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

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

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

Married individuals filing jointly and surviving spouses

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

Head of household

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

Single individuals

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

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

Married individuals filing jointly and surviving spouses

                Tax rate    Brackets

Heads of household

                Tax rate    Brackets

                Tax rate    Brackets

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

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

 Filing status                            AGI phase-out

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

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

Rate adjustment

Beginning in 1988, the benefit of the 15-percent bracket is phased out for taxpayers having taxable income exceeding specified levels. The income tax liability of Such taxpayers is increased by five percent of their taxable income within specified ranges.

The rate adjustment occurs between $71,900 and $149,250 of taxable income for married individuals filing jointly; between $61,650 and $123,790 of taxable income for heads of household; between $43,150 and $89,560 of taxable income for single individuals; and between $35,950 and $113,300 of taxable income for married individuals filing separately. These amounts will be adjusted for inflation beginning in 1989.

The maximum amount of the rate adjustment generally equals 13 percent of the maximum amount of taxable income within the 15-percent bracket applicable to the taxpayer (for a married individual filing separately, within the 15-percent bracket applicable for married taxpayers filing jointly.) Thus, if the maximum rate adjustment applies, the 28-percent rate in effect applies to all of the taxpayer's taxable income, rather than only to the amount of taxable income above the breakpoint.

Transitional rate structure for 1987

For taxable years beginning in 1987, five-bracket rate schedules are provided, as shown in the table below. Neither the rate adjustment (described above) nor the personal exemption phaseout (described below) applies to taxable years beginning in 1987.

                  Taxable income brackets

2. Standard deduction (zero bracket amount)

           Filing status                  ZBA

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

                                          Standard

Elderly or blind individuals

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

Floor under itemized deductions

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

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

                                          Standard

Elderly or blind individuals

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

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

                                          Standard

Elderly or blind individuals

An additional standard deduction amount of $600 is allowed for an elderly or blind individual who is married (whether filing jointly or separately) or is a surviving spouse ($1,200 for such an individual who is both elderly and blind), An additional standard deduction amount of $750 is allowed for an unmarried individual (other than a surviving spouse), or for a head of household, who is elderly or blind ($1,500 if both). For elderly or blind taxpayers only, the new standard deduction amounts (listed above) and the additional $600 or $750 standard deduction amounts are effective beginning in 1987. Beginning in 1989, the $600 and $750 additional standard deduction amounts will be adjusted for inflation.

Standard deduction for 1987

For all individual taxpayers other than elderly or blind individuals, the standard deduction amounts for taxable years beginning in 1987 are $3,760 for married individuals filing jointly and surviving spouses; $2,540 for heads of household and single individuals; and $1,880 for married individuals filing separately.

Floor under itemized deductions

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

3. Personal exemptions

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

Rules for dependents

Each taxpayer may claim a personal exemption for himself or herself and for a dependent child (or other dependent) whose gross income does not exceed the personal exemption amount ($1,080 for 1986). In addition, parents may claim a personal exemption for a dependent child who has income exceeding the personal exemption amount if the dependent child is under age 19 or a full-time student. The child or other dependent also may claim a full personal exemption on his or her return.

A child eligible to be claimed as a dependent on his or her parents' return may use the ZBA only to offset earned income. Thus, a child with unearned income exceeding the personal exemption amount must file a return and pay tax on the excess (reduced by any allowable itemized deductions).

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

Rules for dependents

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

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

Phase-out

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

Rules for dependents

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

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

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

Phase-out

Beginning in 1988, the benefit of the personal exemption is phased out for taxpayers having taxable income exceeding specified levels. The income tax liability of such taxpayers is increased by five percent of taxable income within certain ranges.

This reduction in the personal exemption benefit starts at the taxable income level at which the benefit of 15-percent rate is totally phased out (see "Rate adjustment," I.A.1., above). For example, in the case of married individuals filing joint returns, in 1988 the personal exemption phaseout begins at taxable income of $149,250.

The benefit of each personal exemption amount is phased out over an income range of $10,920 in 1988. The phase-out occurs serially; e.g., the phaseout of the benefit of the second personal exemption on a joint return does not begin until the phaseout of the first is complete. Thus, in the case of a married couple filing jointly who have two children, in 1988 the benefit of the four personal exemptions would phase out over an income range of $43,680 (four times $10,920) and would be phased out completely at taxable income of $192,930. In 1989, the benefit of each exemption would phase out over an income range of $11,200.

Rules for dependents

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

As in the present-law rule that the ZBA may be used by such a dependent individual only to offset earned income, the conference agreement generally follows the House bill and the Senate amendment in providing that the standard deduction may be used by such a dependent individual only to offset earned income. However, the conference agreement liberalizes this limitation (in lieu of the $100 de minimus rule in the Senate amendment) by providing that for such a dependent individual, the individual's standard deduction is limited to the greater of (a) $500 (to be adjusted for inflation beginning in 1989) or (b) the individual's earned income up to the basic standard deduction amount (in 1988, $3,000 for a single individual). Under the conference agreement, such a dependent child must file a Federal income tax return only if he or she either has gross income exceeding the standard deduction amount for such a dependent child (i.e., the greater of earned income or $500) or has unearned income exceeding $500.

These rules for dependents are effective beginning in 1987.

4. Adjustments for inflation

5. Two-earner deduction

6. Income averaging

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

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

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

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

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

2. Scholarships and fellowships

Present law provides an exclusion from gross income for (1) amounts received as a scholarship at an educational institution (described in sec. 170(b)(1)(A)(ii)), or as a fellowship grant, and (2) incidental amounts received and spent for travel, research, clerical help, or equipment (sec. 117).

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

An educational institution is described in section 170(b)(l)(A)(ii) if it normally maintains a regular faculty and curriculum and normally has a regularly enrolled body of pupils or students in attendance at the place where its educational activities are regularly carried on. This definition encompasses primary and secondary schools, colleges and universities, and technical schools, mechanical schools, and similar institutions, but not noneducational institutions, on-the-job training, correspondence schools, night schools, and so forth (Reg. secs. 1.117-3(b), 1.151-3(c)). The term candidate for a degree means (1) an undergraduate or graduate student at a college or university who is pursuing studies or conducting research to meet the requirements for an academic or professional degree and (2) a student who receives a scholarship for study at a secondary school or other educational institution (Reg. sec. 1.117-3(e)).

Payments for services

In general, amounts paid to an individual to enable pursuit of studies or research are not excludable from income if they represent compensation for past, present, or future services, or if the studies or research are primarily for the benefit of the grantor or are under the direction or supervision of the grantor.² In the case of degree candidates, the statute specifically provides that the exclusion does not apply to any portion of an otherwise qualifying scholarship or fellowship grant that represents payment for teaching, research, or other services in the nature of part-time employment required as a condition of receiving the scholarship or fellowship grant. However, an exception permits the exclusion for payments for services if all candidates for a particular degree must perform such services.

Federal grants

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

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

Payments for services

The House bill repeals the exception under present law permitting scholarship or fellowship grants received by degree candidates representing payment for services to be excludable under section 117 if all candidates for the particular degree are required to perform such services. Thus, under the House bill, the general rule applies requiring inclusion in gross income and wages of amounts received that represent payment for services required as a condition of receiving the grant. This inclusion rule applies both to such grants received in cash and to amounts (representing payment for services) by which the tuition of the person who performs services is reduced, whether or not pursuant to a tuition reduction plan described in section 117(d).

Federal grants

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

The amendments made by the conference agreement are effective for taxable years beginning on or after January 1, 1987, except that present law continues to apply to scholarships and fellowships granted before August 17, 1986. Under this rule, in the case of a scholarship or fellowship granted after August 16, 1986 and before January 1, 1987, any amount of such scholarship or fellowship grant that is received prior to January 1, 1987 and is attributable to expenditures incurred prior to January 1, 1987 (such as tuition, room, and board attributable to the period prior to January 1, 1987) is eligible for the present-law exclusion under section 117.

The conference agreement also clarifies that only for purposes of the rule that a child eligible to be claimed as a dependent on the return of his or her parents may use the standard deduction only to offset the greater of $500 or earned income (see I.A.3., above), any amount of a noncompensatory scholarship or fellowship grant that is includible in gross income as a result of these amendment to section 117 (including the repeal of any section 117 exclusion for nondegree candidates) constitutes earned income. (Amounts received as payment for teaching or other services also constitute earned income.)

3. Prizes and awards

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

Employee awards

Section 61 provides that "gross income means all income from whatever source derived," including compensation for services whether in the form of cash, fringe benefits, or similar items. However, an item transferred from an employer to an employee, other than a prize or award that is includible under section 74, may be excludable from gross income if it qualifies as a gift under section 102.

The U.S. Supreme Court, in a case involving payments made "in a context with business overtones," has defined excludable gifts as payments made out of "detached and disinterested generosity" and not in return for past or future services or from motives of anticipated benefit (Comm'r v. Duberstein, 363 U.S. 278 (1960)). Under this standard, the Court said, transfers made in connection with employment constitute gifts only in the "extraordinary" instance.

If an award to an employee constitutes a gift excludable from income under section 102, the employer's deduction is limited pursuant to section 274(b). That provision generally disallows business deductions for gifts to the extent that the total cost of all gifts of cash, tangible personal property, and other items to the same individual from the taxpayer during the taxable year exceeds $25. Under an exception to the $25 limitation, the ceiling on the deduction is $400 in the case of an excludable gift of an item of tangible personal property awarded to an employee for length of service, safety achievement, or productivity. In addition, the ceiling on the employer's business gift deduction is $1,600 for an excludable employee award for such purposes when provided under a qualified award plan, if the average cost of all plan awards in the year does not exceed $400.

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

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

Employee awards

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

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

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

Employee awards

Under the Senate amendment, employee awards of tangible personal property for length of service or safety achievement are excludable by the employee from gross income for income tax purposes, and are deductible by the employer, to the extent that during the year the aggregate cost of awards (safety and length of service) made to the same employee does not exceed $1,600 for all awards and $400 for all awards that are not qualified plan awards, subject to certain additional requirements, limitations, and computation rules. To the extent that the new exclusion does not apply, all prizes or awards by employers to employees are includible in gross income other than (as under the House bill) items of low value that are excludable as de minimis fringe benefits (as defined in sec. 132(e)). The latter term would include, for example, (1) a pin or similar item with a value of $15 awarded to an employee on joining a business, on completing six months' employment, or on completing a probationary employment period, and (2) a traditional retirement gift presented to an employee on his or her retirement after completing lengthy service. The new employee achievement award exclusion is not available for any award made by a sole proprietorship to the sole proprietor.

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

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

Employee awards

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

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

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

2. Charitable deduction for nonitemizers

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

3. Medical expense deduction

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

Capital expenditures

Treasury regulations provide that the total cost of an unreimbursed capital expenditure may be deductible in the year of acquisition as a medical expense if its primary purpose is medical care. In addition, the cost of a permanent improvement to property that ordinarily would not have a medical purpose may be deductible as a medical expense if directly related to prescribed medical care, but only for any portion of the cost that exceeds the increased value of the property attributable to the improvement. Related operating and maintenance costs also may be deducted provided that the medical reason for the capital expenditure continues to exist. Under these rules, eligible medical expenses include the additional costs of modifying an automobile to accommodate wheelchair passengers, and certain capital expenditures to accommodate a residence to a handicapped individual.

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

Capital expenditures

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

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

Capital expenditures

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

4. Adoption expenses

In addition, the House bill amends the adoption assistance program in Title IV-E of the Social Security Act to provide matching funds as an administrative expense for adoption expenses for any child with special needs who has been placed for adoption in accordance with applicable State and local law. Such expenses include all qualified adoption expenses to which the present-law tax deduction provision applies. The effective date of amending the adoption assistance program is coordinated with repeal of the deduction.

