis while the Lifetime Learning credit is computed on a family-wide basis. The Lifetime Learning credit amount that a taxpayer may otherwise claim is phased out ratably for taxpayers with modified AGI between $55,000 and $65,000 ($110,000 and $130,000 for married taxpayers filing a joint return) in 2014, based on inflation adjustments determined by the staff of the Joint Committee on Taxation. These phaseout ranges are the same as those for the Hope credit as it applies for tax years beginning before 2009, and are similarly indexed for inflation.

The proposal lowers the phaseout range of the credit. The credit phases out for joint filers with modified AGI between $86,000 and $126,000, and for all other filers with modified AGI between $43,000 and $63,000. Both the credit amounts and the phaseout ranges are indexed for inflation for taxable years beginning after 2018.

The proposal repeals the provision that denies the credit with respect to qualified tuition and related expenses for the enrollment or attendance of any student who has been convicted of a felony offense consisting of the possession or distribution of a controlled substance.

The proposal contains a provision that coordinates the credit with Pell Grants, such that Pell Grant amounts are deemed to first apply to expenses other than the qualified tuition and related expenses that are eligible for the credit. Thus, for purposes of calculating the credit, qualified tuition and related expenses are reduced by Pell Grant amounts only to the extent the Pell Grant exceeds the cost of college attendance (other than qualified tuition and related expenses).

The proposal modifies present-law reporting requirements, such that an eligible institution may only report the aggregate amount of tuition received with respect to any individual during the calendar year period. Additionally, the proposal adds a requirement that any taxpayer claiming the credit must include on the tax return the Employer Identification Number of any institution to whom qualified tuition was paid.

The proposal repeals the Lifetime Learning credit.

2. Expansion of Pell grant exclusion from gross income (sec. 1202 of the discussion draft and sec. 117 of the Code)

In general, a qualified scholarship is any amount received by such an individual as a scholarship or fellowship grant if the amount is used for qualified tuition and related expenses. Qualified tuition and related expenses include tuition and fees required for enrollment or attendance, or for fees, books, supplies, and equipment required for courses of instruction, at the qualifying educational organization. This definition does not include regular living expenses, such as room and board. A qualifying educational organization is an educational organization which normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on.

3. Repeal of exclusion of income from United States savings bonds used to pay higher education expenses (sec. 1203 of the discussion draft and sec. 135 of the Code)

The exclusion is phased out for certain higher-income taxpayers, determined by the taxpayer's modified AGI during the year the bond is redeemed. For 2014, the exclusion is phased out for taxpayers with modified AGI between $76,000 and $91,000 ($113,950 and $143,950 for married taxpayers filing a joint return). To prevent taxpayers from effectively avoiding the income phaseout limitation through the purchase of bonds directly in the child's name, the interest exclusion is available only with respect to U.S. Series EE savings bonds issued to taxpayers who are at least 24 years old.

4. Repeal of deduction for interest on education loans (sec. 1204 of the discussion draft and sec. 221 of the Code)

A qualified education loan generally is defined as any indebtedness incurred solely to pay for the costs of attendance (including room and board) of the taxpayer, the taxpayer's spouse, or any dependent of the taxpayer as of the time the indebtedness was incurred in attending on at least a half-time basis (1) eligible educational institutions, or (2) institutions conducting internship or residency programs leading to a degree or certificate from an institution of higher education, a hospital, or a health care facility conducting postgraduate training. The cost of attendance is reduced by any amount excluded from gross income under the exclusions for qualified scholarships and tuition reductions, employer-provided educational assistance, interest earned on education savings bonds, qualified tuition programs, and Coverdell education savings accounts, as well as the amount of certain other scholarships and similar payments.

The maximum allowable deduction per year is $2,500.⁵⁸ For 2014, the deduction is phased out ratably for taxpayers with AGI between $65,000 and $80,000 ($130,000 and $160,000 for married taxpayers filing a joint return). The income phaseout ranges are indexed for inflation and rounded to the next lowest multiple of $5,000.

5. Repeal of deduction for qualified tuition and related expenses (sec. 1205 of the discussion draft and sec. 222 of the Code)

The maximum deduction is $4,000 for an individual whose AGI for the taxable year does not exceed $65,000 ($130,000 in the case of a joint return), or $2,000 for other individuals whose AGI does not exceed $80,000 ($160,000 in the case of a joint return).⁶⁰ No deduction is allowed for an individual whose AGI exceeds the relevant AGI limitations, for a married individual who does not file a joint return, or for an individual with respect to whom a personal exemption deduction may be claimed by another taxpayer for the taxable year. The deduction is not available for taxable years beginning after December 31, 2013.

6. No new contributions to Coverdell education savings accounts (sec. 1206 of the discussion draft and sec. 530 of the Code)

Earnings on contributions to a Coverdell education savings account generally are subject to tax when withdrawn.⁶² However, distributions from a Coverdell education savings account are excludable from the gross income of the distributee (i.e., the student) to the extent that the distribution does not exceed the qualified education expenses incurred by the beneficiary during the year the distribution is made. The earnings portion of a Coverdell education savings account distribution not used to pay qualified education expenses is includible in the gross income of the distributee and generally is subject to an additional 10-percent tax.⁶³

Tax-free (and free of additional 10-percent tax) transfers or rollovers of account balances from one Coverdell education savings account benefiting one beneficiary to another Coverdell education savings account benefiting another beneficiary (as well as redesignations of the named beneficiary) are permitted, provided that the new beneficiary is a member of the family of the prior beneficiary and is under age 30 (except in the case of a special needs beneficiary). In general, any balance remaining in a Coverdell education savings account is deemed to be distributed within 30 days after the date that the beneficiary reaches age 30 (or, if the beneficiary dies before attaining age 30, within 30 days of the date that the beneficiary dies).

Qualified education expenses include qualified elementary and secondary expenses and qualified higher education expenses. Such qualified education expenses generally include only out-of-pocket expenses. They do not include expenses covered by employer-provided educational assistance or scholarships for the benefit of the beneficiary that are excludable from gross income.

The term qualified elementary and secondary school expenses, means expenses for: (1) tuition, fees, academic tutoring, special needs services, books, supplies, and other equipment incurred in connection with the enrollment or attendance of the beneficiary at a public, private, or religious school providing elementary or secondary education (kindergarten through grade 12) as determined under State law; (2) room and board, uniforms, transportation, and supplementary items or services (including extended day programs) required or provided by such a school in connection with such enrollment or attendance of the beneficiary; and (3) the purchase of any computer technology or equipment (as defined in section 170(e)(6)(F)(i)) or internet access and related services, if such technology, equipment, or services are to be used by the beneficiary and the beneficiary's family during any of the years the beneficiary is in elementary or secondary school. Computer software primarily involving sports, games, or hobbies is not considered a qualified elementary and secondary school expense unless the software is predominantly educational in nature.

The term qualified higher education expenses includes tuition, fees, books, supplies, and equipment required for the enrollment or attendance of the designated beneficiary at an eligible education institution, regardless of whether the beneficiary is enrolled at an eligible educational institution on a full-time, half-time, or less than half-time basis.⁶⁴ Moreover, qualified higher education expenses include certain room and board expenses for any period during which the beneficiary is at least a half-time student. Qualified higher education expenses include expenses with respect to undergraduate or graduate-level courses. In addition, qualified higher education expenses include amounts paid or incurred to purchase tuition credits (or to make contributions to an account) under a qualified tuition program for the benefit of the beneficiary of the Coverdell education savings account.⁶⁵

7. Repeal of exclusion for discharge of student loan indebtedness (sec. 1207 of the discussion draft and sec. 108(f) of the Code)

Student loans eligible for this special rule must be made to an individual to assist the individual in attending an educational institution that normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of students in attendance at the place where its education activities are regularly carried on. Loan proceeds may be used not only for tuition and required fees, but also to cover room and board expenses. The loan must be made by (1) the United States (or an instrumentality or agency thereof), (2) a State (or any political subdivision thereof), (3) certain tax-exempt public benefit corporations that control a State, county, or municipal hospital and whose employees have been deemed to be public employees under State law, or (4) an educational organization that originally received the funds from which the loan was made from the United States, a State, or a tax-exempt public benefit corporation.

In addition, an individual's gross income does not include amounts from the forgiveness of loans made by educational organizations (and certain tax-exempt organizations in the case of refinancing loans) out of private, nongovernmental funds if the proceeds of such loans are used to pay costs of attendance at an educational institution or to refinance any outstanding student loans (not just loans made by educational organizations) and the student is not employed by the lender organization. In the case of such loans made or refinanced by educational organizations (or refinancing loans made by certain tax-exempt organizations), cancellation of the student loan must be contingent upon the student working in an occupation or area with unmet needs and such work must be performed for, or under the direction of, a tax-exempt charitable organization or a governmental entity.

Finally, an individual's gross income does not include any loan repayment amount received under the National Health Service Corps loan repayment program or certain State loan repayment programs.

8. Repeal of exclusion for qualified tuition reductions (sec. 1208 of the discussion draft and sec. 117(d) of the Code)

9. Repeal of exclusion for education assistance programs (sec. 1209 of the discussion draft and sec. 127 of the Code)

For purposes of the exclusion, educational assistance means the payment by an employer of expenses incurred by or on behalf of the employee for education of the employee including, but not limited to, tuition, fees and similar payments, books, supplies, and equipment. Educational assistance also includes the provision by the employer of courses of instruction for the employee (including books, supplies, and equipment). Educational assistance does not include (1) tools or supplies that may be retained by the employee after completion of a course, (2) meals, lodging, or transportation, and (3) any education involving sports, games, or hobbies. The exclusion for employer-provided educational assistance applies only with respect to education provided to the employee (i.e., it does not apply to education provided to the spouse or a child of the employee).

10. Repeal of exception to 10-percent penalty for higher education (sec. 1210 of the discussion draft and sec. 72(t) of the Code)

Generally, a qualifying individual is: (1) a qualifying child of the taxpayer under the age of 13 for whom the taxpayer may claim a dependency exemption, or (2) a dependent or spouse of the taxpayer if the dependent or spouse is physically or mentally incapacitated, and shares the same principal place of abode with the taxpayer for over one half the year. Married taxpayers must file a joint return in order to claim the credit.

2. Repeal of credit for adoption expenses (sec. 1302 of the discussion draft and sec. 23 of the Code)

For taxable years beginning in 2014, the maximum credit amount is $13,190, and the credit is phased out ratably for taxpayers with modified adjusted gross income ("AGI") above a certain amount. In 2014, the phase out range begins at modified AGI of $197,880, with no credit allowed for taxpayers with a modified AGI of $237,880. Modified AGI is the sum of the taxpayer's AGI plus amounts excluded from income under sections 911, 931, and 933 (relating to the exclusion of income of U.S. citizens or residents living abroad; residents of Guam, American Samoa, and the Northern Mariana Islands and residents of Puerto Rico, respectively).

3. Nonbusiness energy property credit (sec.1303 of the discussion draft and sec. 25C of the Code)

4. Credit for residential energy efficient property (sec. 1304 of the discussion draft and sec. 25D of the Code)

5. Repeal of credits for alternative fuel vehicles and alternative fuel refueling property (secs. 1305 through 1308 of the discussion draft and secs. 30, 30B, 30C, and 30D of the Code)

A credit is available through 2014 for new vehicles propelled by chemically combining oxygen with hydrogen and creating electricity. The base credit is $4,000 for vehicles weighing 8,500 pounds or less. Heavier vehicles can get up to a $40,000 credit, depending on their weight. An additional $1,000 to $4,000 credit is available to cars and light trucks to the extent their fuel economy exceeds the 2002 base fuel economy set forth in the Code.

Plug-in electric-drive motor vehicles (secs. 30 and 30D)

A credit is available for new four-wheeled vehicles (excluding low speed vehicles and vehicles weighing 14,000 pounds or more) propelled by a battery with at least 4 kilowatt-hours of electricity that can be charged from an external source. The base credit is $2,500 plus $417 for each kilowatt-hour of additional battery capacity in excess of 4 kilowatt-hours (for a maximum credit of $7,500). Qualified vehicles are subject to a 200,000 vehicle-per-manufacturer limitation.

A 10-percent credit up to $2,500 is available for vehicles acquired before 2012 that otherwise qualify for the above credit but for the fact that they have limited speed. A similar 10-percent credit is available for two- and three-wheeled vehicles acquired before 2014 that have a battery capacity of at least 2.5 kilowatt-hours and are capable of achieving a speed of 45 miles per hour or greater. The 10-percent credits are not subject to the 200,000 vehicle-per-manufacturer limitation.

Credit for alternative fuel refueling property (sec. 30C)

A 30-percent credit is available through 2013 (2014 for hydrogen refueling property) for property that dispenses alternative fuels, including ethanol, biodiesel, natural gas, hydrogen, and electricity. The credit may not exceed $30,000 per location for business property and $1,000 for property installed at a principal residence.

6. Repeal of credit for health insurance costs of eligible individuals (sec. 1309 of the discussion draft and sec. 35 of the Code)

Eligibility for the credit is determined on a monthly basis. In general, an eligible coverage month is any month if the month begins before January 1, 2014, and, as of the first day of the month, the individual (1) is an eligible individual, (2) is covered by qualified health insurance, (3) does not have other specified coverage, and (4) is not imprisoned under Federal, State, or local authority. In the case of a joint return, the eligibility requirements are met if at least one spouse satisfies the requirements.

An eligible individual is an individual who is (1) an eligible Trade Adjustment Assistance ("TAA") recipient, (2) an eligible alternative TAA recipient, or (3) an eligible Pension Benefit Guaranty Corporation ("PBGC") pension recipient. In general, an individual is an eligible TAA recipient for a month if the individual (1) receives for any day of the month a trade readjustment allowance under the Trade Act of 1974 or would be eligible to receive such an allowance but for the requirement that the individual exhaust unemployment benefits before being eligible to receive an allowance and (2) with respect to such allowance, is covered under a required certification.⁷⁸ An individual is an eligible alternative TAA recipient for a month if the individual participates in a certain program under the Trade Act of 1974 and receives a related benefit for the month. Generally, an individual is a PBGC pension recipient for any month if the individual (1) is age 55 or over as of the first day of the month and (2) receives a benefit, any portion of which is paid by the PBGC. A person who may be claimed as a dependent on another person's tax return is not an eligible individual. In addition, an otherwise eligible individual is not eligible for the credit for a month if, as of the first day of the month, the individual has certain specified coverage, such as certain employer-provided coverage or coverage under certain governmental health programs.

7. Repeal of first time homebuyer credit (sec. 1310 of the discussion draft and sec. 36 of the Code)

The exclusion under this provision may not be claimed for more than one sale or exchange during any two-year period.

The proposal limits the exclusion so that the exclusion may not apply to more than one sale or exchange during any five-year period.

The proposal phases-out the exclusion by one dollar for every dollar a taxpayer's AGI exceeds $250,000 ($500,000 if married filing a joint return).

2. Mortgage interest (sec. 1402 of the discussion draft and sec. 163 of the Code)

Acquisition indebtedness also includes indebtedness from the refinancing of other acquisition indebtedness but only to the extent of the amount (and term) of the refinanced indebtedness. Thus, for example, if the taxpayer incurs $200,000 of acquisition indebtedness to acquire a principal residence and pays down the debt to $150,000, the taxpayer's acquisition indebtedness with respect to the residence cannot thereafter be increased above $150,000 (except by indebtedness incurred to substantially improve the residence).

Interest on acquisition indebtedness is allowable in computing alternative minimum taxable income. However, in the case of a second residence, the acquisition indebtedness may only be incurred with respect to a house, apartment, condominium, or a mobile home that is not used on a transient basis.

The amount of home equity indebtedness may not exceed $100,000 ($50,000 in the case of a married individual filing a separate return) and may not exceed the fair market value of the residence reduced by the acquisition indebtedness.

Interest on home equity indebtedness is not deductible in computing alternative minimum taxable income.

Interest on qualifying home equity indebtedness is deductible, regardless of how the proceeds of the indebtedness are used. For example, personal expenditures may include health costs and education expenses for the taxpayer's family members or any other personal expenses such as vacations, furniture, or automobiles. A taxpayer and a mortgage company can contract for the home equity indebtedness loan proceeds to be transferred to the taxpayer in a lump sum payment (e.g., a traditional mortgage), a series of payments (e.g., a reverse mortgage), or the lender may extend the borrower a line of credit up to a fixed limit over the term of the loan (e.g., a home equity line of credit).

Thus, the aggregate limitation on the total amount of a taxpayer's acquisition indebtedness and home equity indebtedness with respect to a taxpayer's principal residence and a second residence that may give rise to deductible interest is $1,100,000 ($550,000, for married persons filing a separate return).

Under the proposal, interest paid on home equity indebtedness incurred after 2014 is not treated as qualified residence interest, and thus is not deductible.

The proposal does not change the treatment of interest on qualified residence indebtedness incurred before 2015.

Special rules apply in the case of indebtedness from refinancing existing qualified residence indebtedness. Specifically, present law continues to apply to any indebtedness incurred on or after January 1, 2015, to refinance qualified residence indebtedness incurred before that date to the extent the amount of the indebtedness resulting from the refinancing does not exceed the amount of the refinanced indebtedness. Thus, the maximum dollar amount that may be treated as qualified indebtedness will not decrease by reason of a refinancing.

The proposal modifies the reporting requirements with respect to taxpayers who, in the course of a trade or business during a calendar year, received from an individual $600 or more of interest during a calendar year on an obligation secured by real property (such as mortgage interest). In addition to the present-law reporting requirements, the proposal requires that taxpayers report both the amount of outstanding principal on the mortgage as of the beginning of the calendar year and the date of origination of the mortgage.

3. Charitable contributions (sec. 1403 of the discussion draft and sec. 170 of the Code)

The Internal Revenue Code allows taxpayers to reduce their income tax liability by taking deductions for contributions to certain organizations, including charities, Federal, State, local and Indian tribal governments, and certain other organizations.

To be deductible, a charitable contribution generally must meet several threshold requirements. First, the recipient of the transfer must be eligible to receive charitable contributions (i.e., an organization or entity described in section 170(c)). Second, the transfer must be made with gratuitous intent and without the expectation of a benefit of substantial economic value in return. Third, the transfer must be complete and generally must be a transfer of a donor's entire interest in the contributed property (i.e., not a contingent or partial interest contribution). To qualify for a current year charitable deduction, payment of the contribution must be made within the taxable year.⁸¹ Fourth, the transfer must be of money or property -- contributions of services are not deductible.⁸² Finally, the transfer must be substantiated and in the proper form.

As also discussed below, special rules limit a taxpayer's charitable contributions in a given year to a percentage of income, and those rules, in part, turn on whether the organization receiving the contributions is a public charity or a private foundation. Other special rules determine the deductible value of contributed property for each type of property.

Contributions of partial interests in property

A charitable contribution deduction generally is not allowable for a contribution of a future interest in tangible personal property.⁸⁴ For this purpose, a future interest is one "in which a donor purports to give tangible personal property to a charitable organization, but has an understanding, arrangement, agreement, etc., whether written or oral, with the charitable organization that has the effect of reserving to, or retaining in, such donor a right to the use, possession, or enjoyment of the property."⁸⁵

A gift of an undivided portion of a donor's entire interest in property generally is not treated as a nondeductible gift of a partial interest in property.⁸⁶ For this purpose, an undivided portion of a donor's entire interest in property must consist of a fraction or percentage of each and every substantial interest or right owned by the donor in such property and must extend over the entire term of the donor's interest in such property.⁸⁷ A gift generally is treated as a gift of an undivided portion of a donor's entire interest in property if the donee is given the right, as a tenant in common with the donor, to possession, dominion, and control of the property for a portion of each year appropriate to its interest in such property.⁸⁸

Other exceptions to the partial interest rule are provided for, among other interests: (1) remainder interests in charitable remainder annuity trusts, charitable remainder unitrusts, and pooled income funds; (2) present interests in the form of a guaranteed annuity or a fixed percentage of the annual value of the property; (3) a remainder interest in a personal residence or farm; and (4) qualified conservation contributions.

Percentage limits on charitable contributions

More specifically, the deduction for charitable contributions by an individual taxpayer of cash and property that is not appreciated to a charitable organization described in section 170(b)(1)(A) (public charities, private foundations other than nonoperating private foundations, and certain governmental units) may not exceed 50 percent of the taxpayer's contribution base. Contributions of this type of property to nonoperating private foundations generally may be deducted up to the lesser of 30 percent of the taxpayer's contribution base or the excess of (i) 50 percent of the contribution base over (ii) the amount of contributions subject to the 50 percent limitation.

Contributions of appreciated capital gain property to public charities and other organizations described in section 170(b)(1)(A) generally are deductible up to 30 percent of the taxpayer's contribution base (after taking into account contributions other than contributions of capital gain property). An individual may elect, however, to bring all these contributions of appreciated capital gain property for a taxable year within the 50-percent limitation category by reducing the amount of the contribution deduction by the amount of the appreciation in the capital gain property. Contributions of appreciated capital gain property to nonoperating private foundations are deductible up to the lesser of 20 percent of the taxpayer's contribution base or the excess of (i) 30 percent of the contribution base over (ii) the amount of contributions subject to the 30 percent limitation.

Finally, more favorable percentage limits sometimes apply to contributions to the donee charity than to contributions that are for the use of the donee charity. Contributions of capital gain property for the use of public charities and other organizations described in section 170(b)(1)(A) also are limited to 20 percent of the taxpayer's contribution base.⁹¹ In contrast to property contributed directly to a charitable organization, property contributed for the use of an organization generally has been interpreted to mean property contributed in trust for the organization.⁹² Charitable contributions of income interests (where deductible) also generally are treated as contributions for the use of the donee organization.

             Table 2. -- Charitable Contribution Percentage Limits

In the case of a corporation (other than a publicly traded corporation) that is a qualified farmer or rancher for the taxable year in which the contribution is made, any qualified conservation contribution is allowable up to 100 percent of the excess of the corporation's taxable income (as computed under section 170(b)(2)) over the amount of all other allowable charitable contributions. Any excess may be carried forward for up to 15 years as a contribution subject to the 100-percent limitation.¹⁰⁰

A qualified farmer or rancher means a taxpayer whose gross income from the trade or business of farming (within the meaning of section 2032A(e)(5)) is greater than 50 percent of the taxpayer's gross income for the taxable year.

Valuation of charitable contributions

Charitable contributions of cash are deductible in the amount contributed, subject to the percentage limits discussed above. In addition, a taxpayer generally may deduct the full fair market value of long-term capital gain property contributed to charity.¹⁰¹ Contributions of tangible personal property also generally are deductible at fair market value if the use by the recipient charitable organization is related to its tax-exempt purpose.

In certain other cases, however, section 170(e) limits the deductible value of the contribution of appreciated property to the donor's tax basis in the property. This limitation of the property's deductible value to basis generally applies, for example, for: (1) contributions of inventory or other ordinary income or short-term capital gain property;¹⁰² (2) contributions of tangible personal property if the use by the recipient charitable organization is unrelated to the organization's tax-exempt purpose;¹⁰³ and (3) contributions to or for the use of a private foundation (other than certain private operating foundations).¹⁰⁴

For contributions of qualified appreciated stock, the above-described rule that limits the value of property contributed to or for the use of a private nonoperating foundation to the taxpayer's basis in the property does not apply; therefore, subject to certain limits, contributions of qualified appreciated stock to a nonoperating private foundation may be deducted at fair market value.¹⁰⁵ Qualified appreciated stock is stock that is capital gain property and for which (as of the date of the contribution) market quotations are readily available on an established securities market.¹⁰⁶ A contribution of qualified appreciated stock (when increased by the aggregate amount of all prior such contributions by the donor of stock in the corporation) generally does not include a contribution of stock to the extent the amount of the stock contributed exceeds 10 percent (in value) of all of the outstanding stock of the corporation.¹⁰⁷

Contributions of property with a fair market value that is less than the donor's tax basis generally are deductible at the fair market value of the property.

As discussed above, a taxpayer's deduction for charitable contributions of inventory property generally is limited to the taxpayer's basis (typically, cost) in the inventory, or if less, the fair market value of the property. For certain contributions of inventory, however, C corporations (but not other taxpayers) may claim an enhanced deduction equal to the lesser of (1) basis plus one-half of the item's appreciation (i.e., basis plus one-half of fair market value in excess of basis) or (2) two times basis.¹⁰⁸ To be eligible for the enhanced deduction value, the contributed property generally must be inventory of the taxpayer, contributed to a charitable organization described in section 501(c)(3) (except for private nonoperating foundations), and the donee must (1) use the property consistent with the donee's exempt purpose solely for the care of the ill, the needy, or infants, (2) not transfer the property in exchange for money, other property, or services, and (3) provide the taxpayer a written statement that the donee's use of the property will be consistent with such requirements.¹⁰⁹ Contributions to organizations that are not described in section 501(c)(3), such as governmental entities, do not qualify for this enhanced deduction.

To use the enhanced deduction provision, the taxpayer must establish that the fair market value of the donated item exceeds basis.

Under a temporary provision that was effective for contributions made before January 1, 2014, any taxpayer engaged in a trade or business, whether or not a C corporation, is eligible to claim the enhanced deduction for certain donations of food inventory.¹¹⁰ Another expired provision (effective for contributions made before January 1, 2012) allowed an enhanced charitable deduction for certain contributions of book inventory.¹¹¹

Vehicles. -- Under present law, the amount of deduction for charitable contributions of vehicles (generally including automobiles, boats, and airplanes for which the claimed value exceeds $500 and excluding inventory property) depends upon the use of the vehicle by the donee organization. If the donee organization sells the vehicle without any significant intervening use or material improvement of such vehicle by the organization, the amount of the deduction may not exceed the gross proceeds received from the sale. In other situations, a fair market value deduction may be allowed.

Patents and other intellectual property. -- If a taxpayer contributes a patent or other intellectual property (other than certain copyrights or inventory)¹¹² to a charitable organization, the taxpayer's initial charitable deduction is limited to the lesser of the taxpayer's basis in the contributed property or the fair market value of the property.¹¹³ In addition, the taxpayer generally is permitted to deduct, as a charitable contribution, certain additional amounts in the year of contribution or in subsequent taxable years based on a specified percentage of the qualified donee income received or accrued by the charitable donee with respect to the contributed intellectual property. For this purpose, qualified donee income includes net income received or accrued by the donee that properly is allocable to the intellectual property itself (as opposed to the activity in which the intellectual property is used).¹¹⁴

Clothing and household items. -- Charitable contributions of clothing and household items generally are subject to the charitable deduction rules applicable to tangible personal property. If such contributed property is appreciated property in the hands of the taxpayer, and is not used to further the donee's exempt purpose, the deduction is limited to basis. In most situations, however, clothing and household items have a fair market value that is less than the taxpayer's basis in the property. Because property with a fair market value less than basis generally is deductible at the property's fair market value, taxpayers generally may deduct only the fair market value of most contributions of clothing or household items, regardless of whether the property is used for exempt or unrelated purposes by the donee organization. Furthermore, a special rule generally provides that no deduction is allowed for a charitable contribution of clothing or a household item unless the item is in good used or better condition. The Secretary is authorized to deny by regulation a deduction for any contribution of clothing or a household item that has minimal monetary value, such as used socks and used undergarments. Notwithstanding the general rule, a charitable contribution of clothing or household items not in good used or better condition with a claimed value of more than $500 may be deducted if the taxpayer includes with the taxpayer's return a qualified appraisal with respect to the property.¹¹⁵ Household items include furniture, furnishings, electronics, appliances, linens, and other similar items. Food, paintings, antiques, and other objects of art, jewelry and gems, and certain collections are excluded from the special rules described in the preceding paragraph.¹¹⁶

College athletic seating rights. -- In general, where a taxpayer receives or expects to receive a substantial return benefit for a payment to charity, the payment is not deductible as a charitable contribution. However, special rules apply to certain payments to institutions of higher education in exchange for which the payor receives the right to purchase tickets or seating at an athletic event. Specifically, the payor may treat 80 percent of a payment as a charitable contribution where: (1) the amount is paid to or for the benefit of an institution of higher education (as defined in section 3304(f)) described in section (b)(1)(A)(ii) (generally, a school with a regular faculty and curriculum and meeting certain other requirements), and (2) such amount would be allowable as a charitable deduction but for the fact that the taxpayer receives (directly or indirectly) as a result of the payment the right to purchase tickets for seating at an athletic event in an athletic stadium of such institution.¹¹⁷

Two-percent floor on charitable deduction for individuals

The proposal imposes a two-percent floor on charitable contributions by taxpayers who are individuals. Specifically, the amount of an individual's charitable contributions for a taxable year (determined without regard to excess contributions carried over from a prior year under section 170(d)) are reduced by two percent of the taxpayer's contribution base for the taxable year.

The two-percent reduction is applied in the following order: (1) first, to charitable contributions to which paragraph 170(b)(1)(B) applies (generally, contributions subject to a 25-percent limitation, as reduced under the proposal); (2) second, to qualified conservation contributions; and (3) third, to charitable contributions to which paragraph 170(b)(1)(A) applies (generally, other contributions subject to a 40-percent limitation, as reduced under the proposal).

Extension of time for individuals to make charitable contributions

The proposal permits individuals to elect to deduct for a taxable year charitable contributions made after the close of the taxable year but not later than the due date (determined without regard to extensions) for the individual's income tax return for the taxable year. The election must be made at the time of the filing of the tax return in the manner provided by the Secretary. For example, if a calendar year taxpayer makes a charitable contribution on February 15, 2015, the individual may elect to treat the contribution as having been made during 2014. The election must be made at the time of the filing of the 2014 income tax return in the manner prescribed by the Secretary.

Deduction for contributions of appreciated property generally limited to basis

Under the proposal a charitable contribution of property generally is reduced by the amount of gain that would have been realized if the property contributed had been sold by the taxpayer for its fair market value (determined at the time of the contribution). In other words, the proposal generally limits a charitable contribution of appreciated property to the taxpayer's basis in the property.

The proposal provides that contributions of certain property are reduced only by the amount of gain that would not have been long-term capital gain if the property contributed had been sold by the taxpayer at its fair market (determined at the time of the contribution). In other words, the amount of such contributions of property need only be reduced by the amount of any short-term capital gain or ordinary income, resulting in more preferential treatment for such property relative to other property under the proposal. These contributions include:

Modifications to income-based percentage limits and repeal of separate, lower percentage limits for contributions of capital gain property

The proposal reduces the income-based percentage limit described in section 170(b)(1)(A) for certain charitable contributions by an individual taxpayer of cash and property that is not appreciated to public charities and certain other organizations from 50 percent to 40 percent. The proposal reduces the percentage limit for certain charitable contributions by an individual taxpayer to nonoperating private foundations from 30 percent to 25 percent.

The proposal repeals the provisions that provide lower percentage limitations on contributions of capital gain property (section 170(b)(1)(C), which generally imposes a 30-percent limit on charitable contributions of capital gain property to public charities and certain other organizations, and 170(b)(1)(D), which generally imposes a 20-percent limit on charitable contributions of capital gain property to nonoperating private foundations and certain other organizations). Thus, all contributions generally qualify for the more preferential 40- and 25-percent limitations, respectively, of sections 170(b)(1)(A) and 170(b)(1)(B), as amended.