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

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

To meet the adequate records standard, documentary evidence (such as receipts or paid bills) is required for any expenditure of $25 or more (except certain transportation charges). The Congress has emphasized that no deductions for expenditures subject to substantiation under section 274(d) are allowable pursuant to the Cohan approximation rule.³

The bill generally reduces to 80 percent the amount of any deduction otherwise allowable for meal expenses, including meals away from home and meals furnished on an employer's premises to its employees (whether or not such meals are excludable from the employee's gross income under sec. 119). The bill provides exceptions allowing full deductibility for (1) reimbursed meal expenses (in which case the employer or person making the reimbursement is subject to the 80-percent rule); (2) employer-furnished meals that are excludable from the employee's gross income as de minimis fringes under Code section 132(e) (including meals at certain eating facilities excludable under sec. 132(e)(2)); (3) meals fully taxed to the recipient as compensation; and (4) items sold to the public (such as expenses incurred by restaurants or dinner theaters for food or entertainment provided to their customers), or furnished to the public as samples or for promotion (such as expenses incurred by a hotel in furnishing complimentary lodging to potential customers). A restaurant or catering firm may deduct 100 percent (rather than 80 percent) of its costs for food and beverage items, purchased in connection with preparing and providing meals to its paying customers, that are consumed at the work site by employees of the restaurant or caterer.

Business-connection requirement

The House bill also provides that deductions for meals are subject to the same business-connection requirement as applies under present law (sec. 274(a)) for other entertainment expenses (see item E.1.b., below). Thus, a food or beverage expense is not deductible unless the taxpayer establishes that the item was directly related to the active conduct of the taxpayer's trade or business, or, in the case of an item directly preceding or following a substantial and bona fide business discussion (including business meetings at a convention or otherwise), that the item was associated with the active conduct of the taxpayer's trade or business. Under this standard, no deduction is allowed unless business is discussed during, or directly before or after, the meal (except where an individual traveling away from home on business has a meal alone or with persons, such as family members, who are not business-connected, and a deduction is claimed only for the meal of such individual).

Disallowance of lavish or extravagant expenditures

The House bill explicitly provides, apart from the present-law statutory rule disallowing deductions for certain lavish and extravagant travel expenses (including meals), that no deduction is allowed for any food or beverage expense unless the expense is not lavish or extravagant under the circumstances. Thus, this disallowance rule applies whether or not the expense is incurred while the taxpayer is away from home, and whether the taxpayer incurs the expense alone or with others. Since the reduction rule is applied only after determining the otherwise allowable deduction under sections 162 and 274, if a taxpayer incurs otherwise deductible business lunch expenses of (for example) $80 for himself and if $30 of that amount is not allowable as lavish or extravagant, the remaining $50 is then reduced by 20 percent, leaving a deduction of $40.

Presence of taxpayer requirement

Under the House bill, no deduction for food or beverage expenses is allowed unless the taxpayer or an employee of the taxpayer is present at the furnishing of the food or beverages (except where an individual traveling away from home on business has a meal alone or with persons, such as family members, who are not business-connected, and a deduction is claimed only for the meal of such individual). For purposes of this rule, an independent contractor who renders significant services to the taxpayer (such as an attorney representing the taxpayer in a legal proceeding) is treated as an employee if he or she attends the meal in connection with such performance of services.

Additional rules

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

Thus, under the conference agreement, deductions for meals are subject to the same business-connection requirement as applies under present law for other entertainment expenses. Accordingly, an expense for food or beverages is not deductible unless (in addition to generally applicable deduction requirements) the taxpayer (1) establishes that the item was directly related to the active conduct of the taxpayer's trade or business, or, in the case of an item directly preceding or following a substantial and bona fide business discussion, that the item was associated with the active conduct of the taxpayer's trade or business, and (2) substantiates the deduction as required by section 274(d) and Treas. Reg. sec. 1.274-5(b)(4). Under this requirement, no deduction is allowed unless business is discussed during, or directly before or after, the meal (except where an individual traveling away from home on business has a meal alone or with persons, such as family members, who are not business-connected, and a deduction is claimed only for the meal of such individual).

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

Since the conference agreement provides that deductions for meals are subject to the same business-connection requirement as applies under present law for other entertainment expenses, the present-law substantiation requirements for such entertainment expenses (e.g., in Treas. reg. sec. 1.274-5(b)(4) with respect to the directly related or associated with deductibility standard) also will apply to all meal expenses. In addition, the conference agreement instructs the Treasury to adopt stricter substantiation requirements for business meals, except that the present-law rule relating to certain expenditures of less than $25 is to be retained. It is reemphasized that under the conference agreement, as under present law, the Internal Revenue Service and the courts are not to apply the Cohan approximation rule to allow deductibility of any food or beverage expense, other entertainment expense, or other expenditure subject to substantiation pursuant to section 274(d) if the expenditure is not substantiated in accordance with section 274(d) and the regulations thereunder.

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

Facilities

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

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

Facilities

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

The Senate amendment is the same as House bill.

Facilities

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

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

Facilities

The conference agreement follows the House bill, except that the skybox deduction disallowance rule is phased in. Under this provision, the amounts disallowed for taxable years beginning in 1987 and 1988 are, respectively, one-third and two-thirds of the amounts that otherwise would be disallowed under the conference agreement if the provision were fully effective in those years. For taxable years beginning after 1989, the conference agreement follows the House bill, i.e., no deduction is allowed for costs of rental or other use of a skybox at a sports arena by the taxpayer or a related party for more than one event.⁴

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

Educational travel

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

Charitable travel

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

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

Educational travel

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

Charitable travel

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

The Senate amendment is the same as the House bill.

Educational travel

The Senate amendment is the same as the House bill.

Charitable travel

No provision.

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

Educational travel

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

Charitable travel

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

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

Foreign conventions

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

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

Foreign conventions

No provision.

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

Foreign conventions

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

The conference agreement follows the Senate amendment.

The conferees also are concerned that some taxpayers may be claiming deductions under section 162 for travel and other costs of attending a convention, seminar, or similar meeting ("convention") at which each convention participant is furnished individually with video tapes of lectures, etc. on topics related to the taxpayer's trade or business, to be viewed at the convenience of the participant, and at which no other significant business-related activities occur during the time allotted for the convention. In such situations, the taxpayer does not participate in activities normally conducted at a business-related convention, such as participating in meetings, discussions, workshops, lectures, or exhibits held during the day, and simply views the tapes at his or her own convenience. Because permitting deductions for travel, meal, or entertainment costs associated with such minimal business-related activities would allow taxpayers to treat expenditures that essentially are for vacation, recreation, or other personal purposes as business expenses, the conferees wish to make clear that no deduction is allowable under section 162 for travel or related costs of attending such a convention.

This clarification does not disallow deductions for the travel and other costs of attending a convention that involves activities otherwise deductible under present law which are related to the taxpayer's trade or business merely because the convention utilizes video-taped or televised materials where the participants must attend a convention session in person to view the video-taped materials, assuming that the generally applicable requirements for deducting expenses of attending a convention are satisfied. Also, this clarification does not disallow deductions for costs, other than travel, meal, or entertainment expenses, of renting or using business-related video tape materials.

Foreign conventions

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

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

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

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

The miscellaneous itemized deductions, including the employee business expenses described above, generally are subject to a floor of two percent of the taxpayer's adjusted gross income. However, the floor does not apply to deductions otherwise allowable for impairment-related work expenses for handicapped employees (new Code sec. 67(d)); the estate tax in the case of income in respect to a decedent (sec. 691(c)); certain adjustments where a taxpayer restores amounts held under a claim of right (sec. 1341); amortizable bond premium (sec. 171); certain costs of cooperative housing corporations (sec. 216); deductions allowable in connection with personal property used in a short sale; certain terminated annuity payments (new Code sec. 72(b)(3)); and gambling losses to the extent of gambling winnings (sec. 165(d)).

Pursuant to Treasury regulations, the floor is to apply with respect to indirect deductions through pass-through entities (including mutual funds) other than estates, nongrantor trusts, cooperatives, and REITs. The floor also applies with respect to indirect deductions through grantor trusts, partnerships, and S corporations by virtue of present-law grantor trust and pass-through rules. In the case of an estate or trust, the conference agreement provides that the adjusted gross income is to be computed in the same manner as in the case of an individual, except that the deductions for costs that are paid or incurred in connection with the administration of the estate or trust and that would not have been incurred if the property were not held in such trust or estate are treated as allowable in arriving at adjusted gross income and hence are not subject to the floor. The regulations to be prescribed by the Treasury relating to application of the floor with respect to indirect deductions through certain pass-through entities are to include such reporting requirements as may be necessary to effectuate this provision.

Under the conference agreement, an actor or other performing artist is allowed a new above-the-line deduction for his or her employee business expenses (allowable under sec. 162) during a year if the performing artist for that year (1) had more than one employer (excluding any nominal employer) in the performing arts, (2) incurred allowable section 162 expenses in connection with such services as an employee in an amount exceeding 10 percent of gross income from such services, and (3) did not have adjusted gross income, as determined before deducting such expenses, exceeding $16,000.

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

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

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

The conference agreement modifies the Accelerated Cost Recovery System (ACRS) for property placed in service after December 31, 1986, except for property covered by transition rules. The Cost of property placed in service after July 31, 1986, and before January 1, 1987, which is not transition-rule property, may, at the election of the taxpayer on an asset-by-asset basis, be covered under the modified rules.

The conference agreement provides more accelerated depreciation for the revised three-year, five-year and 10-year classes, reclassifies certain assets according to their present class life (or "ADR midpoints", Rev. Proc. 83-35, 1983-1 C.B. 745), and creates a seven-year class, a 20-year class, a 27.5-year class, and a 31.5-year class. The conference agreement prescribes depreciation methods for each ACRS class (in lieu of providing statutory tables). Eligible personal property and certain real property are assigned among a three-year class, a five-year class, a seven-year class, a 10-year class, a 15-year class, or a 20-year class.

The depreciation method applicable to property included in the three-year, five-year, seven-year, and 10-year classes is the double declining balance method, switching to the straight-line method at a time to maximize the depreciation allowance. For property in the 15-year and 20-year class, the conference agreement applies the 150-percent declining balance method, switching to the straight-line method at a time to maximize the depreciation allowance. The cost of section 1250 real property generally is recovered over 27.5 years for residential rental property and 31.5 years for nonresidential property, using the straight-line method.

Classes of property

Property is classified as follows:

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

Five-year class.--ADR midpoints of more than 4 years and less than 10 years, and adding automobiles, light trucks, qualified technological equipment, computer-based telephone central office switching equipment, research and experimentation property, and geothermal, ocean thermal, solar, and wind energy properties, and biomass properties that constitute qualifying small power production facilities (within the meaning of section 3(17)(C) of the Federal Power Act).

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

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

15-year class.--ADR midpoints of 20 years and less than 25 years, and adding municipal wastewater treatment plants, and telephone distribution plant and comparable equipment used for the two-way exchange of voice and data communications.

20-year class.--ADR midpoints of 25 years and more, other than section 1250 real property with an ADR midpoint of 27.5 years and more, and adding municipal sewers.

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

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

The conference agreement provides new ADR midpoint lives for the following assets:

The conferees wish to clarify that under present law cargo containers have an ADR midpoint of six years and this present class life shall be used in applying the provisions of the conference agreement.

As under present law, property which the taxpayer properly elects to depreciate under the unit-of-production method or any other method not expressed in terms of years (other than the retirement-replacement-betterment method or similar method), will be so depreciated. For example, depreciation is allowable with respect to landfills on a unit basis (without regard to whether the space for dumping waste was excavated by the taxpayer), to the extent capital costs are properly allocable to the space to be filled with waste rather than to the underlying land.

Any class life prescribed under the Secretary's authority must reflect the anticipated useful life, and the anticipated decline in value over time, of an asset to the industry or other group. Useful life means the economic life span of property over all users combined and not, as under prior law, the typical period over which a taxpayer holds the property. Evidence indicative of the useful life of property which the Secretary is expected to take into account in prescribing a class life includes the depreciation practices followed by taxpayers for book purposes with respect to the property. It also includes useful lives experienced by taxpayers, according to their reports. It further includes independent evidence of minimal useful life--the terms for which new property is leased, used under a service contract, or financed--and independent evidence of the decline in value of an asset over time, such as is afforded by resale price data. If resale price data is used to prescribe class lives, such resale price data should be adjusted downward to remove the effects of historical inflation. This adjustment provides a larger measure of depreciation than in the absence of such an adjustment. Class lives using this data should be determined such that the present value of straight-line depreciation deductions over the class life, discounted at an appropriate real rate of interest, is equal to the present value of what the estimated decline in value of the asset would be in the absence of inflation.

Initial studies are expected to concentrate on property that now has no ADR midpoint. Additionally, clothing held for rental and scientific instruments (especially those used in connection with a computer) should be studied to determine whether a change in class life is appropriate.

Certain other assets specifically assigned a recovery period (including horses in the three-year class, qualified technological equipment, computer-based central office switching equipment, research and experimentation property, certain renewable energy and biomass properties, semiconductor manufacturing equipment, railroad track, single-purpose agricultural or horticultural structures, telephone distribution plant and comparable equipment, municipal wastewater treatment plants, and municipal sewers) may not be assigned a longer class life by the Treasury Department if placed in service before January 1, 1992. Additionally, automobiles and light trucks may not be reclassified by the Treasury Department during this five-year period.

Such property placed in service after December 31, 1991, and before July 1, 1992, may be prescribed a different class life if the Secretary has notified the Committee on Ways and Means of the House of Representatives and the Committee on Finance of the Senate of the proposed change at least 6 months before the date on which such change is to take effect.

2. Alternative cost recovery system

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

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

(ii) Tax-exempt bond financed property

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

(iii) Elective alternative recovery system

Taxpayers can elect to use the straight-line method over the applicable ACRS recovery period (or over a longer recovery period) with respect to one or more classes of ACRS property placed in service during a taxable year.

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

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

(ii) Tax-exempt bond property

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

(iii) Elective alternative recovery system

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

Generally, the Senate amendment follows the House bill.

(ii) Tax-exempt bond property

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

(iii) Elective alternative recovery system

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

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

For purposes of (1), (2) and (3), the conference agreement follows the House bill and the Senate amendment. For purposes of determining whether property is tax-exempt use property, in the case of a corporation the stock of which is publicly traded on an established securities market, the test of whether 50 percent or more (in value) of the stock of such corporation is held by tax-exempt entities, shall be made only by including tax-exempt entities which hold 5 percent or more (in value) of the stock in such corporation.

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

(ii) Tax-exempt bond property

The conference agreement generally follows the Senate amendment. Property, to the extent it is financed with tax-exempt bonds, is depreciated using the straight-line method over the same lives as provided in (i). Only the portion of the cost of property which is attributable to tax-exempt financing is recovered using this method. If only a part of a facility is financed with tax-exempt bonds, the tax-exempt bond financed portion will be allocated to property first placed in service. An exception is provided to recover the cost of low-income housing financed with tax-exempt bonds over 27.5 years.

(iii) Elective alternative recovery system

The conference agreement follows the Senate amendment.

3. Indexing

4. Accounting conventions

5. Gain on disposition

6. Lessee leasehold improvements

7. Expensing

8. Vintage accounts

9. Public utility property

10. Regular investment tax credit

A credit against income tax liability is allowed for up to 10 percent of a taxpayer's investment in certain tangible depreciable property (generally, not including buildings or their structural components) (secs. 38 and 46). The amount of the regular investment credit is based on the ACRS recovery class to which the property is assigned. The 10-percent credit is allowed for eligible property in the 5-year and 10-year classes, and the 15-year public utility property class. Three-year ACRS property is eligible for a six-percent regular credit (even if the taxpayer elects to use a longer recovery period). The maximum amount of a taxpayer's investment in used property that is eligible for the regular investment credit is $125,000 per year; the limitation on used property is scheduled to increase to $150,000 for taxable years beginning after 1987.

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

Unused credits for a taxable year can be carried back to each of the three preceding taxable years and then carried forward to each of the 15 following taxable years (sec. 39).

Public utility property

Public utility property is eligible for the regular investment credit only if the tax benefits of the credit are normalized in setting rates charged by the utility to customers and in reflecting operating results in regulated books of account (sec. 46(f). The investment credit is denied for public utility property if the regulatory commission's treatment of the credit results in benefits being flowed through to customers more rapidly than under either (1) the ratable flow-through method or (2) the rate base reduction method.

11. Finance leases

The finance lease rules were to have been generally effective for agreements entered into after December 31, 1983, with three temporary restrictions intended to limit the tax benefits of finance leasing in 1984 and 1985. First, no more than 40 percent of property placed in service by a lessee during any calendar year beginning before 1986 was to qualify for finance lease treatment. Second, a lessor could not have used finance lease rules to reduce its tax liability for any taxable year by more than 50 percent. This 50-percent lessor cap was to apply to property placed in service on or before September 30, 1985. Third, the investment tax credit for property subject to a finance lease and placed in service on or before September 30, 1985, was only allowable ratably over 5 years, rather than entirely in the year the property is placed in service.

Notwithstanding these general rules, finance leasing was to be available for up to $150,000 per calendar year of a lessee's farm property for agreements entered into after July 1, 1982, and before 1984. Furthermore, the 40-percent lessee cap, 50-percent lessor cap, and 5-year spread of the investment credit did not apply to this amount of farm property.

The Tax Reform Act of 1984, however, postponed the effective date of the finance lease rules to generally apply to agreements entered into after December 31, 1987, and extended the three restrictions. Thus, the 40-percent lessee cap was extended to property placed in service by a lessee during any calendar year beginning before 1990; the 50-percent lessor cap was extended through September 30, 1989; and the 5-year spread of the investment credit for property subject to a finance lease was extended to property placed in service on or before September 30, 1989.

The Tax Reform Act of 1984 provided transitional rules which exempted property from the 4-year postponement if, before March 7, 1984, (1) a binding contract to acquire or construct the property was entered into by or for the lessee, (2) the property was acquired by the lessee, or (3) construction of the property was begun by or for the lessee. In addition, the Act exempted from the 4-year postponement property which is placed in service before 1988 and is (1) a qualified lessee's automotive manufacturing property (limited to an aggregate of $150 million of cost basis per lessee) or (2) property that was part of a coal-fired cogeneration facility for which certification and construction permit applications were filed on specified dates. The special rules relating to the availability of finance leasing for up to $150,000 per calendar year of a lessee's farm property were extended to cover agreements entered into before 1988.

12. Effective dates

The conference agreement provides certain exceptions to the general effective dates, in the case of property constructed, reconstructed, or acquired pursuant to a written contract that was binding as of March 1, 1986, (December 31, 1985, for purposes of the investment tax credit) or in other transitional situations discussed below. Except in the case of qualified solid waste disposal facilities and certain satellites (described below), the application of the transitional rules is conditioned on property being placed in service by a prescribed date in the future. In addition, special rules are provided for investment credits claimed on transitional property, for tax-exempt bond financed property, and for the finance lease rules.

The conferees are aware that taxpayers may have difficulty in identifying under their accounting systems whether a particular item placed in service on or after January 1, 1987, (1986, for the investment tax credit) was acquired pursuant to a contract that was binding before March 2, 1986, (December 31, 1985, for the investment tax credit) or meets the rule for self-constructed property. The problem arises where a taxpayer regularly enters into contracts for (or manufactures itself) large stocks of identical or similar items of property to be placed in service as needed. The taxpayer's accounting system may not identify the date on which the contract for an item's acquisition was entered into (or the date on which manufacture commenced). In such a situation, a taxpayer is to assume that the first items placed in service after December 31, 1986, (1985, for the investment tax credit) were those they had under a binding contract on that date. A similar rule is to apply to self-constructed property.

Except as otherwise provided, for purposes of the depreciation transitional rules, the rules described below do not apply to any property unless the property has an ADR midpoint of seven years or more and is placed in service before the applicable date, determined according to the following: (1) for property with an ADR midpoint less than 20 years (other than computer-based telephone central office switching equipment), January 1, 1989, and (2) for property with an ADR midpoint of 20 years or more, residential rental property, and nonresidential real property, January 1, 1991.

For purposes of the investment tax credit transitional rules, the applicable placed-in-service dates are: (1) for property with an ADR midpoint less than five years, July 1, 1986, (2) for property with an ADR midpoint of at least five but less than seven years and including computer-based telephone central office switching equipment, January 1, 1987, (3) for property with an ADR midpoint of at least seven but less than 20 years (other than computer-based telephone central office switching equipment), January 1, 1989, and (4) for property with an ADR midpoint of 20 years or more, January 1, 1991. Property that is incorporated into an equipped building or plant facility need not independently satisfy the placed-in-service requirements. Instead, such property would qualify for transition relief as part of the equipped building or plant facility--as long as the equipped building or plant facility is placed in service by the prescribed date.

For purposes of the general effective dates, if at least 80 percent of a target corporation's stock is acquired on or before December 31, 1986, (December 31, 1985, for purposes of the investment tax credit) and the acquiring corporation makes a section 338 election to treat the stock purchase as an asset purchase after the relevant date, then the deemed new target corporation is treated as having purchased the assets before the general effective date.

Anti-churning rules

The conference agreement expands the scope of the present law anti-churning rules to prevent taxpayers from bringing certain property placed in service after December 31, 1980, under the modified ACRS. The expanded anti-churning rules apply to all ACRS property, other than residential rental property and nonresidential real property, where the result would be to qualify such property for more generous depreciation than would be available under present law. The conference agreement retains the anti-churning rules applicable to property that was originally placed in service before January 1, 1981. The anti-churning rules will not apply to property that is placed in service before January 1, 1987, for personal use and converted to business use on or after January 1, 1987.

Binding contracts

The conference agreement does not apply to property that is constructed, reconstructed, or acquired by a taxpayer pursuant to a written contract that was binding as of March 1, 1986 (December 31, 1985, for investment tax credits), and at all times thereafter. If a taxpayer transfers his rights in any such property under construction or such contract to another taxpayer, the bill does not apply to the property in the hands of the transferee, as long as the property was not placed in service by the transferee before the transfer by the transferor. For purposes of this rule, if by reason of sales or exchanges of interests in a partnership, there is a deemed termination and reconstitution of a partnership under section 708(b)(1)(B), the partnership is to be treated as having transferred its rights in the property under construction or the contract to the new partnership.

The general binding contract rule applies only to contracts in which the construction, reconstruction, erection, or acquisition of property is itself the subject matter of the contract.

A contract is binding only if it is enforceable under State law against the taxpayer, and does not limit damages to a specified amount (e.g., by use of a liquidated damages provisions), A contractual provision that limits damages to an amount equal to at least five percent of the total contract price is not treated as limiting damages.

For purposes of the general binding contract rule, a contract under which the taxpayer is granted an option to acquire property is not to be treated as a binding contract to acquire the underlying property. In contrast, a contract under which the taxpayer grants an irrevocable put (i.e., an option to sell) to another taxpayer is treated as a binding contract, as the grantor of such an option does not have the ability to unilaterally rescind the commitment. In general, a contract is binding even if subject to a condition, as long as the condition is not within the control of either party or a predecessor (except in the limited circumstances described below). A contract that was binding as of March 1, 1986 (or December 31, 1985, in the case of the investment tax credit) will not be considered binding at all times thereafter if it is substantially modified after that date.

A binding contract to acquire a component part of a larger property will not be treated as a binding contract to acquire the larger property under the general rule for binding contracts. For example, if a written binding contract to acquire an aircraft engine was entered into before March 2, 1986, there would be a binding contract to acquire only the engine, not the entire aircraft.

The conferees wish to clarify the general binding contract rule with respect to investment credit and ACRS allowances. Design changes to a binding contract to construct a project that are made for reasons of technical or economic efficiencies of operation and that cause an insignificant increase in the original price will not constitute substantial modifications of the contract so as to affect the status of the project under the binding contract rule. In addition, a supplementary contract that stands on its own and is not protected by the binding contract rule, for example, to build an addition to a project protected by the binding contract rule, will not adversely affect the status of the portion of the project subject to a separate binding contract.

The conferees also wish to clarify that the general binding contract rule does not apply to supply agreements with manufacturers, where such contracts fail to specify the amount or design specifications of property to be purchased; such contracts are not to be treated as binding contracts until purchase orders are actually placed. A purchase order for a specific number of properties, based on the pricing provisions of the supply agreement, will be treated as a binding contract.

Self-constructed property

The conference agreement does not apply to property that is constructed or reconstructed by the taxpayer, if (1) the lesser of $1 million or five percent of the cost of the property was incurred or committed, (i.e., required to be incurred pursuant to a written binding contract in effect) as of March 1, 1986 (December 31, 1985, for purposes of the investment tax credit) and (2) the construction or reconstruction began by that date. For purposes of this rule, a taxpayer who serves as the engineer and general contractor of a project is to be treated as constructing the property. For purposes of this rule, the construction of property is considered to begin when physical work of a significant nature starts. Construction of a facility or equipment is not considered as begun if work has started on minor parts or components. Physical work does not include preliminary activities such as planning or designing, securing financing, exploring, researching, or developing.

For purposes of the rule for self-constructed property, in the context of a building, the term "property" includes all of the normal and customary components that are purchased from others and installed without significant modification (e.g., light fixtures).