Qualified conservation contributions

The proposal extends and makes permanent the special rules for qualified conservation contributions that provide for increased charitable contribution percentage limits and extended carryforward periods for excess contributions.

Golf course easements

The proposal modifies the definition of a qualified real property interest that may be treated as a qualified conservation contribution under section 170(h) generally to exclude golf course property. Specifically, an interest in real property is not treated as a qualified real property interest if (at the time of the contribution of such interest) the property is, or is intended to be, used as a golf course. As a result, charitable contributions of conservation easements on golf course property will not: (1) be excepted from the "partial interest" rule that generally denies a charitable deduction for a contribution of a partial interest in property, and (2) qualify for the preferential percentage limit and carryforward rules that generally apply to qualified conservation contributions.

College athletic event seating rights

The proposal repeals section 170(l), which generally provides that a taxpayer may deduct 80 percent of certain payments to institutions of higher education in exchange for which the taxpayer receives the right to purchase tickets or seating at an athletic event of such an institution.

Contributions of intellectual property

The proposal repeals section 170(m), under which certain donee income from intellectual property is treated as an additional charitable contribution.

Effective Date

The proposal generally is effective for contributions made in taxable years beginning after December 31, 2014.

The permanent extension of the special rules for qualified conservation contributions is effective for contributions made in taxable years beginning after December 31, 2013.

4. Denial of deduction for expenses attributable to the trade or business of being an employee (sec. 1404 of the discussion draft and sec. 62(a)(2) and new sec. 262A of the Code)

A working condition fringe provided to an employee is excluded from the employee's income and wages.¹²² For this purpose, a working condition fringe means property or services provided to an employee to the extent that, if the employee paid for the property or service, the payment would be deductible as a business expense or depreciation.

5. Repeal of deduction for taxes not paid or accrued in a trade or business (sec. 1405 of the discussion draft and sec. 164 of the Code)

Property taxes may be allowed as a deduction in computing adjusted gross income if incurred in connection with property used in a trade or business; otherwise they are an itemized deduction. In the case of State and local income taxes, the deduction is an itemized deduction notwithstanding that the tax may be imposed on profits from a trade or business.¹²⁹

Individuals also are permitted a deduction for Federal and State generation skipping transfer tax ("GST tax") imposed on certain income distributions that are included in the gross income of the distributee.¹³⁰

In determining a taxpayer's alternative minimum taxable income, no itemized deduction for property, income, or sales tax is allowed.

The proposal also provides that in the case of an individual, State and local income, war profits, and excess profits taxes are not allowable as a deduction.

6. Repeal of deduction for personal casualty losses (sec. 1406 of the discussion draft and sec. 165 of the Code)

7. Limitation on wagering losses (sec. 1407 of the discussion draft and sec. 165(d) of the Code)

The proposal is intended to clarify that the limitation on losses from wagering transactions applies not only to the actual costs of wagers incurred by an individual, but to other expenses incurred by the individual in connection with the conduct of that individual's gambling activity.¹³⁴ The proposal clarifies, for instance, an individual's otherwise deductible expenses in traveling to or from a casino are subject to the limitation under section 165(d).

8. Repeal of deduction for tax preparation expenses (sec. 1408 of the discussion draft and sec. 212 of the Code)

9. Repeal of deduction for medical expenses (sec. 1409 of the discussion draft and sec. 213 of the Code)

10. Repeal of the disqualification of expenses for over-the-counter drugs under certain accounts and arrangements (sec. 1410 of the discussion draft and secs. 106 and 223 of the Code)

Expenses for medical care, not compensated for by insurance or otherwise, are deductible by an individual under the rules relating to itemized deductions to the extent the expenses exceed 10 percent of adjusted gross income ("AGI").¹³⁶ Medical care generally is defined broadly as amounts paid for diagnoses, cure, mitigation, treatment or prevention of disease, or for the purpose of affecting any structure of the body.¹³⁷

Under an explicit limitation, any amount paid during a taxable year for medicine or drugs is deductible as a medical expense only if the medicine or drug is a prescribed drug or insulin.¹³⁸ The term prescribed drug means a drug or biological which requires a prescription of a physician for its use by an individual.¹³⁹ Thus, any amount paid for medicine available without a prescription ("over-the-counter medicine") is not deductible as a medical expense, including any medicine prescribed or recommended by a physician.¹⁴⁰

Exclusion for employer-provided health care

Employees are not taxed on (that is, may exclude from gross income) the value of employer-provided health coverage under an accident or health plan.¹⁴¹ In addition, any reimbursements under an employer-provided accident or health plan for medical care expenses for employees, their spouses, their dependents, and adult children under age 27 generally are excludible from gross income.¹⁴² An employer may agree to reimburse expenses for medical care of its employees (and their spouses and dependents), not covered by a health insurance plan, through a flexible spending arrangement ("FSA") which allows reimbursement not in excess of a specified dollar amount. The amounts available for reimbursement must be exclusively for reimbursement for medical care because the exclusion does not apply to amounts to which the employee would be entitled irrespective of whether he or she incurs expenses for medical care.¹⁴³

Such dollar amount is either elected by an employee under a cafeteria plan ("Health FSA") or otherwise specified by the employer under a health reimbursement arrangement ("HRA"). Reimbursements under these arrangements are also excludible from gross income as reimbursements for medical care under employer-provided health coverage.

Health savings accounts

An individual with a high deductible health plan (and no other health plan other than a plan that provides certain permitted insurance or permitted coverage) may establish a health savings account ("HSA"). In general, HSAs provide tax-favored treatment for current medical expenses as well as the ability to save on a tax-favored basis for future medical expenses. In general, HSAs are tax-exempt trusts or custodial accounts created exclusively to pay for the qualified medical expenses of the account holder and his or her spouse and dependents. Thus, earnings on amounts in HSAs are not taxable.

Subject to limits,¹⁴⁴ contributions made to an HSA by an employer, including contributions made through a cafeteria plan through salary reduction, are excludible from income (and from wages for payroll tax purposes). Contributions made by individuals are deductible for income tax purposes, regardless of whether the individuals itemize. Distributions from an HSA that are used for qualified medical expenses are excludible from gross income. Distributions from an HSA that are not used for qualified medical expenses are includible in gross income and are subject to an additional tax of 20 percent. The 20-percent additional tax does not apply if the distribution is made after death, disability, or the individual attains the age of Medicare eligibility (i.e., age 65). Similar rules apply for another type of medical savings arrangement called an Archer medical savings account ("Archer MSA").¹⁴⁵

Medical care for excludible reimbursements

For purposes of the exclusion for reimbursements under employer-provided accident and health plans (including under Health FSAs and HRAs), and for distributions from HSAs and Archer MSAs used for qualified medical expenses, the definition of medical care is generally the same as the definition that applies for the itemized deduction for the cost of medical care. However, prior to the enactment of the Patient Protection and Affordable Care Act (referred to as the "Affordable Care Act"),¹⁴⁶ the limitation (applicable to the itemized deduction) that only prescription medicines or drugs and insulin are taken into account did not apply. Thus, for example, amounts paid from a Health FSA or HRA, or funds distributed from an HSA to reimburse a taxpayer for nonprescription drugs, such as nonprescription aspirin, allergy medicine, antacids, or pain relievers, were excludible from income even though, if the taxpayer paid for such amounts directly (without such reimbursement), the expenses could not be taken into account in determining the itemized deduction for medical expenses.¹⁴⁷

For years beginning after December 31, 2010, the Affordable Care Act changed the definition of medical care for purposes of the exclusion for reimbursements for medical care under employer-provided accident and health plans and for distributions from HSAs and Archer MSAs used for qualified medical expenses to require that over-the-counter medicine (other than insulin) be prescribed by a physician in order for the medicine to be medical care for these purposes.¹⁴⁸ Thus, under present law, a Health FSA or an HRA is only permitted to reimburse an employee for the cost of over-the-counter medicine if the medicine is prescribed by a physician and distributions from an HSA or an Archer MSA used to purchase over-the-counter medicine is not a qualified medical expense unless the medicine is prescribed by a physician.

11. Repeal of deduction for alimony payments and corresponding inclusion in gross income (sec. 1411 of the discussion draft and secs. 71 and 215 of the Code)

12. Repeal of deduction for moving expenses (sec. 1412 of the discussion draft and sec. 217 of the Code)

13. Termination of deduction and exclusions for contributions to medical savings accounts (sec. 1413 of the discussion draft and secs. 106(b) and 220 of the Code)

As of 1997, certain individuals are permitted to contribute to an Archer MSA, which is a tax-exempt trust or custodial account.¹⁵³ Within limits, contributions to an Archer MSA are deductible in determining adjusted gross income if made by an individual and are excludable from gross income and wages for employment tax purposes if made by the employer of an individual.

An individual is generally eligible for an Archer MSA if the individual is covered by a high deductible health plan and no other health plan other than a plan that provides certain permitted insurance or permitted coverage. In addition, the individual either must be an employee of a small employer (generally an employer with 50 or fewer employees on average) that provides the high deductible health plan or must be self-employed or the spouse of a self-employed individual and the high deductible health plan is not provided by the employer of the individual or spouse.

For 2014, a high deductible health plan for purposes of Archer MSA eligibility is a health plan with an annual deductible of at least $2,200 and not more than $3,250 in the case of self-only coverage and at least $4,350 and not more than $6,550 in the case of family coverage. In addition, for 2014, the maximum out-of-pocket expenses with respect to allowed costs must be no more than $4,350 in the case of self-only coverage and no more than $$8,000 in the case of family coverage. Out-of-pocket expenses include deductibles, co-payments, and other amounts (other than premiums) that the individual must pay for covered benefits under the plan. A plan does not fail to qualify as a high deductible health plan if substantially all of the coverage under the plan is certain permitted insurance or is coverage (whether provided through insurance or otherwise) for accidents, disability, dental care, vision care, or long-term care.

The maximum annual contribution that can be made to an Archer MSA for a year is 65 percent of the annual deductible under the individual's high deductible health plan in the case of self-only coverage (65 percent of $3,250 for 2014) and 75 percent of the annual deductible in the case of family coverage (75 percent of $6,550 for 2014), but in no case more than the individual's compensation income. In addition, the maximum contribution can be made only if the individual is covered by the high deductible health plan for the full year.

Distributions from an Archer MSA for qualified medical expenses are not includible in gross income. Distributions not used for qualified medical expenses are includible in gross income and subject to an additional 20-percent tax unless an exception applies. A distribution from an Archer MSA may be rolled over on a nontaxable basis to another Archer MSA or to a health savings account and does not count against the contribution limits.

After 2007, no new contributions can be made to Archer MSAs except by or on behalf of individuals who previously had made Archer MSA contributions and employees of small employers that previously contributed to Archer MSAs (or at least 20 percent of whose employees who were previously eligible to contribute to Archer MSAs did so).

Health savings accounts

As of 2004, an individual with a high deductible health plan (and no other health plan other than a plan that provides certain permitted insurance or permitted coverage) generally may contribute to a health savings account ("HSA"), which is a tax-exempt trust or custodial account. HSAs provide similar tax-favored savings treatment as Archer MSAs. That is, within limits, contributions to an HSA are deductible in determining adjusted gross income if made by an individual and are excludable from gross income and wages for employment tax purposes if made by the employer of an individual, and distributions for qualified medical expenses are not includible in gross income.¹⁵⁴ However, the rules for HSAs are in various aspects more favorable than the rules for Archer MSAs. For example, the availability of HSAs is not limited to employees of small employers or self-employed individuals and their spouses.

For 2014, a high deductible health plan for purposes of HSA eligibility is a health plan with an annual deductible of at least $1,250 in the case of self-only coverage and at least $2,500 in the case of family coverage. In addition, for 2013, the sum of the deductible and the maximum out-of-pocket expenses with respect to allowed costs must be no more than $6,350 in the case of self-only coverage and no more than $12,700 in the case of family coverage. A plan does not fail to qualify as a high deductible health plan for HSA purposes merely because it does not have a deductible for preventive care.

For 2014, the maximum aggregate annual contribution that can be made to an HSA is $3,300 in the case of self-only coverage and $6,550 in the case of family coverage. The annual contribution limits are increased by $1,000 for individuals who have attained age 55 by the end of the taxable year (referred to as "catch-up contributions"). The maximum amount that an individual make contribute is reduced by the amount of any contributions to the individual's Archer MSA and any excludable HSA contributions made by the individual's employer. In some cases, an individual may make the maximum HSA contribution, even if the individual is covered by the high deductible health plan for only part of the year. A distribution from an HSA may be rolled over on a nontaxable basis to another HSA and does not count against the contribution limits.

14. Repeal of two-percent floor on miscellaneous itemized deductions (sec. 1414 of the discussion draft and sec. 67 of the Code)

To be deductible, an unreimbursed employee business expense must be: (1) paid or incurred during the taxable year; (2) for carrying on the trade or business of being an employee; and (3) an ordinary and necessary business expense. Thus, unreimbursed employee business expenses are those expenses that would be deductible above the line if the employee were engaged in a trade or business (other than the trade or business of being an employee). Generally, the two-percent floor applies to unreimbursed employee business expenses after any other deduction limit (such as the 50-percent limit on expenses for business-related meals and entertainment). Unreimbursed employee expenses include such expenses as certain business and professional dues, uniform costs, home office deductions, business bad debts of an employee, employment related education expenses, licenses and regulatory fees, malpractice insurance premiums, medical examinations required by an employer, occupational taxes, publications and subscriptions, job search, employment and outplacement agency fees, and union dues and expenses.

The two-percent floor does not apply to the following itemized deductions: (1) otherwise deductible interest; (2) State and local income (or in lieu of such, State sales), real property, and certain personal property taxes; (3) casualty and theft losses; (4) gambling losses to the extent of gambling winnings; (5) charitable contributions; (6) medical expenses; (7) impairment-related work expenses of a disabled individual; (8) the estate tax on income in respect to a decedent; (9) any deduction allowable in connection with personal property used in a short sale; (10) certain adjustments occurring when a taxpayer restores amounts held under a claim of right; (11) amortizable bond premium; (12) certain terminated annuity payments; and (13) deductions in connection with cooperative housing corporations. The two-percent floor does not apply to deductions allowable to estates or trusts under sections 642(c), 651, and 661.

15. Repeal of overall limitation on itemized deductions (sec. 1415 of the discussion draft and sec. 68 of the Code)

For 2014, the threshold amounts are $254,200 for single taxpayers, $279,650 for heads of household, $305,050 for married couples filing jointly, and $152,525 for married taxpayers filing separately. These threshold amounts are indexed for inflation. The otherwise allowable itemized deductions may not be reduced by more than 80 percent by reason of the overall limit on itemized deductions.

16. Deduction for amortizable bond premium allowed in determining adjusted gross income (sec. 1416 of the discussion draft and sec. 62 of the Code)

17. Repeal of exclusion, etc., for employee achievement awards (sec. 1417 of the discussion draft and secs. 74(c) and 274(j) of the Code)

18. Clarification of special rule for certain governmental plans (sec. 1418 of the discussion draft and sec. 105(j) of the Code)

Under a limited exception, reimbursements under a plan do not fail to be excluded from income solely because the plan provides for reimbursements of medical expenses of a deceased employee's beneficiary, without regard to whether the beneficiary is the employee's surviving spouse, dependent, or child under age 27. In order for the exception apply, the plan must have provided, on or before January 1, 2008, for reimbursement of the medical expenses of a deceased employee's beneficiary. In addition, the plan must be funded by a medical trust (1) that is established in connection with a public retirement system, and (2) that either has been authorized by a State legislature, or has received a favorable ruling from the IRS that the trust's income is not includible in gross income by reason of the exclusion for income of a State or political subdivision.¹⁶⁵ This exception preserves the exclusion for reimbursements of expenses of the employee and the employee's spouse, dependents, and children under age 27 (or the employee's surviving spouse, dependents, and children under age 27). Reimbursements of expenses of other beneficiaries are included in income.

The proposal also clarifies that this exception preserves the exclusion for reimbursements of expenses of the employee and the employee's spouse, dependents, and children under age 27 (or the employee's surviving spouse, dependents, and children under age 27) and that, as under present law, reimbursements of expenses of other beneficiaries are included in income.

19. Limitation on exclusion for employer-provided housing (sec. 1419 of the discussion draft and sec. 119 of the Code)

20. Fringe benefits (sec. 1420 of the discussion draft and sec. 132 of the Code)

A fringe benefit that is a no-additional-cost service, qualified employee discount, or a qualified transportation fringe is excluded from an employee's gross income and wages for employment tax purposes.¹⁶⁸

No-additional-cost services and qualified employee discounts

A no-additional-cost service is a service provided by an employer to an employee for use by the employee if (1) the service is offered for sale to customers in the ordinary course of the employer's line of business in which the employee performs services, and (2) the employer incurs no substantial additional cost (including foregone revenue) in providing the service to the employee. A qualified employee discount may apply to services provided by an employer to an employee at a discount (that is, at less than the price the employer offers the services to customers) for use by the employee, (1) if the services are offered for sale to customers in the ordinary course of the employer's line of business in which the employee performs services, and (2) to the extent the discount does not exceed 20 percent of the price at which the services are offered by the employer to customers. For purposes of these exclusions, use by a spouse or dependent child of an employee is treated as use by the employee. In addition, use of air transportation by a parent of an employee is treated as use by the employee.

Qualified transportation fringes

Qualified transportation fringes include parking, transit passes, vanpool benefits, and qualified bicycle commuting reimbursements. Qualified transportation fringes also include a cash reimbursement (under a bona fide reimbursement arrangement) by an employer to an employee for parking, transit passes, or vanpooling. In the case of transit passes, however, a cash reimbursement is considered a qualified transportation fringe only if a voucher or similar item that may be exchanged only for a transit pass is not readily available for direct distribution by the employer to the employee.

In general, the amount that can be excluded as qualified transportation fringe benefits is limited to $100 per month in combined transit pass and vanpool benefits and $175 per month in qualified parking benefits, with the limits being adjusted annually for inflation. For months beginning on or after February 17, 2009¹⁶⁹ and before January 1, 2014, the exclusion limit that applies to employer-provided parking applies also to combined employer-provided transit pass and vanpool benefits. For 2013, the monthly exclusion amount is $245. After 2013, the lower monthly exclusion amount (as adjusted for inflation) applies to combined employer-provided transit pass and vanpool benefits. For 2014, the monthly exclusion amount for qualified parking benefits is $250, and the monthly exclusion amount for combined employer-provided transit pass and vanpool benefits is $130.

With respect to any calendar year, a qualified bicycle commuting reimbursement is an employer reimbursement, during the 15-month period beginning with the first day of the calendar year, for reasonable expenses incurred by an employee during the calendar year for the purchase of a bicycle and bicycle improvements, repair, and storage, if such bicycle is regularly used for travel between the employee's residence and place of employment. The exclusion for a qualified bicycle commuting reimbursement for a calendar year is limited to $20 multiplied by the number of months during the year for which the employee regularly uses the bicycle for a substantial portion of the travel between the employee's residence and place of employment and does not receive any other qualified transportation fringe.

With respect to the qualified transportation fringe exclusion for parking, the proposal applies a permanent monthly limit of $250, which is not adjusted in the future for inflation. With respect to the qualified transportation fringe exclusion for employer-provided transit passes, vanpool benefits or combined transit pass and vanpool benefits, the proposal applies a permanent combined monthly limit of $130, which is not adjusted in the future for inflation. The proposal also repeals the qualified transportation fringe exclusion for qualified bicycle commuting reimbursements.

21. Repeal of exclusion of net unrealized appreciation in employer securities (sec. 1421 of the discussion draft and sec. 402(e)(4) of the Code)

However, if employer securities are distributed by a qualified retirement plan and either the distribution is a lump sum distribution or the employer securities are attributable to after-tax employee contributions, the net unrealized appreciation in the securities is excluded from the recipient's gross income.¹⁷⁰ Net unrealized appreciation is defined as the excess of the market value of the securities at the time of distribution over the cost or other basis of the securities to the trust.¹⁷¹ In other words, it generally is the amount by which the value of the securities increased while held by the trust of the qualified retirement plan. The basis of the employer securities after distribution does not include the amount of net unrealized appreciation excluded from gross income.¹⁷²

The exclusion for net unrealized appreciation is not available upon subsequent distribution after the securities are contributed to another eligible retirement plan in a tax-free rollover.¹⁷³ When the securities are received as part of a lump sum distribution, the recipient may elect not to exclude net unrealized appreciation.¹⁷⁴

22. Consistent basis reporting between estate and person acquiring property from decedent (sec. 1422 of the discussion draft and secs. 6035 and 6724 of the Code)

An executor of a decedent's estate that is required to file an estate tax return under section 6018(a) is required to report to both the recipient and the IRS the value of each interest in property included in the gross estate. A person that is required to file an estate tax return under section 6018(b) (returns by beneficiaries) is required to report to each other person holding a legal or beneficial interest in property to which the return relates and to the IRS the value of each interest in property included in the gross estate. The required reports must be furnished by the time proscribed by the Secretary, but in no case later than the earlier of 30 days after the return is due under section 6018 or 30 days after the return is filed. In any case where reported information is adjusted after a statement has been filed, a supplemental statement must be filed not later than 30 days after such adjustment is made.

The proposal grants the Secretary authority to prescribe regulations necessary to carry out the proposal, including the application of the proposal when no estate tax return is required to be filed and when the surviving joint tenant or other recipient may have better information than the executor regarding the basis or fair market value of the property.

The proposal applies the penalty for failure to file correct information returns under section 6721, and failure to furnish correct payee statements under section 6722, to failure to file the new information returns required under the proposal. Additionally, the proposal applies the accuracy-related penalty under section 6662 to any inconsistent estate basis. Inconsistent estate basis for purposes of the accuracy-related penalty is the portion of the understatement attributable to a basis determination with respect to property which is not consistent with the value of the property finally determined for estate tax purposes, or if not finally determined, in accordance with the statement provided under the proposal.

The Federal Insurance Contributions Act ("FICA") imposes tax on employers and employees based on the amount of wages (as defined for FICA purposes) paid to an employee during the year.¹⁸⁰ The tax imposed on the employer and on the employee is each composed of two parts: (1) the Social Security or old age, survivors, and disability insurance ("OASDI") tax equal to 6.2 percent of covered wages up to the taxable wage base ($117,000 for 2014); and (2) the Medicare or hospital insurance ("HI") tax equal to 1.45 percent of all covered wages.¹⁸¹ The employee portion of the FICA tax generally must be withheld and remitted to the Federal government by the employer.

The employer portion of the FICA tax is not treated as income or wages to the employee. That is, it is not included in the employee's income and is not subject to FICA tax.

SECA taxes

As a parallel to FICA taxes, taxes under the Self-Employment Contributions Act ("SECA") apply to the self-employment income of self-employed individuals.¹⁸² The rate of the OASDI portion of SECA taxes is generally 12.4 percent, which is equal to the combined employee and employer OASDI tax rates, and applies to self-employment income up to the OASDI taxable wage base (reduced by the individual's OASDI wages, if any). Similarly, the rate of the HI portion of SECA tax is 2.9 percent, the same as the combined employer and employee HI rates, and there is no cap on the amount of self-employment income to which the rate applies.¹⁸³

Self-employment income for SECA purposes means net earnings from self-employment with certain modifications. Net earnings from self-employment generally means the income from a self-employed individual's trade or business less deductions attributable to the trade or business. In determining net earnings from self-employment, a self-employed individual is permitted a deduction equal to the product of the taxpayer's net earnings from self-employment determined without regard to this deduction ("preliminary" net earnings from self-employment or NESE) and one-half of the sum of the rates for OASDI (12.4 percent) and HI (2.9 percent), i.e., 7.65 percent of preliminary NESE.¹⁸⁴ This deduction reflects the fact that the FICA rates apply to an employee's wages, which do not include FICA taxes paid by the employer, whereas a self-employed individual's net earnings are economically the equivalent of an employee's wages plus the employer share of FICA taxes. The deduction is intended to provide parity between FICA and SECA taxes.

The OASDI portion of the deduction is 7.1064 percent of preliminary net earnings from self-employment up to 1.0765 multiplied by the OASDI taxable wage base (reduced by the individual's OASDI wages, if any). The HI portion of the deduction is 1.4293 percent of preliminary net earnings from self-employment in excess of the amount taken into account in determining the OASDI portion of the deduction (that is, preliminary net earnings from self-employment up to 1.0765 multiplied by the OASDI taxable wage base (reduced by the individual's OASDI wages, if any)).

The calculation is summarized in the following table. For purposes of the table, the OASDI base amount is 1.0765 times the OASDI taxable wage base reduced by the individual's OASDI wages, if any.

             Table 3. -- Calculation of Deduction Allowed

2. Determination of net earnings from self-employment (sec. 1502 of the discussion draft and secs. 3101, 3102, 2111, 1401, and 1402 of the Code)

As part of the financing for Social Security and Medicare benefits, a tax is imposed on the wages of an individual received with respect to his or her employment under the Federal Insurance Contributions Act ("FICA").¹⁸⁶ A similar tax is imposed on the net earnings from self-employment of an individual under the Self-Employment Contributions Act ("SECA").¹⁸⁷

For SECA tax purposes, net earnings from self-employment generally includes the gross income derived by an individual from any trade or business carried on by the individual, less the deductions attributable to the trade or business that are allowed under the self-employment tax rules.¹⁹² Net earnings from self-employment generally includes the distributive share of income or loss from any trade or business of a partnership in which the individual is a partner.

Specified types of income or loss are excluded, such as rentals from real estate in certain circumstances, dividends and interest, and gains or loss from the sale or exchange of a capital asset or from timber, certain minerals, or other property that is neither inventory nor held primarily for sale to customers.

S corporation shareholders

An S corporation is treated as a passthrough entity for Federal income tax purposes. Each shareholder takes into account and is subject to Federal income tax on the shareholder's pro rata share of the S corporation's income.¹⁹³

A shareholder of an S corporation who performs services as an employee of the S corporation is subject to FICA tax on his or her wages from the S corporation.

A shareholder of an S corporation generally is not subject to FICA tax on amounts that are not wages, such as the shareholder's share of the S corporation's income. Unlike a partner's distributive share of income or loss from the partnership's trade or business, which is generally subject to SECA tax, an S corporation shareholder's pro rata share of S corporation income is not subject to SECA tax. Nevertheless, courts have held that an S corporation shareholder is subject to FICA tax on the amount of his or her reasonable compensation, even though the amount may have been characterized by the taxpayer as other than wages. The case law has addressed the issue of whether amounts paid to shareholders of S corporations constitute reasonable compensation and therefore are wages subject to the FICA tax, or rather, are properly characterized as another type of income that is not subject to FICA tax.¹⁹⁴

In cases addressing whether payments to an S corporation shareholder were wages for services or were corporate distributions, courts have recharacterized a portion of corporate distributions as wages if the shareholder performing services did not include any amount as wages.¹⁹⁵ In cases involving whether reasonable compensation was paid (not exclusively in the S corporation context), courts have applied a multi-factor test to determine reasonable compensation, including such factors as whether the individual's compensation was comparable to compensation paid at comparable firms.¹⁹⁶ The Seventh Circuit, however, has adopted an "independent investor" analysis differing from the multi-factor test in that it asks whether an inactive, independent investor would be willing to compensate the employee as he was compensated.¹⁹⁷ The independent investor test has been examined and partially adopted in some other Circuits, changing the analysis under the multi-factor test.¹⁹⁸

Partners

A partner's distributive share of partnership items is not treated as wages for FICA tax purposes. Rather, a partner who is an individual is subject to the SECA tax on his or her distributive share of trade or business income of the partnership. The net earnings from self-employment generally include the partner's distributive share (whether or not distributed) of income or loss from any trade or business carried on by the partnership (excluding specified types of income, such as rent, dividends, interest, and capital gains and losses, as described above²⁰⁰ ). This rule applies to individuals who are general partners.

The owners of a limited liability company that is classified as a partnership for Federal tax purposes are treated as partners for tax purposes. However, under State law, limited liability company owners are not defined as either general partners or limited partners.²⁰³

The proposal modifies the determination of net earnings from self-employment under the SECA tax by adding the shareholder's pro rata share of income from S corporations, repealing the exception for limited partners, providing a new deduction related to nonlabor income, and providing a new 100-percent deduction for individuals who do not have material participation.

S corporation shareholders

The proposal provides that net earnings from self-employment generally include the income or loss from any trade or business of an S corporation in which the individual is a stockholder. Specifically, the amount included is the individual's pro rata share of nonseparately computed income or loss described in section 1366(a)(2) from any trade or business carried on by an S corporation in which he is a stockholder.

Under the proposal, the same exceptions apply in determining net earnings from self-employment of a stockholder in an S corporation as apply to a partner in a partnership and to an individual carrying on a trade or business. Thus, the same specified types of income or loss are excluded: rentals from real estate in certain circumstances, dividends and interest, and gains or loss from the sale or exchange of a capital asset, or gains or losses from other property that is neither inventory nor held primarily for sale to customers. Consequently, under this rule, an S corporation shareholder is treated in the same manner as a partner in a partnership under the SECA tax.

The proposal does not change the present-law rules applying FICA tax to wages, including wages paid by an S corporation.

Authority is provided to the Treasury Department to provide regulations or other guidance to coordinate for any year to which the proposal applies the application of the cap (which is $117,000 for 2014) on wages of an individual from an S corporation that are subject to the FICA tax with the application of the cap to amounts subject to the SECA tax with respect to that individual's pro rata share of income of that S corporation.

Limited partners

The proposal repeals the present-law exclusion for a limited partner's distributive share of partnership income or loss in determining net earnings from self-employment (including repeal of the exception for partnership guaranteed payments in the nature of remuneration for services). Thus, under the proposal, limited partners are treated the same as other partners for purposes of determining net earnings from self-employment. Any person who is treated for Federal income tax purposes as a partner in any entity that is treated for Federal income tax purposes as a partnership is treated as a partner in a partnership for purposes of the SECA tax. Thus, for example, a member of an LLC who is treated for Federal income tax purposes as a partner in a partnership is treated as a partner for purposes of the SECA tax. A person treated as a partner under the Federal income tax is so treated for purposes of the SECA tax regardless of whether the person is treated as a partner under applicable State, local, or foreign law.

Nonlabor income deduction

The proposal provides a deduction that reduces net earnings from self-employment by a percentage that is derived from the historical portion of U.S. gross domestic product that represents income other than labor income. The deduction does not depend in any case on the type or nature of any particular item of income or earnings, but rather is calculated under a formula derived by reference to historical nonlabor income.

Under the proposal, an individual's net earnings from self-employment are reduced (but not below zero) by the lesser of (1) 30 percent of the sum of his pass-through net earnings from self-employment and his FICA wages paid by an S corporation in which he is a shareholder, or (2) his pass-through net earnings from self-employment. Thus, in determining the deduction, both the FICA wages paid by an S corporation to an individual shareholder, and the individual shareholder's pro rata share of S corporation income (subject to SECA), are taken into account.