Equipped buildings

Under the conference agreement, where construction of an equipped building began on or before March 1, 1986 (December 31, 1985, for purposes of the investment tax credit), pursuant to a written specific plan, and more than one-half the cost of the equipped building (including any machinery and equipment for it) was incurred or committed before March 2, 1986 (January 1, 1986, for the investment tax credit) the entire equipped building project and incidental appurtenances are excepted from the bill's application.¹ Where the costs incurred or committed before March 2, 1986 (January 1, 1986, for the investment tax credit) do not equal more than half the cost of the equipped building, each item of machinery and equipment is treated separately for purposes of determining whether the item qualifies for transitional relief.

Under the equipped building rule, the conference agreement will not apply to equipment and machinery to be used in the completed building, and also incidental machinery, equipment, and structures adjacent to the building (referred to here as appurtenances) which are necessary to the planned use of the building, where the following conditions are met:

The equipped building rule can be illustrated by an example where the taxpayer has a plan providing for the construction of a $100,000 building with $80,000 of machinery and equipment to be placed in the building and used for a specified manufacturing process. In addition, there may be other structures or equipment, here called appurtenances, which are incidental to the operations carried on in the building, that are not themselves located in the building. Assume that the incidental appurtenances have further costs of $30,000. These appurtenances might include, for example, an adjacent railroad siding, a dynamo or water tower used in connection with the manufacturing process, or other incidental structures or machinery and equipment necessary to the planned use of the building. Of course, appurtenances, as used here, do not include a plant needed to supply materials to be processed or used in the building under construction. In this case, if construction of the building is under a binding contract and property but no equipment had been ordered, and the appurtenances had not been constructed or placed under binding order, the equipped building rule would apply. This is true because the building cost represents more than 50 percent of the total $180,000. As a result, the machinery and equipment, even though not under binding contract, is eligible for the rule. In this connection, it should be noted that the additional cost of appurtenances, $30,000, is not taken into account for purposes of determining whether the 50-percent test is met. Nevertheless, the bill would not apply to these appurtenances since the 50-percent test is met as to the equipped building.

Plant facilities

The conference agreement also provides a plant facility rule that is comparable to the equipped building rule (described above), for cases where the facility is not housed in a building. For purposes of this rule, the term "plant facility" means a facility that does not include any building (or of which buildings constitute an insignificant portion), and that is a self-contained single operating unit or processing operation--located on a single site--identifiable as a single unitary project as of March 1, 1986.

If pursuant to a written specific plan of a taxpayer in existence as of March 1, 1986 (December 31, 1985, for the investment tax credit), the taxpayer constructed, reconstructed, or erected a plant facility, the construction, reconstruction, or erection commenced as of March 1, 1986 (December 31, 1985, for the investment tax credit), and the 50-percent test is met, then the conference agreement will not apply to property that makes up the facility. For this purpose, construction, etc., of a plant facility is not considered to have begun until it has commenced at the site of the plant facility. (This latter rule does not apply if the facility is not to be located on land and, therefore, where the initial work on the facility must begin elsewhere.) In this case, as in the case of the commencement of construction of a building, construction begins only when actual work at the site commences; for example, when work begins on the excavation for footings, etc., or pouring the pads for the facility, or the driving of foundation pilings into the ground. Preliminary work, such as clearing a site, test drilling to determine soil condition, or excavation to change the contour of the land (as distinguished from excavation for footings), does not constitute the beginning of construction, reconstruction or erection.

The conferees wish to clarify the application of the plant facility rule where the original construction of a power plant is pursuant to a written specific plan of a taxpayer in existence as of March 1, 1986 (December 31, 1985, in the case of the investment tax credit), and both the original construction and more than one-half of the total cost of the property to be used at the power plant has been incurred or committed by such date. The plant facility rule will apply to the power plant even though the type of fuel to be utilized at the plant may have changed subsequent to the original plan and other changes may be made to accommodate the change in the fuel source, as long as more than one-half of the total cost of the plant, including all conversion costs, were incurred or committed by March 1, 1986.

Special rules for sale-leasebacks within three months

Property is treated as meeting the requirements of a transitional or general effective date rule if (1) the property is placed in service by a taxpayer who acquired the property from a person in whose hands the property would qualify under a transitional or general effective date rule, (2) the property is leased back by the taxpayer to such person, and (3) the leaseback occurs within three months after such property was originally placed in service, but no later than the applicable date. The committee intends that the special rule for sale-leasebacks apply to any property that qualifies for transitional relief under the bill or that was originally placed in service by the lessee under the sale-leaseback before the general effective date. This rule would apply where a taxpayer acquires property from a manufacturer, places the property in service by leasing it to the ultimate user, and subsequently engages in a sale-leaseback within three months after the property was originally placed in service under the initial lease.

In the case of a facility that would otherwise qualify for transitional relief as an equipped building (described above), if a portion of such equipped building is sold and leased back in accordance with the requirements of the special rule for sale-leasebacks, both the leased and retained portions will continue to qualify for transitional relief as an equipped building.

Special rules for tax-exempt bond financed property

The provision restricting ACRS deductions for property financed with tax-exempt bonds applies to property placed in service after December 31, 1986, to the extent such property is financed (directly or indirectly) by the proceeds of bonds issued after March 1, 1986. The revised restrictions on ACRS deductions do not apply to facilities placed in service after December 31, 1986, if--

The restrictions on ACRS deductions for bond-financed property do not apply to property placed in service after December 31, 1986, to the extent that the property is financed with tax-exempt bonds issued before March 2, 1986. ACRS deductions for such property may be determined, however, under the rules generally provided by the bill. For purposes of this exception, a refunding issue issued after March 1, 1986, generally is treated as a new issue and the taxpayer must use the alternative depreciation method provided by the bill for costs that are unrecovered on the date of the refunding issue.

In cases where a change of recovery method is required because of a refunding issue, only the remaining unrecovered cost of the property is required to be recovered using the alternative depreciation system provided by the bill. Therefore, no retroactive adjustments to ACRS deductions previously claimed are required when a pre-March 2, 1986, bond issue is refunded where no significant expenditures are made with respect to the facility after December 31, 1986.

Contract with persons other than a person who will construct or supply the property

The bill provides transitional relief for certain situations where written binding contracts require the construction or acquisition of property, but the contract is not between the person who will own the property and the person who will construct or supply the property. This rule applies to written service or supply contracts and agreements to lease entered into before March 2, 1986 (January 1, 1986, in the case of the investment tax credit). An example of a case to which this rule would apply would be lease agreements under which a grantor trust is obligated to provide property under a finance lease (to the extent continued under the bill). The conferees wish to clarify that this rule applies to cable television franchise agreements embodied in whole or in part in municipal ordinances or similar enactments before March 2, 1986 (January 1, 1986, for the investment tax credit).

This transitional rule is applicable only where the specifications and amount of the property are readily ascertainable from the terms of the contract, or from related documents. A supply or service contract or agreement to lease must satisfy the requirements of a binding contract (discussed above). A change in the method or amount of compensation for services under the contract, without more, will not be considered a substantial modification of the contract if, taken as a whole, the change does not affect the scope or function of the project. This rule does not provide transitional relief to property in addition to that covered under a contract described above, which additional property is included in the same project but does not otherwise qualify for transitional relief.

As a further example, where a taxpayer before January 1, 1986 entered into a written binding contract to construct a wastewater treatment facility and to provide wastewater treatment services, the subsequent amendment of the contract to (1) extend the date for completion of construction by a short period (e.g., three months), (2) provide for a letter of credit or other financial protection against defaults of the service provider, (3) add a pledge of net revenue and a sewer use rate covenant by the service recipient, (4) cause the service recipient's options to purchase the facility to comply with "service contract" definitional requirements of the Internal Revenue Code, (5) merely clarify rights and remedies in the event of performance defaults, and (6) treat the obligations of the taxpayer to accept and treat wastewater as separate obligations (and treat similarly the obligation of the service recipient to pay for such services) would not in the aggregate constitute a "substantial modification," if the taxpayer's obligations to provide wastewater treatment services and to construct or acquire the facility are not affected thereby.

Development agreements relating to large-scale multi-use urban projects

The conference agreement does not apply to property that is included in a "qualified urban renovation project." The term qualified urban renovation project includes certain projects that satisfy the following requirements as of March 1, 1986 (December 31, 1985, for the investment tax credit): the project is described in the conference agreement and (1) was publicly announced by a political subdivision, for the renovation of an urban area in its jurisdiction, (2) was either the subject of an agreement for development or a lease between such political subdivision and the primary developer of the project, or was undertaken pursuant to the political subdivision's grant of development rights to a primary developer-purchaser; or (3) was identified as a single unitary project in the internal financing plans of the primary developer, and (4) is not substantially modified at any time after March 1, 1986 (December 31, 1985, for the investment tax credit).

Federal Energy Regulatory Commission application or action

The requirements of the general binding contract rule will be treated as satisfied with respect to a project if, on or before March 1, 1986 (for purposes of depreciation and the investment tax credit), the Federal Energy Regulatory Commission ("FERC") licensed the project or certified the project as a "qualifying facility" for purposes of the Public Utility Regulatory Policies Act of 1978 ("PURPA"). A project that a developer has simply put FERC on notice as a qualifying facility is not certified as a qualifying facility.

This rule will not apply if a FERC license or certification is substantially amended after March 1, 1986. On the other hand, minor modifications will not affect the application of this rule (e.g., technical changes in the description of a project, extension of the deadline for placing property in operation, changes in equipment or in the configuration of equipment).

The committee is informed that FERC does not distinguish between an application to amend an existing certificate and one to have a project recertified and responds in both cases by "recertifying" the project. The committee intends that substance should control over form, and property will remain transitional property if no substantial change occurs. Similarly, a mere change in status from a "qualifying small power production facility" to a "qualifying cogeneration facility," under PURPA, without more, would not affect application of the transitional rule. The following paragraph provides guidance about how the "substance over form" rule applies in typical cases.

The requirements of the transitional rule for FERC Certification will not be violated under the following circumstances: (1) after FERC certification, the introduction of efficiencies results in a reduction of the project cost and an increase in net electricity output, and the FERC certificate is amended to reflect the higher electricity output, (2) a project was originally certified as three separate facilities, but the taxpayer determines that it is more efficient to have a single powerhouse, and the FERC certification is amended to have the facilities combined under a single certificate.

The conference agreement also provides transitional relief for hydroelectric projects of less than 80 megawatts if an application for a permit, exemption, or license was filed with FERC before March 2, 1986 (for purposes of depreciation and the investment tax credit).

Qualified solid waste disposal facilities

The conference agreement does not apply to a qualified solid waste disposal facility if, before March 2, 1986 (for purposes of depreciation and the investment tax credit) (1) there is a written binding contract between a service recipient and a service provider, providing for the operation of such facility and the payment for services to be provided by the facility, or (2) a service recipient, governmental unit, or any entity related to such an entity made a financial commitment of at least $200,000 to the financing or construction of the facility.

For purposes of this rule, a qualified solid waste disposal facility is a facility (including any portion of the facility used for power generation or resource recovery) that provides solid waste disposal services for residents of part or all of one or more governmental units, if substantially all of the solid waste processed at such facility is collected from the general public. This rule does not apply to replacement property. For example, assume a taxpayer/service provider enters into a long-term service contract before January 1, 1986, and a facility is initially placed in service after that date. Assume that the taxpayer finds it necessary to replace the facility 20 years later, pursuant to its obligation to provide continuing services under the pre-1987 service contract. The special rule will apply only to the first facility necessary to fulfill the taxpayer's obligations under the service contract.

For purposes of this provision, a contract is to be considered as binding notwithstanding the fact that the obligations of the parties are conditioned on factors such as the receipt of permits, satisfactory construction or performance of the facility, or the availability of acceptable financing. A change in the method or amount of compensation for services under the contract will not be considered a substantial modification of the contract if, taken as a whole, the change does not materially affect the scope or function of the project.

A service recipient or governmental unit or a related party is to be treated as having made a financial commitment of at least $200,000 for the financing or construction of a facility if one or more entities have issued bonds or other obligations aggregating more than 10 percent of the anticipated capital cost of such facility, the proceeds of which are identified as being for such facility or for a group of facilities that include the facility, and if the proceeds of such bonds or other obligations to be applied to the development or financing of such facility are at least $200,000 in the aggregate. Alternatively, the test would be satisfied if one or more entities have expended in the aggregate at least $200,000 of their funds, or utilized or committed at least $200,000 of their assets, toward the development or financing of such facility (e.g., for the cost of feasibility studies and consultant fees). If a governmental entity acquires a site for a facility by purchase, option to purchase,² purchase contract, condemnation, or entering into an exchange of land, it shall be considered to have made a financial commitment equal to the fair market value of such site for purposes of this rule. For purposes of this provision, entities are related if they are described in section 168(h)(4)(A)(i).

Other exceptions

The conference agreement also provides other special transitional rules of limited application. The conference agreement does not apply to (1) those mass commuting vehicles exempted from the application of the tax-exempt leasing rules under DEFRA, (2) a qualified lessee's automotive manufacturing property that was exempted from deferral of the finance lease rules, (3) a qualified lessee's farm property that was exempted from deferral of the finance lease rules, or (4) property described in section 216(b)(3) of TEFRA. Property that qualifies under one of these provisions is also excepted from the 35-percent reduction of the investment credit and the full-basis adjustment (described below).

A master plan for a project will be considered to exist on March 1, 1986 if the general nature and scope of the project was described in a written document or documents in existence on March 1, 1986, or was otherwise clearly identifiable on that date. The conferees understand that each of the projects described in this rule had a master plan in existence on March 1, 1986, and does not intend the existence of such a plan to be a separate requirement for transitional relief for property comprising these projects.

Special rules applicable to the regular investment credit

Under the conference agreement, the investment tax credit allowable for carryovers is reduced by 35 percent. The reduction in investment tax credit carryovers is phased in with the corporate rate reduction. The 35-percent reduction is fully effective for taxable years beginning on or after July 1, 1987. Taxpayers having a taxable year that straddles July 1, 1987, will be subject to a partial reduction that reflects the reduction for the portion of their year after that date. For example, for a calendar year taxable year, the reduction for 1987 is 17.5 percent. The investment tax credit earned on transition property is reduced in the same manner as carryovers.

The amount by which the credit is reduced will not be allowed as a credit for any other taxable year. For purposes of determining the extent to which an investment credit determined under section 46 is used in a taxable year, the regular investment credit is assumed to be used first. This rule is inapplicable to credits that a taxpayer elects to carryback 15 years under the special rules described below.

As described above, a full basis adjustment is required with respect to the reduced amount of the investment tax credit. Thus, for transition property that is eligible for a 6.5 percent investment tax credit, the basis reduction would be with respect to the 6.5 percent credit, not the unreduced 10 percent credit.

The phased-in 35-percent reduction is to be applied to the investment tax credit before application of the general 75-percent limitation. Further, the amount of investment tax credit carryovers subject to reduction shall be adjusted to reflect credits that were recaptured.

Estimated tax payments

The conferees are aware that the repeal of the regular investment tax credit for property placed in service after December 31, 1985, presents an issue about the manner in which estimated tax payments should be calculated for payment due dates occurring before the date of enactment of this Act. In general, for example, a corporation calculates estimated tax by determining its expected regular tax liability, less any allowable tax credits. Any underpayment of estimated corporate tax generally results in the imposition of penalties.

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

Elective 15-year carryback for certain taxpayers

Certain companies can elect a 15-year carryback of 50 percent of investment tax credit carryforwards in existence as of the beginning of a taxpayer's first taxable year beginning after December 31, 1985. The amount carried back is treated as a payment against the tax imposed by chapter 1 of the Internal Revenue Code, made on the last day prescribed by law (without regard to extensions) for filing a return of tax under chapter 1 of the Code for the first taxable year beginning on or after January 1, 1987. The amount carried back would reduce tax liability for the first taxable year beginning after December 31, 1986; to the extent the amount carried back exceeds the tax liability for such year, any excess could be claimed as a refund under generally applicable rules. Carryforwards taken into account under the carryback rule are not taken into account under section 38 for any other taxable year. Generally, taxpayers eligible to elect the 15-year carryback are domestic corporations engaged in the manufacture and production of steel. A similar election is available to qualified farmers, except a $750 limitation applies.

The amount claimed as a payment against the tax for the first taxable year beginning on or after January 1, 1987 cannot exceed the taxpayer's net tax liability. The net tax liability is the amount of tax liability for all taxable years during the carryback period (not including minimum tax liability), reduced by the sum of credits allowable (other than the credit under section 34 relating to certain fuel taxes). The carryback period is the period that (1) begins with the taxpayer's 15th taxable year preceding the first taxable year from which there is a credit included in the taxpayer's existing carryforward (in no event can such period begin before the first taxable year ending after December 31, 1961), and (2) ends with the corporation's last taxable year beginning before January 1, 1986.

Normalization requirement for public utility property

If the tax benefits of previously allowed investment tax credits on public utility property are not normalized, then certain investment tax credits will be recaptured. In general, the amount recaptured is the greater of (1) all investment tax credits for open taxable years of the taxpayer or (2) unamortized credits of the taxpayer or credits not previously restored to rate base (whether or not for open years), whichever is applicable. If such credits have not been utilized and are being carried forward, the carryforward amount is reduced in lieu of recapture. These rules apply to violations of the relevant normalization requirements occurring in taxable years ending after December 31, 1985. Similar principles apply to the failure to normalize the tax benefits of previously allowed employee stock ownership plan credits.

General treatment of QPEs

Neither the repeal of the regular investment credit nor the phased-in 35-percent reduction of credits affects QPEs claimed with respect to the portion of the basis of any progress expenditure property attributable to progress expenditures for periods before January 1, 1986. If a taxpayer elected to take a reduced rate of credit on a QPE basis in lieu of the 50-percent basis adjustment of present law, the portion of basis attributable to such QPEs, claimed for periods before 1986, will not be reduced and such election will not apply to any other portion of such basis. After December 31, 1985, QPEs cannot be claimed unless it is reasonable to expect that the property will be placed in service before the applicable date. The determination of whether it is reasonable to expect that the placement-in-service requirement will be met is to be made on a year-by-year basis, beginning with the first taxable year that includes January 1, 1986. For any taxable year in which reasonable expectations change, no QPEs will be allowed, and previously claimed post-1985 QPEs will be recaptured. Further, if the property is not placed in service on or before the last applicable date, post-1985 QPEs will be recaptured in the taxable year that includes such date.

Special rules for television and motion picture films

Special transitional rules apply to television and motion picture films for purposes of the investment credit (but not depreciation). For purposes of the general binding contract rule, (1) construction is treated as including production, (2) in accordance with industry practice, written contemporaneous evidence of a binding contract is treated as a written binding contract, and (3) in the case of any television film, a license agreement or agreement for production services between a television network and a producer (including written evidence of such an agreement as provided in (2) above) is treated as a binding contract to produce property. For these purposes, license agreement options are binding contracts as to the optionor (non-exercising party) but not as to the optionee (exercising party). In addition, a special rule is provided for certain films produced pursuant to a permanent financing arrangement described by the bill. For purposes of the placed-in-service requirement, films and sound recordings are treated as having ADR midpoints of 12 years.

Finance leases

The finance lease rules continue to apply to any transaction permitted by reason of section 12(c)(2) of DEFRA or section 209(d)(1)(B) of TEFRA.

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

b. Rate

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

c. Research definition

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

d. Qualified expenditures

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

e. University basic research

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

f. Credit use limitation

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

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

b. Rate

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

c. Research definition

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

d. Qualified expenditures

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

e. University basic research credit

Under the House bill, a 20-percent tax credit applies to the excess of (1) 100 percent of corporate cash expenditures (including grants or contributions) paid for university basic research over (2) the sum of (a) the greater of two fixed research floors plus (b) an amount reflecting any decrease in nonresearch giving to universities by the corporation as compared to such giving during a fixed base period, as adjusted for inflation.¹

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

^{f. Credit use limitation}

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

^{g. Effective date}

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

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

b. Rate

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

c. Research definition

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

d. Qualified expenditures

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

e. University basic research credit

The Senate amendment is the same as the House bill.

f. Credit use limitation

The Senate amendment is the same as the House bill.

g. Effective date

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

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

b. Rate

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

c. Research definition

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

Under the conference agreement, research satisfying the section 174 expensing definition is eligible for the credit only if the re. search is undertaken for the purpose of discovering information (a) that is technological in nature, and also (b) the application of which is intended to be useful in the development of a new or improved business component of the taxpayer. In addition, such research is eligible for the credit only if substantially all of the activities of the research constitute elements of a process of experimentation for a functional purpose. The conference agreement also expressly sets forth exclusions from eligibility for the credit for certain research activities that might otherwise qualify and for certain nonresearch activities.

Thus, for example, costs of developing a new or improved business component are not eligible for the credit if the method of reaching the desired objective (the new or improved product characteristics) is readily discernible and applicable as of the beginning of the research activities, so that true experimentation in the scientific or laboratory sense would not have to be undertaken to develop, test, and choose among viable alternatives. On the other hand, costs of experiments undertaken by chemists or physicians in developing and testing a new drug are eligible for the credit because the researchers are engaged in scientific experimentation. Similarly, engineers who design a new computer system, or who design improved or new integrated circuits for use in computer or other electronic products, are engaged in qualified research because the design of those items is uncertain at the outset and can only be determined through a process of experimentation relating to specific design hypotheses and decisions as described above.

Thus, the requirements are applied first at the level of the entire product, etc. to be offered for sale, etc. by the taxpayer. If all aspects of such requirements are not met at that level, the test applies at the most significant subset of elements of the product, etc. This "shrinking back" of the product is to continue until either a subset of elements of the product that satisfies the requirements is reached, or the most basic element of the product is reached and such element fails to satisfy the test. Treasury regulations may prescribe rules for applying these rules where a research activity relates to more than one business component.

A plant process, machinery, or technique for commercial production of a business component is treated as a different component than the product being produced. Thus, research relating to the development of a new or improved production process is not eligible for the credit unless the definition of qualified research is met separately with respect to such production process research, without taking into account research relating to the development of the product.

The conferees intend that these regulations will make the costs of new or improved internal-use software eligible for the credit only if the taxpayer can establish, in addition to satisfying the general requirements for credit eligibility, (1) that the software is innovative (as where the software results in a reduction in cost, or improvement in speed, that is substantial and economically significant); (2) that the software development involves significant economic risk (as where the taxpayer commits substantial resources to the development and also there is substantial uncertainty, because of technical risk, that such resources would be recovered within a reasonable period); and (3) that the software is not commercially available for use by the taxpayer (as where the software cannot be purchased, leased, or licensed and used for the intended purpose without modifications that would satisfy the first two requirements just stated). The conferees intend that these regulations are to apply as of the effective date of the new specific rule relating to internal-use software; i.e., internal-use computer software costs that qualify under the three-part test set forth in this paragraph are eligible for the research credit even if incurred prior to issuance of such final regulations.

The specific rule in the conference agreement relating to internal-use computer software is not intended to apply to the development costs of a new or improved package of software and hardware developed together by the taxpayer as a single product, of which the software is an integral part, that is used directly by the taxpayer in providing technological services in its trade or business to customers. For example, the specific rule would not apply where a taxpayer develops together a new or improved high technology medical or industrial instrument containing software that processes and displays data received by the instrument, or where a telecommunications company develops a package of new or improved switching equipment plus software to operate the switches. In these cases, eligibility for the incremental research tax credit is to be determined by examining the combined hardware-software product as a single product, and thus the specific rule applicable to internal-use computer software would not apply to the combined hardware-software product.

In the case of computer software costs incurred in taxable years before the effective date for the new specific rule, the eligibility of such costs for the research credit is to be determined in the same manner as the eligibility of hardware product costs. The conferees expect and have been assured by the Treasury Department that guidance to this effect is to be promulgated on an expedited basis.

By way of further illustration, the credit is not available for costs of additional clinical testing of a pharmaceutical product after the product is made commercially available to the general public. However, the clinical testing in the United States of a product prior to production for sale in this country, or clinical testing seeking to establish new functional uses, characteristics, indications, combinations, dosages, or delivery forms as improvements to an existing product, is eligible for the credit. Thus, research (e.g., body chemistry research) undertaken on a product approved for one specified indication to determine its effectiveness and safety for other potential indications is eligible for the credit. Similarly, testing a drug currently used to treat hypertension for a new anti-cancer application, and testing an antibiotic in combination with a steroid to determine its therapeutic value as a potential new anti-inflammatory drug, would be eligible for the credit.

d. Qualified expenditures

The conference agreement follows the House bill.

e. University basic research credit

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

f. Credit use limitation

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

g. Effective date

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

2. Augmented charitable deduction for certain donations of scientific equipment

3. Tax credit for orphan drug clinical testing

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

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

2. Pollution control facilities

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

3. Qualified railroad grading and tunnel bores

In addition, special ACRS treatment is provided for a particular railroad disaster and involuntary conversion treatment of insurance proceeds in that case is specified.