For example, assume an individual performs services for or on behalf of an S corporation that pays him wages, and the individual also wholly owns the S corporation. Further assume that the S corporation's income (before any deduction for wages) is $100 for the year, and the individual has wages from the S corporation of $70 and a pro rata share (as shareholder) of $30. Under the proposal, 30 percent of the sum of the individual's pass-through net earnings from self-employment and his FICA wages is $30, and the individual's pass-through net earnings from self-employment are the same amount, $30. The nonlabor income deduction reduces the individual's net earnings from self-employment by $30 to $0. The individual's FICA tax on the $70 of wages is unaffected. Because both FICA wages and pass-through net earnings from self-employment are subject to payroll tax at the same rate and both are taken into account in determining the nonlabor income deduction, application of the judicially-developed reasonable compensation test is not necessary to determine FICA wages. The nonlabor income deduction is applied after application of the present-law exclusions from net earnings from self-employment for rentals from real estate in certain circumstances, dividends and interest, and gains or loss from the sale or exchange of a capital asset or from timber, certain minerals, or other property that is neither inventory nor held primarily for sale to customers.

Pass-through net earnings from self-employment is defined as net earnings from self-employment (computed without regard to the proposal) determined without regard to any trade or business carried on by the individual. Thus, for example, if the individual carries on a widget business as a sole proprietor, and also is a partner in a gadget business carried on by the partnership, pass-through net earnings from self-employment is determined with regard only to the gadget business of the partnership, and does not take into account the widget business the individual conducts as a sole proprietor. The Treasury Department is accorded regulatory authority to reallocate items of income, gain, or loss among businesses in which the taxpayer has an interest in any capacity, to carry out the purposes of the proposal.

100-percent deduction for individuals who do not have material participation

The proposal generally provides a 100-percent deduction from net earnings from self-employment for specified amounts in circumstances in which an individual does not have material participation with respect to an entity.

The rule has the effect that an individual's net earnings from self-employment are separated into items from nonparticipation entities, and items that are not from nonparticipation entities. An individual's net earnings from self-employment generally are reduced (but not below zero) by the sum of (1) the reduction determined above under the nonlabor income deduction, but modified to take account only of items from nonparticipation entities at 100 percent, and (2) the reduction determined above under the nonlabor income deduction, but modified to take account only of items that are not from nonparticipation entities at 30 percent.

For this purpose, a nonparticipation entity with respect to any individual is any entity with respect to which the individual does not have material participation.

An individual does not have material participation with respect to a top-tier entity if the individual demonstrates to the satisfaction of the Treasury Department that he or she does not materially participate in any activity carried on by the top-tier entity, and does not materially participate in any activity carried on by any other entity in which the top-tier entity directly or indirectly holds an interest. For this purpose, material participation has the same meaning as under the passive loss rules (sec. 469(h)). The participation of an individual in any activity is treated as including that of the individual's spouse and the lineal descendants of the individual and the individual's spouse.

3. Repeal of exemption from FICA taxes for certain foreign workers (sec. 1503 of the discussion draft and secs. 3121(b)(1) and (b)(19) and section 3231(e)(1) of the Code)

Wages as defined for FICA purposes means all remuneration for employment, with certain specified exceptions. Employment as defined for FICA purposes generally means any service, of whatever nature, performed by an employee for an employer within the United States, with certain specified exceptions.²⁰⁶

Exceptions from employment apply to service performed by certain categories of employees who are lawfully admitted to the United States on a temporary basis in order to work, specifically, agricultural workers holding H-2A visas and individuals (for example, certain students, researchers, and cultural exchange participants) holding F-1, J-1, M-1, Q-1 or Q-2 visas.²⁰⁷ Exceptions from employment apply also to certain other types of service, and, in some cases, an employee's service may be eligible for both a FICA exception applicable to certain visa holders and also for another exception.

Instead of FICA taxes, railroad employers and employees are subject, under the Railroad Retirement Tax Act ("RRTA"), to taxes equivalent to the OASDI and HI taxes under FICA with respect to compensation as defined for RRTA purposes ("RRTA compensation").²⁰⁸ An exception applies for individuals holding F-1, J-1, M-1, Q-1 or Q-2 visas.²⁰⁹

4. Repeal of exemption from FICA taxes for certain students (sec. 1504 of the discussion draft and sec. 3121(b)(2) and (b)(10) of the Code)

Wages as defined for FICA purposes means all remuneration for employment, with certain specified exceptions. Employment as defined for FICA purposes generally means any service, of whatever nature, performed by an employee for an employer within the United States, with certain specified exceptions.²¹³

An exception from employment for FICA purposes applies in the case of certain services performed by a student in the employ of a school, college, or university.²¹⁴ Specifically, FICA does not apply to services performed by a student who is enrolled and regularly attending classes at the school, college, or university. A FICA exception applies also to domestic service performed in a local college club, or local chapter of a college fraternity or sorority, by a student who is enrolled and regularly attending classes at a school, college, or university.²¹⁵ Exceptions from employment apply also to certain other types of service, and, in some cases, an employee's service may be eligible for both a FICA exception applicable to students and also for another exception.

Some FICA exceptions are subject to dollar limits. For example, cash remuneration of less than a specified amount ($1,900 for 2014) paid to an employee in a year for domestic service in a private home is exempt from FICA.²¹⁶ The FICA rules provide that, in cases in which a FICA exception is subject to a dollar limit, the employer may withhold the employee share of FICA from payments made to the employee even though, at the time of payment, the total amount paid to the employee is less than the limit and, thus, may be exempt from FICA.²¹⁷

Under the Social Security Act, an individual's wages are credited to the individual's earnings record for purposes of determining an individual's eligibility for Social Security benefits and Medicare coverage and for purposes of determining the amount of an individual's Social Security benefits. Eligibility for Social Security benefits and Medicare coverage is based in part on credits (referred to as "quarters of coverage") received for wages. Up to four quarters of coverage can be earned for a year, depending on total wages for the year and the amount needed to earn each quarter of coverage. For 2014, credit for a quarter of coverage is provided for each $1,200 of wages, with a maximum of four quarters of coverage for $4,800 in wages.

Under the proposal, the rules and procedures relating to the withholding of the employee share of FICA that apply under present law in the case of FICA exceptions that are subject to dollar limits apply also for purposes of the student exception. For example, the employer may withhold the employee share of FICA from payments made to the employee even though, at the time of payment, the total amount paid to the employee is less than the limit.

5. Override of Treasury guidance providing that certain employer-provided supplemental unemployment benefits are not subject to employment taxes (sec. 1505 of the discussion draft and sec. 3402(o)(1)(A) and (o)(2)(A) of the Code)

Employment taxes generally consist of taxes on employee wages under the Federal Insurance Contributions Act ("FICA"), the Railroad Retirement Tax Act ("RRTA") and the Federal Unemployment Tax Act ("FUTA"), and required Income Tax Withholding ("ITW") from employee wages.²¹⁹ For these purposes, wages is defined broadly to include all remuneration, subject to exceptions specifically provided in the relevant statutory provisions.²²⁰ Remuneration does not fail to be subject to employment taxes merely because it is paid after termination of employment.²²¹

Dismissal pay and supplemental unemployment benefits

Income tax withholding is required with respect to dismissal payments, described as any payments made by an employer to an employee on account of dismissal (that is, involuntary separation from the service of the employer), regardless of whether the employer is legally bound by contract, statute, or otherwise to make such payments.²²² Dismissal payments are also subject to FICA and FUTA.²²³ Similarly, lump sum separation and severance allowances paid to laid-off employees in the railway industry are subject to RRTA.²²⁴

The IRS has established a limited administrative exception to the application of FICA, RRTA, FUTA and income tax withholding in the case of supplemental unemployment benefit ("SUB") pay meeting certain requirements.²²⁵ In order to qualify for the exception, SUB pay benefits must be linked to eligibility for State unemployment compensation and must not be paid in a lump sum.²²⁶

Income tax withholding is required with respect to the payment of supplemental unemployment compensation benefits.²²⁷ For this purpose, the term supplemental unemployment compensation benefits means amounts paid to an employee, pursuant to a plan to which the employer is a party, because of the employee's involuntary separation from employment (whether or not the separation is temporary), resulting directly from a reduction in force, the discontinuance of a plant or operation, or other similar conditions, but only to the extent such benefits are includible in the employee's gross income.

The proposal also repeals the present-law provision requiring income tax withholding on supplemental unemployment compensation benefits. These amounts are subject to income tax withholding as wages.

6. Certified professional employer organizations (sec. 1506 of the discussion draft and new secs. 3511 and 7706 of the Code)

Employment taxes generally consist of the taxes under the Federal Insurance Contributions Act ("FICA"), the taxes under the Railroad Retirement Tax Act ("RRTA"), the tax under the Federal Unemployment Tax Act ("FUTA"), and income taxes required to be withheld by employers from wages paid to employees ("income tax withholding").²²⁸

FICA tax consists of two parts: (1) old age, survivor, and disability insurance ("OASDI"), which correlates to the Social Security program that provides monthly benefits after retirement, disability, or death; and (2) Medicare hospital insurance ("HI"). The OASDI tax rate is 6.2 percent on both the employee and employer (for a total rate of 12.4 percent). The OASDI tax rate applies to wages up to the OASDI wage base for the calendar year ($117,000 for 2014). The HI tax rate is 1.45 percent on both the employee and the employer (for a total rate of 2.9 percent). Unlike the OASDI tax, the HI tax is not limited to a specific amount of wages, but applies to all wages.²²⁹

RRTA taxes consist of tier 1 taxes and tier 2 taxes. Tier 1 taxes parallel the OASDI and HI taxes applicable to employers and employees. Tier 2 taxes consist of employer and employee taxes on railroad compensation up to the tier 2 wage base for the calendar year.

Under FUTA, employers must pay a tax of 6 percent of wages up to the FUTA wage base of $7,000. An employer may take a credit against its FUTA tax liability for its contributions to a State unemployment fund and, in certain cases, an additional credit for contributions that would have been required if the employer had been subject to a higher contribution rate under State law. For purposes of the credit, contributions means payments required by State law to be made by an employer into an unemployment fund, to the extent the payments are made by the employer without being deducted or deductible from employees' remuneration.

Employers are required to withhold income taxes from wages paid to employees. Withholding rates vary depending on the amount of wages paid, the length of the payroll period, and the number of withholding allowances claimed by the employee.

Wages paid to employees, and FICA, RRTA, and income taxes withheld from the wages, are required to be reported on employment tax returns and on Forms W-2.²³⁰

Employment taxes generally apply to all remuneration paid by an employer to an employee. However, various exclusions apply to certain types of remuneration or certain types of services, which may depend on the type of employer for whom an employee performs services.²³¹ For example, remuneration (subject to a dollar limit) paid to an employee by a tax-exempt organization is excluded from wages for FICA purposes, and services performed in the employ of certain tax-exempt organizations are excluded from employment for FUTA purposes.²³² In addition, various definitions and special rules apply to certain types of employers.²³³

As discussed above, certain employment taxes apply only on amounts up to a specified wage base. If an employee works for multiple employers during a year, separate wage bases generally apply to each employer. However, a single OASDI, RRTA tier 1 or tier 2, or FUTA wage base applies in certain cases in which an employer (a "successor" employer) takes over the business of another employer (the "predecessor" employer) and employs the employees of the predecessor employer.

Responsibility for employment tax compliance

Employment tax responsibility generally rests with the person who is the employer of an employee under a common-law test that has been incorporated into Treasury regulations.²³⁴ Under the regulations, an employer-employee relationship generally exists if the person for whom services are performed has the right to control and direct the individual who performs the services, not only as to the result to be accomplished by the work, but also as to the details and means by which that result is accomplished. That is, an employee is subject to the will and control of the employer, not only as to what is to be done, but also as to how it is to be done. It is not necessary that the employer actually control the manner in which the services are performed, rather it is sufficient that the employer have a right to control. Whether the requisite control exists is determined on the basis of all the relevant facts and circumstances. The test of whether an employer-employee relationship exists often arises in determining whether a worker is an employee or an independent contractor. However, the same test applies in determining whether a worker is an employee of one person or another.

In some cases, a person other than the common-law employer (a "third party") may be liable for employment taxes. For example, if wages are paid to an employee by a third party and the third party, rather than the employer, has control of the payment of the wages, the third party is the statutory employer responsible for complying with applicable employment tax requirements.²³⁵ In addition, an employer may designate a reporting agent to be responsible for FICA tax and income tax withholding compliance,²³⁶ including filing employment tax returns and issuing Forms W-2 to employees.²³⁷ In that case, the reporting agent and the employer are jointly and severally liable for compliance.²³⁸

Professional employer organizations

A professional employer organization (sometimes called an employee leasing company) is a term used for a firm that provides employees to perform services in the businesses of the professional employer organization's customers, generally small and medium-sized businesses. In many cases, before the professional employer organization arrangement is entered into, the employees already work in the customer's business as employees of the customer. The terms of a typical professional employer organization arrangement provide that the professional employer organization is the employer of the employees and is responsible for paying the employees and for the related employment tax compliance. The customer typically pays the professional employer organization a fee based on payroll costs plus an additional amount.²³⁹

In some cases, the employees provided to work in the customer's business are legally the employees of the customer, and the customer is legally responsible for employment tax compliance. Nonetheless, customers generally rely on the professional employer organization for employment tax compliance (without designating the professional employer organization as a reporting agent) and treat the employees as employees of the professional employer organization.

Reporting by large food and beverage establishments

Certain reporting requirements relating to tips apply to large food or beverage establishments.²⁴⁰ In the case of such an establishment, an employer is generally required to report the following information to the IRS each calendar year: (1) the gross receipts of the establishment from the provision of food and beverages (other than certain receipts); (2) the aggregate amount of charge receipts (other than certain receipts); (3) the aggregate amount of charged tips on the charge receipts; (4) the sum of the aggregate amount of tips reported to the employer by employees and certain amounts required to be reported by the employer on employees' Form W-2s; and (5) with respect to each employee, the amount of tips allocated to the employee based on the receipts of the establishment. The employer must also provide employees with written statements showing certain information each calendar year, including the amount of tips allocated to the employee for the year.

User fees

User fees apply to requests to the IRS for ruling letters, opinion letters, determination letters, and similar requests.²⁴¹ The user fees that apply are determined by the IRS and are generally required to be determined after taking into account the average time and difficulty involved in a request.

Under the proposal, if certain requirements are met, for purposes of employment taxes and other obligations under the employment tax rules, a certified professional employer organization is treated as the employer of any work site employee performing services for any customer of the certified professional employer organization, but only with respect to remuneration remitted to the work site employee by the certified professional employer organization. In addition, no other person is treated as the employer for employment tax purposes with respect to remuneration remitted by the certified professional employer organization to a work site employee.

Under the proposal, exceptions, exclusions, definitions, and other rules that are based on the type of employer and that would apply if the certified professional employer organization were not treated as the employer under the proposal continue to apply. Thus, for example, if services performed in the employ of a customer that is a tax-exempt organization would be excluded from employment for FUTA purposes, the fact that a certified professional employer organization is treated as the employer for employment tax purposes does not affect the application of the exclusion.

The proposal provides rules under which, on entering into a service contract with a customer with respect to a work site employee, a certified professional employer organization is treated as a successor employer and the customer is treated as the predecessor employer. Similarly, on termination of a service contract with respect to a worksite employee, the customer is treated as a successor employer and the certified professional employer organization is treated as a predecessor employer. Thus, wages paid by the customer and the certified professional employer organization to a work site employee during a calendar year are subject to a single OASDI, RRTA tier 1 or tier 2, or FUTA wage base.

The proposal does not apply in the case of a customer who is related to the certified professional employer organization.²⁴² In addition, an individual with net earnings from self-employment derived from a customer's trade or business (i.e., a self-employed individual), including a customer who is a sole proprietor or a partner of a customer that is a partnership, is not a work site employee for employment tax purposes with respect to remuneration paid by a certified professional employer organization.

As discussed more fully below, a work site employee is an individual who performs services (1) for a customer pursuant to a contract between the customer and the certified professional employer organization that meets certain requirements and (2) at a work site that meets certain requirements. Thus, if the contract or work site fails to meet these requirements, the individual is not a work site employee. The proposal applies also in the case of an individual (other than a self-employed individual) who is not a work site employee, but who performs services under a contract that meets the specified requirements. In this case, solely for purposes of a certified professional employer organization's liability for employment taxes and other obligations under the employment tax rules, a certified professional employer organization is treated as the employer of such an individual, but only with respect to remuneration remitted to the individual by the certified professional employer organization. With respect to such an individual, exceptions, exclusions, definitions, and other rules that are based on the type of employer and that would apply if the certified professional employer organization were not treated as the employer under the proposal continue to apply.

A certified professional employer organization is eligible for the FUTA credit with respect to contributions made to a State unemployment fund with respect to a work site employee by the certified professional employer organization or a customer. An additional FUTA credit may be claimed by a certified professional employer organization if, under State law, a certified professional employer organization is permitted to collect and remit contributions with respect to a work site employee to the State unemployment fund.

Except to the extent necessary for purposes of the proposal treating a certified professional employer organization as the employer for employment tax purposes, nothing in the proposal is to be construed to affect the determination of who is an employee or employer for purposes of the Code.

Certified professional employer organization

A certified professional employer organization is a person who has been certified by the Secretary of the Treasury ("Secretary"), for purposes of being treated as the employer for employment tax purposes under the proposal, as meeting certain requirements. These requirements are met if the person:

• demonstrates that the person (and any owner, officer, and such other persons as may be specified in regulations) meets requirements established by the Secretary with respect to tax status, background, experience, business location, and annual financial audits;

• agrees to satisfy the bond and independent financial review requirements (described below) on an ongoing basis;

• agrees to satisfy any reporting obligations imposed by the Secretary;

• computes its taxable income using an accrual method of accounting unless the Secretary approves another method;

• agrees to verify on such periodic basis as prescribed by the Secretary that it continues to meet the requirements for certification; and

• agrees to notify the Secretary in writing within such time as prescribed by the Secretary of any change that materially affects the continuing accuracy of any agreement or information that was previously made or provided.

Under the independent financial review requirements, a certified professional employer organization must: (1) have, as of the most recent audit date (that is, six months after the completion of the certified professional employer organization's fiscal year), caused to be prepared and provided to the Secretary an opinion of an independent certified public accountant as to whether the certified professional employer organization's financial statements are presented fairly in accordance with generally accepted accounting principles; and (2) provide to the Secretary, not later than the last day of the second month beginning after the end of each calendar quarter, from an independent certified public accountant an assertion regarding Federal employment tax payments and an examination level attestation on the assertion. The assertion must state that the certified professional employer organization has withheld and made deposits of all required FICA, RRTA, and withheld income taxes for the calendar quarter, and the attestation must state that the assertion is fairly stated in all material respects. If a certified professional employer organization fails to file the required assertion and attestation with respect to any calendar quarter, the independent financial review requirements are treated as not satisfied for the period beginning on the due date for the attestation.

For purposes of the bond and independent financial review requirements, all professional employer organizations that are members of a controlled group of corporations or under common control are treated as a single organization.²⁴³ The Secretary may suspend or revoke the certification of a person's certified professional employer organization status if the Secretary determines that the person does not satisfy the representations or other requirements for certification or fails to satisfy the applicable accounting, reporting, payment, or deposit requirements.

Work site employee

A work site employee is an individual who: (1) performs services for a customer of a certified professional employer organization pursuant to a contract between the customer and the certified professional employer organization that meets certain requirements (described below); and (2) performs services at a work site meeting certain requirements (described below).²⁴⁴

The contract between the customer and the certified professional employer organization must be in writing and, with respect to an individual performing services for the customer, must provide that the certified professional employer organization will:

• assume responsibility for payment of wages to the individual, without regard to the receipt or adequacy of payment from the customer;

• assume responsibility for reporting, withholding, and paying any employment taxes with respect to the individual's wages, without regard to the receipt or adequacy of payment from the customer;

• assume responsibility for any employee benefits that the contract may require the certified professional employer organization to provide, without regard to the receipt or adequacy of payment from the customer;

• assume responsibility for recruiting, hiring and firing workers in addition to the customer's responsibility for recruiting, hiring and firing workers;

• maintain employee records relating to the individual; and

• agree to be treated as a certified professional employer organization for employment tax purposes with respect to such individual.

Regulations

The Secretary is directed to prescribe such regulations as may be necessary or appropriate to carry out the purposes of the proposal. The Secretary is also directed to develop reporting and recordkeeping rules, regulations, and procedures to ensure compliance with the proposal with respect to entities applying for and receiving certification as certified professional employer organizations. These are to be designed in a manner to streamline, to the extent possible, the application of the requirements of the proposal, the exchange of information between a certified professional employer organization and its customers, and the reporting and recordkeeping obligations of a certified professional employer organization.

Other rules

There are two basic types of individual retirement arrangements ("IRAs") under present law: traditional IRAs,²⁴⁶ to which both deductible and nondeductible contributions may be made,²⁴⁷ and Roth IRAs, to which only nondeductible contributions may be made.²⁴⁸ The principal difference between these two types of IRAs is the timing of income tax inclusion. For a traditional IRA, an eligible contributor may deduct the contributions made for the year, but distributions are includible in gross income to the extent attributable to earnings on the account and the deductible contributions. For a Roth IRA, all contributions are after-tax (that is, no deduction is allowed), but qualified distributions are not includible in gross income.

An annual limit applies to contributions to IRAs. The contribution limit is coordinated so that the aggregate maximum amount that can be contributed to all of an individual's IRAs (both traditional and Roth) for a taxable year is the lesser of a certain dollar amount ($5,500 for 2014) or the individual's compensation. In the case of a married couple, contributions can be made up to the dollar limit for each spouse if the combined compensation of the spouses is at least equal to the contributed amount. The dollar limit is increased to reflect increases in the cost-of living using calendar year 2007 as the base year. The index used is the consumer price index for all-urban consumers published by the Department of Labor (CPI-U). However, if the amount of any increase is not a multiple of $500, the increase is rounded down to the nearest multiple of $500.

An individual who has attained age 50 before the end of the taxable year may also make catch-up contributions up to $1,000 to an IRA. The IRA catch-up contribution limit is not indexed.

Traditional IRAs

An individual may make deductible contributions to a traditional IRA up to the IRA contribution limit (reduced by any contributions to Roth IRAs) if neither the individual nor the individual's spouse is an active participant in an employer-sponsored retirement plan. If an individual (or the individual's spouse) is an active participant in an employer-sponsored retirement plan, the deduction is phased out for taxpayers with adjusted gross income ("AGI") for the taxable year over certain indexed levels.²⁴⁹ To the extent an individual cannot or does not make deductible contributions to a traditional IRA or contributions to a Roth IRA for the taxable year, the individual may make nondeductible contributions to a traditional IRA (that is, no AGI limits apply), subject to the same contribution limits as the limits on deductible contributions, including catch-up contributions. An individual who has attained age 70 1/2 prior to the close of a year is not permitted to make contributions to a traditional IRA.

Amounts held in a traditional IRA are includible in income when withdrawn, except to the extent that the withdrawal is a return of the individual's basis.²⁵⁰ All traditional IRAs of an individual are treated as a single contract for purposes of recovering basis in the IRAs.

Roth IRAs

Individuals with AGI below certain levels may make nondeductible contributions to a Roth IRA. The maximum annual contribution that can be made to a Roth IRA is phased out for taxpayers with AGI for the taxable year over certain indexed levels. The AGI phase-out ranges for 2014 for Roth IRA contributions are: (1) for single taxpayers, $114,000 to $129,000; (2) for married taxpayers filing joint returns, $181,000 to $191,000; and (3) for married taxpayers filing separate returns, $0 to $10,000. Contributions to a Roth IRA may be made even after the account owner has attained age 70 1/2.

Amounts held in a Roth IRA that are withdrawn as a qualified distribution are not includible in income. A qualified distribution is a distribution that (1) is made after the five-taxable-year period beginning with the first taxable year for which the individual first made a contribution to a Roth IRA, and (2) is made after attainment of age 59 1/2, on account of death or disability, or is made for first-time homebuyer expenses of up to $10,000.²⁵¹

Distributions from a Roth IRA that are not qualified distributions are includible in income to the extent attributable to earnings; amounts that are attributable to a return of contributions to the Roth IRA are not includible in income. All Roth IRAs are treated as a single contract for purposes of determining the amount that is a return of contributions.

Separation of traditional and Roth IRA accounts

Contributions to traditional IRAs and to Roth IRAs must be segregated into separate IRAs, meaning arrangements with separate trusts, accounts, or contracts, and separate IRA documents. Except in the case of a conversion or recharacterization, amounts cannot be transferred or rolled over between the two types of IRAs.

Taxpayers generally may convert an amount in a traditional IRA into a Roth IRA.²⁵² The amount converted is includible in the taxpayer's income as if a withdrawal had been made, except that the 10-percent early distribution tax does not apply.²⁵³ The conversion is accomplished by a trustee-to-trustee transfer of the amount from the traditional IRA to the Roth IRA, or by a distribution from the traditional IRA and contribution to the Roth IRA within 60 days.

Rollovers to IRAs of distributions from tax-favored employer-sponsored plans (qualified retirement plans, section 403(b) plans, and governmental section 457(b) plans) are also permitted. For tax-free rollovers, distributions from pretax accounts under an employer-sponsored plan must be contributed to a traditional IRA and distributions from a designated Roth account are only permitted to be contributed to a Roth IRA. A distribution from an employer-sponsored plan that is not from a designated Roth account is also permitted to be rolled over into a Roth IRA, subject to the rules that apply to conversions from a traditional IRA into a Roth IRA. Thus, a rollover from an eligible employer plan into a Roth IRA is includible in gross income (except to the extent it represents a return of after-tax contributions), and the 10-percent early distribution tax does not apply.²⁵⁴

Recharacterization

If an individual makes a contribution to an IRA (traditional or Roth) for a taxable year, the individual is permitted to recharacterize (by a trustee-to-trustee transfer to the other type of IRA) the amount of that contribution as a contribution to the other type of IRA (traditional or Roth) before the due date for the individual's income tax return for that year.²⁵⁵ In the case of a recharacterization, the contribution will be treated as having been made to the transferee plan (and not the transferor plan) as of the date of the original contribution. Both regular contributions and conversion contributions to a Roth IRA can be recharacterized as having been made to a traditional IRA. The amount transferred must be accompanied by any net income allocable to the contribution and no deduction is allowed with respect to the contribution to the transferor plan. Even if a recharacterization is accomplished by transferring a specific asset, net income is calculated as a prorata portion of income on the entire account rather than income allocable to the specific asset transferred. However, when doing a Roth conversion of an amount for a year, an individual may divide up the amount being converted and establish multiple Roth IRAs (for example, Roth IRAs with different investment strategies) and select which Roth IRA to recharacterize as a traditional IRA by transferring the entire amount in the account to a traditional IRA (for example, the entire amount in the account of any IRA for which the value of the assets in the account declines during the year).²⁵⁶ The individual may then later convert that traditional IRA to Roth IRA, including the lower value in income. Treasury regulations prevent the conversion from taking place immediately after the recharcterization. The regulations require a minimum period to elapse before a reconversion after a recharacterization (meaning a conversion of an amount previously contributed to a Roth IRA in a Roth conversion and then recharacterized as a contribution to a traditional IRA).²⁵⁷ Generally the reconversion cannot occur sooner than the later of 30 days after the recharacterization or a date during the taxable year following the taxable year of the original conversion.

Simple IRA plans and simplified employee pensions

Simple IRA plans and simplified employee pensions are special types of employer-sponsored retirement plans under which the employer makes contributions to IRAs established for each of its employees in accordance with the Code requirements for each type of plan. Only contributions to traditional IRAs are allowed for these plans.

Rollover contributions from employer sponsored retirement plans

Distributions from tax-favored employer-sponsored plans are permitted to be rolled over tax-free to a traditional IRA or another tax-favored employer-sponsored plan.

Elimination of income limits on contributions to Roth IRAs

The AGI limits on making contributions to a Roth IRA are eliminated. Thus contributions are permitted to be made to a Roth IRA by a taxpayer for a year regardless of the taxpayer's AGI.

No deductible or nondeductible contributions to traditional IRAs

No deductible or nondeductible contributions are allowed to be made to traditional IRAs. Only rollover contributions of distributions from other traditional IRAs or tax-favored retirement plans and contributions under a SIMPLE IRA plan or a simplified employee pension plan are allowed to be made to a traditional IRA. Nondeductible contributions continue to be allowed to be made to Roth IRAs.

Suspension of inflation adjustment of dollar limit on contributions to Roth IRAs

The proposal suspends cost-of-living adjustments to the dollar limit on contributions to Roth IRAs through 2023. Thus, the 2014 annual limit on contributions to a Roth IRA remains at $5,500 through 2023. Cost-of living adjustments resume beginning with 2024 using calendar year 2022 as the base year, rounding down to the nearest multiple of $500 (as under present law). As under present law, Roth IRA catch-up contributions are not indexed, and thus remain at $1,000 per year even after 2023.

Repeal of special rule permitting recharacterization of IRA contributions

Under the proposal, the special rule that allows IRA contributions to one type of IRA (either traditional or Roth) to be recharacterized as a contribution to the other type of IRA is repealed. Thus, for example, under the proposal, a conversion contribution establishing a Roth IRA during a taxable year can no longer be recharacterized as a contribution to a traditional IRA (thereby unwinding the conversion) because the investment experience of the Roth IRA after the conversion resulted in net losses, rather than net gains, and the individual wanted to be able convert that amount at the lower value, including in income only that lower value.

Effective Date

The proposal is effective for taxable years beginning after December 31, 2014.

2. Repeal of exception to 10-percent penalty for first-time home purchases and elimination of first-time home purchase as a qualified distribution from a Roth IRA (sec. 1605 of the discussion draft and secs. 72(t) and 408A of the Code)

The Code imposes an early distribution tax on distributions made from qualified retirement plans, 403(b) plans, and IRAs before an employee (or an IRA owner) attains age 59 1/2 unless an exception applies.²⁵⁸ The tax is equal to 10 percent of the amount of the distribution that is includible in gross income.²⁵⁹ One of the exceptions is for qualified first-time homebuyer distributions which are distributions from IRAs used for first-time homebuyer expenses that meet certain requirements and are limited to $10,000.²⁶⁰

Qualified distributions from Roth IRAs

There are two basic types of individual retirement arrangements ("IRAs") under present law: traditional IRAs,²⁶¹ to which both deductible and nondeductible contributions may be made,²⁶² and Roth IRAs, to which only nondeductible contributions may be made.²⁶³ The principal difference between these two types of IRAs is the timing of income tax inclusion. For a traditional IRA, an eligible contributor may deduct the contributions made for the year, but distributions are includible in gross income to the extent attributable to earnings on the account and the deductible contributions. For a Roth IRA, all contributions are after-tax (that is, no deduction is allowed) but, qualified distributions from the Roth IRA are not includible in gross income.

A qualified distribution from a Roth IRA is a distribution that (1) is made after the five-taxable-year period beginning with the first taxable year for which the individual first made a contribution to a Roth IRA, and (2) is made after attainment of age 59 1/2, on account of death or disability of the IRA owner, or is a qualified first-time home buyer distribution.²⁶⁴ Distributions from a Roth IRA that are not qualified distributions are includible in income to the extent attributable to earnings; amounts that are attributable to a return of contributions to the Roth IRA are not includible in income.

3. Termination of new simplified employee pensions (sec. 1611 of the discussion draft and sec. 408(k) of the Code)

Effective for taxable years beginning before January 1, 1997, certain employers with no more than 25 employees could maintain a salary reduction SEP ("SARSEP") under which employees could make elective deferrals. However, contributions may continue to be made to SARSEPs that were established before 1997. Elective deferrals under a SARSEP are subject to the same limit that applies to elective deferrals under a section 401(k) plan ($17,500 for 2014). An individual who has attained age 50 before the end of the taxable year may also make catch-up contributions under a SARSEP up to a limit of $5,500 (for 2014).

4. Termination for new SIMPLE 401(k) plans (sec. 1612 of the discussion draft and sec. 401(k)(11) of the Code)

Employer contributions to a simple retirement plan generally must satisfy one of two contribution formulas. Under the matching contribution formula, the employer generally is required to match employee elective deferrals on a dollar-for-dollar basis up to three percent of the employee's compensation. Alternatively, for any year, an employer is permitted to elect, in lieu of making matching contributions, to make a nonelective contribution of two percent of compensation on behalf of each eligible employee whether or not the employee makes elective deferrals. No contributions other than employee elective deferrals, required employer matching contributions, or employer nonelective contributions can be made to a simple retirement plan.

5. Rules related to designated Roth contributions (sec. 1613 of the discussion draft and secs. 401(a)(30), 402(g), 402A, and 408(p) of the Code)

Amounts contributed pursuant to these qualified cash or deferred arrangements and salary reduction agreements generally are referred to as elective deferrals. The elective deferrals generally are excludable from gross income (pretax elective deferrals) and only taxed along with attributable earnings upon distribution from the plan. Alternatively the plan may include a qualified Roth contribution program under which eligible employees are offered a choice of either making pretax elective deferrals or making elective deferrals that are not excluded from income and are designated as Roth contributions.²⁶⁸ However, the plan is not permitted to only allow employees to make designated Roth contributions; pretax elective deferrals must also be permitted.²⁶⁹ If certain requirements are satisfied, distributions of designated Roth contributions and attributable earnings are excluded from gross income. The employer may also make nonelective and matching contributions for employees under a section 401(k) or 403(b) plan. These are not permitted to be designated as Roth contributions and generally are pretax contributions.

A dollar limit applies to the aggregate amount of elective deferrals (both pretax elective deferrals and designated Roth contributions) that an employee is permitted to contribute to section 401(k) and section 403(b) plans for a taxable year, which is $17,500 for 2014.²⁷⁰ An employee age 50 or over is allowed to contribute an additional catch up amount of $5,500 for 2014.²⁷¹

If an individual's total elective deferrals for a taxable year under section 401(k) plans and section 403(b) plans exceed the $17,500 limit plus, if applicable, the catch-up contributions limit, and the plan distributes the excess (plus allocable income) by April 15 following the taxable year, the excess amount is includable in the individual's gross income.²⁷² If the excess is not distributed by April 15, the excess is includable in gross income but the individual receives no basis in the account for the amount included in gross income. Thus, that amount will be taxed again when distributed. In the case of an excess in the form of designated Roth contributions that is not distributed by April 15, any distribution attributable to the excess cannot be a qualified distribution, and the individual is not entitled to basis to reflect that the excess amount is an after-tax contribution.

A governmental section 457(b) plan may also provide for elective deferrals. Contributions to a governmental section 457(b) plan are subject to a dollar limit of $17,500 (for 2014) plus an additional $5,500 catch-up contribution limit (for 2014) for participants at least age 50 (or the participant's compensation, if less).²⁷³ This limit is separate from the limit on elective deferrals to section 401(k) and section 403(b) plans.²⁷⁴ As in the case of a section 401(k) plan or a section 403(b) plan, the plan may include a qualified Roth contribution program under which employees are given the choice between making pretax elective deferrals and designated Roth contributions.

Designated Roth accounts

All designated Roth contributions made under the plan must be maintained in a separate account (a designated Roth account). A qualified distribution from a designated Roth account is excludable from gross income. A qualified distribution is a distribution that is made after (1) an employee's completion of a specified 5-year period and (2) the employee's attainment of age 59 1/2, death, or disability.

A distribution from a designated Roth account (other than a qualified distribution) is included in the distributee's gross income to the extent allocable to income under the contract and excluded from gross income to the extent allocable to investment in the contract (commonly referred to as basis), taking into account only the designated Roth contributions as basis.

SIMPLE IRA plan

An eligible employer can establish a simplified tax-favored retirement plan, which is called a SIMPLE IRA plan. An eligible employer is an employer which had no more than 100 employees who received at least $5,000 of compensation from the employer for the preceding year. Compensation for this purpose is wages reported on the employees Form W-2 plus elective pretax deferrals. An employer that maintains a SIMPLE IRA plan for one or more years and then exceeds this limit may remain an eligible employer for 2 years following the year in which the employer last satisfied the limit.

A SIMPLE IRA under a SIMPLE IRA plan is not permitted to be a Roth IRA. Under a SIMPLE IRA plan, contributions are made only to a traditional IRA (not a Roth IRA) for each employee (a "SIMPLE IRA"). A SIMPLE IRA plan allows employees to make pretax elective deferrals to a SIMPLE IRA, subject to a limit of $12,000 (for 2014). An individual who has attained age 50 before the end of the taxable year may also make catch-up contributions under a SIMPLE IRA plan up to a limit of $2,500 (for 2014). The employer is required to make certain specified matching or nonelective contributions to the SIMPLE IRA for each eligible employee. In the case of a SIMPLE IRA plan, the group of eligible employees generally must include any employee who has received at least $5,000 in compensation from the employer in any two preceding years and is reasonably expected to receive $5,000 in the current year.²⁷⁵

Except as described below for plans of eligible employers, under the proposal, the combined limit on pretax elective deferrals under section 401(k) plans and 403(b) plans, and pretax deferrals under a governmental section 457(b) plan is reduced to one half the dollar limits on total elective deferrals and catch-up contributions (the aggregate amount of pretax elective deferrals and designated Roth contributions). Thus, the general limit on pretax elective deferrals is $8,750 (one half of $17,500), and the catch-up contribution limit is $2,750 (one half of $5,500). As a result, for an employee over age 50, the general elective contribution limit applicable to the aggregate amount of pretax elective deferrals and designated Roth contributions is $23,000, but the pretax elective deferrals cannot exceed one half that amount or $11,500.

Qualified Roth contribution program

The limit on designated Roth contributions is the full $17,500 limit, plus (if applicable) the full $5,500 catch up contribution limit, reduced by the amount of any pretax elective deferrals. Under the proposal, section 401(k) plans, section 403(b) plans, and governmental section 457(b) plans are permitted to offer only a qualified Roth contribution program with respect to elective deferrals (both with respect to the $17,500 limit and the $5,500 catch-up contribution limit), and are not required to also offer employees the opportunity to make pretax elective deferrals.²⁷⁶

Plan maintained by an eligible employer

The rule reducing the limit on pretax elective deferrals to one half the elective deferral limit and, if applicable, the catch-up contribution limit does not apply to a section 401(k) plan, section 403(b) plan, or governmental section 457(b) plan, maintained by an eligible employer. Under the proposal, the only change to the present-law rules applicable to one of these types of plans maintained by an eligible employer is that the plan is permitted to only allow designated Roth contributions (under a qualified Roth contribution program) and is not required to also allow pretax elective deferrals. Otherwise the rules remain unchanged. Thus, the employer may maintain a plan that only allows pretax elective deferrals and the limit remains the maximum limit of $17,500 (plus $5,500 catch up, if applicable). Reporting will be required on the employee's Form W-2 to identify that the elective deferrals are under a plan of an eligible employer.

The definition of an eligible employer for this purpose is the definition of an eligible employer under the SIMPLE IRA plan rules, generally an employer that had no more than 100 employees who received at least $5,000 of compensation from the employer for the preceding year with a 2-year grace period for an employer with employees that exceed this limit.

SIMPLE IRA plans

The proposal permits a SIMPLE IRA to be a Roth IRA. The proposal also allows a SIMPLE IRA plan to permit employees to choose to make after-tax elective deferrals to Roth IRAs in lieu of elective deferrals to traditional IRAs, subject to the combined limit of $12,000 (plus $2,500 for catch-up contributions, if applicable). However, a SIMPLE IRA plan is also permitted to continue to only allow pretax elective deferrals to traditional IRAs.

The proposal also provides a new option for a SIMPLE IRA plan under which the plan may provide for elective deferrals up to the full limit of $17,500 plus catch-up contributions of $5,500 (applicable to elective deferrals under section 401(k) and 403(b) plans, and governmental section 457(b) plans), but only if the plan allows after-tax elective deferrals to be made to a SIMPLE IRA that is a Roth IRA and does not allow pretax elective deferrals to be made to traditional IRAs in excess of one half the applicable limit, $8,750 plus catch-up contributions, if applicable of $2,750.²⁷⁷

6. Modification of required distribution rules for pension plans (sec. 1614 of the discussion draft and sec. 401(a)(9) of the Code)

Required beginning date

For traditional IRAs, the required beginning date is April 1 following the calendar year in which the employee (or IRA owner) attains age 70 1/2. For employer-sponsored tax-favored retirement plans, for an employee other than an employee who is a five-percent owner in the year the employee attains age 70 1/2, the required beginning date is April 1 after the later of the calendar year in which the employee attains age 70 1/2 or retires. For an employee who is a five-percent owner under an employer-sponsored tax-favored retirement plan in the year the employee attains age 70 1/2, the required beginning date is the same as for IRAs even if the employee continues to work past age 70 1/2.

Lifetime rules

While an employee (or IRA owner) is alive, distributions of the individual's interest are required to be made (in accordance with regulations) over the life or life expectancy of the employee (or IRA owner), or over the joint lives or joint life expectancy of the employee (or IRA owner) and a designated beneficiary.²⁸² For defined contribution plans and IRAs, the required minimum distribution for each year is determined by dividing the account balance as of the end of the prior year by a distribution period which, while the employee (or IRA owner) is alive, is the factor for the employee (or IRA owner's) age from the uniform lifetime table included in the Treasury regulations.²⁸³ This table is based on the joint life and last survivor expectancy of the individual and a hypothetical beneficiary 10 years younger. The distribution period for annuity payments under a defined benefit plan or annuity contract (to the extent not limited to the life of the employee (or IRA owner) or the joint lives of the employee (or IRA owner) and a designated beneficiary) is generally subject to the same limitations as apply to individual accounts.

Distributions after death

If an employee (or IRA owner) dies on or after the required beginning date, the basic statutory rule is that the remaining interest must be distributed at least as rapidly as under the method of distribution being used before death.²⁸⁶ Under the regulations, for individual accounts, this rule is also interpreted as requiring the minimum required distribution to be calculated using a distribution period. If there is no designated beneficiary, the distribution period is equal to the remaining years of the employee's (or IRA owner's) life, as of the year of death.²⁸⁷ If there is a designated beneficiary, the distribution period (if longer) is the beneficiary's life expectancy calculated using the life expectancy table in the regulations, calculated in the year after the year of death.²⁸⁸

If an employee (or IRA owner) dies before the required beginning date and any portion of the benefit is payable to a designated beneficiary, the statutory rule is that distributions are generally required to begin within one year of the employee's (or IRA owner's) death (or such later date as prescribed in regulations) and are permitted to be paid (in accordance with regulations) over the life or life expectancy of the designated beneficiary. If the beneficiary of the employee (or IRA owner) is the individual's surviving spouse, distributions are not required to commence until the year in which the employee (or IRA owner) would have attained age 70 1/2. If the surviving spouse dies before the employee (or IRA owner) would have attained age 70 1/2, the after-death rules apply after the death of the spouse as though the spouse were the employee (or IRA owner). Under the regulations, for individual accounts, the required minimum distribution for each year is determined using a distribution period and the period is measured by the designated beneficiary's life expectancy, calculated in the same manner as if the individual died on or after the required beginning date.²⁸⁹

In cases where distribution after death is based on life expectancy (either the remaining life expectancy of the employee (or IRA owner) or a designated beneficiary), the distribution period generally is fixed at death and then reduced by one for each year that elapses after the year in which it is calculated. If the designated beneficiary dies during the distribution period, distributions continue to the subsequent beneficiaries over the remaining years in the distribution period.²⁹⁰

The distribution period for annuity payments under a defined benefit plan or annuity contract (to the extent not limited to the life of a designated beneficiary) is generally subject to the same limitations as apply to individual accounts.

Defined benefit plans and annuity distribution

The regulations provide rules for the amount of annuity distributions from a defined benefit plan or an annuity purchased from an insurance company paid over life or life expectancy. Annuity distributions are generally required to be nonincreasing with certain exceptions, which include, for example, increases to the extent of certain specified cost of living indexes, a constant percentage increase (for a qualified plan, the constant percentage cannot exceed five-percent per year), certain accelerations of payments, increases to reflect when an annuity is converted to a single life annuity after the death of the beneficiary under a joint and survivor annuity or after termination of the survivor annuity under a QDRO.²⁹² If distributions are in the form of a joint and survivor annuity and the survivor annuitant both is not the surviving spouse and is younger than the employee (or IRA owner), the survivor annuitant is limited to a percentage of the life annuity benefit for the employee (or IRA owner). The survivor benefit as a percentage of the benefit of the primary annuitant is required to be smaller (but not required to be less than 52 percent) as the difference in the ages of the primary annuitant and the survivor annuitant become greater.

Under the proposal, if an employee becomes a five-percent owner after age 70 1/2 but before retiring and thus before the employee's required beginning date with respect to tax-favored retirement plans of the employee's employer, the required beginning date for that employee becomes April 1 of the year following the year that the employee becomes a five-percent owner.

Other than the modification to the required beginning date for five-percent owners, the proposal makes no changes to the required minimum distribution rules during the lifetime of the employee (or IRA owner). Thus, for example, the proposal is not expected to result in a change to the regulations under section 401(a)(9) for required minimum distributions during the lifetime of the employee (or IRA owner) under which the required minimum distribution for each year is generally determined by dividing the account balance as of the end of the prior year by a distribution period which is the number corresponding to the employee's (or IRA owner's) age for the year from the uniform lifetime table included in the Treasury regulations.

After death rules

However, unlike present law, under the proposal, the five-year rule also applies after the death of an eligible beneficiary or after a child reaches age 22. Thus for example, if a disabled child of an employee (or IRA owner) is an eligible beneficiary of a parent who dies when the child is age 20 and the child dies at age 30, even though 52.1 years remain in the life expectancy of the child calculated for the child's age (21) in the year after the employee's (or IRA owner's) death, the disabled child's remaining beneficiary interest must be distributed by the end of the fifth year following the death of the disabled child. If a child is an eligible beneficiary based on having not reached the age 22 before the employee's (or IRA owner's) death, the five-year rule applies beginning with the earlier of date of the child's death or the date that the child reaches age 22. The child's entire interest must be distributed by the end of the fifth year following that date.

As under present law, if the surviving spouse is the beneficiary, there is a special rule that allows the commencement of distribution to be delayed until end of the year that the employee (or IRA owner) would have been age 70 1/2. If the spouse dies before distributions were required to begin to the spouse, the surviving spouse is treated as the employee (or IRA owner) in determining the required distributions to beneficiaries of the surviving spouse.

Under the proposal, the definition of a chronically ill individual for qualified long-term care insurance under section 7702B(c)(2) is incorporated by reference with a modification. Under this definition, a chronically ill individual is any individual who (1) is unable to perform (without substantial assistance from another individual) at least two activities of daily living for an indefinite period (expected to be lengthy in nature)²⁹⁴ due to a loss of functional capacity, (2) has a level of disability similar (as determined under regulations prescribed by the Secretary in consultation with the Secretary of Health and Human Services) to the level of disability described above requiring assistance with daily living based on loss of functional capacity, or (3) requires substantial supervision to protect the individual from threats to health and safety due to severe cognitive impairment. The activities of daily living for which assistance is needed for purposes of determining loss of functional capacity are eating, toileting, transferring, bathing, dressing, and continence.

For the proposal changing the definition of required beginning date for employees who become five-percent owners after age 70 1/2, the proposal applies to any employee who becomes five-percent owner with respect to plan years ending in calendar years beginning before, on, or after the date of the enactment. If an employee became a five percent owner with respect to a plan year ending in a calendar year before January 1, 2014, and the employee has not retired before the calendar year 2014, the employee's required beginning date is April 1, 2015. However if under present law, an employee's required beginning date occurred before April 1, 2015 because the employee retired during a year before 2014, the proposal does not cause the employee to have an earlier required beginning date.

Required distributions after death

For determining minimum required distributions after the death of an employee (or IRA owner), the proposal is generally effective for distributions with respect to employees (or IRA owners) who die after December 31, 2014.

In the case of an employee (or IRA owner) who dies before January 1, 2015, if the designated beneficiary of the employee (or IRA owner) dies after December 31, 2014, the proposal applies to any beneficiary of the designated beneficiary as though the designated beneficiary were an eligible beneficiary. Thus, the entire interest must be distributed by the end of the fifth year after the death of the designated beneficiary.

In the case of an employee (or IRA owner) who dies after December 31, 2014, the proposal does not apply to a qualified annuity that is a binding annuity contract in effect on the date of the enactment and at all times thereafter. To be a qualified annuity, the annuity must be a commercial annuity (as defined in section 3405(e)(6)) or an annuity payable by a defined benefit plan, and (2) an annuity under which the annuity payments are substantially equal periodic payments (not less frequently than annually) over the lives of such employee (or IRA owner) and a designated beneficiary (or over a period not extending beyond the life expectancy of such employee (or IRA owner) or the life expectancy of such employee (or IRA owner) and a designated beneficiary) in accordance with the required minimum distribution regulations for annuity payments (as in effect before enactment of this proposal). In addition to these requirements, to be a qualified annuity, annuity payments to the employee (or IRA owner) must begin before January 1, 2015 and the employee (or IRA owner) must have made an irrevocable election before that date as to the method and amount of the annuity payments to the employee or any designated beneficiaries. Alternatively, if an annuity is not a qualified annuity solely based on annuity payments not having begun irrevocably before January 1, 2015, an annuity can be a qualified annuity if the employee (or IRA owner) has made an irrevocable election before the date of enactment as to the method and amount of the annuity payments to the employee (or IRA owner) or any designated beneficiaries.

7. Reduction in age for allowable in-service distributions (sec. 1615 of the discussion draft and secs. 401(a)(36) and sec. 457(d)(1) of the Code)

There are three basic types of funded tax-favored employer-sponsored defined contribution plans: qualified retirement plans, section 403(b) plans, and governmental section 457(b) plans. These tax-favored employer-sponsored retirement plans are accorded special tax treatment under present law. Most contributions, earnings on contributions, and benefits are not included in gross income until amounts are distributed, even if the arrangement is funded and benefits are vested. Additionally, many distributions can be rolled over to another plan for further deferral of income inclusion. Defined contribution plans may provide for nonelective contributions and matching contributions by employers and elective deferrals or after-tax contributions by employees. Elective deferrals are contributions made pursuant to an election by an employee between cash compensation and a contribution to the plan.

Elective deferrals under a qualified retirement plan may only be made under a section 401(k) plan. A section 401(k) plan legally is not a separate type of plan, but is a profit-sharing or stock bonus plan that contains a qualified cash or deferred arrangement.²⁹⁷ Thus, such arrangements are subject to the rules generally applicable to qualified defined contribution plans. In addition, special rules apply to such arrangements. One requirement is that no distributions prior to severance from employment generally are permitted for amounts attributable to elective deferrals unless the employee has attained age 59 1/2.

Section 403(b) plans are another form of tax-favored employer-sponsored plan that provide tax benefits similar to qualified retirement plans. Section 403(b) plans may be maintained only by (1) charitable organizations tax-exempt under section 501(c)(3), and (2) educational institutions of State or local governments (i.e., public schools, including colleges and universities). Elective deferrals are also permitted under section 403(b) plans and are subject to the same requirement that generally no distributions are permitted prior to severance from employment unless the employee has attained age 59 1/2.

Governmental section 457(b) plans

In the case of a State or local government employer, a section 457(b) plan is generally limited to elective deferrals and provides tax benefits similar to a section 401(k) or 403(b) plan in that deferrals are contributed to a trust or custodial account for the exclusive benefit of participants, but are not included in income until distributed (and may be rolled over to another tax-favored plan).²⁹⁸ However distributions from a governmental section 457(b) plan prior to severance from employment are generally not permitted until the employee attains age 70 1/2.²⁹⁹

Pension plans

For purposes of the qualification requirements applicable to pension plans, stock bonus plans, and profit-sharing plans under the Code, a pension plan is a plan established and maintained primarily to provide systematically for the payment of definitely determinable benefits to employees over a period of years, usually life, after retirement.³⁰⁰ A pension plan (i.e., a defined benefit plan or money purchase pension plan) generally may not provide for distributions before the attainment of the normal retirement age under the plan to participants who have not separated from employment. However, a pension plan is not treated as failing to be a qualified retirement plan solely because the plan provides that a distribution may be made to an employee who has attained age 62 (even if earlier than the normal retirement age under the plan) and who is not separated from employment at the time of the distribution.³⁰¹

8. Modification of rules governing hardship distributions (sec. 1616 of the discussion draft and sec. 401(k)(2) of the Code)

The Treasury regulations provide a safe harbor under which a distribution may be deemed necessary to satisfy an immediate and heavy financial need. One requirement of this safe harbor is that the employee be prohibited from making elective deferrals and employee contributions to the plan and all other plans maintained by the employer for at least six months after receipt of the hardship distribution. The same rules apply to hardship distributions of elective deferrals from section 403(b) plans.

9. Extended rollover period for the rollover of plan loan offset amounts in certain cases (sec. 1617 of the discussion draft and sec. 402(c) of the Code)

Qualified retirement plans, section 403(b) plans, and governmental section 457(b) plans are required to offer a direct rollover with respect to any eligible rollover distribution before paying the amount to the participant or beneficiary.³⁰⁷ If an eligible rollover distribution is not directly rolled over into an eligible retirement plan, the taxable portion of the distribution generally is subject to mandatory 20-percent income tax withholding.³⁰⁸ Participants who do not elect a direct rollover but who roll over eligible distributions within 60 days of receipt also defer tax on the rollover amounts; however, the 20 percent withheld will remain taxable unless the participant substitutes funds within the 60-day period.

Plan loan as a deemed distribution

Tax-favored employer-sponsored retirement plans may provide loans to participants. Unless the loan satisfies certain requirements in both form and operation, the amount of a retirement plan loan is a deemed distribution from the retirement plan.³⁰⁹ These requirements include the following: the amount of the loan must not exceed the lesser of 50 percent of the participant's account balance or $50,000; the terms of the loan must provide for a repayment period of not more than five years and provide for level amortization of loan payments (with payments not less frequently than quarterly); and the terms of the loan must be legally enforceable. Loans specifically for home purchases may be repaid over a longer period. Thus if a plan participant ceases to make payments on a loan before it is repaid, a deemed distribution of the outstanding loan balance generally occurs.

A deemed distribution of an unpaid loan balance is generally taxed as though an actual distribution occurred, including being subject to a 10-percent early distribution tax, if applicable. However, a deemed distribution is not eligible for rollover to another eligible retirement plan.

Loan offset amount

A plan may also provide that, in certain circumstances (for example, upon a participant's termination of employment with the employer), a participant's obligation to repay a loan is accelerated and, if the loan is not repaid, the loan is cancelled and the amount in participant's account balance is offset by the amount attributable to the loan (the amount of the unpaid loan balance). In the case of a loan offset, an actual distribution equal to the unpaid loan balance (as opposed to a deemed distribution under section 72(p)) occurs, and (unlike a deemed distribution) the amount of the distribution is eligible for tax-free rollover to another eligible retirement plan. However, the plan is not required to offer a direct rollover with respect to a plan loan offset amount that is an eligible rollover distribution and the plan loan offset amount is generally not subject to 20-percent income tax withholding.

10. Coordination of contribution limitations for 403(b) plans and governmental 457(b) plans (sec. 1618 of the discussion draft and secs. 402(g), 403(b), 415 and 457(b) of the Code)

In the case of a section 401(k) plan or a section 403(b) plan, specific annual limits apply to elective deferrals by a participant and additional annual limits apply to aggregate contributions for the participant. For 2014, elective deferrals are generally limited to the lesser of (1) $17,500 plus an additional $5,500 catch-up contribution limit for participants at least age 50 and (2) the participant's compensation. If an employee participates in both a section 401(k) plan and a section 403(b) plan of the same employer,³¹⁰ a single limit applies to elective deferrals under both plans. However, under a special rule, in the case of employees who have completed 15 years of service, additional elective deferrals are permitted under a section 403(b) plan maintained by an educational organization, hospital, home health service agency, health and welfare service agency, church, or convention or association of churches. In this case, the annual limit is increased by the least of (1) $3,000, (2) $15,000 reduced by the employee's additional elective deferrals for previous years, and (3) $5,000 multiplied by the employee's years of service and reduced by the employee's elective deferrals for previous years.

For 2014, the limit on aggregate contributions to a qualified defined contribution plan (including a section 401(k) plan) or a section 403(b) plan is the lesser of (1) $52,000 and (2) the participant's compensation.³¹¹ Because employees generally do not receive compensation for years after they have terminated employment, contributions generally cannot be made for former employees. However, under a special rule, employer contributions to a section 403(b) plan can be made for up to five years after termination of employment. In addition, under special rules, certain contribution amounts are permitted for church employees and foreign missionaries.

The limit described above on aggregate contributions to a qualified defined contribution plan applies to contributions for a participant to any defined contribution plans maintained by the same employer, defined generally to include any members of a controlled group (using an ownership standard of more than 50 percent, rather than at least 80 percent) or affiliated service group. Similarly, the limit on aggregate contributions to a section 403(b) plan applies to contributions for a participant to any section 403(b) plan maintained by the same employer, including any members of a controlled group or affiliated service group. However, contributions to a qualified defined contribution plan and to a section 403(b) plan maintained by the same employer are subject to separate limits unless the participant in the section 403(b) plan is in control of the employer maintaining the qualified defined contribution plan. This could occur, for example, if the participant in the section 403(b) plan owns a separate business that maintains a qualified defined contribution plan. In that case, a single limit applies to the contributions for the participant to the section 403(b) plan and the defined contribution plan. However, deferrals under a governmental section 457(b) plan are not taken into account in applying this limit.

In the case of a governmental section 457(b) plan, all contributions are subject to a single limit, generally for 2014, the lesser of (1) $17,500 plus an additional $5,500 catch-up contribution limit for participants at least age 50 and (2) the participant's compensation. This limit is separate from the limit on elective deferrals to section 401(k) and section 403(b) plans. Thus, for example, if an employee participates in both a section 403(b) plan and a governmental section 457(b) plan of the same employer, the employee may contribute up to $17,500 (plus $5,500 catch-up contributions if at least age 50) to the section 403(b) plan and up to $17,500 (plus $5,500 catch-up contributions if at least age 50) to the section 457(b) plan. In addition, under a special rule, catch-up contributions may be made by a participant to a governmental section 457(b) for the last three years before attainment of normal retirement age. Additional contributions may be made up to the lesser of (1) two times the otherwise applicable dollar limit for the year (two times $17,500 for 2014, or $35,000) and (2) the participant's otherwise applicable limit for the year plus the amount by which the limit applicable to the participant for previous years exceeded the participant's deferrals for the previous years. If a higher limit applies to a participant for a year under this special rule than under the general catch-up rule, the general catch-up rule does not apply for the year.

The proposal repeals the special rules allowing additional elective deferrals and catch-up contributions under section 403(b) plans and governmental section 457(b) plans. Thus, the same limits apply to elective deferrals and catch-up contributions under section 401(k) plans, section 403(b) plans and governmental section 457(b) plans.

The proposal repeals the special rules allowing employer contributions to section 403(b) plans for up to five years after termination of employment and the special contribution rules for church employees and foreign missionaries.

The proposal also revises application of the limit on aggregate contributions to a qualified defined contribution plan or a section 403(b) plan (that is, the lesser of (1) $52,000 (for 2014) and (2) the participant's compensation). As revised, a single aggregate limit applies to contributions for a participant to any defined contribution plans, any section 403(b) plans, and any governmental section 457(b) plans maintained by the same employer, including any members of a controlled group or affiliated service group.³¹²

11. Application of 10-percent early distribution tax to governmental 457 plans (sec. 1619 of the discussion draft and sec. 72(t) of the Code)

Governmental section 457(b) plans

Special rules apply with respect to deferred compensation arrangements of State and local government and tax-exempt employers.³¹³ Amounts deferred under an eligible deferred compensation plan, i.e., a section 457(b) plan, are not currently included in income. In the case of a State or local government employer, a section 457(b) plan is generally limited to elective deferrals and provides tax benefits similar to a section 401(k) or 403(b) plan in that deferrals are contributed to a trust or custodial account for the exclusive benefit of participants, but are not included in income until distributed (and may be rolled over to another tax-favored plan).³¹⁴

Deferrals under a governmental section 457(b) plan are subject to the same limits as elective deferrals ($17,500 for 2014) and catch-up contributions ($5,500 for 2014) under a section 401(k) plan or a section 403(b) plan, or, if less, the employee's compensation.³¹⁵ As of 2011, a governmental section 457(b) plan may include a qualified Roth contribution program, allowing a participant to elect to have all or a portion of the participant's deferrals under the plan be treated as designated Roth contributions.

Early distribution tax

The Code imposes provides an early distribution tax on distributions made from qualified retirement plans, 403(b) plans and IRAs before employee or an IRA owner attains age 59 1/2 unless an exception applies.³¹⁶ The tax is equal to 10 percent of the amount of the distribution that is includible in gross income. The 10-percent tax is in addition to the taxes that would otherwise be due on distribution. This early distribution tax does not apply to distributions from governmental section 457(b) plans.

12. Inflation adjustments for employer-sponsored retirement plan dollar limitations on benefits and contributions (secs. 1620 to 1624 of the discussion draft and secs. 402(g), 415(d), and 408(p) of the Code)

There are several types of funded tax-favored employer-sponsored retirement plans: qualified retirement plans, section 403(b) plans, governmental section 457(b) plans, simplified employee pensions, and simple retirement plans. Tax-favored retirement plans are of two general types: defined benefit plans, under which benefits are determined under a plan formula and paid from general plan assets, rather than individual accounts; and defined contribution plans, under which benefits are based on a separate account for each participant, to which are allocated contributions, earnings and losses. Defined contribution plans generally may provide for nonelective contributions and matching contributions by employers and elective deferrals or after-tax contributions by employees. Elective deferrals are contributions made pursuant to an election by an employee between cash compensation and a contribution to the plan. Among the requirements that apply to tax-favored qualified retirement plans are dollar limits on the benefits and contributions that are permitted to be provided under the plan.³¹⁷

The dollar limits generally are indexed to reflect cost-of-living increases. The index used for adjusting the dollar limits is generally the same index used for cost-of-living increases in Social Security benefits. An adjustment with respect to any calendar year is based on the index for the calendar quarter ending September 30 of the preceding calendar year over such index for the base period which starts from the base calendar quarter. However for each limit, there is a rounding rule under which any increase that is not a multiple of a specified dollar amount (such as $500) is rounded down to the next lowest multiple for that dollar amount.