The repeal of the election generally applies to expenses paid or incurred on or after January 1, 1986. However, present law continues to apply to expenditures incurred: (1) pursuant to a written contract that was binding as of September 25, 1985; or (2) with respect to construction, reconstruction, alteration, improvement, replacement or restoration commenced as of September 25, 1985, if the lesser of $1 million or 5 percent of cost has been incurred or committed by that date, provided in each case the improvements are placed in service before January 1, 1988.

The repeal of the election generally applies to expenses paid or incurred on or after January 1, 1987. However, present law continues to apply to expenditures incurred: (1) pursuant to a written contract that was binding as of March 1, 1986; or (2) with respect to construction, reconstruction, alteration, improvement, replacement or restoration commenced as of March 1, 1986, if the lesser of $1 million or 5 percent of cost has been incurred or committed by that date, provided in each case the improvements are placed in service before January 1, 1988.

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

4. Bus operating authorities; freight forwarders

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

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

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

Qualified rehabilitation expenditures are eligible for the credit only if incurred in connection with a substantial rehabilitation that satisfies an external-walls requirement. The test of substantial rehabilitation generally is met if the qualified expenditures during a 24-month measuring period exceed the greater of the adjusted basis of the building as of the first day of the 24-month period, or $5,000. (In phased rehabilitations, the 24-month measuring period is extended to 60 months).

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

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

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

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

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

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

3. Tax credit for low-income rental housing

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

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

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

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

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

Definition of low-income housing

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

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

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

Federally assisted housing

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

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

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

At-risk limitation

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

An exception is provided for certain lenders related to the buyer of the low income housing property. Another exception is provided for financing (including seller financing) not in excess of 60 percent of the basis of the property that is lent by charitable and social welfare organizations whose exempt purpose includes fostering low income housing. The credit is recaptured if the financing provided by such organizations is not repaid with interest by the end of the 15-year credit compliance period (described below).

Compliance requirements

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

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

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

Transferability

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

Coordination with other provisions

The credit is subject to the rules of the general business credit, including the maximum amount of income tax liability that may be reduced by general business tax credits in any year. Unused credits for any taxable year may be carried back to each of the three preceding taxable years and then carried forward to each of the 15 following taxable years.

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

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

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

Credit amount

The conference agreement provides two separate credit amounts: (1) a 70-percent present value credit for qualified new construction and rehabilitation expenditures that are not federally subsidized and (2) a 30-percent present value credit for other qualifying expenditures. Expenditures qualifying for the 30-percent present value credit consist of the cost of acquisition, certain rehabilitation expenditures incurred in connection with the acquisition of an existing building, and federally subsidized new construction or rehabilitation expenditures. A taxpayer's credit amount in any taxable year is computed by applying the appropriate credit percentage to the appropriate qualified basis amount in such year.

Credit percentage

For buildings placed in service in 1987, the credit percentages are 9 percent annually over 10 years for the 70-percent present value credit, and 4 percent annually over 10 years for the 30-percent present value credit.

For buildings placed in service after 1987, these credit percentages are to be adjusted monthly by the Treasury to reflect the present values of 70 percent and 30 percent at the time the building is placed in service. The Treasury's monthly adjustments of the credit percentages are to be determined on a discounted after-tax basis, based on the average of the annual applicable Federal rates (AFR) for mid-term and long-term obligations for the month the building is placed in service. The after-tax interest rate is to be computed as the product of (1) the average AFR and (2) .72 (one minus the maximum individual statutory Federal income tax rate). The discounting formula assumes each credit is received on the last day of each year and that the present value is to be computed as of the last day of the first year. In a project consisting of two or more buildings placed in service in different months, a separate credit percentage may apply to each building.

The credit percentage for rehabilitation expenditures not claimed in connection with the acquisition of an existing building is determined when rehabilitation is completed and the property is placed in service, but no later than the end of the 24-month period for which such expenditures are aggregated. These rehabilitation expenditures are treated as a separate new building for purposes of the credit. The determination of whether the rehabilitation expenditures are federally subsidized is made without regard to the source of financing for the construction or acquisition of the building to which the rehabilitation expenditures are made (also, see the discussion of qualified basis, below, for a description of federally subsidized expenditures).

Qualified basis

The qualified basis amounts with respect to which the credit amount is computed are determined as the proportion of eligible basis in a qualified low-income building attributable to the low-income rental units. This proportion is the lesser of (1) the proportion of low-income units to all residential rental units or (2) the proportion of floor space of the low-income units to the floor space of all residential rental units. Generally, in these calculations, low-income units are those units presently occupied by qualifying tenants, whereas residential rental units are all units, whether or not presently occupied.

Eligible basis consists of (1) the cost of new construction, (2) the cost of rehabilitation, or (3) the cost of acquisition of existing buildings acquired through a purchase and the cost of rehabilitation, if any, to such buildings incurred before the close of the first taxable year of the credit period. Only the adjusted basis of the building may be included in eligible basis. The adjusted basis is determined by taking into account the adjustments described in section 1016 (other than paragraphs (2) and (3) of sec. 1016(a), relating to depreciation deductions), including, for example, the basis adjustment provided in section 48(g) for any rehabilitation credits allowed under section 38. The cost of land is not included in adjusted basis.

Generally, the eligible basis of a building is determined at the time the building is placed in service. For this purpose, rehabilitation expenditures are treated as placed in service at the close of the 24-month aggregation period. In the case of rehabilitation expenditures claimed in connection with the acquisition of a building, the capital expenditures incurred through the end of the first year of the credit period may be included in eligible basis.

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

Costs of the residential rental units in a building which are not low-income units may be included in eligible basis only if such units are not above the average quality standard of the low-income units. Units are of comparable quality if the construction or acquisition costs are comparable and if such units are provided in a similar proportion for both the low-income and other tenants. Rehabilitation expenditures may not be included in eligible basis if such expenditures improve any unit in the building beyond comparability with the low-income units. Eligible basis may include the cost of amenities, including personal property, only if the included amenities are comparable to the cost of the amenities in the low-income units. Additionally, the allocable cost of tenant facilities, such as swimming pools, other recreational facilities, and parking areas, may be included provided there is no separate fee for the use of these facilities and they are made available on a comparable basis to all tenants in the project. (See generally, Treas. Reg. sec. 1.103-8(b)(4)(iii).)

Residential rental property may qualify for the credit even though a portion of the building in which the residential rental units are located is used for a commercial use. No portion of the cost of such nonresidential rental property may be included in eligible basis. The conferees intend that the costs of such a mixed-use facility may be allocated according to any reasonable method that properly reflects the proportionate benefit to be derived, directly or indirectly, by the nonresidential rental property and the residential rental units. (See, e.g., Prop. Treas. Reg. sec. 1.103-8(b)(4)(v).)

The qualified basis attributable to rehabilitation expenditures not claimed in connection with the acquisition of an existing building must equal at least $2,000 per low-income unit in order for rehabilitation expenditures to qualify for the credit. The $2,000 minimum is computed as an average based on all qualifying expenditures in the building, rather than on a unit-by-unit determination. Qualified basis is determined in the same fractional manner as for new construction or acquisition costs even if all rehabilitation expenditures are made only to low-income units. Rehabilitation expenditures may be included in eligible basis without a transfer of property. Rehabilitation expenditures may be aggregated only for rehabilitation expenditures incurred before the close of the two-year period beginning on the date rehabilitation is commenced by the taxpayer. Where rehabilitation is limited to a group of units, Treasury may provide regulations treating a group of units as a separate new building.

The cost of acquisition of an existing building may be included in eligible basis and any rehabilitation expenditures to such buildings incurred before the close of the first year of the credit period may also be included in eligible basis, without a minimum rehabilitation requirement. These costs may be included in eligible basis only if the building or a substantial improvement (a capital expenditure of 25 percent or more of the adjusted basis of the building to which five-year rapid amortization was elected or to which ACRS applied (as in effect before the enactment of this Act)) to the building has not been previously placed in service within 10 years and if the building (or rehabilitated property within the building) is not subject to the 15-year compliance period. The Treasury Department may waive this 10-year requirement for any building substantially assisted, financed or operated under the HUD section 8, section 221(d)(3), or section 236 programs, or under the Farmers' Home Administration section 515 program in order to avert an assignment of the mortgage secured by property in the project to HUD or the Farmers Home Administration, to avert a claim against a Federal mortgage insurance fund, or other similar circumstances relating to financial distress of these properties as prescribed by the Treasury Department. A transfer of ownership of a building where the basis of the property in the hands of the new owner is determined in whole or in part by the adjusted basis of the previous owner, is considered not to have been newly placed in service for purposes of the 10-year requirement (also, see the discussion of transferability, below). Any other transfer will begin a new 10-year period.

Eligible basis may not include in any taxable year the amount of any Federal grant, regardless of whether such grants are included in gross income. A Federal grant includes any grant funded in whole or in part by the Federal government, to the extent funded with Federal funds. Examples of grants which may not be included in eligible basis include Community Development Block Grants, Urban Development Action Grants, Rental Rehabilitation Grants, and Housing Development Grants.

If any portion of the eligible basis attributable to new construction or the eligible basis attributable to rehabilitation expenditures is financed with Federal subsidies, the qualified basis is eligible only for the 30-percent present value credit, unless such Federal subsidies are excluded from eligible basis. A Federal subsidy is defined as any obligation the interest on which is exempt from tax under section 103 or a direct or indirect Federal loan, if the interest rate on such loan is less than the applicable Federal rate. A Federal loan under the Farmers' Home Administration section 515 program is an example of such a Federal subsidy, as is a reduced interest rate loan attributable in part to a Federal grant. The determination of whether rehabilitation expenditures are federally subsidized is made without regard to the source of financing for the construction or acquisition of the building to which the rehabilitation expenditures are made. For example, a Federal loan or tax-exempt bond financing that is continued or assumed upon purchase of existing housing is disregarded for purposes of the credit on rehabilitation expenditures.

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

The Treasury Department may provide regulations for projects consisting of two or more buildings. Unless prescribed in regulations, the qualified basis of a project consisting of two or more buildings is determined separately for each building. Common facilities in such a project must be allocated in an appropriate manner to all buildings (whether existing or to be constructed) in the project.

The first year the credit is claimed, the allowable credit amount is determined using an averaging convention to reflect the number of months units comprising the qualified basis were occupied by low-income individuals during the year. For example, if half of the low-income units included in qualified basis were first occupied in October and the remaining half were occupied in December, a calendar year taxpayer would adjust the allowable first-year credit to reflect that these units were occupied on average only one-sixth of the year. To the extent there is such a reduction of the credit amount in the first year, an additional credit in the amount of such reduction is available in the eleventh taxable year. (This first-year adjustment does not affect the amount of qualified basis with respect to which the credit is claimed in subsequent years of the 10-year credit period.)

Additions to qualified basis

The qualified basis of a building may be increased subsequent to the initial determination only by reason of an increase in the number of low-income units or in the floor space of the low-income units. Credits claimed on such additional qualified basis are determined using a credit percentage equal to two-thirds of the applicable credit percentage allowable for the initial qualified basis and must receive an allocation of credit authority as described below (see the discussion on the State low-income housing credit authority limitation). Unlike credits claimed on the initial qualified basis, credits claimed on additions to qualified basis are allowable annually for the remainder of the required 15-year compliance period, regardless of the year such additional qualified basis is determined. The additional basis is determined by reference to the original adjusted basis (before deductions for depreciation) of the property.

The credit amount on the additional qualified basis is adjusted in the first year such additions are made using an averaging convention to reflect the number of months units comprising the additional qualified basis were occupied by low-income individuals during the year. Any reduction of the credit amount in the first year may not be claimed in a later year. (This first-year adjustment does not affect the amount of additional qualified basis with respect to which the credit is claimed in subsequent years of the compliance period.)