Qualified retirement plans and annuities

Elective deferrals up to these limits are either not includable in gross income (but then subsequent distributions attributable to the contributions are includable in gross income) or are designated Roth contributions (in which case the contributions are includable in gross income but then subsequent qualified distributions attributable to the Roth contributions are excludible from gross income).

The amount of elective deferrals (but not catch up contributions) is also included in the contributions subject to the general limit ($52,000 for 2014).

Section 403(b) plans

Section 403(b) plans may be maintained only by (1) tax-exempt charitable organizations,³²² and (2) educational institutions of State or local governments (i.e., public schools, including colleges and universities). Many of the rules that apply to section 403(b) plans are similar to the rules applicable to qualified retirement plans, including section 401(k) plans. Employers may make nonelective or matching contributions to such plans on behalf of their employees, and the plan may provide for employees to make pretax elective deferrals, designated Roth contributions or other after-tax contributions.

Contributions to a section 403(b) plan are generally subject to the same contribution limits applicable to qualified defined contribution plans, including the general limit on contributions ($52,000 for 2014) and the special limits for elective deferrals ($17,500 for 2014) and catch-up contributions ($5,500 for 2014) under a section 401(k) plan. If elective deferral and catch-up contributions are made to both a section 401(k) plan and a section 403(b) plan for the same employee, a single limit applies to the elective deferrals under both plans.³²³

Governmental section 457(b) plans

Deferrals under a governmental section 457(b) plan are generally subject to the same limits as elective deferrals ( $17,500 for 2014) and catch-up contributions ($5,500 for 2014) under a section 401(k) plan or a section 403(b) plan. However, the section 457(b) plan limits apply separately from the combined limit applicable to section 401(k) and 403(b) plan contributions, so that an employee covered by a governmental section 457(b) plan and a section 401(k) or 403(b) plan can contribute the full amount to each plan.³²⁴

Employer-sponsored retirement plans using IRAs

Certain SEP plans established before 1997 may include a salary reduction feature ("SARSEP") under which employees can make elective deferrals. Elective deferrals under a SARSEP are subject to the same limit that applies to elective deferrals under a section 401(k) plan ($17,500, plus catch-up contribution up to $5,500 for a participant age 50 or over, for 2014).

Prior to IRS Notice 2012-75 (the "Notice"),³²⁶ there was some uncertainty concerning the application of the general welfare doctrine to certain benefits provided by Indian tribes to their members. Benefits that have been scrutinized by the IRS include payments for housing, cultural, education, and elder programs provided by Indian tribal governments. The issue is whether the tribal governments can provide such benefits tax-free to their members because they are addressing a social welfare need, without considering the financial need of the members.

In response to requests from tribes to provide guidance on this issue, the IRS has issued the Notice, which provides safe harbors under which the IRS presumes that the individual need requirement of the general welfare exclusion is met for benefits provided under certain Indian tribal governmental programs.

The proposal requires the Secretary of the Treasury ("Secretary") to establish a Tribal Advisory Committee to advise on matters relating to the taxation of Indians. In consultation with the Committee, the proposal requires the Secretary to establish and require training of IRS agents on Federal Indian law and training of tribal financial officers about the proposal. The proposal also requires the Secretary to suspend audits and examinations of Indian tribal governments and tribe members relating to the general welfare exclusion until this education has been completed. The proposal allows the Secretary to waive interest and penalties to the extent those penalties relate to excluding a payment under the general welfare exclusion.

The proposal applies to years for which the tribal member's refund statute of limitation period has not expired and provides a one-year waiver of the refund statute of limitations period in the event that the period expires before the end of the one-year period beginning on the date of enactment of the Act.

The exemption amounts for taxable years beginning in 2014 are: (1) $82,100 in the case of married individuals filing a joint return and surviving spouses; (2) $52,800 in the case of other unmarried individuals; (3) $41,050 in the case of married individuals filing separate returns; and (4) $23,500 in the case of an estate or trust. For taxable years beginning in 2014, the exemption amounts are phased out by an amount equal to 25 percent of the amount by which the individual's AMTI exceeds (1) $156,500 in the case of married individuals filing a joint return and surviving spouses, (2) $117,300 in the case of other unmarried individuals, and (3) $78,250 in the case of married individuals filing separate returns or an estate or a trust. The amounts are indexed for inflation.

Alternative minimum taxable income is the taxpayer's taxable income increased by certain preference items and adjusted by determining the tax treatment of certain items in a manner that negates the deferral of income resulting from the regular tax treatment of those items.

The alternative minimum tax foreign tax credit reduces the tentative minimum tax.

The various nonrefundable business credits allowed under the regular tax generally are not allowed against the AMT. Certain exceptions apply.

If an individual is subject to AMT in any year, the amount of tax exceeding the taxpayer's regular tax liability is allowed as a credit (the "AMT credit") in any subsequent taxable year to the extent the taxpayer's regular tax liability exceeds his or her tentative minimum tax liability in such subsequent year. The AMT credit is allowed only to the extent that the taxpayer's AMT liability is the result of adjustments that are timing in nature. The individual AMT adjustments relating to itemized deductions and personal exemptions are not timing in nature, and no minimum tax credit is allowed with respect to these items.

An individual may elect to write off certain expenditures paid or incurred with respect of circulation expenses, research and experimental expenses, intangible drilling and development expenditures, development expenditures, and mining exploration expenditures over a specified period (three years in the case of circulation expenses, 60 months in the case of intangible drilling and development expenditures, and 10 years in case of other expenditures). The election applies for purposes of both the regular tax and the alternative minimum tax.

Corporate alternative minimum tax

AMTI is the taxpayer's taxable income increased by certain preference items and adjusted by determining the tax treatment of certain items in a manner that negates the deferral of income resulting from the regular tax treatment of those items.

A corporation with average gross receipts of less than $7.5 million for the prior three taxable years is exempt from the corporate minimum tax. The $7.5 million threshold is reduced to $5 million for the corporation's first 3-taxable year period.

The various nonrefundable business credits allowed under the regular tax generally are not allowed against the AMT. Certain exceptions apply.

If a corporation is subject to AMT in any year, the amount of AMT is allowed as a credit ("AMT credit") in any subsequent taxable year to the extent the taxpayer's regular tax liability exceeds its tentative minimum tax in the subsequent year. Corporations are allowed to claim a limited amount of AMT credits in lieu of bonus depreciation.

A corporation may elect to write off certain expenditures paid or incurred with respect of circulation expenses, research and experimental expenses, intangible drilling and development expenditures, development expenditures, and mining exploration expenditures over a specified period (three years in the case of circulation expenses, 60 months in the case of intangible drilling and development expenditures, and 10 years in case of other expenditures). The election applies for purposes of both the regular tax and the alternative minimum tax.

The proposal allows the AMT credit to offset the taxpayer's regular tax liability for any taxable year. In addition, the AMT credit is refundable for any taxable year beginning after 2015 and before 2020 in an amount equal to 50 percent (100 percent in the case of taxable years beginning in 2019) of the excess of the minimum tax credit for the taxable year over the amount of the credit allowable for the year against regular tax liability. Thus, full amount of the minimum tax credit will be allowed in taxable years beginning before 2020.

In determining the alternative minimum taxable income for taxable years beginning before January 1, 2015, the net operating loss deduction carryback from taxable years beginning on December 31, 2014, are determined without regard to any AMT adjustments or preferences.

The repeal of the election to write off certain expenditures over a specified period applies to amounts paid or incurred after December 31, 2014.

                Table 4. -- Corporate Income Tax Rates

Certain personal service corporations pay tax on their entire taxable income at the rate of 35 percent.

Present law provides if the maximum corporate tax rate exceeds 35 percent, the maximum rate on a corporation's net capital gain will be 35 percent.

The proposal is phased-in. For taxable years beginning in 2015 the maximum rate is 33 percent; for taxable years beginning in 2016 the maximum rate is 31 percent; for taxable years beginning in 2017 the maximum rate is 29 percent; and for taxable years beginning in 2018 the maximum rate is 27 percent.³²⁷ For each of these taxable years the 25-percent rate applies to so much of the taxable income as does not exceed $75,000.

Personal service corporations are taxed at the same tax rates as other corporations.

The proposal repeals the maximum corporate tax rate on net capital gain as obsolete.

The proposal provides a withholding rate on certain foreign income equal to the maximum corporate tax rate.

If property is acquired by a corporation as a contribution to capital and is not contributed by a shareholder as such, the adjusted basis of the property is zero.³³² If the contribution consists of money, the corporation must first reduce the basis of any property acquired with the contributed money within the following 12-month period, and then reduce the basis of other property held by the corporation.³³³ Similarly, a utility's adjusted basis of any property acquired with a contribution in aid of construction will be zero.³³⁴

Further, the proposal provides that a contribution to capital, other than a contribution of money or property made in exchange for stock of a corporation or any interest in an entity, is included in gross income of a taxpayer.³³⁵

For example, a contribution of municipal land by a municipality that is not in exchange for stock (or for a partnership interest or other interest) of equivalent value is considered a contribution to capital that is includable in gross income. By contrast, a municipal tax abatement for locating a business in a particular municipality is not considered a contribution to capital.

2. Repeal of deduction for local lobbying expenses (sec. 3102 of the discussion draft and sec. 162(e) of the Code)

Exceptions

For purposes of this exception, legislation of an Indian tribal government is treated in the same manner as local legislation.³⁴²

3. Expenditures for repairs in connection with casualty losses (sec. 3103 of the discussion draft and sec. 165 of the Code)

With respect to restoration of a unit of property, a taxpayer generally must capitalize as an improvement amounts paid to restore a unit of property, including an amount paid to make good the exhaustion for which an allowance is or has been made.³⁵⁰ A restoration includes, in relevant part, an amount paid for the restoration of damage to a unit of property for which the taxpayer is required to take a basis adjustment either as a result of a casualty loss or relating to a casualty event.³⁵¹ However, with respect to amounts paid or incurred for repairs in connection with casualty losses or events, the regulations limit the amount required to be capitalized to the excess (if any) of (1) the taxpayer's basis adjustments resulting from the casualty, over (2) the amount paid for the restoration of damage to the unit of property as a result of the casualty that also constitutes an improvement.³⁵² Amounts paid in excess of such limitation are analyzed under the applicable provisions of the Internal Revenue Code and regulations³⁵³ to determine if capitalization is required.³⁵⁴

4. Reform of accelerated cost recovery system (sec. 3104 of the discussion draft and sec. 168 of the Code)

For Federal income tax purposes, a taxpayer is allowed to recover through annual depreciation deductions the cost of certain property used in a trade or business or for the production of income.³⁵⁶ Under the modified accelerated cost recovery system ("MACRS"), adopted in 1986, the amount of the depreciation deduction allowed with respect to tangible property for a taxable year is determined for different types of property based on an assigned applicable depreciation method, recovery period, and convention.³⁵⁷

Recovery periods and depreciation methods

The applicable recovery period for an asset is determined in part by statute and in part by historic Treasury guidance.³⁵⁸ The "type of property" of an asset is used to determine the "class life" of the asset, which in turn dictates the applicable recovery period for the asset.

The MACRS recovery periods applicable to most tangible personal property range from three to 20 years. The depreciation methods generally applicable to tangible personal property are the 200 -- percent and 150-percent declining balance methods,³⁵⁹ switching to the straight-line method for the first taxable year where using the straight-line method with respect to the adjusted basis as of the beginning of that year will yield a larger depreciation allowance. The recovery periods for most real property are 39 years for nonresidential real property and 27.5 years for residential rental property. Table 5 provides general rules for class lives and recovery periods as provided in sections 168(c) and (e).

    Table 5. -- General Rules for Class Lives and Recovery Periods

Depreciation of an asset begins when the asset is deemed to be placed in service under the applicable convention.³⁶⁰ Under MACRS, nonresidential real property, residential rental property, and any railroad grading or tunnel bore generally are subject to the mid-month convention, which treats all property placed in service during any month (or disposed of during any month) as placed in service (or disposed of) on the mid-point of such month.³⁶¹ All other property generally is subject to the half-year convention, which treats all property placed in service during any taxable year (or disposed of during any taxable year) as placed in service (or disposed of) on the mid-point of such taxable year.³⁶² However, if substantial property is placed in service during the last three months of a taxable year, a special rule requires use of the mid-quarter convention,³⁶³ designed to prevent the recognition of disproportionately large amounts of first-year depreciation under the half-year convention.

Alternative depreciation system

The alternative depreciation system ("ADS") is required to be used for property used predominantly outside the United States, tax-exempt bond financed property, and certain tax-exempt use property.³⁶⁴ An election to use ADS is available to taxpayers for any class of property for any taxable year.³⁶⁵ Under ADS, all property is depreciated using the straight-line method, over recovery periods which generally are equal to the class life of the property, with certain exceptions.³⁶⁶

• Property with no class life (12 years);

• Any race horse, and any horse other than a race horse that is more than 12 years old at the time it is placed in service (3 years);

• Semi-conductor manufacturing equipment (5 years);

• Qualified technological equipment (5 years);

• Automobile or light general purpose truck (5 years);

• Qualified rent-to-own property (9 years);

• Certain telephone switching equipment (9.5 years);

• Railroad track (10 years);

• Smart electric distribution property (10 years);

• Airplanes (12 years);³⁶⁸

• Natural gas gathering line (14 years);

• Tree or vine bearing fruit or nuts (20 years);

• Telephone distribution plant (24 years);

• Real property, including nonresidential real property and residential rental property (40 years);

• Water treatment and utility property (50 years);

• Clearing and grading improvements, and tunnel bore (50 years); and

• Tax-exempt use property subject to lease (recovery period shall be no less than 125 percent of the lease term).

The below table illustrates depreciation for an asset with a cost of $1,000 and a seven-year recovery period under the straight-line method using the half-year convention with and without the election to apply the inflation adjustment. For purposes of the inflation adjustment, an inflation rate of three percent is assumed in the below table.

                              Table 6. -- Example

The proposal continues the rule that the tax benefits of public utility property may be normalized in setting rates charged by utilities to customers and in reflecting operating results in regulated books of account. In addition to requiring the normalization of depreciation deductions, the proposal provides for the normalization of excess deferred tax reserves resulting from the reduction of corporate income tax rates (with respect to prior depreciation or recovery allowances taken on assets placed in service before the date of enactment).

If an excess deferred tax reserve is reduced more rapidly or to a greater extent than such reserve would be reduced under the average rate assumption method, the taxpayer will not be treated as using a normalization method of accounting with respect to any of its assets. Thus, if the excess deferred tax reserve is not normalized, the taxpayer must compute its depreciation allowances using the depreciation method, useful life determination, averaging convention, and salvage value limitation used for purposes of setting rates and reflecting operating results in regulated books of account.

The excess deferred tax reserve is the reserve for deferred taxes computed under prior law over what the reserve for deferred taxes would be if the tax rate in effect under the proposal had been in effect for all prior periods. The average rate assumption method is the method that reduces the excess deferred tax reserve over the remaining regulatory lives of the property that gave rise to the reserve for deferred taxes. Under this method, the excess deferred tax reserve is reduced as the timing differences (i.e., differences between tax depreciation and regulatory depreciation with respect to each asset or group of assets in the case of vintage accounts) reverse over the life of the asset. The reversal of timing differences generally occurs when the amount of the tax depreciation taken with respect to an asset is less than the amount of the regulatory depreciation taken with respect to the asset. The excess deferred tax reserve is multiplied by a formula that is designed to insure that the excess is reduced to zero at the end of the regulatory life of the asset that generated the reserve.

5. Repeal of amortization of pollution control facilities (sec. 3105 of the discussion draft and sec. 169 of the Code)

For a pollution control facility with a useful life greater than 15 years, only the portion of the basis attributable to the first 15 years is eligible to be amortized over a 60-month or 84-month period.³⁷⁵ In addition, a corporation must reduce the amount of basis otherwise eligible for the 60-month or 84-month recovery period by 20 percent.³⁷⁶ The amount of basis not eligible for 60-month or 84-month amortization is depreciable under the regular tax rules for depreciation.³⁷⁷

6. Net operating loss deduction (sec. 3106 of the discussion draft and sec. 172 of the Code)

Different carryback periods apply with respect to NOLs arising in different circumstances. Extended carryback periods are allowed for NOLs attributable to specified liability losses and casualty and certain disaster losses. Limitations are placed on the carryback of excess interest losses attributable to corporate equity reduction transactions. Extended carrybacks for bank bad debt losses, 2008 and 2009 net operating losses, losses where investment in transmission property and pollution control investments, and losses attributable to federally declared disasters were provided but have expired.

The proposal repeals the special carryback provisions other than the provision relating to certain casualty and disaster losses.

The repeal of the special carryback rules generally applies to losses arising in taxable years beginning after December 31, 2014. The repeal of the extended carryback provisions which have expired is effective on the date of enactment.

7. Circulation expenditures (sec. 3107 of the discussion draft and sec. 173 of the Code)

In the case of retired, abandoned, or disposed property with respect to which specified circulation expenditures are paid or incurred, any remaining basis may not be recovered in the year of retirement, abandonment, or disposal, but instead must continue to be amortized over the remaining amortization period.

The proposal provides transition relief allowing 75 percent of specified circulation expenditures made in taxable years beginning in 2016, 50 percent of specified circulation expenditures made in taxable years beginning in 2017, and 25 percent of specified circulation expenditures made in taxable years beginning in 2018, to be deducted, with the remaining percentage of the specified circulation expenditures to be capitalized and amortized over 36 months. The taxpayer may make an irrevocable election not to apply the transition rule.

8. Amortization of research and experimental expenditures (sec. 3108 of the discussion draft and sec. 174 of the Code)

Amounts defined as research or experimental expenditures under section 174 generally include all costs incurred in the experimental or laboratory sense related to the development or improvement of a product.³⁸⁶ In particular, qualifying costs are those incurred for activities intended to discover information that would eliminate uncertainty concerning the development or improvement of a product.³⁸⁷ Uncertainty exists when information available to the taxpayer is not sufficient to ascertain the capability or method for developing, improving, and/or appropriately designing the product.³⁸⁸ The determination of whether expenditures qualify as deductible research expenses depends on the nature of the activity to which the costs relate, not the nature of the product or improvement being developed or the level of technological advancement the product or improvement represents. Examples of qualifying costs include salaries for those engaged in research or experimentation efforts, amounts incurred to operate and maintain research facilities (e.g., utilities, depreciation, rent), and expenditures for materials and supplies used and consumed in the course of research or experimentation (including amounts incurred in conducting trials).³⁸⁹ In addition, under administrative guidance, the costs of developing computer software have been accorded treatment similar to research expenditures.³⁹⁰

However, generally no current deduction under section 174 is allowable for expenditures for the acquisition or improvement of land or of depreciable or depletable property used in connection with any research or experimentation.³⁹¹ In addition, no current deduction is allowed for research expenses incurred for the purpose of ascertaining the existence, location, extent, or quality of any deposit of ore or other mineral, including oil and gas.³⁹²

In the case of retired, abandoned, or disposed property with respect to which specified research or experimental expenditures are paid or incurred, the remaining basis may not be recovered in the year of retirement, abandonment, or disposal, but instead must continue to be amortized over the remaining amortization period.

As a conforming amendment to the repeal of the alternative minimum tax,³⁹⁴ taxpayers may no longer elect to amortize their research expenditures over a period of 10 years.

A transition rule is provided for domestic research or experimental expenditures³⁹⁵ paid or incurred during any taxable year beginning before 2021. For taxable years beginning in 2015, 60 percent of domestic research or experimental expenditures are allowed as a deduction and the remainder are capitalized and amortized over a two-year period. For taxable years beginning in 2016 and 2017, 40 percent of domestic research or experimental expenditures are allowed as a deduction and the remainder are capitalized and amortized over a three-year period. For taxable years beginning in 2018, 2019, and 2020, 20 percent of domestic research or experimental expenditures are allowed as a deduction and the remainder are capitalized and amortized over a four-year period. The taxpayer may make an irrevocable election not to apply the transition rule.

9. Repeal of deductions for soil and water conservation expenditures and endangered species recovery expenditures (sec. 3109 of the discussion draft and sec. 175 of the Code)

10. Amortization of certain advertising expenses (sec. 3110 of the discussion draft and new sec. 177 of the Code)

The proposal provides an exemption from the capitalization requirement for taxpayers with advertising expenses for the taxable year of $1 million or less. However, if the taxpayer's otherwise deductible advertising expenses for any taxable year exceed $1.5 million, the $1 million amount is reduced (but not below zero) by twice such excess amount. The $1 million and $1.5 million amounts are adjusted for inflation in taxable years beginning after 2015.

A "specified advertising expense" is defined as any amount paid or incurred for the development, production, or placement (including any form of transmission, broadcast, publication, display, or distribution) of any communication to the general public (or portions thereof) which is intended to promote the taxpayer or a trade of business of the taxpayer, including any service, facility, or product provided as part of such trade or business. Specified advertising expense includes only deductions that would (but for this section) be deductible by the taxpayer for the taxable year under other provisions of the Code. Thus, the determination of amounts that are capitalizable under section 263 or other Code sections is not affected by this proposal.

The proposal provides certain exclusions from the definition of a specified advertising expense: (1) wages paid to the taxpayer's employees unless the employee's services are primarily related to specified advertising activities (including supervision of such employees); (2) depreciation expense allowed under section 167 for tangible property; (3) amortization deductions allowable under section 197;⁴⁰¹ (4) any discount, coupon, rebate, slotting allowance, sample, prize, loyalty reward point, or any other item determined by the Secretary to be similar; (5) amounts paid or incurred with respect to any communications appearing on the taxpayer's tangible property subject to depreciation or treated as inventory;⁴⁰² (6) amounts paid or incurred for the creation of any logo, trademark, or trade name; (7) amounts paid or incurred for package design;⁴⁰³ (8) amounts paid or incurred for marketing research; (9) amounts paid or incurred for business meals; and (10) amounts paid or incurred as qualified sponsorship payments (as defined in section 513(i)(2)) with respect to an organization subject to the tax imposed by section 511.

In the case of retired, abandoned, or disposed property with respect to which specified advertising expenses are paid or incurred, the remaining basis may not be recovered in the year of retirement, abandonment, or disposal, but instead must continue to be amortized over the remaining amortization period.

A transition rule is provided for specified advertising expenses paid or incurred during any taxable year beginning before 2018. For taxable years beginning in 2015, 20 percent of specified advertising expenses are required to be capitalized and amortized over the 10-year period. For taxable years beginning in 2016, 30 percent of specified advertising expenses are required to be capitalized and amortized over the 10-year period. For taxable years beginning in 2017, 40 percent of specified advertising expenses are required to be capitalized and amortized over the 10-year period. The taxpayer may make an irrevocable election not to apply the transition rule.

While package design expenses are excluded from capitalization under new section 177, the proposal requires such costs to be treated as allocable indirect costs for purposes of section 263A with respect to packages which utilize such design.⁴⁰⁴

11. Expensing certain depreciable business assets for small business (sec. 3111 of the discussion draft and sec. 179 of the Code)

In general, qualifying property is defined as depreciable tangible personal property that is purchased for use in the active conduct of a trade or business. For taxable years beginning before 2014, qualifying property also includes off-the-shelf computer software and qualified real property (i.e., qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property).⁴⁰⁸ Of the $500,000 expense amount available under section 179, the maximum amount available with respect to qualified real property is $250,000 for each taxable year.⁴⁰⁹

For taxable years beginning in 2014 and thereafter, a taxpayer may elect to deduct up to $25,000 of the cost of qualifying property placed in service for the taxable year, subject to limitation. The $25,000 amount is reduced (but not below zero) by the amount by which the cost of qualifying property placed in service during the taxable year exceeds $200,000. The $25,000 and $200,000 amounts are not indexed for inflation. In general, qualifying property is defined as depreciable tangible personal property (not including off-the-shelf computer software or qualified real property) that is purchased for use in the active conduct of a trade or business.

The amount eligible to be expensed for a taxable year may not exceed the taxable income for such taxable year that is derived from the active conduct of a trade or business (determined without regard to this provision).⁴¹⁰ Any amount that is not allowed as a deduction because of the taxable income limitation may be carried forward to succeeding taxable years (subject to limitations). However amounts attributable to qualified real property that are disallowed under the trade or business income limitation may only be carried over to taxable years in which the definition of eligible section 179 property includes qualified real property.⁴¹¹ Thus, if a taxpayer's section 179 deduction for 2012 with respect to qualified real property is limited by the taxpayer's active trade or business income, such disallowed amount may be carried over to 2013. Any such carryover amounts that are not used in 2013 are treated as property placed in service in 2013 for purposes of computing depreciation. That is, the unused carryover amount from 2012 is considered placed in service on the first day of the 2013 taxable year.⁴¹²

No general business credit under section 38 is allowed with respect to any amount for which a deduction is allowed under section 179.⁴¹³ An expensing election is made under rules prescribed by the Secretary.⁴¹⁴ In general, any election or specification made with respect to any property may not be revoked except with the consent of the Commissioner. However, an election or specification under section 179 may be revoked by the taxpayer without consent of the Commissioner for taxable years beginning after 2002 and before 2014.⁴¹⁵

In addition, the proposal makes permanent, for taxable years beginning after 2013, the treatment of off-the-shelf computer software as qualifying property. The proposal also makes permanent the treatment of qualified real property as eligible section 179 property for taxable years beginning after 2013.

The proposal permits the taxpayer to revoke any election and any specification contained therein, made under section 179 after 2002.

Further, the proposal strikes the flush language in section 179(d)(1) that excludes air conditioning and heating units from the definition of qualifying property.

12. Repeal of election to expense certain refineries (sec. 3112 of the discussion draft and sec. 179C of the Code)

13. Repeal of deduction for energy efficient commercial buildings (sec. 3113 of the discussion draft and sec. 179D of the Code)

If a deduction is allowed under this section, the basis of the property is reduced by the amount of the deduction.⁴²⁰ The deduction is effective for property placed in service after December 31, 2005, and prior to January 1, 2014.⁴²¹

If a corporation makes an election under section 179D to deduct expenditures, the full amount of the deduction does not reduce earnings and profits. Rather, the expenditures that are deducted reduce corporate earnings and profits ratably over a five-year period.⁴²²

14. Repeal of election to expense advanced mine safety equipment (sec. 3114 of the discussion draft and sec. 179E of the Code)

Advanced mine safety equipment property means any of the following: (1) emergency communication technology or devices used to allow a miner to maintain constant communication with an individual who is not in the mine; (2) electronic identification and location devices that allow individuals not in the mine to track at all times the movements and location of miners working in or at the mine; (3) emergency oxygen-generating, self-rescue devices that provide oxygen for at least 90 minutes; (4) pre-positioned supplies of oxygen providing each miner on a shift the ability to survive for at least 48 hours; and (5) comprehensive atmospheric monitoring systems that monitor the levels of carbon monoxide, methane and oxygen that are present in all areas of the mine and that can detect smoke in the case of a fire in a mine.⁴²⁵

15. Repeal of deduction for expenditures by farmers for fertilizer, etc. (sec. 3115 of the discussion draft and sec. 180 of the Code)

16. Repeal of special treatment of certain qualified film and television productions (sec. 3116 of the discussion draft and sec. 181 of the Code)

A qualified film or television production means any production of a motion picture (whether released theatrically or directly to video cassette or any other format) or television program if at least 75 percent of the total compensation expended on the production is for services performed in the United States by actors, directors, producers, and other relevant production personnel.⁴³² The term "compensation" does not include participations and residuals (as defined in section 167(g)(7)(B)).⁴³³ With respect to property which is one or more episodes in a television series, each episode is treated as a separate production and only the first 44 episodes qualify under the provision.⁴³⁴ Qualified property does not include sexually explicit productions as defined by section 2257 of title 18 of the U.S. Code.⁴³⁵

For purposes of recapture under section 1245, any deduction allowed under section 181 is treated as if it were a deduction allowable for amortization.⁴³⁶

17. Repeal of special rules for recoveries of damages of antitrust violations, etc. (sec. 3117 of the discussion draft and sec. 186 of the Code)

When a compensatory amount is received or accrued during a year for a compensable injury, a deduction is allowed for the compensatory amount or, if smaller, the unrecovered losses sustained as a result of the compensable injury.⁴⁴⁰ Compensable injuries are those sustained as a result of a patent infringement, a breach of contract, or a breach of fiduciary duty or an antitrust injury for which there is a recovery under section 4 of the Clayton Act.⁴⁴¹

The compensatory amount is the amount received or accrued as damages either as an award in or settlement of a civil action for recovery of a compensable injury.⁴⁴² This is to be reduced by the expenses in securing the award or settlement. The provision applies only to recoveries for actual injury and not for any additional amounts.

The unrecovered losses are the net operating losses attributable to the compensatory injury reduced by those allowed as a deduction as a loss carryback or carryover.⁴⁴³ These net operating losses are also reduced by the amount (if any) of a recovery of a compensatory amount in any other years against which these losses were offset.

18. Treatment of reforestation expenditures (sec. 3118 of the discussion draft and sec. 194 of the Code)

Qualifying reforestation expenditures are the direct costs a taxpayer incurs in connection with the forestation or reforestation of a site by planting or seeding, and include costs for the preparation of the site, the cost of the seed or seedlings, and the cost of the labor and tools (including depreciation of long lived assets such as tractors and other machines) used in the reforestation activity.⁴⁴⁸ Qualifying reforestation expenditures do not include expenditures that would otherwise be deductible and do not include costs for which the taxpayer has been reimbursed under a governmental cost sharing program, unless the amount of the reimbursement is also included in the taxpayer's gross income.⁴⁴⁹

Qualifying timber property means a woodlot or other site located in the United States which will contain trees in significant commercial quantities and which is held by the taxpayer for the planting, cultivating, caring for, and cutting of trees for sale or use in the commercial production of timber products.⁴⁵⁰ Qualified timber property does not include either property on which the taxpayer has planted shelter beds (for which section 175 deductions are allowed) or ornamental trees.⁴⁵¹

Reforestation amortization is subject to recapture as ordinary income on the sale of qualifying timber property within 10 years of the year in which the qualifying reforestation expenditures were incurred.⁴⁵²

The proposal changes the definition of qualified timber property to include only property held by the taxpayer for the planting, cultivating, caring for, and cutting of evergreen trees (that are more than six years old when cut) for sale for ornamental purposes. It is intended that costs related to property that no longer meets the definition of qualified timber property shall be included in basis and recovered using cost depletion.⁴⁵⁴

19. 20-year amortization of goodwill and certain other intangibles (sec. 3119 of the discussion draft and sec. 197 of the Code)

However, interests in land, including leases, easements, grazing rights, and mineral rights granted by a government, may not be amortized over the 15-year period provided in section 197, but instead must be amortized over the period of the grant of the right.⁴⁵⁹ Certain financial interests,⁴⁶⁰ certain computer software readily available for purchase by the general public,⁴⁶¹ and certain rights acquired separately from the acquisition of assets constituting a trade or business (or substantial portion thereof)⁴⁶² are not subject to the 15-year amortization. Certain interests under leases and debt instruments,⁴⁶³ any right to service indebtedness which is secured by residential real property (unless such right is acquired as part of the acquisition of a trade or business, or substantial portion thereof) ("mortgage servicing rights"),⁴⁶⁴ and certain transaction costs⁴⁶⁵ are not section 197 intangibles. In addition, certain self-created intangibles, such as goodwill created through advertising and other expenses, are not subject to section 197.⁴⁶⁶

While mortgage servicing rights are explicitly excluded from section 197, section 167 provides that mortgage servicing rights are depreciated using the straight-line method over a 108-month period.⁴⁶⁷ Similarly, section 167 provides that computer software excluded from section 197 is depreciated using the straight-line method over a 36-month period.⁴⁶⁸ With respect to certain interests or rights not acquired as part of a purchase of a trade or business that are excluded from section 197, the regulations under section 167 prescribe the amortization method and period based on the type of interest or right separately acquired.⁴⁶⁹

20. Treatment of environmental remediation costs (sec. 3120 of the discussion draft and sec. 198 of the Code)

Taxpayers may elect to treat certain environmental remediation expenditures paid or incurred before January 1, 2012, that would otherwise be chargeable to capital account as deductible in the year paid or incurred.⁴⁷⁴ The deduction applies for both regular and alternative minimum tax purposes. The expenditure must be incurred in connection with the abatement or control of hazardous substances at a qualified contaminated site.⁴⁷⁵ In general, any expenditure for the acquisition of depreciable property used in connection with the abatement or control of hazardous substances at a qualified contaminated site does not constitute a qualified environmental remediation expenditure.⁴⁷⁶ However, depreciation deductions allowable for such property that would otherwise be allocated to the site under the principles set forth in Commissioner v. Idaho Power Co.⁴⁷⁷ and section 263A are treated as qualified environmental remediation expenditures.⁴⁷⁸

A "qualified contaminated site" (a so-called "brownfield") generally is any property that is held for use in a trade or business, for the production of income, or as inventory and is certified by the appropriate State environmental agency to be an area at or on which there has been a release (or threat of release) or disposal of a hazardous substance.⁴⁷⁹ Both urban and rural property may qualify. However, sites that are identified on the national priorities list under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 ("CERCLA")⁴⁸⁰ cannot qualify as targeted areas. Hazardous substances generally are defined by reference to sections 101(14) and 102 of CERCLA, subject to additional limitations applicable to asbestos and similar substances within buildings, certain naturally occurring substances such as radon, and certain other substances released into drinking water supplies due to deterioration through ordinary use, as well as petroleum products defined in section 4612(a)(3).⁴⁸¹

In the case of property to which a qualified environmental remediation expenditure otherwise would have been capitalized, any deduction allowed under section 198 is treated as a depreciation deduction and the property is treated as section 1245 property.⁴⁸² Thus, deductions for qualified environmental remediation expenditures are subject to recapture as ordinary income upon a sale or other disposition of the property. In addition, sections 280B (demolition of structures) and 468 (special rules for mining and solid waste reclamation and closing costs) do not apply to amounts that are treated as expenses under section 198.⁴⁸³

21. Repeal of expensing of qualified disaster expenses (sec. 3121 of the discussion draft and sec. 198A of the Code)

For purposes of this provision, "business-related property" is property held by the taxpayer for use in a trade or business, for the production of income, or as inventory.⁴⁸⁸ In addition, for purposes of recapture as ordinary income, any deduction allowed under this provision is treated as a deduction for depreciation and the property to which the amount would have been capitalized is treated as section 1245 property for purposes of depreciation recapture.⁴⁸⁹

This provision does not apply to any disaster that has been declared by the President on or after May 20, 2008, and before August 1, 2008, under section 401 of the Robert T. Stafford Disaster Relief and Emergency Assistance Act (the "Act") by reason of severe storms, tornados, or flooding occurring during 2008 in any of the States of Arkansas, Illinois, Indiana, Iowa, Kansas, Michigan, Minnesota, Missouri, Nebraska, and Wisconsin.⁴⁹⁰

22. Phaseout and repeal of deduction for income attributable to domestic production activities (sec. 3122 of the discussion draft and sec. 199 of the Code)

In general, qualified production activities income is equal to domestic production gross receipts reduced by the sum of: (1) the costs of goods sold that are allocable to those receipts; and (2) other expenses, losses, or deductions which are properly allocable to those receipts.⁴⁹⁴

Domestic production gross receipts generally are gross receipts of a taxpayer that are derived from: (1) any sale, exchange, or other disposition, or any lease, rental, or license, of qualifying production property⁴⁹⁵ that was manufactured, produced, grown or extracted by the taxpayer in whole or in significant part within the United States⁴⁹⁶ (2) any sale, exchange, or other disposition, or any lease, rental, or license, of qualified film⁴⁹⁷ produced by the taxpayer; (3) any lease, rental, license, sale, exchange, or other disposition of electricity, natural gas, or potable water produced by the taxpayer in the United States; (4) construction of real property performed in the United States by a taxpayer in the ordinary course of a construction trade or business; or (5) engineering or architectural services performed in the United States for the construction of real property located in the United States.⁴⁹⁸

The amount of the deduction for a taxable year is limited to 50 percent of the W-2 wages paid by the taxpayer, and properly allocable to domestic production gross receipts, during the calendar year that ends in such taxable year.⁴⁹⁹

23. Unification of deduction for organizational expenditures (sec. 3123 of the discussion draft and secs. 195, 248, and 709 of the Code)

Start-up expenditures are amounts that would have been deductible as trade or business expenses had they not been paid or incurred before business began.⁵⁰⁶ Organizational expenditures are expenditures that are incident to the creation of a corporation or the organization of a partnership, are chargeable to capital, and that would be eligible for amortization had they been paid or incurred in connection with the organization of a corporation or partnership with a limited or ascertainable life.⁵⁰⁷

24. Prevention of arbitrage of deductible interest expense and tax-exempt interest income (sec. 3124 of the discussion draft and sec. 265 of the Code)

Present law disallows a deduction for interest on indebtedness incurred or continued to purchase or carry obligations the interest on which is exempt from tax.⁵⁰⁹ In general, an interest deduction is disallowed only if the taxpayer has a purpose of using borrowed funds to purchase or carry tax-exempt obligations; a determination of the taxpayer's purpose in borrowing funds is made based on all of the facts and circumstances.⁵¹⁰

Similarly, in the case of a corporation that is not a financial institution or a dealer in tax-exempt obligations, where there is no direct evidence of a purpose to purchase or carry tax-exempt obligations, the corporation's holdings of tax-exempt obligations are presumed to be insubstantial if the average adjusted basis of the corporation's tax-exempt obligations is two percent or less of the average adjusted basis of all assets held by the corporation in the active conduct of its trade or business.

A qualified small issuer is an issuer that reasonably anticipates that the amount of tax-exempt obligations that it will issue during the calendar year will be $10 million or less. The Code specifies the circumstances under which an issuer and all subordinate entities are aggregated. For purposes of the $10 million limitation, an issuer and all entities that issue obligations on behalf of such issuer are treated as one issuer. All obligations issued by a subordinate entity are treated as being issued by the entity to which it is subordinate. An entity formed (or availed of) to avoid the $10 million limitation and all entities benefiting from the device are treated as one issuer.

Composite issues (i.e., combined issues of bonds for different entities) qualify for the qualified tax-exempt obligation exception only if the requirements of the exception are met with respect to (1) the composite issue as a whole (determined by treating the composite issue as a single issue) and (2) each separate lot of obligations that is part of the issue (determined by treating each separate lot of obligations as a separate issue). Thus a composite issue may qualify for the exception only if the composite issue itself does not exceed $10 million, and if each issuer benefitting from the composite issue reasonably anticipates that it will not issue more than $10 million of tax-exempt obligations during the calendar year, including through the composite arrangement.

Investment interest expense

In the case of a taxpayer other than a corporation, the deduction allowable for investment interest for any taxable year may not exceed the investment income for the year.⁵¹⁵ Investment interest means interest paid or accrued on indebtedness incurred to purchase or carry property held for investment. Net investment income includes gross income from property held for investment reduced by investment expenses (other than interest) directly connected with the production of investment income.

The two-percent floor on miscellaneous itemized deductions allows taxpayers to deduct investment expenses connected with investment income only to the extent such deductions exceed two percent of the taxpayer's adjusted gross income ("AGI").⁵¹⁶ Miscellaneous itemized deductions⁵¹⁷ that are not investment expenses are disallowed first before any investment expenses are disallowed.⁵¹⁸

The proposal applies the present-law financial institution rules to all C corporations. That is, in the case of a C corporation or financial institution, no deduction is allowed for that portion of the taxpayer's interest expense that is allocable to tax-exempt interest. The amount of interest that is disallowed is an amount that bears the same ratio to such interest expense as the taxpayer's average adjusted bases of tax-exempt obligations acquired on or after February 26, 2014 (August 7, 1986, in the case of a financial institution), bears to the average adjusted bases for all assets of the taxpayer.

The proposal repeals the special exception for any qualified tax-exempt obligation of a qualified small issuer and the special exception for certain bonds issued during 2009 or 2010. The proposal also repeals the tracing rule of section 265(a) with respect to interest.

Investment interest expense

In the case of a taxpayer other than a corporation or financial institution, the amount otherwise allowed as a deduction for investment interest for a taxable year is reduced by the amount of tax-exempt interest received by the taxpayer during the year. The amount of investment interest after the reduction is limited to the amount of investment income as under present law, with the excess (if any) carried over and treated as investment interest in the succeeding taxable year.

Under the proposal, tax-exempt debt is treated as property held for investment so that any interest expense properly allocable to tax-exempt debt is treated as investment interest subject to the limitations described above.

The following examples illustrate the application of the proposal in the case of a taxpayer other than a corporation or financial institution:

Example 1. -- Assume an individual has $100 taxable interest income, $100 tax-exempt interest income, and $20 interest expense properly allocable to the property that produced that income. Under the proposal, $20 of the interest expense is not allowed as a deduction in any taxable year.

Example 2. -- Assume the same facts except that the interest expense is $120. $100 is not allowed as a deduction, $20 is allowed as a deduction currently.

Example 3. -- Assume the same facts except that the interest expense is $220. $100 is not allowed as a deduction, $100 is allowed as a deduction currently, and $20 is carried forward to the next succeeding taxable year.

The repeal of the special exceptions for any qualified tax-exempt obligation of a qualified small issuer and the special exception for certain bonds issued during 2009 or 2010 applies for obligations issued on or after February 26, 2014.

The limitation on investment interest for a taxpayer other than a corporation or financial institution applies to taxable years beginning after December 31, 2014.

25. Prevention of transfer of certain losses from tax indifferent parties (sec. 3125 of the discussion draft and sec. 267 of the Code)

Sections 267(a)(1) and 707(b) generally disallow a deduction for a loss on the sale or exchange of property, directly or indirectly, to certain related parties or controlled partnerships. Section 267(d)⁵¹⁹ provides that if a loss has been disallowed under either of such provisions, the transferee may reduce any gain that the transferee later recognizes on a disposition of the asset by the amount of loss disallowed to the transferor. Thus, section 267(d) shifts the benefit of the loss to the transferee to the extent of post-sale appreciation.

In the case of a sale or exchange between two corporations that are members of the same controlled group,⁵²⁰ section 267(f) provides a rule different from that of sections 267(a)(1), 707(b), and 267(d). Under section 267(f), the loss to the transferor is not denied entirely, but rather is deferred until such time as the property is transferred outside the controlled group and there would be recognition of loss under consolidated return principles, or such other time as may be prescribed in regulations. While the loss is deferred, it is not transferred to another party.

Sections 267 and 707 generally operate on an item-by item basis, so that if a transferor sells several items of separately acquired property to a related or controlled party in a single transaction, the disallowance at the time of the sale applies to each loss regardless of any gains recognized on other property in the same transfer.⁵²¹

Transferee basis in gift cases

In the case of property acquired by gift, the basis generally is the basis in the hands of the transferor except that if the basis exceeds the fair market value at the time of the gift, the basis for purposes of determining loss is the fair market value at that time.⁵²² This rule has the same effect as the rule in section 267(d) which in effect allows the loss at the time of the transfer to offset post-transfer appreciation.

Transferee basis in certain nontaxable corporate organizations and reorganizations

In the case of certain nontaxable organizations and reorganizations, section 362(a) generally provides that the transferee takes the same basis in property that the property had in the hands of the transferor, increased by the amount of any gain (or dividend) recognized by the transferor. However, section 362(e)(1) provides that in cases involving the importation of a net built-in loss, the transferee's aggregate adjusted basis may not exceed the fair market value of the property immediately after the transaction. This rule applies to a transfer of property if (i) gain or loss with respect to such property is not subject to Federal income tax in the hands of the transferor immediately before the transfer and (ii) gain or loss with respect to such property is subject to such tax in the hands of the transferee immediately after such transfer.

26. Entertainment, etc. expenses (sec. 3126 of the discussion draft and sec. 274 of the Code)

Under present law, no deduction is allowed with respect to (1) an activity generally considered to be entertainment, amusement or recreation (referred to collectively as "entertainment"), unless the taxpayer establishes that the item was directly related to (or, in certain cases, associated with) the active conduct of the taxpayer's trade or business, or (2) a facility (e.g., an airplane) used in connection with such activity.⁵²³ If the taxpayer establishes that entertainment expenses are directly related to (or associated with) the active conduct of its trade or business, the deduction generally is limited to 50 percent of the amount otherwise deductible under the Code.⁵²⁴ Similarly, a deduction for any expense for food or beverages generally is limited to 50 percent of the amount otherwise deductible under the Code.⁵²⁵ In addition, no deduction is allowed for membership dues with respect to any club organized for business, pleasure, recreation or other social purpose.⁵²⁶

The Code includes a number of exceptions to the general rule disallowing deductions of entertainment expenses and the rules limiting deductions to 50 percent of the otherwise deductible amount. Under one such exception, these rules do not apply to expenses for goods, services, and facilities to the extent that the expenses are reported by the taxpayer as compensation and wages to an employee.⁵²⁷ The deduction disallowance rules also do not apply to expenses paid or incurred by the taxpayer for goods, services, and facilities to the extent that the expenses are includible in the gross income of a recipient who is not an employee (e.g., a nonemployee director) as compensation for services rendered or as a prize or award.⁵²⁸ The exceptions apply only to the extent that amounts are properly reported by the company as compensation and wages or otherwise includible in income. In no event can the amount of the deduction exceed the amount of the taxpayer's actual cost, even if a greater amount (i.e., fair market value) is includible in income.⁵²⁹

These rules also do not apply to expenses paid or incurred by the taxpayer, in connection with the performance of services for another person (other than an employee) under a reimbursement or other expense allowance arrangement if the taxpayer accounts for the expenses to such person.⁵³⁰ Another exception applies for expenses for recreational, social or similar activities primarily for the benefit of employees other than certain owners and highly compensated employees.⁵³¹ An exception applies also to the 50 percent deduction limit for food and beverages provided to crew members of certain commercial vessels and certain oil or gas platform or drilling rig workers.⁵³²

Expenses treated as compensation

Except as otherwise provided, gross income includes compensation for services, including fees, commissions, fringe benefits, and similar items.⁵³³ In general, an employee or other service provider must include in gross income the amount by which the fair market value of a fringe benefit exceeds the amount paid by the individual (plus the amount, if any excluded from gross income).⁵³⁴ Treasury regulations provide rules regarding the valuation of fringe benefits, including flights on an employer-provided aircraft.⁵³⁵ In general, the value of a non-commercial flight generally is determined under the base aircraft valuation formula, also known as the Standard Industry Fare Level formula or "SIFL."⁵³⁶ If the SIFL valuation rules do not apply, the value of a flight on a company-provided aircraft generally is equal to the amount that an individual would have to pay in an arm's-length transaction to charter the same or a comparable aircraft for that period for the same or a comparable flight.⁵³⁷

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 as not limiting the company's deduction for expenses attributable to the operation of the aircraft to the amount of compensation reportable to its employees, which can result in a deduction many times larger than the amount required to be included in income.⁵³⁸ In many cases, the individual including amounts attributable to personal travel in income directly benefits from the enhanced deduction, resulting in a net deduction for the personal use of the company aircraft.

The exceptions were subsequently modified in the case of specified individuals such that 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 of the specified individual.⁵³⁹ Specified individuals are individuals who, with respect to an employer or other service recipient (or a related party), are subject to the requirements of section 16(a) of the Securities Exchange Act of 1934, or would be subject to such requirements if the employer or service recipient (or related party) were an issuer of equity securities referred to in section 16(a).⁵⁴⁰

As a result, in the case of specified individuals, no deduction is allowed with respect to expenses for (1) a nonbusiness activity generally considered to be entertainment, amusement or recreation, or (2) a facility (e.g., an airplane) used in connection with such activity to the extent that such expenses exceed the amount treated as compensation or includible in income to the specified individual. For example, a company's deduction attributable to aircraft operating costs and other expenses for a specified individual's vacation use of a company aircraft is limited to the amount reported as compensation to the specified individual. However, in the case of other employees or service providers, the company's deduction is not limited to the amount treated as compensation or includible in income.⁵⁴¹

Excludable fringe benefits

Certain employer-provided fringe benefits are excluded from an employee's gross income and wages for employment tax purposes, including de minimis fringes and qualified transportation fringes.⁵⁴² A de minimis fringe generally means any property or services the value of which is (taking into account the frequency with which similar fringes are provided by the employer) so small as to make accounting for it unreasonable or administratively impracticable.⁵⁴³ Qualified transportation fringes include qualified parking (i.e., on or near the employer's business premises or on or near a location from which the employee commutes to work by public transit), transit passes, vanpool benefits, and qualified bicycle commuting reimbursements.⁵⁴⁴

Under the proposal, in the case of all individuals (not just specified 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. Thus, under those exceptions, no deduction is allowed with respect to expenses for (1) a nonbusiness activity generally considered to be entertainment, amusement or recreation, or (2) a facility (e.g., an airplane) used in connection with such activity to the extent that such expenses exceed the amount treated as compensation or includible in income. As under present law, the exceptions apply only if amounts are properly reported by the company as compensation and wages or otherwise includible in income.

The proposal amends the present-law exception for reimbursed expenses. The proposal disallows a deduction for amounts paid or incurred by a taxpayer in connection with the performance of services for another person (other than an employee) under a reimbursement or other expense allowance arrangement if the person for whom the services are performed is a tax-exempt entity⁵⁴⁵ or the arrangement is designated by the Secretary as having the effect of avoiding the 50 percent deduction disallowance.

The proposal clarifies that the exception to the 50 percent deduction limit for food or beverages applies to any expense excludible from the gross income of the recipient related to meals furnished for the convenience of the employer. The proposal thereby repeals as deadwood the special exceptions for food or beverages provided to crew members of certain commercial vessels and certain oil or gas platform or drilling rig workers.

27. Repeal of limitation on corporate acquisition indebtedness (sec. 3127 of the discussion draft and sec. 279 of the Code)

One provision, enacted in 1969, denies a corporate interest deduction for interest in excess of five million dollars on corporate acquisition indebtedness. Corporate acquisition indebtedness is debt under certain subordinated obligations⁵⁴⁶ issued to provide consideration for the acquisition of stock or assets of another corporation. The conditions under which the provision applies are further limited. Also, the provision does not apply unless, as of the last day of the taxable year of the issuing corporation in which it issues an obligation, the debt to equity ratio of the issuing corporation exceeds two to one and the projected earnings (as defined)⁵⁴⁷ do not exceed three times the annual interest to be paid or incurred. Also, the obligation must be either convertible directly or indirectly into stock of the issuing corporation, or part of an investment unit or other arrangement which includes, in addition to such bond or other evidence of indebtedness, an option to acquire, directly or indirectly, stock in the issuing corporation. Special rules apply to banks and lending or finance companies.

28. Denial of deductions and credits for expenditures in illegal businesses (sec. 3128 of the discussion draft and sec. 280E of the Code)

These nondeductible expenses include bribes, kickbacks, and other payments that are illegal under Federal or State law.⁵⁴⁹ Specified types of payments that are not illegal, but are of such nature that the Congress has determined that deductibility would frustrate a public policy objective, also are made nondeductible.

One such specified type of nondeductible payment that would frustrate public policy relates to illegal sales of drugs. Specifically, section 280E disallows deductions in connection with the trade or business of trafficking in controlled substances.

29. Limitation on Deduction for FDIC Premiums (sec. 3129 of the discussion draft and sec. 162 of the Code)

Corporations organized under the laws of any of the 50 States (and the District of Columbia) generally are subject to the U.S. corporate income tax on their worldwide taxable income. The taxable income of a C corporation⁵⁵⁰ generally is comprised of gross income less allowable deductions. A taxpayer generally is allowed a deduction for ordinary and necessary expenses paid or incurred in carrying on any trade or business.⁵⁵¹

Corporations that make a valid election pursuant to section 1362 of subchapter S of Chapter 1 of the Code, referred to as S corporations, are taxed differently. In general, an S corporation is not subject to corporate-level income tax on its items of income and loss. Instead, an S corporation passes through to shareholders its items of income and loss. The shareholders separately take into account their shares of these items on their individual income tax returns.

Banks, thrifts, and credit unions

FDIC premiums

The Federal Deposit Insurance Corporation ("FDIC") provides deposit insurance for banks and savings institutions. To maintain its status as an insured depository institution, a bank must pay semiannual assessments into the deposit insurance fund. Assessments for deposit insurance are treated as ordinary and necessary business expenses. These assessments, also known as premiums, are deductible once the all events test for the premium is satisfied.⁵⁵⁹

FDIC premium means any assessment imposed under section 7(b) of the Federal Deposit Insurance Act.⁵⁶⁰ The term total consolidated assets has the meaning given such term under section 165 of the Dodd-Frank Wall Street Reform and Consumer Protection Act.⁵⁶¹

For purposes of determining a taxpayer's total consolidated assets, members of an expanded affiliated group are treated as a single taxpayer. An expanded affiliated group means an affiliated group as defined in section 1504(a) (related to consolidated returns) determined by substituting "more than 50 percent" for "at least 80 percent" each place it appears and without regard to the exceptions from the definition of includible corporation for insurance companies and foreign corporations. A partnership or any other entity other than a corporation is treated as a member of an expanded affiliated group if such entity is controlled by members of such group.

30. Repeal of percentage depletion (sec. 3130 of the discussion draft and secs. 613 and 613A of the Code)

Depletion, like depreciation, is a form of capital cost recovery. In both cases, the taxpayer is allowed a deduction in recognition of the fact that an asset is being expended to produce income.⁵⁶² Certain costs incurred prior to drilling an oil or gas property or extracting minerals are recovered through the depletion deduction.⁵⁶³ These include the cost of acquiring the lease or other interest in the property. In certain instances, the cost of land used in production also is recovered through the depletion deduction.⁵⁶⁴

Depletion is available to any person having an economic interest in a producing property.⁵⁶⁵ An economic interest is possessed in every case in which the taxpayer has acquired by investment any interest in minerals in place, and secures, by any form of legal relationship, income derived from the extraction of the mineral, to which it must look for a return of its capital.⁵⁶⁶ Thus, for example, both working interests and royalty interests in an oil- or gas-producing property constitute economic interests, thereby qualifying the interest holders for depletion deductions with respect to the property. A taxpayer who has no capital investment in the mineral deposit, however, does not acquire an economic interest merely by possessing an economic or pecuniary advantage derived from production through a contractual relation.⁵⁶⁷

Two methods of depletion are currently allowable under the Code: (1) the cost depletion method, and (2) the percentage depletion method.⁵⁶⁸ Under the cost depletion method, the taxpayer deducts that portion of the adjusted basis of the depletable property which is equal to the ratio of units sold from that property during the taxable year to the number of units remaining as of the end of taxable year plus the number of units sold during the taxable year.⁵⁶⁹ Thus, the amount recovered under cost depletion may never exceed the taxpayer's basis in the property.⁵⁷⁰

Under the percentage depletion method, a percentage, varying from five percent to 22 percent, of the taxpayer's gross income from a producing property is allowed as a deduction in each taxable year.⁵⁷¹ The Code generally limits the percentage depletion method for oil and gas properties to independent producers and royalty owners.⁵⁷² Such producers and royalty owners generally may claim percentage depletion at a rate of 15 percent.⁵⁷³

The amount deducted generally may not exceed 50 percent (100 percent in the case of oil and gas properties) of the taxable income from the property in any taxable year.⁵⁷⁴ Additionally, the percentage depletion deduction for all oil and gas properties may not exceed 65 percent of the taxpayer's overall taxable income for the year (determined before such deduction, as well as before any deduction allowable under section 199, and adjusted for certain loss carrybacks and trust distributions).⁵⁷⁵ Because percentage depletion, unlike cost depletion, is computed without regard to the taxpayer's basis in the depletable property, cumulative depletion deductions may be greater than the amount expended by the taxpayer to acquire and/or develop the property.⁵⁷⁶

A taxpayer is required to determine the depletion deduction for each property under both the percentage depletion method (if the taxpayer is entitled to use this method) and the cost depletion method. If the cost depletion deduction is larger, the taxpayer must utilize that method for the taxable year in question.⁵⁷⁷

Limitation on oil and gas percentage depletion to independent producers and royalty owners

As stated above, percentage depletion of oil and gas properties generally is not permitted, except for independent producers and royalty owners, certain fixed-price gas contracts, and natural gas from geopressured brine. For purposes of the percentage depletion allowance, an independent producer is any producer that is not a "retailer" or "refiner." A retailer is any person that directly, or through a related person, sells oil or natural gas (or a derivative thereof): (1) through any retail outlet operated by the taxpayer or related person, or (2) to any person that is obligated to market or distribute such oil or natural gas (or a derivative thereof) under the name of the taxpayer or the related person, or that has the authority to occupy any retail outlet owned by the taxpayer or a related person.⁵⁷⁸

Bulk sales of crude oil and natural gas to commercial or industrial users, and bulk sales of aviation fuel to the Department of Defense, are not treated as retail sales.⁵⁷⁹ Further, if the combined gross receipts of the taxpayer and all related persons from the retail sale of oil, natural gas, or any product derived therefrom do not exceed $5 million for the taxable year, the taxpayer will not be treated as a retailer.⁵⁸⁰

A refiner is any person that directly or through a related person engages in the refining of crude oil in excess of an average daily refinery run of 75,000 barrels during the taxable year.⁵⁸¹

Percentage depletion for eligible taxpayers is allowed for up to 1,000 barrels of average daily production of domestic crude oil or an equivalent amount of domestic natural gas.⁵⁸² For producers of both oil and natural gas, this limitation applies on a combined basis. All production owned by businesses under common control and members of the same family must be aggregated;⁵⁸³ each group is then treated as one producer in applying the 1,000-barrel limitation.

In addition to independent producers and royalty owners, certain sales of natural gas under a fixed contract in effect on February 1, 1975, and certain natural gas from geopressured brine, are eligible for percentage depletion, at rates of 22 percent and 10 percent, respectively. These exceptions apply without regard to the 1,000-barrel-per-day limitation and regardless of whether the producer is an independent producer or an integrated oil company.

Prior to the enactment of the Omnibus Budget Reconciliation Act of 1990 (the "1990 Act"), if an interest in a proven oil or gas property was transferred (subject to certain exceptions), the production from such interest did not qualify for percentage depletion.⁵⁸⁴ The 1990 Act repealed the limitation on claiming percentage depletion on transferred properties effective for property transfers occurring after October 11, 1990.

Percentage depletion on marginal production

The 1990 Act also created a special percentage depletion provision for oil and gas production from so-called marginal properties held by independent producers or royalty owners.⁵⁸⁵ Under this provision, the statutory percentage depletion rate is increased (from the general rate of 15 percent) by one percent for each whole dollar that the average price of crude oil for the immediately preceding calendar year is less than $20 per barrel. In no event may the rate of percentage depletion under this provision exceed 25 percent for any taxable year. The increased rate applies for the taxpayer's taxable year that immediately follows a calendar year for which the average crude oil price falls below the $20 floor. To illustrate the application of this provision, the average price of a barrel of crude oil for calendar year 1999 was $15.56.⁵⁸⁶ Thus, the percentage depletion rate for production from marginal wells was increased to 19 percent for taxable years beginning in 2000. Since the price of oil currently is above the $20 floor, there is no increase in the statutory depletion rate for marginal production (and has not been since 2000).⁵⁸⁷

The Code defines the term "marginal production" for this purpose as domestic crude oil or domestic natural gas which is produced during any taxable year from a property which (1) is a stripper well property for the calendar year in which the taxable year begins, or (2) is a property substantially all of the production from which during such calendar year is heavy oil (i.e., oil that has a weighted average gravity of 20 degrees API or less, corrected to 60 degrees Fahrenheit).⁵⁸⁸ A stripper well property is any oil or gas property that produces a daily average of 15 or fewer equivalent barrels of oil and gas per producing oil or gas well on such property in the calendar year during which the taxpayer's taxable year begins.⁵⁸⁹

The determination of whether a property qualifies as a stripper well property is made separately for each calendar year. The fact that a property is or is not a stripper well property for one year does not affect the determination of the status of that property for a subsequent year. Further, a taxpayer makes the stripper well property determination for each separate property interest (as defined under section 614) held by the taxpayer during a calendar year. The determination is based on the total amount of production from all producing wells that are treated as part of the same property interest of the taxpayer. A property qualifies as a stripper well property for a calendar year only if the wells on such property were producing during that period at their maximum efficient rate of flow.⁵⁹⁰

If a taxpayer's property consists of a partial interest in one or more oil- or gas-producing wells, the determination of whether the property is a stripper well property or a heavy oil property is made with respect to total production from such wells, including the portion of total production attributable to ownership interests other than the taxpayer's interest.⁵⁹¹ If the property satisfies the requirements of a stripper well property, then the benefits of this provision apply with respect to the taxpayer's allocable share of the production from the property.⁵⁹² The deduction is allowed for the taxable year that begins during the calendar year in which the property so qualifies.

The allowance for percentage depletion on production from marginal oil and gas properties is subject to the 1,000-barrel-per-day limitation discussed above. Unless a taxpayer elects otherwise, marginal production is given priority over other production for purposes of utilization of that limitation.

Percentage depletion for hard mineral fossil fuel properties

Percentage depletion is available for taxpayers with an economic interest in a coal mine or other hard mineral fossil fuel property such as lignite or oil shale properties. The depletion rate for coal and lignite is 10 percent.⁵⁹³ For oil shale, the rate generally is 15 percent, but the rate drops to 7.5 percent for shale used or sold for use in the manufacture of sewer pipe or brick or as sintered or burned lightweight aggregates.⁵⁹⁴

As noted above, the percentage depletion deduction is limited to 50 percent of the taxable income from the property (determined before depletion and the deduction under section 199). Additionally, a corporation's percentage depletion deduction with respect to coal or lignite properties is reduced by 20 percent of the excess of the percentage depletion deduction over the adjusted basis of the property at the close of the taxable year (determined without regard to the depletion deduction for the taxable year).⁵⁹⁵

The excess of percentage depletion over cost depletion is a tax preference in computing a taxpayer's alternative minimum taxable income.⁵⁹⁶

31. Repeal of passive activity exception for working interests in oil and gas property (sec. 3131 of the discussion draft and sec. 469 of the Code)

Losses from certain working interests in oil and gas property are not limited under the passive loss rule.⁶⁰³ Thus, losses and credits from such interests can be used to offset other income of the taxpayer without limitation under the passive loss rule. Specifically, a passive activity does not include a working interest in any oil or gas property that the taxpayer holds directly or through an entity that does not limit the liability of the taxpayer with respect to the interest.⁶⁰⁴ This rule applies without regard to whether the taxpayer materially participates in the activity.⁶⁰⁵ If the taxpayer has a loss from a working interest in any oil or gas property that is treated as not from a passive activity, then net income from the property for any succeeding taxable year is treated as income of the taxpayer that is not from a passive activity.⁶⁰⁶

In general, a working interest is an interest with respect to an oil and gas property that is burdened with the cost of development and operation of the property.⁶⁰⁷ Rights to overriding royalties, production payments, and the like, do not constitute working interests, because they are not burdened with the responsibility to share expenses of drilling, completing, or operating oil and gas property. Similarly, contract rights to extract or share in oil and gas, or in profits from extraction, without liability to share in the costs of production, do not constitute working interests. Income from such interests generally is considered to be portfolio (i.e., passive) income.