Minimum set-aside requirement for low-income individuals

Residential rental projects providing low-income housing qualify for the credit only if (1) 20 percent or more of the aggregate residential rental units in a project are occupied by individuals with incomes of 50 percent or less of area median income, as adjusted for family size, or (2) 40 percent or more of the aggregate residential rental units in a project are occupied by individuals with incomes of 60 percent or less of area median income, as adjusted for family size.⁶

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

^{The owner must irrevocably elect the minimum set-aside requirement at the time the project is placed in service. The set-aside requirement must be met within 12 months of the date a building (or rehabilitated property) is placed in service, and complied with continuously throughout each year after first meeting the requirement for a period of 15 years beginning on the first day of the first taxable year in which the credit is claimed.}

^{Special rules apply to projects consisting of multiple buildings placed in service on different dates. Unless prescribed by regulations, the initial building, within 12 months of being placed in service, must meet the set-aside requirement determined only by reference to those units in the building. When a second or subsequent building is placed in service, the project must meet the set-aside requirement with respect to the units in all buildings placed-in-service up to that time within 12 months of the date the second or subsequent building is placed in service and comply with this expanded requirement continuously after first meeting the requirements for a period of 15 years beginning on the later of (1) the first day of the taxable year in which the expanded requirement is met or (2) if a credit is claimed with respect to the building, the first day of the taxable year in which the credit period begins with such building.7} Subsequent buildings are subject to separate 15-year compliance periods. After the 15-year period has expired on an initial building, but while other buildings in the same project are still subject to the compliance period, the project must continue to meet the set-aside requirement determined by reference to all buildings in the project or, at the taxpayer's election, all buildings subject to the compliance period.

The determination of whether a tenant qualifies for purposes of the low-income set-aside is made on a continuing basis, both with regard to the tenant's income and the qualifying area income, rather than only on the date the tenant initially occupies the unit. An increase in a tenant's income may, therefore, result in a unit ceasing to qualify as occupied by a low-income person. However, a qualified low-income tenant is treated as continuing to be such notwithstanding de minimis increases in his or her income. Under this rule, a tenant qualifying when initially occupying a rental unit will be treated as continuing to have such an income provided his or her income does not increase to a level more than 40 percent in excess of the maximum qualifying income, adjusted for family size. If the tenant's income increases to a level more than 40 percent above the otherwise applicable ceiling (or if the tenant's family size decreases so that a lower maximum family income applies to the tenant), however, that tenant may no longer be counted in determining whether the project satisfies the set-aside requirement. (For a discussion of the rules for complying with the set-aside requirements, see the discussion of the compliance period and penalty for noncompliance, below.)

A special rule is provided for projects that elect to satisfy a stricter set-aside requirement and that significantly restrict the rents on the low-income units relative to the other residential units in the building. Projects qualify for this rule only if, as part of the general set-aside requirement, 15 percent or more of all low-income units are occupied by individuals having incomes of 40 percent (rather than 50 percent or 60 percent) or less of area median income, and the average rent charged to tenants in the residential rental units which are not low-income units is at least 300 percent of the average rent charged to low-income tenants for comparable units. Under this special rule, (a) a low-income tenant will continue to qualify as such, as long as the tenant's income does not exceed 170 percent of the qualifying income, and (b) if the project ceases to comply with the set-aside requirement because of increases in existing tenants' incomes, no penalties are imposed if each available low income unit is rented to tenants having incomes of 40 percent or less of area median income, until the project is again in compliance.

As stated above, the conference agreement requires that adjustments for family size be made in determining the incomes used to qualify tenants as having low income. In general, these adjustments are the same as the adjustments presently made under section 8 of the United States Housing Act of 1937. Thus, for a project which qualifies by setting aside 20 percent of the units for tenants having incomes of 50 percent or less of area median income, a family of four generally will be treated as meeting this standard if the family has an income of 50 percent or less of the area median income; a family of three having an income of 45 percent or less generally will qualify; a family of two having an income of 40 percent or less generally will qualify; and, a single individual having an income of 35 percent or less generally will qualify. The conferees are aware that, in certain cases, the use of section 8 guidelines may result in qualifying incomes below the amounts reflected by these percentages because of dollar ceilings that are applied under the section 8 program. Income limits may be adjusted by the Secretary for areas with unusually low family income or high housing costs relative to family income in a manner consistent with determinations of very low income families and area median gross income under section 8 to reflect the 50-percent and 60-percent income levels.

Vacant units, formerly occupied by low-income individuals, may continue to be treated as occupied by a qualified low-income individual for purposes of the set-aside requirement (as well as for determining qualified basis) provided reasonable attempts are made to rent the unit and no other units of comparable or smaller size in the project are rented to nonqualifying individuals (see the section "Compliance period and penalty for noncompliance," below).

In no case is a unit considered to be occupied by low-income individuals if all of the occupants of such unit are students (as determined under sec. 151(c)(4)), no one of whom is entitled to file a joint income tax return.

Gross rent limitation

The gross rent paid by families in units included in qualified basis may not exceed 30 percent of the applicable qualifying income for a family of its size. Gross rent is to include the cost of any utilities, other than telephone. If any utilities are paid directly by the tenant, the maximum rent that may be paid by the tenant is to be reduced by a utility allowance prescribed by the Secretary, after taking into consideration the procedures under section 8 of the United States Housing Act of 1937.

The gross rent limitation applies only to payments made directly by the tenant. Any rental assistance payments made on behalf of the tenant, such as through section 8 of the United States Housing Act of 1937, are not included in gross rent.

Low-income unit

A low-income unit includes any unit in a qualified low-income building if the individuals occupying such unit meet the income limitation elected for the project for purposes of the minimum set-aside requirement and if the unit meets the gross rent requirement, as well as all other requirements applicable to units satisfying the minimum set-aside requirement.

Qualified low-income housing projects and qualified low-income buildings

A qualified low-income building is a building subject to the 15-year compliance period and which is part of a qualified low-income housing project.

A qualified low-income housing project is a project that meets the minimum set-aside requirement and other requirements with respect to the set-aside units at all times that buildings comprising the project are subject to the 15-year compliance period. A qualified low-income housing project includes a qualified low-income building containing residential rental units and other property that is functionally related and subordinate to the function of providing residential rental units. A project may include multiple buildings having similarly constructed housing units, provided the buildings are located on the same tract of land, are owned by the same person for Federal income tax purposes, and are financed pursuant to a common plan of financing.

Residential rental units must be for use by the general public and all of the units in a project must be used on a nontransient basis. Residential rental units are not for use by the general public, for example, if the units are provided only for members of a social organization or provided by an employer for its employees. Generally, a unit is considered to be used on a nontransient basis if the initial lease term is six months or greater. Additionally, no hospital, nursing home, sanitarium, lifecare facility, retirement home, or trailer park may be a qualified low-income project.

Unlike the requirements for units in projects financed with tax-exempt bonds, certain single room occupancy housing used on a nontransient basis may qualify for the credit, even though such housing may provide eating, cooking, and sanitation facilities on a shared basis. An example of housing that may qualify for the credit is a residential hotel used on a nontransient basis that is available to all members of the public. The residential units in such a building may share bathrooms and have a common dining area.

Compliance period and penalty for noncompliance

Qualified residential rental projects must remain as rental property and must satisfy the minimum set-aside requirement, described above, throughout a prescribed compliance period. Low-income units comprising the qualified basis on which additional credits are based are required to comply continuously with all requirements in the same manner as units satisfying the minimum set-aside requirements.

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

The conference agreement defines the compliance period for any building as the period beginning on the first day of the first taxable year of the credit period of such building and ending 15 years from such date. The minimum set-aside requirement must be met, in all cases, within 1 year of the date the building (or rehabilitated property) is placed in service.

Within 90 days of the end of the first taxable year for which the credit is claimed and for each taxable year thereafter during the compliance period, the taxpayer must certify to the Secretary that the project has continuously complied throughout the year with the set-aside requirement and report the dollar amount of the qualified basis of the building and the maximum applicable percentage and qualified basis permitted to be taken into account by the housing credit agency. Additionally, the certification must include the date (including the taxable year) in which the building was placed in service and any other information required by Treasury.

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

Generally, any change in ownership of a building subject to the compliance period is also a recapture event. An exception is provided if the seller posts a bond to the Secretary in an amount satisfactory to the Treasury, and provided it can reasonably be expected that such building will continue to be operated as a qualified low-income building for the remainder of the compliance period. For partnerships consisting of more than 35 individual taxpayers, at the partnership's election, no change in ownership will be deemed to occur provided within a 12-month period at least 50 percent (in value) of the original ownership is unchanged.

In the year of a recapture event, no credit is allowable for the building. Additionally, the accelerated portion of credits paid in earlier years is recaptured with interest, from the date the recaptured amount was claimed, at the overpayment rate established under section 6621. The accelerated portion of the credit in any year is the amount of credits determined for the year, less the amount which would have been determined for the year if all credits had been allowed ratably over the compliance period (with no further discounting). Because credits on the initial qualified basis of a building are claimed ratably over a 10-year credit period rather than the 15-year compliance period, the amount of credit recaptured for noncompliance during the first 11 years is one-third of the credit determined for the year, plus interest. Because credits claimed on additions to qualified basis are paid ratably over the remainder of the compliance period (the credit percentage is two-thirds of the otherwise applicable percentage), there is no accelerated portion of credits attributable to additions to qualified basis. In the absence of additions to qualified basis and previous recapture events, the credits are recaptured in the following amounts (in addition to interest): one-third for violations after year 1 and before expiration of year 11; four-fifteenths for violations after year 11 but before expiration of year 12; three-fifteenths for violations after year 12 but before expiration of year 13; two-fifteenths for violations after year 13 but before expiration of year 14; and one-fifteenth for violations after year 14 but before expiration of year 15.

The penalty for a decrease in the qualified basis of a building, while still remaining part of a qualified low-income project, is recapture of the credits with respect to the accelerated amount claimed for all previous years on the amount of the reduction in qualified basis.

Owners and operators of low-income housing projects on which a credit has been claimed must correct any noncompliance with the set-aside requirement or with a reduction in qualified basis within a reasonable period after the noncompliance is discovered or reasonably should have been discovered. If any noncompliance is corrected within a reasonable period, there is no recapture. The conferees do not intend, however, that tenants be evicted to return a project to compliance. Rather, the conferees intend that each residential rental unit of comparable or smaller size that becomes vacant while a project is not in compliance must be rented to a tenant having a qualifying income before any units in the project are rented to tenants not so qualifying until the project again is in compliance. In general, therefore, the event that gives rise to the penalty for noncompliance (i.e., recapture or a reduction in the allowable credit) will be rental of a unit to other than a low-income tenant (on other than a temporary basis) during any period when the project does not comply with the set-aside requirement or with the qualified basis amounts on which the credit is computed (or would not qualify as a result of that rental).

An example of how the recapture provisions operate follows:

A reduction in qualified basis by reason of a casualty loss shall not be a recapture event provided such property is restored by reconstruction or replacement within a reasonable period.

State low-income housing credit authority limitation

Generally, any building eligible for the credit not financed with the proceeds of tax-exempt bonds, which received an allocation pursuant to the new private activity bond volume limitation, must receive an allocation of credit authority from the State or local credit agency in whose jurisdiction the qualifying low-income housing project is located. The aggregate amount of such credits allocated within the State is limited by the State annual low-income credit authority limitation. Credit allocations are counted against a State's annual credit authority limitation for the calendar year in which the credits are allocated. Credits may not be allocated before the calendar year in which the building is placed in service. The credit amount allocated to a building applies for the year the allocation is made and all future years of the compliance period.

Allowable credit authority

To qualify for allocations from this set-aside, an organization must be a section 501(c)(3) or 501(c)(4) organization, one of the exempt purposes of which includes the fostering of low-income housing, and the qualifying project with respect to which the credits are allocated must be one in which such organization materially participates (within the meaning of the passive loss rule). Among the operations in which the organization must be involved in on a regular, continuous, and substantial basis, in addition to the continuing operation of the project, is the development of the project.

Credits subject to the credit authority limitation

Generally, credits subject to the State credit authority limitation include any credits attributable to expenditures not financed with tax-exempt bonds subject to the new private activity bond volume limitation.

In the case of a building financed with the proceeds of tax-exempt bonds subject to the bond volume limitation, if 70 percent or more of the aggregate basis of the building and land on which the building is located is financed with such proceeds, no portion of the credits attributable to such building is subject to the credit authority limitation.