When the taxpayer's form of ownership limits the liability of the taxpayer, the interest possessed by such taxpayer is not a working interest for purposes of the passive loss provision.⁶⁰⁸ Thus, for purposes of the passive loss rules, an interest owned by a limited partnership is not treated as a working interest with regard to any limited partner, and an interest owned by an S corporation is not treated as a working interest with regard to any shareholder.⁶⁰⁹ The same result follows with respect to any form of ownership that is substantially equivalent in its effect on liability to a limited partnership interest or interest in an S corporation, even if different in form.

When an interest is not treated as a working interest because the taxpayer's form of ownership limits his liability, the general rules regarding material participation apply to determine whether the interest is treated as a passive activity.⁶¹⁰ Thus, for example, a limited partner's interest generally is treated as a passive activity. In the case of a shareholder in an S corporation, the general facts and circumstances test for material participation applies and the working interest exception does not apply, because the form of ownership limits the taxpayer's liability.

A special rule applies in any case where, for a prior taxable year, net losses from a working interest in a property were treated by the taxpayer as not from a passive activity.⁶¹¹ In such a case, any net income realized by the taxpayer from the property (or from any substituted basis property, e.g., property acquired in a section 1031 like kind exchange for such property) in a subsequent year also is treated as active. Under this rule, for example, if a taxpayer claims losses for a year with regard to a working interest and then, after the property to which the interest relates begins to generate net income, transfers the interest to an S corporation in which he is a shareholder, or to a partnership in which he has an interest as a limited partner, his interest with regard to the property continues to be treated as not passive.⁶¹²

32. Repeal of special rules for gain or loss on timber, coal, or domestic iron ore (sec. 3132 of the discussion draft and sec. 631 of the Code)

In general, proceeds from the sale of inventoriable goods are taxed as ordinary income for Federal income tax purposes.⁶¹³ However, a taxpayer disposing of timber held for more than one year is eligible to elect capital gains treatment in the following situations. First, if the taxpayer sells or exchanges timber that is a capital asset⁶¹⁴ or property used in the trade or business,⁶¹⁵ the gain generally is long-term capital gain; however, if the timber is held for sale to customers in the taxpayer's business, the gain will be ordinary income. Second, if the taxpayer disposes of the timber and either retains an economic interest in such timber or makes an outright sale of such timber, the gain is eligible for capital gain treatment.⁶¹⁶ Third, if the taxpayer cuts standing timber, the taxpayer may elect to treat the cutting as a sale or exchange eligible for capital gains treatment.⁶¹⁷

Coal or domestic iron ore

Similar to proceeds from the sale of inventoriable goods, royalties generally are taxed as ordinary income for Federal income tax purposes. However, the Code provides a special rule that treats royalties from certain dispositions of coal or domestic iron ore as capital gains. Specifically, in the case of the disposal of coal (including lignite), or iron ore mined in the United States, held for more than one year prior to disposal by the owner in a form under which the owner retains an economic interest in such coal or iron ore, the excess of the amount realized from the sale over the adjusted depletable basis of the coal or iron ore plus certain disallowed deductions is treated as the sale of depreciable property used in the owner's trade or business (i.e., the sale of section 1231 property).⁶¹⁸ For these purposes, an owner means any person who owns an economic interest in coal or iron ore in place, including a lessee or sublessor thereof.⁶¹⁹The exception does not apply to income realized by any owner as a co-adventurer, partner, or principal in the mining of such coal or iron ore.⁶²⁰

Section 1231 generally provides that if recognized gains on the sale or exchange of property used in a taxpayer's trade or business,⁶²¹ plus certain gains on involuntary conversions, exceed losses from such sales, exchanges, or conversions, the gain is long-term capital gain.⁶²² If losses exceed gains, the losses are treated as ordinary losses. The net ordinary losses are subject to certain recapture provisions. Thus, if the owner's section 1231 gains, including royalties from coal or iron ore disposals described in section 631(c), exceed its section 1231 losses, the royalties will be treated as long-term capital gains.

Section 631(c) is not elective. Thus, if a taxpayer meets the requirements of the section, royalties from the disposal of coal or iron ore will be treated as the disposition of section 1231 property. An owner may not claim percentage depletion with respect to coal or iron ore that is subject to section 631(c) if for the taxable year of the sale the maximum tax rate for capital gains or losses is less than the maximum tax rate for ordinary income.⁶²³

33. Repeal of like-kind exchanges (sec. 3133 of the discussion draft and sec. 1031 of the Code)

The nonrecognition of gain in a like-kind exchange applies only to the extent that like-kind property is received in the exchange. Thus, if an exchange of property would meet the requirements of section 1031, but for the fact that the property received in the transaction consists not only of the property that would be permitted to be exchanged on a tax-free basis, but also other property or money, then the gain to the recipient of the other property or money is to be recognized, but not in an amount exceeding the fair market value of such other property or money.⁶²⁸ Additionally, any gain realized on a section 1031 exchange must be recognized to the extent that the gain is subject to the recapture provisions of sections 1245 and 1250.⁶²⁹ No losses may be recognized from a like-kind exchange.⁶³⁰

If section 1031 applies to an exchange of properties, the basis of the property received in the exchange⁶³¹ is equal to the basis of the property transferred. This basis is increased to the extent of any gain recognized due to the receipt of other property or money in the like-kind exchange, and decreased to the extent of any money received by the taxpayer.⁶³² The holding period of qualifying property received includes the holding period of the qualifying property transferred, but the nonqualifying property received is required to begin a new holding period.⁶³³

34. Restriction on trade or business property treated as similar or related in service to involuntarily converted property in disaster areas (sec. 3134 of the discussion draft and sec. 1033 of the Code)

Section 1033 provides an exception to this rule in the case of certain involuntary conversions of property.⁶³⁵ Under section 1033, gain realized by a taxpayer from an involuntary conversion of property is deferred to the extent the taxpayer purchases property similar or related in service or use to the converted property within the applicable period.⁶³⁶ If the taxpayer receives money (e.g., insurance proceeds) and acquires qualified replacement property within the prescribed time period, the taxpayer's basis in the replacement property generally is the cost of such property, reduced by the amount of gain not recognized.⁶³⁷

The applicable period for the taxpayer to replace the converted property begins with the date of the disposition of the converted property (or if earlier, the earliest date of the threat or imminence of requisition or condemnation of the converted property) and ends two years after the close of the first taxable year in which any part of the gain upon conversion is realized (the "replacement period").⁶³⁸

Special rules extend the replacement period for certain real property⁶³⁹ and principal residences damaged by a Federally declared disaster⁶⁴⁰ to three years and four years, respectively, after the close of the first taxable year in which gain is realized. Similarly, the replacement period for livestock sold on account of drought, flood, or other weather-related conditions is extended from two years to four years after the close of the first taxable year in which any part of the gain on conversion is realized.⁶⁴¹

35. Repeal of rollover of publicly traded securities gain into specialized small business investment companies (sec. 3135 of the discussion draft and sec. 1044 of the Code)

36. Termination of special rules for gain from certain small business stock (sec. 3136 of the discussion draft and secs. 1045 and 1202 of the Code)

The portion of the gain includible in taxable income is taxed at a maximum rate of 28 percent under the regular tax.⁶⁴³ Seven percent of the excluded gain is an alternative minimum tax preference;⁶⁴⁴ the portion of the gain includible in alternative minimum taxable income is taxed at a maximum rate of 28 percent under the alternative minimum tax.

For stock acquired after September 27, 2010, and before January 1, 2014, the percentage exclusion for qualified small business stock sold by an individual is increased to 100 percent and the minimum tax preference does not apply.

Rollover of gain from sale of small business stock

An individual may elect to rollover gain from the sale of qualified small business stock held more than six months where other qualified small business stock is purchased during the 60 day period beginning on the date of sale.⁶⁴⁵

The repeal of the rollover provision applies to sales and exchanges after that date.

37. Certain self-created property not treated as a capital asset (sec. 3137 of the discussion draft and sec. 1221 of the Code)

Self-created intangibles subject to the exception are copyrights, literary, musical, or artistic compositions, letters or memoranda, or similar property which is held either by the taxpayer who created the property, or (in the case of a letter, memorandum, or similar property) a taxpayer for whom the property was produced. For the purpose of determining gain, a taxpayer with a substituted or transferred basis from the taxpayer who created the property, or for whom the property was created, also is subject to the exception.⁶⁴⁹ However, a taxpayer may elect to treat musical compositions and copyrights in musical works as capital assets.⁶⁵⁰

Since the intent of Congress is that profits and losses arising from everyday business operations be characterized as ordinary income and loss, the general definition of capital asset is narrowly applied and the categories of exclusions are broadly interpreted.⁶⁵¹

The proposal also repeals the elective capital treatment for musical compositions and copyrights in musical works. Thus, gains or losses from the sale or exchange of musical compositions and copyrights in musical works will not receive capital gain treatment.

38. Repeal special rule for sale or exchange of patents (sec. 3138 of the discussion draft and sec. 1235 of the Code)

A holder is defined as (1) any individual whose efforts created such property, or (2) any other individual who has acquired his interest in such property in exchange for consideration in money or money's worth paid to such creator prior to actual reduction to practice of the invention covered by the patent, if such individual is neither the employer of such creator nor related (as defined) to such creator.⁶⁵⁴

39. Depreciation recapture on gain from disposition of certain depreciable realty (sec. 3139 of the discussion draft and sec. 1250 of the Code)

The depreciation recapture rules require taxpayers to recognize ordinary income in an amount equal to all or a portion of the gain realized as a result of the disposition of property. The purpose of the rules is to limit a taxpayer's ability to reduce ordinary income via depreciation deductions and then receive capital gain treatment for the portion of any gain on the disposition of the depreciated property that resulted from the taking of depreciation deductions. There are two regimes that dictate depreciation recapture, sections 1245 and 1250.⁶⁵⁸

Depreciable personal property, whether tangible or intangible, and certain depreciable real property (typically real property that performs specific functions in a business, but not buildings or structural components of buildings) disposed of at a gain are known as section 1245 property.⁶⁵⁹ When a taxpayer disposes of section 1245 property, the taxpayer must recapture the gain on disposition of the property as ordinary income to the extent of earlier depreciation or amortization deductions taken with respect to the asset.⁶⁶⁰ Any remaining gain recognized upon the sale of section 1245 property is treated as section 1231 gain.

Depreciable real property, other than that included within the definition of section 1245 property, disposed of at a gain is known as section 1250 property.⁶⁶¹ Gain on the disposition of section 1250 property is treated as ordinary income, rather than capital gain, only to the extent of the excess of post-1969 depreciation allowances over the depreciation that would have been available under the straight-line method.⁶⁶² However, if section 1250 property is held for one year or less, all depreciation is recaptured, regardless of whether it exceeds the depreciation that would have been available under the straight-line method. Special rules phase out the recapture for certain types of property held over a specified period of time.⁶⁶³ Further, for corporations, the amount treated as ordinary income on the disposition of section 1250 property is increased by 20 percent of the additional amount that would be treated as ordinary income if the property were subject to recapture under the rules for section 1245 property.⁶⁶⁴

The alcohol mixture credit also was available as an excise tax credit or payment. The excise tax credits and payments were coordinated with the Section 40 income tax credit, so that the income tax credit was reduced by any benefit received as an excise tax credit or payment. The excise tax credit and payment incentives for alcohol fuel also expired December 31, 2011.

2. Repeal of credit for biodiesel and renewable diesel used as fuel (sec. 3202 of the discussion draft and sec. 40A, 6426 and 6427(e) of the Code)

For purposes of the Code, renewable diesel generally is afforded the same incentives as biodiesel, except there is no small producer credit for renewable diesel.

The income tax, excise tax and payment provisions related to biodiesel and renewable diesel expired on December 31, 2013.

3. Research credit modified and made permanent (sec. 3203 of the discussion draft and sec. 41 of the Code)

For general research expenditures, a taxpayer may claim a research credit equal to 20 percent of the amount by which the taxpayer's qualified research expenses for a taxable year exceed its base amount for that year.⁶⁶⁶ Thus, the research credit is generally available with respect to incremental increases in qualified research. An alternative simplified research credit (with a 14 percent rate and a different base amount) may be claimed in lieu of this credit.⁶⁶⁷

A 20-percent research tax credit also is available with respect to the excess of (1) 100 percent of corporate cash expenses (including grants or contributions) paid for basic research conducted by universities (and certain nonprofit scientific research organizations) over (2) the sum of (a) the greater of two minimum basic research floors plus (b) an amount reflecting any decrease in nonresearch giving to universities by the corporation as compared to such giving during a fixed-base period, as adjusted for inflation.⁶⁶⁸ This separate credit computation commonly is referred to as the basic research credit.⁶⁶⁹

Finally, a research credit is available for a taxpayer's expenditures on research undertaken by an energy research consortium.⁶⁷⁰ This separate credit computation commonly is referred to as the energy research credit. Unlike the other research credits, the energy research credit applies to all qualified expenditures, not just those in excess of a base amount.

The research credit, including the basic research credit and the energy research credit, expired for amounts paid or incurred after December 31, 2013.⁶⁷¹

Computation of allowable credit

Except for energy research payments, the research tax credit applies only to the extent that the taxpayer's qualified research expenses for the current taxable year exceed its base amount. In general, the base amount for the current year generally is computed by multiplying the taxpayer's fixed-base percentage by the average amount of the taxpayer's gross receipts for the four preceding years. If a taxpayer both incurred qualified research expenses and had gross receipts during each of at least three years from 1984 through 1988, then its fixed-base percentage is the ratio that its total qualified research expenses for the 1984-1988 period bears to its total gross receipts for that period (subject to a maximum fixed-base percentage of 16 percent). Special rules apply to all other taxpayers (so called start-up firms).⁶⁷² In computing the research credit, a taxpayer's base amount cannot be less than 50 percent of its current-year qualified research expenses. Slightly different rules apply in calculating the basic research credit, which generally has a base period that extends from 1981 through 1983.

To prevent artificial increases in research expenditures by shifting expenditures among commonly controlled or otherwise related entities, a special aggregation rule provides that all members of the same controlled group of corporations are treated as a single taxpayer.⁶⁷³ Under regulations prescribed by the Secretary, special rules apply for computing the credit when a major portion of a trade or business (or unit thereof) changes hands. Under these rules, qualified research expenses and gross receipts for periods prior to the change of ownership of a trade or business are treated as transferred with the trade or business that gave rise to those expenses and receipts for purposes of recomputing a taxpayer's fixed-base percentage.⁶⁷⁴

Alternative simplified credit

The alternative simplified research credit is equal to 14 percent of qualified research expenses that exceed 50 percent of the average qualified research expenses for the three preceding taxable years.⁶⁷⁵ The rate is reduced to six percent if a taxpayer has no qualified research expenses in any one of the three preceding taxable years.⁶⁷⁶ An election to use the alternative simplified credit applies to all succeeding taxable years unless revoked with the consent of the Secretary.⁶⁷⁷

Eligible expenses

Qualified research expenses eligible for the research tax credit consist of: (1) in-house expenses of the taxpayer for wages and supplies attributable to qualified research; (2) certain time-sharing costs for computer use in qualified research; and (3) 65 percent of amounts paid or incurred by the taxpayer to certain other persons for qualified research conducted on the taxpayer's behalf (so-called contract research expenses).⁶⁷⁸ Notwithstanding the limitation for contract research expenses, qualified research expenses include 100 percent of amounts paid or incurred by the taxpayer to an eligible small business, university, or Federal laboratory for qualified energy research.

To be eligible for the credit, the research not only has to satisfy the requirements of section 174,⁶⁷⁹ but also must be undertaken for the purpose of discovering information that is technological in nature, the application of which is intended to be useful in the development of a new or improved business component of the taxpayer, and substantially all of the activities of which constitute elements of a process of experimentation for functional aspects, performance, reliability, or quality of a business component. Research does not qualify for the credit if substantially all of the activities relate to style, taste, cosmetic, or seasonal design factors.⁶⁸⁰ In addition, research does not qualify for the credit if: (1) conducted after the beginning of commercial production of the business component; (2) related to the adaptation of an existing business component to a particular customer's requirements; (3) related to the duplication of an existing business component from a physical examination of the component itself or certain other information; (4) related to certain efficiency surveys, management function or technique, market research, market testing, or market development, routine data collection or routine quality control; (5) related to software developed primarily for internal use by the taxpayer; (6) conducted outside the United States, Puerto Rico, or any U.S. possession; (7) in the social sciences, arts, or humanities; or (8) funded by any grant, contract, or otherwise by another person (or government entity).⁶⁸¹

Relation to deduction

Deductions allowed to a taxpayer under section 174 (or any other section) are reduced by an amount equal to 100 percent of the taxpayer's research tax credit determined for the taxable year.⁶⁸² Taxpayers may alternatively elect to claim a reduced research tax credit amount under section 41 in lieu of reducing deductions otherwise allowed.⁶⁸³

The proposal also makes permanent the basic research credit, but reduces the credit rate to 15 percent and changes the base period from a fixed period to a three-year rolling average. The proposal repeals the energy research credit.

The proposal eliminates the research credit with respect to research related to computer software. In addition, the proposal removes from the definition of qualified research expenses amounts paid for supplies in the conduct of qualified research. The proposal also eliminates the special rules in the research credit that allow, in certain cases, for contract research expenses to exceed 65 percent of the amount actually paid for such expenses.

Finally, the proposal eliminates a taxpayer's ability to claim a reduced research credit amount in lieu of reducing research and development deductions otherwise allowed.

4. Modification of low-income housing tax credit (sec. 3204 of the discussion draft and sec. 42 of the Code)

The low-income housing tax credit ("LIHTC") may be claimed over a 10-year period for the cost of building rental housing occupied by tenants having incomes below specified levels.⁶⁸⁵ The amount of the credit for any taxable year in the credit period is the applicable percentage of the qualified basis of each qualified low-income building. The applicable percentage is designed to produce a credit with a present value equal to a fixed percentage of the qualified basis of the building. The qualified basis of any qualified low-income building for any taxable year equals the applicable fraction of the eligible basis of the building. Eligible basis is generally adjusted basis at the close of the first taxable year of the credit period.

Qualified low-income housing project

To qualify for the low-income housing tax credit, the incomes of the tenants must satisfy certain targeting rules. Under the LIHTC rules, a project is a qualified low-income housing project if 20 percent or more of the residential units in such project are occupied by individuals whose income is 50 percent or less of area median gross income (the "20-50 test"). Alternatively, a project is a qualified low-income housing project if 40 percent or more of the residential units in such project are occupied by individuals whose income is 60 percent or less of area median gross income (the "40-60 test"). The owner must elect to apply either the 20-50 test or the 40-60 test. Operators of qualified low-income housing projects must annually certify that such project meets the requirements for qualification, including meeting the 20-50 test or the 40-60 test. In practice, many projects have every unit satisfy the income targeting rules so that the entire project qualifies for the credit.

Present value credit

Where existing housing is substantially rehabilitated, the existing housing is eligible for the 30-percent credit and the qualified rehabilitation expenses (if not Federally subsidized) are eligible for the 70-percent credit.

Calculation of the applicable percentage

The credit percentage for a low-income building is set for the earlier of: (1) the month the building is placed in service; or (2) at the election of the taxpayer, (a) the month the taxpayer and the housing credit agency enter into a binding agreement with respect to such building for a credit allocation, or (b) in the case of a tax-exempt bond-financed project for which no credit allocation is required, the month in which the tax-exempt bonds are issued.

These credit percentages (used for the 70-percent credit and 30-percent credit) are adjusted monthly by the IRS on a discounted after-tax basis (assuming a 28-percent tax rate) based on the average of the applicable Federal rates for mid-term and long-term obligations for the month the building is placed in service.⁶⁸⁶ The discounting formula assumes that each credit is received on the last day of each year and that the present value is computed on the last day of the first year. In a project consisting of two or more buildings placed in service in different months, a separate credit percentage may apply to each building.

Substantial rehabilitation requirement

Rehabilitation expenditures paid or incurred by a taxpayer with respect to a low-income building are treated as a separate building and may be eligible for the 70-percent credit if they satisfy the otherwise applicable credit rules. To qualify for the credit, the rehabilitation expenditures must equal the greater of an amount that is (1) at least 20 percent of the adjusted basis of the building being rehabilitated; or (2) at least $6,000 per low-income unit in the building being rehabilitated. The $6,000 amount is indexed for inflation, so it is $6,500 in 2014.

At the election of the taxpayer, a special rule applies allowing the 30-percent credit to both existing buildings and rehabilitation expenditures if the second prong (i.e., at least $6,000 of rehabilitation expenditures per low-income unit) of the rehabilitation expenditures test is satisfied. This special rule applies only in the case where the taxpayer acquired the building and immediately prior to that acquisition the building was owned by or on behalf of a government unit.

Enhanced credit for buildings in high-cost areas

Generally, buildings located in three types of high-cost areas (i.e., qualified census tracts, difficult development areas and buildings designated by the State housing credit agency as requiring the enhanced credit in order for such buildings to be financially feasible) are eligible for an enhanced credit. Under the enhanced credit, the 70-percent and 30-percent credits are increased to a 91-percent and 39-percent credit, respectively. The mechanism for this increase is through an increase from 100 to 130 percent of the otherwise applicable eligible basis of a new building or the rehabilitation expenditures of an existing building. A further requirement for the enhanced credit in qualified census tracts and difficult development areas is that the portions of each metropolitan statistical area or nonmetropolitan statistical area designated as difficult to develop areas cannot exceed an aggregate area having 20 percent of the population of such statistical area. Buildings designated by the State housing credit agency as requiring the enhanced credit in order for such buildings to be financially feasible are not subject to the limitation limiting high cost areas to 20 percent of the population of each metropolitan statistical area or nonmetropolitan statistical area.

Recapture

The compliance period for any building is the period beginning on the first day of the first taxable year of the credit period of such building and ending 15 years from such date.

The penalty for any building subject to the 15-year compliance period failing to remain part of a qualified low-income project (due, for example, to noncompliance with the minimum set aside requirement, or the gross rent requirement, or other requirements with respect to the units comprising the set aside) is recapture of the accelerated portion of the credit, with interest, for all prior years.

Allocation of credits

A low-income housing tax credit is allowable only if the owner of a qualified building receives a housing credit allocation from the State or local housing credit agency. Generally, the aggregate credit authority provided annually to each State for calendar year 2014 is $2.30 per resident, with a minimum annual cap of $2,635,000 for certain small population States.⁶⁸⁷ These amounts are indexed for inflation. Projects that also receive financing with proceeds of tax-exempt bonds issued subject to the private activity bond volume limit do not require an allocation of the low-income housing credit, but the related use of tax-exempt bonds is subject to limitation.

Under the proposal, a low-income housing tax credit is only allowed if the owner of a qualified building receives an allocation of qualified basis, as opposed to housing credits under present law, from the State or local housing credit agency. Generally, the aggregate basis authority provided annually to each State for calendar year 2015 is $31.20 per resident, with a minimum annual cap of $36.3 million for certain small population States. These amounts are indexed annually for inflation in increments of $0.20 and $100,000, respectively.

The enhanced credits for 130 percent of the otherwise applicable basis of buildings in high-cost areas are repealed.

The proposal repeals the part of the calculation of the State housing credit ceiling that allows unused housing credit carryovers to be allocated among certain States (the so called national reallocation pool).

The proposal repeals the special rule for States with constitutional home rule cities.

Credit period

The proposal changes the credit period from 10 years to 15 years. The credit recapture rules are repealed. As the credit period and compliance period are both 15 years, there is no accelerated portion of the credit to recapture.

Applicable percentage

As a result of the lengthening of the credit period, the applicable percentage for determining the 70-percent credit is reduced relative to present law. However, the applicable percentage is determined in such a way as to maintain a credit with a present value equal to 70 percent of the building's qualified basis. The discount rate used to determine the applicable percentage is the applicable discount percentage of the average of the mid-term and long-term applicable Federal rates. The applicable discount percentage is the number of percentage points by which 100 percent exceeds the highest corporate income tax rate for a taxable year which begins in such month.⁶⁸⁸

The proposal repeals the 30-percent credit, and related rules, for qualified basis of a building that is not a new building or any building that is Federally subsidized.⁶⁸⁹ Rehabilitation expenditures that are substantial are treated as a separate new building as under present law and are eligible for the 70-percent credit.

Modification of rules against preferential treatment

The proposal repeals the exception to the general public use requirement for preferences that favor tenants who are involved in artistic or literary activities and adds an exception for veterans.

Selection criteria

The proposal modifies the selection criteria that a qualified allocation plan must include to remove the energy efficiency and historic nature criteria.

5. Repeal of enhanced oil recovery credit (sec. 3205 of the discussion draft and sec. 43 of the Code)

6. Modification and repeal of electricity produced from certain renewable resources (sec. 3206 of the discussion draft and sec. 45 of the Code)

A production credit is available for electricity produced from certain renewable resources during the 10-year period beginning after the renewable power facility has been placed in service. The full credit rate is 1.5 cents per kilowatt-hour (adjusted for inflation; 2.3 cents per kilowatt-hour for 2013) and is available for power produced at qualified wind, closed-loop biomass, and geothermal facilities. A credit equal to one-half the full credit rate (1.1 cents per kilowatt hour for 2013) is available for power produced at open-loop biomass, small irrigation power, landfill gas, trash combustion, marine/hydrokinetic, and certain hydropower facilities. The credit expired for facilities the construction of which began after December 31, 2013.

Election to claim energy credit in lieu of renewable electricity production credit

A taxpayer may make an irrevocable election to have certain property which is part of a qualified renewable power facility be treated as energy property eligible for a 30-percent investment credit under section 48. For this purpose, qualified renewable power facilities are facilities otherwise eligible for the renewable electricity production credit with respect to which no credit under section 45 has been allowed. A taxpayer electing to treat a facility as energy property may not claim the renewable electricity production credit. The eligible basis for the investment credit for taxpayers making this election is the basis of the depreciable (or amortizable) property that is part of a facility capable of generating electricity eligible for the renewable electricity production credit. No credit is available for facilities the construction of which began after December 31, 2013.

Refined coal production credit

A production credit of $4.375 per ton (adjusted for inflation; $6.59 per ton for 2013) is available for refined coal produced at a qualified facility during the 10-year period beginning on the date such facility has been placed in service. Refined coal is defined as a synthetic fuel produced from coal (including lignite) or high-carbon fly ash that when burned emits 20 percent less nitrogen oxide and 40 percent less sulfur dioxide or mercury compared to feedstock coal predominantly available in the marketplace as of January 1, 2003. The refined coal must be sold to a third party with the reasonable expectation that it will be used for the purpose of producing steam. Qualified refined coal facilities must be placed in service before January 1, 2010.

Description of Proposal

The proposal eliminates the credit rate inflation adjustments for the renewable electricity and refined coal production tax credits. Thus, for renewable electricity, the full credit rate is 1.5 cents per kilowatt-hour and the half credit rate is 0.75 cents per kilowatt-hour. For refined coal, the credit rate reverts to $4.375 per ton.

The proposal also clarifies that for purposes of determining whether the construction of a qualified renewable power facility (including modifications, improvements, additions, or the construction of other related property) is treated as beginning before January 1, 2014, there must be a continuous program of construction that begins before such date and ends on the date such property is placed in service.

Finally, the proposal repeals the section 45 credit (including the credits for renewable electricity and refined coal) in its entirety for electricity and coal produced and sold after December 31, 2024.

7. Indian employment credit (sec. 3207 of the discussion draft and sec. 45A of the Code)

Qualified wages means wages paid or incurred by an employer for services performed by a qualified employee. A qualified employee means any employee who is an enrolled member of an Indian tribe or the spouse of an enrolled member of an Indian tribe, who performs substantially all of the services within an Indian reservation, and whose principal place of abode while performing such services is on or near the reservation in which the services are performed. An "Indian reservation" is a reservation as defined in section 3(d) of the Indian Financing Act of 1974⁶⁹¹ or section 4(10) of the Indian Child Welfare Act of 1978.⁶⁹² For purposes of the preceding sentence, section 3(d) is applied by treating "former Indian reservations in Oklahoma" as including only lands that are (1) within the jurisdictional area of an Oklahoma Indian tribe as determined by the Secretary of the Interior, and (2) recognized by such Secretary as an area eligible for trust land status under 25 C.F.R. Part 151 (as in effect on August 5, 1997).

An employee is not treated as a qualified employee for any taxable year of the employer if the total amount of wages paid or incurred by the employer with respect to such employee during the taxable year exceeds an amount determined at an annual rate of $30,000, as adjusted for inflation in the manner described (which is $45,000 for 2013). In addition, an employee will not be treated as a qualified employee under certain specific circumstances, such as where the employee is related to the employer (in the case of an individual employer) or to one of the employer's shareholders, partners, or grantors. Similarly, an employee will not be treated as a qualified employee where the employee has more than a five percent ownership interest in the employer. Finally, an employee will not be considered a qualified employee to the extent the employee's services relate to gaming activities or are performed in a building housing such activities.

The wage credit is available for wages paid or incurred in taxable years that begin on or before December 31, 2013.

8. Repeal of credit for portion of employer Social Security taxes paid with respect to employee cash tips (sec. 3208 of the discussion draft and sec. 45B of the Code)

A business tax credit is provided equal to an employer's FICA taxes paid on tips in excess of those treated as wages for purposes of meeting the minimum wage requirements of the Fair Labor Standards Act (the "FLSA") as in effect on January 1, 2007.⁶⁹⁴ The credit applies only with respect to FICA taxes paid on tips received from customers in connection with the providing, delivering, or serving of food or beverages for consumption if the tipping of employees delivering or serving food or beverages by customers is customary. The credit is available whether or not the employee reports the tips on which the employer FICA taxes were paid. No deduction is allowed for any amount taken into account in determining the tip credit. A taxpayer may elect not to have the credit apply for a taxable year.

9. Repeal of credit for clinical testing expenses for certain drugs for rare diseases or conditions (sec. 3209 of the discussion draft and sec. 45C of the Code)

Amounts included in computing the credit under this section are excluded from the computation of the research credit under section 41.⁶⁹⁸

10. Repeal of credit for small employer pension plan startup costs (sec. 3210 of the discussion draft and sec. 45E of the Code)

An eligible employer is an employer that, for the preceding year, had no more than 100 employees with compensation of $5,000 or more. In addition, the employer must not have had a plan covering substantially the same employees as the new plan during the three years preceding the first year for which the credit would apply. Members of controlled groups and affiliated service groups are treated as single employers for purposes of these requirements.

11. Repeal of credit for employer-provided childcare (sec. 3211 of the discussion draft and section 45F of the Code)

Qualified child care expenses include costs paid or incurred: (1) to acquire, construct, rehabilitate or expand property that is to be used as part of the taxpayer's qualified child care facility;⁶⁹⁹ (2) for the operation of the taxpayer's qualified child care facility, including the costs of training and certain compensation for employees of the child care facility, and scholarship programs; or (3) under a contract with a qualified child care facility to provide child care services to employees of the taxpayer. To be a qualified child care facility, the principal use of the facility must be for child care (unless it is the principal residence of the taxpayer), and the facility must meet all applicable State and local laws and regulations, including any licensing laws.

12. Repeal of railroad track maintenance credit (sec. 3212 of the discussion draft and sec. 45G of the Code)

Qualified railroad track maintenance expenditures are defined as gross expenditures (whether or not otherwise chargeable to capital account) for maintaining railroad track (including roadbed, bridges, and related track structures) owned or leased as of January 1, 2005, by a Class II or Class III railroad (determined without regard to any consideration for such expenditure given by the Class II or Class III railroad which made the assignment of such track).⁷⁰⁴

An eligible taxpayer means any Class II or Class III railroad, and any person who transports property using the rail facilities of a Class II or Class III railroad or who furnishes railroad-related property or services to a Class II or Class III railroad, but only with respect to miles of railroad track assigned to such person by such railroad under the provision.⁷⁰⁵

The terms Class II or Class III railroad have the meanings given by the Surface Transportation Board.⁷⁰⁶

13. Repeal of credit for production of low sulfur diesel fuel (sec. 3213 of the discussion draft and sec. 45H of the Code)

The total production credit claimed by the taxpayer is limited to 25 percent of the capital costs incurred to come into compliance with the EPA diesel fuel requirements. The percentage limitation phases down pro rata for refiners that had runs in 2002 exceeding 155,000 barrels but less than 205,000 barrels.

Costs qualifying for the credit are those costs paid or incurred with respect to any facility of a small business refiner during the period beginning on January 1, 2003 and ending on the earlier of the date that is one year after the date on which the taxpayer must comply with the applicable EPA regulations or December 31, 2009. The taxpayer's basis in property with respect to which the credit applies is reduced by the amount of the production credit claimed. Although the period for incurring qualified expenditures ended on December 31, 2009, a taxpayer may claim the production credit until the 25 percent limit is reached.

14. Repeal of credit for producing oil and gas from marginal wells (sec. 3214 of the discussion draft and sec. 45I of the Code)

A qualified marginal well is defined as domestic well: (1) production from which is treated as marginal production for purposes of the Code percentage depletion rules; or (2) that during the taxable year had average daily production of not more than 25 barrel equivalents and produces water at a rate of not less than 95 percent of total well effluent. The maximum amount of production on which credit could be claimed is 1,095 barrels or barrel equivalents.

The credit is not available to production occurring if the reference price of oil exceeds $18 ($2.00 for natural gas). The credit is reduced proportionately as for reference prices between $15 and $18 ($1.67 and $2.00 for natural gas). Currently the credit is totally phased out.

In the case of production from a qualified marginal well which is eligible for the credit allowed under section 45K for the taxable year, no marginal well credit is allowable unless the taxpayer elects not to claim the credit under section 45K with respect to the well. The credit is treated as a general business credit. Unused credits can be carried back for up to five years rather than the generally applicable carryback period of one year. The credit is indexed for inflation.

15. Repeal of credit for production from advanced nuclear power facilities (sec. 3215 of the discussion draft and sec. 45J of the Code)

16. Repeal of credit for producing fuel from a nonconventional source (sec. 3216 of the discussion draft and sec. 45K of the Code)

17. Repeal of energy efficient new homes credit (sec. 3217 of the discussion draft and sec. 45l of the Code)

18. Repeal of energy efficient appliance credit (sec. 3218 of the discussion draft and sec. 45M of the Code)

19. Repeal of mine rescue team training credit (sec. 3219 of the discussion draft and sec. 45N of the Code)

An eligible employer is any taxpayer which employs individuals as miners in underground mines in the United States.⁷¹⁰ The term "wages" has the meaning given to such term by section 3306(b)⁷¹¹ (determined without regard to any dollar limitation contained in that section).⁷¹²

No deduction is allowed for the portion of the expenses otherwise deductible that is equal to the amount of the credit.⁷¹³ The credit does not apply to taxable years beginning after December 31, 2013.⁷¹⁴ Additionally, the credit is not allowable for purposes of computing the alternative minimum tax.⁷¹⁵

20. Repeal of agricultural chemicals security tax credit (sec. 3220 of the discussion draft and sec. 45O of the Code)

The credit is limited to $100,000 per facility; this amount is reduced by the aggregate amount of the credits allowed for the facility in the prior five years. In addition, each taxpayer's annual credit is limited to $2,000,000.⁷¹⁷ The credit only applies to expenditures paid or incurred before December 31, 2012. The taxpayer's deductible expense is reduced by the amount of the credit claimed.

21. Repeal of credit for carbon dioxide sequestration (sec. 3221 of the discussion draft and section 45Q of the Code)

22. Repeal of credit for employee health insurance expenses of small employers (sec. 3222 of the discussion draft and sec. 45R of the Code)

An eligible small employer may be eligible for a tax credit for nonelective contributions to purchase health insurance for its employees.⁷¹⁸ An eligible small employer for this purpose generally is an employer with no more than 25 full-time equivalent employees ("FTEs") during the employer's taxable year, whose average annual wages do not exceed $50,000.⁷¹⁹ However, the full amount of the credit is available only to an employer with 10 or fewer FTEs whose average annual wages do not exceed $25,000.

An employer's FTEs are calculated by dividing the total hours worked by all employees during the employer's tax year (up to 2,080 for any employee) by 2,080 (and rounding down to the nearest whole number of FTEs) . Average annual wages are determined by dividing the total wages paid by the employer by the number of FTEs (and rounding down to the nearest $1,000).

For purposes of the credit, the employer is determined by applying the aggregation rules for controlled groups, groups under common control, and affiliated service groups.⁷²⁰ In addition, for purposes of the credit, the term "employee" includes a leased employee, i.e., an individual who is not an employee of the employer, who provides services to the employer pursuant to an agreement between the employer and another person (a "leasing organization") and under the primary direction or control of the employer, and who has performed such services on a substantially full-time basis for at least one year.⁷²¹

Self-employed individuals (including partners and sole proprietors), two-percent shareholders of an S corporation, and five-percent owners of the employer are not employees for purposes of the credit with the result that they are disregarded in determining number of FTEs, average annual wages, and nonelective contributions for employees' health insurance. Family members of these individuals and any member of the individual's household who is a dependent for tax purposes are also not employees for purposes of the credit. In addition, the hours of service worked by and wages paid to a seasonal worker of an employer are not taken into account in determining number of FTEs and average annual wages unless the worker works for the employer on more than 120 days during the taxable year.

The employer contributions must be provided under an arrangement that requires the eligible small employer to make, on behalf of each employee who enrolls in qualifying health insurance offered by the employer, a nonelective contribution equal to a uniform percentage (not less than 50 percent) of the premium cost of the qualifying health insurance (described below).

The credit is available only to offset actual tax liability and is claimed on the employer's tax return. The credit is a general business credit and generally can be carried back for one year and carried forward for 20 years. The credit is available for tax liability under the alternative minimum tax. The dollar amount of the credit reduces the amount of employer contributions the employer may deduct as a business expense.

Years credit available and qualifying health insurance

An initial credit is available for any taxable year beginning in 2010, 2011, 2012, or 2013. Qualifying health insurance for claiming the credit for this first phase of the credit is health insurance coverage as defined for purposes of the group health plan requirements under the Code, which is generally health insurance coverage offered by an insurance company licensed under State law.

For taxable years beginning after 2013, the credit is available only for nonelective contributions for premiums for qualified health plans offered by the employer through an American Health Benefit Exchange and is available for a maximum credit period of two consecutive taxable years beginning with the first taxable year in which the employer (or any predecessor) offers one or more qualified health plans to its employees through an American Health Benefit Exchange. The maximum two-year credit period does not take into account any taxable years beginning before 2014.

Calculation of credit amount

Only nonelective contributions by the employer are taken into account in calculating the credit. The credit is equal to the lesser of the following two amounts multiplied by an applicable credit percentage: (1) the amount of contributions the employer made on behalf of the employees during the taxable year for the qualifying health insurance and (2) the amount of contributions the employer would have made during the taxable year if each employee with the qualifying health insurance had enrolled in insurance with a benchmark premium (as described below). As discussed above, the credit is available only if nonelective contributions are a uniform percentage of at least 50 percent of the premium cost of the qualifying health insurance.

For the first phase of the credit (taxable years beginning in 2010, 2011, 2012, or 2013), the applicable credit percentage is generally 35 percent, and the benchmark premium is the average premium for the small group market (i.e., insurance coverage provided by small employers) in the employer's State, as determined by the Secretary of Health and Human Services ("HHS"). For taxable years beginning after 2013, the applicable credit percentage is generally 50 percent, and the benchmark premium is the average premium for the small group market in the rating area in which the employee enrolls for coverage, as determined by the Secretary of HHS.

The credit is reduced for an employer with between 10 and 25 FTEs ("FTE phase-out"). The credit is also reduced for an employer for whom the average annual wages per FTE is between $25,000 and $50,000 ("average annual wages phase-out"). For an employer with both more than 10 FTEs and average annual wages in excess of $25,000, the reduction is the sum of the amount of the two reductions.

Tax-exempt organizations

For tax-exempt organizations, the applicable credit percentage during the first phase of the credit (taxable years beginning in 2010, 2011, 2012, or 2013) is limited to 25 percent and the applicable credit percentage during the second phase (taxable years beginning after 2013) is limited to 35 percent. In addition, instead of a general business credit, the credit is a refundable credit limited to the amount of the payroll taxes of the employer during the calendar year in which the taxable year begins.⁷²²

23. Repeal of rehabilitation credit (sec. 3223 of the discussion draft and sec. 47 of the Code)

A 20-percent credit is provided for qualified rehabilitation expenditures with respect to a certified historic structure. For this purpose, a certified historic structure means any building that is listed in the National Register, or that is located in a registered historic district and is certified by the Secretary of the Interior to the Secretary of the Treasury as being of historic significance to the district.

A 10-percent credit is provided for qualified rehabilitation expenditures with respect to a qualified rehabilitated building, which generally means a building that was first placed in service before 1936. The pre-1936 building must meet requirements with respect to retention of existing external walls and internal structural framework of the building in order for expenditures with respect to it to qualify for the 10-percent credit. A building is treated as having met the substantial rehabilitation requirement under the 10-percent credit only if the rehabilitation expenditures during the 24-month period selected by the taxpayer and ending within the taxable year exceed the greater of (1) the adjusted basis of the building (and its structural components), or (2) $5,000.

The provision requires the use of straight-line depreciation or the alternative depreciation system in order for rehabilitation expenditures to be treated as qualified under the provision.

24. Repeal of energy credit (sec. 3224 of the discussion draft and sec. 48 of the Code)

25. Repeal of qualifying advanced coal project credit (sec. 3225 of the discussion draft and sec. 48A of the Code)

26. Repeal of qualifying gasification project credit (sec. 3226 of the discussion draft and section 48B of the Code)

27. Repeal of qualifying advanced energy project credit (sec. 3227 of the discussion draft and section 48C of the Code)

Credits are allocated by the Secretary and are capped at $2.3 billion. All credits have been fully allocated. Credits for projects that fail to meet certain benchmarks may be reallocated by the Secretary.

28. Repeal of qualifying therapeutic discovery project credit (sec. 3228 of the discussion draft and sec. 48D of the Code)

Under present law, a taxpayer is eligible for a 50 percent nonrefundable investment tax credit for qualified investments in qualifying therapeutic discovery projects.⁷²⁴ Qualified investments must be made in a taxable year beginning in 2009 and 2010 and the total amount of credits allocated for the program for the two-year period 2009 through 2010 is $1 billion.⁷²⁵ The Secretary, in consultation with the Secretary of Health and Human Services, awards certifications for qualified investments.⁷²⁶ The credit is available only to companies having 250 or fewer employees.⁷²⁷

A "qualifying therapeutic discovery project" is a project which is designed to develop a product, process, or therapy to diagnose, treat, or prevent diseases and afflictions by: (1) conducting pre-clinical activities, clinical trials, clinical studies, and research protocols, or (2) by developing technology or products designed to diagnose diseases and conditions, including molecular and companion drugs and diagnostics, or to further the delivery or administration of therapeutics.⁷²⁸

The qualified investment for any taxable year is the aggregate amount of the costs paid or incurred in such year for expenses necessary for, and directly related to, the conduct of a qualifying therapeutic discovery project.⁷²⁹ The qualified investment for any taxable year with respect to any qualifying therapeutic discovery project does not include any cost for: (1) remuneration for an employee described in section 162(m)(3), (2) interest expense, (3) facility maintenance expenses, (4) a service cost identified under Treas. Reg. sec. 1.263A-1(e)(4), or (5) any other expenditure as determined by the Secretary as appropriate to carry out the purposes of the provision.⁷³⁰

Companies must apply to the Secretary to obtain certification for qualifying investments.⁷³¹ The Secretary, in determining qualifying projects, will consider only those projects that show reasonable potential to: (1) result in new therapies to treat areas of unmet medical need or to prevent, detect, or treat chronic or acute disease and conditions; (2) reduce long-term health care costs in the United States; or (3) significantly advance the goal of curing cancer within a 30-year period.⁷³² Additionally, the Secretary will take into consideration which projects have the greatest potential to: (1) create and sustain (directly or indirectly) high quality, high paying jobs in the United States; and (2) advance the United States' competitiveness in the fields of life, biological, and medical sciences.⁷³³

Qualified therapeutic discovery project expenditures do not qualify for the research credit, orphan drug credit, or bonus depreciation.⁷³⁴ If a credit is allowed for an expenditure related to property subject to depreciation, the basis of the property is reduced by the amount of the credit.⁷³⁵ Additionally, expenditures taken into account in determining the credit are nondeductible to the extent of the credit claimed that is attributable to such expenditures.

Election to receive grant in lieu of tax credit

Taxpayers may elect to receive credits that have been allocated to them in the form of Treasury grants equal to 50 percent of the qualifying investment.⁷³⁶ Any such grant is not includible in the taxpayer's gross income.

In making grants under this section, the Secretary is to apply rules similar to the rules of section 50.⁷³⁷ In applying such rules, if an investment ceases to be a qualified investment, the Secretary shall provide for the recapture of the appropriate percentage of the grant amount in such manner as the Secretary determines appropriate. The Secretary shall not make any grant under this section to: (1) any Federal, State, or local government (or any political subdivision, agency, or instrumentality thereof); (2) any organization described in section 501(c) and exempt from tax under section 501(a); (3) any entity referred to in section 54(j)(4); or (4) any partnership or other pass-thru entity any partner (or other holder of an equity or profits interest) of which is described in paragraph (1), (2), or (3).

29. Repeal of the work opportunity tax credit (sec. 3229 of the discussion draft and sec. 51 of the Code)

The work opportunity tax credit is available on an elective basis for employers hiring individuals from one or more of nine targeted groups. The amount of the credit available to an employer is determined by the amount of qualified wages paid by the employer. Generally, qualified wages consist of wages attributable to service rendered by a member of a targeted group during the one-year period beginning with the day the individual begins work for the employer (two years in the case of an individual in the long-term family assistance recipient category).

Targeted groups eligible for the credit

Generally, an employer is eligible for the credit only for qualified wages paid to members of a targeted group.

A veteran is an individual who has served on active duty (other than for training) in the Armed Forces for more than 180 days or who has been discharged or released from active duty in the Armed Forces for a service-connected disability. However, any individual who has served for a period of more than 90 days during which the individual was on active duty (other than for training) is not a qualified veteran if any of this active duty occurred during the 60-day period ending on the date the individual was hired by the employer. This latter rule is intended to prevent employers who hire current members of the armed services (or those departed from service within the last 60 days) from receiving the credit.

Qualified wages

Generally, qualified wages are defined as cash wages paid by the employer to a member of a targeted group. The employer's deduction for wages is reduced by the amount of the credit.

For purposes of the credit, generally, wages are defined by reference to the FUTA definition of wages contained in section 3306(b) (without regard to the dollar limitation therein contained). Special rules apply in the case of certain agricultural labor and certain railroad labor.

Calculation of the credit

The credit available to an employer for qualified wages paid to members of all targeted groups except for long-term family assistance recipients equals 40 percent (25 percent for employment of 400 hours or less) of qualified first-year wages. Generally, qualified first-year wages are qualified wages (not in excess of $6,000) attributable to service rendered by a member of a targeted group during the one-year period beginning with the day the individual began work for the employer. Therefore, the maximum credit per employee is $2,400 (40 percent of the first $6,000 of qualified first-year wages). With respect to qualified summer youth employees, the maximum credit is $1,200 (40 percent of the first $3,000 of qualified first-year wages). Except for long-term family assistance recipients, no credit is allowed for second-year wages.

In the case of long-term family assistance recipients, the credit equals 40 percent (25 percent for employment of 400 hours or less) of $10,000 for qualified first-year wages and 50 percent of the first $10,000 of qualified second-year wages. Generally, qualified second-year wages are qualified wages (not in excess of $10,000) attributable to service rendered by a member of the long-term family assistance category during the one-year period beginning on the day after the one-year period beginning with the day the individual began work for the employer. Therefore, the maximum credit per employee is $9,000 (40 percent of the first $10,000 of qualified first-year wages plus 50 percent of the first $10,000 of qualified second-year wages).

In the case of a qualified veterans, the credit is calculated as follows: (1) in the case of a qualified veteran who was eligible to receive assistance under a supplemental nutritional assistance program (for at least a three month period during the year prior to the hiring date) the employer is entitled to a maximum credit of 40 percent of $6,000 of qualified first-year wages; (2) in the case of a qualified veteran who is entitled to compensation for a service connected disability, who is hired within one year of discharge, the employer is entitled to a maximum credit of 40 percent of $12,000 of qualified first-year wages; (3) in the case of a qualified veteran who is entitled to compensation for a service connected disability, and who has been unemployed for an aggregate of at least six months during the one year period ending on the hiring date, the employer is entitled to a maximum credit of 40 percent of $24,000 of qualified first-year wages; (4) in the case of a qualified veteran unemployed for at least four weeks but less than six months (whether or not consecutive) during the one-year period ending on the date of hiring, the maximum credit equals 40 percent of $6,000 of qualified first-year wages; and (5) in the case of a qualified veteran unemployed for at least six months (whether or not consecutive) during the one-year period ending on the date of hiring, the maximum credit equals 40 percent of $14,000 of qualified first-year wages.

Expiration

The work opportunity tax credit is not available with respect to wages paid to individuals who begin work for an employer after December 31, 2013.

30. Repeal of deduction for certain unused business credits (sec. 3230 of the discussion draft and sec. 196 of the Code)

Section 196 allows a deduction to the extent that certain portions of the GBC expire unused after the end of the carry forward period. In general, 100 percent of the unused credit is allowed as a deduction in the taxable year after such credit expired. However, with respect to the investment credit determined under section 46 (other than the rehabilitation credit) and the research credit determined under section 41(a) (for a taxable year beginning before January 1, 1990), section 196 limits the deduction to 50 percent of such unused credits.⁷⁴¹

A C corporation, a partnership that has a C corporation as a partner, or a tax-exempt trust with unrelated business income generally may not use the cash method of accounting. Exceptions are made for farming businesses, qualified personal service corporations, and the aforementioned entities to the extent their average annual gross receipts do not exceed $5 million for all prior years (including the prior taxable years of any predecessor of the entity) (the "gross receipts test"). The cash method of accounting may not be used by any tax shelter. In addition, the cash method generally may not be used if the purchase, production, or sale of merchandise is an income producing factor.⁷⁴⁵ Such taxpayers generally are required to keep inventories and use an accrual method of accounting with respect to inventory items.⁷⁴⁶

A farming business is defined as a trade or business of farming, including operating a nursery or sod farm, or the raising or harvesting of trees bearing fruit, nuts, or other crops, timber, or ornamental trees.⁷⁴⁷ Such farming businesses are not precluded from using the cash method regardless of whether they meet the gross receipts test.⁷⁴⁸

A qualified personal service corporation is a corporation: (1) substantially all of whose activities involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting and (2) substantially all of the stock of which is owned by current or former employees performing such services, their estates, or heirs. Qualified personal service corporations are allowed to use the cash method without regard to whether they meet the gross receipts test.

Accrual method taxpayers are not required to include in income that portion of any amounts to be received for the performance of services in the fields of health, law, engineering, architecture, accounting actuarial science, performing arts, or consulting, that, on the basis of experience, will not be collected (the "nonaccrual experience method").⁷⁴⁹ The availability of this method is conditioned on the taxpayer not charging interest or a penalty for failure to timely pay the amount charged.

Under the proposal, the cash method of accounting may only be used by natural persons (i.e., sole proprietors) and taxpayers other than tax shelters that satisfy the gross receipts test. The gross receipts test allows taxpayers with annual average gross receipts that do not exceed $10 million for the three prior taxable-year period to use the cash receipts and disbursements method, so long as use of such method clearly reflects income.⁷⁵⁰

The proposal eliminates the exceptions for qualified personal service corporations. Thus, personal service corporations generally are precluded from using the cash method unless such personal service corporation satisfies the gross receipts test. However, the proposal retains the exception for farming business such that farming businesses are not precluded from using the cash method regardless of whether they meet the gross receipts test.

Under the proposal, the rules for the nonaccrual experience method are retained and are moved from section 448 to new subsection (j) under section 451.

In the case of any taxpayer required by this section to change its method of accounting for any taxable year, such change is treated as initiated by the taxpayer and made with the consent of the Secretary.

2. Rules for determining whether taxpayer has adopted a method of accounting (sec. 3302 of the discussion draft and sec. 446 of the Code)

A taxpayer filing its first return may adopt any permissible method of accounting in computing taxable income for such year.⁷⁵⁸ Except as otherwise provided, section 446(e) requires taxpayers to secure consent of the Secretary before changing a method of accounting. The regulations under this section provide rules for determining: (1) what a method of accounting is, (2) how an adoption of a method of accounting occurs, and (3) how a change in method of accounting is effectuated.⁷⁵⁹

A change in method of accounting includes a change in the overall plan of accounting for gross income or deductions (e.g., cash method or an accrual method) or a change in the treatment of any material item used in such overall plan (e.g., timing of deduction of prepaid insurance). A material item is any item that involves the proper time for the inclusion of the item in income or taking of a deduction.⁷⁶⁰ A change in method of accounting does not include a correction of a mathematical or posting error, or an error in the computation of tax liability.⁷⁶¹ Also, a change in method of accounting does not include adjustment of any item of income or deduction that does not involve the proper time for the inclusion of the item of income or the taking of a deduction. A change in method of accounting also does not include a change in treatment resulting from a change in underlying facts.

There are instances where taxpayers change their method of accounting without securing consent of the Secretary. Additionally, there are instances where taxpayers adopt an impermissible method of accounting. In such instances, the IRS has taken the position that a taxpayer's method of accounting is adopted (1) when a permissible method of accounting is used on a single tax return or (2) when the same impermissible method of accounting has been used on two or more consecutive tax returns.⁷⁶²

3. Certain special rules for taxable year of inclusion (sec. 3303 of the discussion draft and sec. 451 of the Code)

A taxpayer generally is required to include an item in income no later than the time of its actual or constructive receipt, unless the item properly is accounted for in a different period under the taxpayer's method of accounting.⁷⁶³ If a taxpayer has an unrestricted right to demand the payment of an amount, the taxpayer is in constructive receipt of that amount whether or not the taxpayer makes the demand and actually receives the payment.⁷⁶⁴

In general, for a cash basis taxpayer, an amount is included in income when actually or constructively received.⁷⁶⁵ For an accrual basis taxpayer, an amount generally is recognized (and included in income) the earlier of when such amount is earned by, due to, or received by the taxpayer, unless an exception permits deferral or exclusion.⁷⁶⁶

A number of exceptions that exist to permit deferral of income relate to advance payments. Advance payment situations arise when amounts are received by the taxpayer in advance of when goods or services are provided by the taxpayer to its customer. The exceptions often allow tax deferral to mirror financial accounting deferral (e.g., income is recognized as the goods are provided or the services are performed).⁷⁶⁷

Special rule for crop insurance proceeds or disaster payments

Under a special rule, in the case of insurance proceeds received as a result of destruction or damage to crops, a cash method taxpayer may elect to include such proceeds in income for the taxable year following the taxable year of destruction or damage, if the taxpayer establishes that the income from such crops would have been reported in the following taxable year.⁷⁶⁸ For this purpose, payments for which these elections are available include disaster assistance received as a result of destruction or damage to crops caused by drought, flood, or other natural disaster, or the inability to plant crops because of such a disaster, under any Federal law (including payments received under the Agricultural Act of 1949, as amended, or title II of the Disaster Assistance Act of 1988).

Special rule for proceeds from livestock sold on account of drought, flood, or other weather-related conditions

A similar special provision exists for a cash method taxpayer whose principal trade or business is farming who is forced to sell livestock due to drought, flood, or other weather-related conditions in excess of the number the taxpayer would sell if the taxpayer followed its usual business practices. Such a taxpayer may elect to include income from the sale of the livestock in the taxable year following the taxable year of the sale.⁷⁶⁹ This elective deferral of income is available only if the taxpayer establishes that, under the taxpayer's usual business practices, the sale would not have occurred but for drought, flood, or weather-related conditions that resulted in the area being designated as eligible for Federal assistance.

Special rule for sales or dispositions to implement Federal Energy Regulatory Commission or State electric restructuring policy

Another such special tax provision permits taxpayers to elect to recognize gain from qualifying electric transmission transactions ratably over an eight-year period beginning in the year of sale if the amount realized from such sale is used to purchase exempt utility property within the applicable period⁷⁷⁰ (the "reinvestment property").⁷⁷¹ If the amount realized exceeds the amount used to purchase reinvestment property, any realized gain is recognized to the extent of such excess in the year of the qualifying electric transmission transaction.

A qualifying electric transmission transaction is the sale or other disposition of property used by a qualified electric utility to an independent transmission company prior to January 1, 2014.⁷⁷² A qualified electric utility is defined as an electric utility, which as of the date of the qualifying electric transmission transaction, is vertically integrated in that it is both (1) a transmitting utility (as defined in the Federal Power Act⁷⁷³) with respect to the transmission facilities to which the election applies, and (2) an electric utility (as defined in the Federal Power Act⁷⁷⁴).⁷⁷⁵

In general, an independent transmission company is defined as: (1) an independent transmission provider⁷⁷⁶ approved by the Federal Energy Regulatory Commission ("FERC"); (2) a person (i) who the FERC determines under section 203 of the Federal Power Act⁷⁷⁷ (or by declaratory order) is not a "market participant" and (ii) whose transmission facilities are placed under the operational control of a FERC-approved independent transmission provider no later than four years after the close of the taxable year in which the transaction occurs; or (3) in the case of facilities subject to the jurisdiction of the Public Utility Commission of Texas, (i) a person which is approved by that Commission as consistent with Texas State law regarding an independent transmission organization, or (ii) a political subdivision, or affiliate thereof, whose transmission facilities are under the operational control of an organization described in (i).⁷⁷⁸

Exempt utility property is defined as: (1) property used in the trade or business of (i) generating, transmitting, distributing, or selling electricity or (ii) producing, transmitting, distributing, or selling natural gas; or (2) stock in a controlled corporation whose principal trade or business consists of the activities described in (1).⁷⁷⁹ Exempt utility property does not include any property that is located outside of the United States.⁷⁸⁰

If a taxpayer is a member of an affiliated group of corporations filing a consolidated return, the reinvestment property may be purchased by any member of the affiliated group (in lieu of the taxpayer).⁷⁸¹

The proposal also codifies the current deferral method of accounting for advance payments for goods and services provided by the IRS under Revenue Procedure 2004-34.⁷⁸⁴ That is, the proposal allows taxpayers to defer the inclusion of income associated with certain advance payments to the end of the tax year following the tax year of receipt if such income also is deferred for financial statement purposes.⁷⁸⁵

The proposal repeals the special rule for crop insurance proceeds or disaster payments. Similar to insurance proceeds or disaster payments received by taxpayers unrelated to destruction or damage of crops, taxpayers that use the cash method of accounting must include crop insurance proceeds and disaster payments in income when received.

The proposal also repeals the special rule for proceeds from livestock sold on account of drought, flood, or other weather-related conditions. As a result of repealing the special rule, taxpayers using the cash method of accounting are required to include amounts received from the sale of livestock in income when received.

Further, the proposal repeals the special rule for sales or dispositions to implement FERC or State electric restructuring policy. That is, gains resulting from a qualifying electric transmission transaction must be recognized in accordance with generally applicable revenue recognition principles.

The proposal repealing the special rule for proceeds from livestock sold on account of drought, flood, or other weather-related conditions applies to sales and exchanges after December 31, 2014.

The proposal repealing the special rule for sales or dispositions to implement FERC or State electric restructuring policy applies to sales and dispositions after December 31, 2013.

The remaining proposals apply to taxable years beginning after December 31, 2014 and application of these rules is a change in the taxpayer's method of accounting for purposes of section 481.

4. Installment sales (sec. 3304 of the discussion draft and secs. 453 and 453A of the Code)

A pledge rule provides that if an installment obligation is pledged as security for any indebtedness, the net proceeds⁷⁸⁹ of such indebtedness are treated as a payment on the obligation, triggering the recognition of income.⁷⁹⁰ Actual payments received on the installment obligation subsequent to the receipt of the loan proceeds are not taken into account until such subsequent payments exceed the loan proceeds that were treated as payments. The pledge rule does not apply to sales by an individual of personal use property,⁷⁹¹ to sales of property used or produced in the trade or business of farming, to sales of timeshares and residential lots where the taxpayer elects to pay interest under section 453(l)(2)(B), or to dispositions where the sales price does not exceed $150,000.

The amount of benefit that may be obtained through the use of the installment method is limited by the imposition of an interest charge on the tax deferral attributable to the portion of the installment obligations that arise during and remain outstanding at the close of the taxable year that exceed $5 million.⁷⁹² Dispositions where the sales price does not exceed $150,000 are not taken into account for the purpose of this $5 million threshold. Interest accrues at the same rate as applies to underpayments of income tax and is treated as interest expense for other Federal income tax purposes.⁷⁹³ An exception from the imposition of an interest charge is provided for installment obligations arising from the disposition by an individual of personal use property or of any property used or produced in the trade or business of farming.⁷⁹⁴ Another exception applies to obligations arising from sales of timeshares and residential lots; however, a separate interest charge applies as described above.⁷⁹⁵