If less than 70 percent of the aggregate basis of the building and land on which the building is located is financed with tax-exempt bonds subject to the bond volume limitation, only credits attributable to those bond-financed expenditures are not subject to the credit authority limitation.

Allocation of credit authority limitation among the State and other qualified governmental units therein

Under the first procedure, each State's credit authority limitation is allocated in its entirety to the State housing agency until either the governor or the legislature makes a different allocation. If more than one such agency exists, they shall be treated as one agency. In the absence of a qualified State agency, no allocation may occur until provided by either the governor or the legislature.

Under the second procedure, the governor of each State is provided authority to allocate the State's credit authority limitation among all of the governmental units and other issuing authorities. This authority and any allocation rules established by the governor terminate as of the effective date of any overriding State legislation.

Under the third procedure, the State legislature may enact a law providing for a different allocation than that provided under the first or second procedures. Under this authority, the State legislature may allocate all or any portion of the State limitation to any governmental unit or other issuing authority in the State.

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

The conferees wish to clarify that gubernatorial proclamations issued before the date of enactment of the conference agreement or State legislation enacted before that date is recognized for purposes of allocating the credit authority limitations, provided that the proclamation or legislation refers to the low-income housing tax credit authority limitation.

The conferees intend that a State be permitted to allocate available credit authority to a local issuer until a specified date during each year (e.g., November 1) at which time the authority, if unused, may revert to the State for reallocation. Similarly, a State statute may provide discretionary authority to a public official (e.g., the governor) to allocate the State's credit authority limitation. Because the credit authority limitation is an annual amount, however, any authority that has not been used for credits issued before the end of the calendar year expires.

The portion of a State's credit authority limitation not allocated to constitutional home rule cities then is allocated under essentially the same three procedures described in the previous section. Thus, under the first procedure, the remaining State credit authority limitation is allocated to the State housing agency. Under the second and third procedures described above, the governor or the State legislature may allocate the State limitation other than that allocated to home rule subdivisions to any governmental units (including home rule subdivisions), but they may not so allocate any amounts specially allocated to the home rule subdivisions.

For purposes of the rules on State action establishing allocation rules for the credit authority limitation, a mayor of a constitutional home rule city is treated as a governor, and a city council is treated as a State legislature.

Constitutional home rule cities are treated as States for purposes of the credit authority limitation set-aside for qualified nonprofit organizations. Pursuant to their general authority to alter credit allocation, described above, these cities may agree with the State in which they are located to exchange authority to allocate credits for qualified nonprofit organizations for authority to allocate credits for other projects.

Determination of credit amount allocation

A building must receive low-income credit authority allocated to it for the calendar year which includes the last day of the first year of the credit period. Authority must be received from the credit agency in whose jurisdiction the qualifying low-income building is located. The credit agency's remaining authority is reduced by the credit percentage multiplied by the amount of qualified basis granted by the credit agency for the building. The credit agency may grant a smaller credit percentage and a smaller qualified basis amount at the time the allocation is made than the maximum percentage and amount that would otherwise be allowed. The conferees intend that the credit agencies reduce the maximum available credit percentage when the financing and rental assistance for a project from all sources is sufficient to provide the continuing operation of the qualifying low-income building without the maximum credit.

A credit agency's credit limitation authority is reduced by the maximum amount of credit granted, whether or not the property ultimately is eligible for this maximum amount, and without regard to the averaging convention used in the first year of the credit period.

If a building is granted more credits than would be claimed in the first year of the credit period, without regard to the averaging convention, such amounts are not restored to the credit agency's authority. Such amounts may, however, be used in a later year by the owner of the building to the extent the credit determined with respect to the building is increased as a result of additions to qualified basis (but not beyond the amount allocated by the agency, and without regard to the reduced percentage applicable to such additions). (Also, see the discussion on additions to qualified basis, above.)

Generally, no carryover authority for unused credit authority is permitted. A limited exception is provided for buildings placed in service in 1990, if expenditures of 10 percent or more of total project costs are incurred before January 1, 1989. Credit authority for such property may be carried over from the 1989 credit allocation for the credit agency.

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

Should a credit agency issue more credits than its credit authority limitation provides, credits will be denied to those buildings last allocated credits until the credit authority limitation is not exceeded.

Credit administration

Credit agencies allocating credits may not condition allocation of credits to the source of financing for the qualifying low-income building. The conference agreement authorizes the Treasury Department to prescribe regulations that may require credit recipients to pay a reasonable fee to cover administrative expenses of the credit agency.

Agencies allocating credits must file reports with the Treasury Department containing (1) the maximum applicable percentage and qualified basis of each building, (2) the fees, if any, charged to credit recipients, (3) the aggregate amount of credits issued, and (4) other information required by Treasury. The time and manner of filing such reports and other information required are to be specified by the Treasury Department.

Transferability

A new owner of a building during its 15-year compliance period is eligible to continue to receive the credit as if the new owner were the original owner, using the same qualified basis and credit percentages as used by the original owner. Rehabilitation expenditures on such property may qualify for a credit in the same manner as rehabilitation expenditures on other qualifying property. The accelerated portion of credits claimed in previous years will be recaptured upon a transfer, subject to the election of the original owner to post a bond. All dispositions of ownership interests in buildings are treated as transfers for purposes of recapture, except for a special rule for certain partnerships. (There is no election for the new owner to assume the recapture liability for prior year credits.)

At-risk limitation

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

Another exception is provided for financing (including seller financing) not in excess of 60 percent of the basis of the property that is lent by charitable and social welfare organizations whose exempt purpose includes fostering low-income housing. Further, if the rate of interest for any financing qualifying for this exception is below the applicable Federal rate at the time the financing is incurred, less 1 percentage point, then the qualified basis to which such financing relates shall be reduced to reflect the present value of the payments of principal and interest, using as the discount rate such applicable Federal rate. The credit is recaptured if the financing provided by such organizations is not repaid with interest by the end of the 15-year credit compliance period.

Coordination with other provisions

The credit is subject to the rules of the general business credit, including the maximum amount of income tax liability that may be reduced by a general business tax credit in any year. Unused credits for any taxable year may be carried back to each of the 3 preceding taxable years and then carried forward to each of the 15 following taxable years.

For purposes of the rules in the conference agreement limiting passive loss deductions, the credit (but not losses) is treated as arising from rental real estate activities in which the taxpayer actively participates. Credits may be used to offset tax on up to $25,000 of nonpassive income, subject to a phaseout between $200,000 and $250,000 of adjusted gross income (disregarding passive losses).

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

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

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

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

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

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

Capital losses are allowed in full against capital gain as under present law. Capital losses are also allowed against up to $3,000 of ordinary income and the excess of net long-term capital loss over net short-term capital gain is allowed in full for this purpose. As under present law, capital losses may be carried forward.

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

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

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

There is no change in the capital loss provisions.

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

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

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

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

The provisions applies to options issued after 1986.

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

2. Year-end rule for qualified covered calls

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

3. Hedging exception

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

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

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

2. Disposition of converted wetlands and highly erodible croplands

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

3. Preproductive period expenses of farmers

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

Expenses relating to grove, orchard and vineyard crops

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

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

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

Expenses relating to grove, orchard, and vineyard crops

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

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

No provision.

Expenses relating to grove, orchard, and vineyard crops

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

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

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

Expenses relating to grove, orchard, and vineyard crops

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

4. Prepayments of farming expenses

5. Treatment of plant variety protection certificates as patents

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

6. Recapture income on installment sales of farm irrigation equipment

7. Discharge of indebtedness income of certain farmers

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

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

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

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

2. Reforestation expenses

3. Capital gains for timber

The conference agreement also provides that any election to treat the cutting of timber as a disposition under section 631(a) made for a taxable year beginning before January 1, 1987, may be revoked on a one-time basis by the taxpayer without the permission of the Secretary of the Treasury. Any revocation of an election made in accordance with this provision will not be considered in determining whether a future election under section 631(a) by the taxpayer is allowed. If a taxpayer revokes an election without consent in accordance with this provision, and thereafter makes an election under section 631(a), any future revocations will require the permission of the Secretary of the Treasury.

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

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

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

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

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

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

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

2. Depletion for oil, gas, and geothermal properties

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

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

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

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

This provision applies to production after December 31, 1985.

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

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

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

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

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

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

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

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

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

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

2. Percentage depletion of hard minerals

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

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

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

This provision applies to production after December 31, 1985.

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

3. Gain on disposition of interest in mining property

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

4. Royalty income from coal and domestic iron ore

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

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

2. Business energy tax credits

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

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

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

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

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

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

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

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

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

3. Credit for fuels from nonconventional sources

4. Alcohol fuels tax credit and import duty

Ethyl alcohol may enter the United States duty-free, if it is imported from a Caribbean Basin Initiative (CBI) country, under the terms of the Caribbean Basin Economic Recovery Act (CBERA).

Under the conference agreement, ethyl alcohol (or an ethyl alcohol mixture) may be admitted into the United States duty-free, if it is an indigenous product of a U.S. insular possession or CBI beneficiary country.

Ethyl alcohol (or ethyl alcohol mixture) may be treated as being an indigenous product of an insular possession or beneficiary country only if the ethyl alcohol (or a mixture) has been both dehydrated and produced by a process of full-scale fermentation within that insular possession or beneficiary country. Alternatively, ethyl alcohol (or a mixture) must have been dehydrated within that insular possession or beneficiary country from hydrous ethyl alcohol that includes hydrous ethyl alcohol which is wholly the product or manufacture of any insular possession or beneficiary country and which has a value not less than (1) 30 percent of the value of the ethyl alcohol or mixture, if entered during calendar year 1987, (2) 60 percent of the value of the ethyl alcohol or mixture, if entered during calendar year 1988, and (3) 75 percent of the value of the ethyl alcohol or mixture, if entered after December 31, 1988.

Transitional exemptions are provided during 1987 and 1988 for up to 20 million gallons per year each produced by certain azeotropic distillation facilities: (1) located in a CBI country or insular possession and in operation on January 1, 1986; or (2) the equipment for which was, on January 1, 1986, ready for shipment to and installation in a CBI country. An additional transitional exemption is provided during 1987 to a facility in the Virgin Islands that received authorization prior to May 1, 1986, to operate a full-scale fermentation facility.

5. Neat alcohol fuels

6. Taxicab fuels tax exemption

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

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

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

The conferees intend that terms of nonrecourse financing are commercially reasonable if the financing is a written unconditional promise to pay on demand or on a specified date or dates a sum or sums certain in money, and the interest rate is a reasonable market rate of interest (taking into account the maturity of the obligation). If the interest rate is below a reasonable market rate, a portion of the principal may in fact represent interest, with the result that the stated principal amount may exceed the fair market value of the financed property. Generally, an interest rate would not be considered commercially reasonable if it is significantly below the market rate on comparable loans by qualified persons who are not related (within the meaning of sec. 465(b)(3)(C)) to the borrowers under the comparable loans. In addition, it is likely that a loan which would be treated as a "below-market loan" within the meaning of sec. 7872(e) of the Code is not commercially reasonable.

Similarly, if the interest rate exceeds a reasonable market rate, or is contingent on profits or gross receipts, a portion of the principal amount may in fact represent a disguised equity interest (and a portion of the interest in fact is a return on equity) with the result that the stated principal amount may exceed the fair market value of the financed property. Thus, generally, an interest rate would not be considered commercially reasonable if it significantly exceeds the market rate on comparable loans by unrelated qualified persons. Nor would an interest rate be considered commercially reasonable if it were contingent. The conferees do not intend, however, to limit the use of interest rates that are not fixed rates, provided that interest is calculated with respect to a market interest index such as the prime rate charged by a major commercial bank, LIBOR, the rate on government securities (such as Treasury bills or notes), or the applicable Federal rate (within the meaning of sec. 1274(d)). For example, an interest rate floating at 1 point above the prime rate charged by a major commercial bank would not generally be considered contingent.

The terms of the financing would also not be considered commercially reasonable if, for example, the term of the loan exceeds the useful life of the property, or if the right to foreclosure or collection with respect to the debt is limited (except to the extent provided under applicable State law).

Generally, the conferees intend that the financing be debt with arms' length terms, to carry out the purpose of the at-risk rule to limit deductions to the taxpayer's amount at risk. Thus, nonrecourse financing from a person related to the taxpayer must be on substantially the same terms as financing involving unrelated persons.

The conference agreement also provides that no inference is to be drawn from this provision (permitting certain nonrecourse financing to be treated as at risk without regard to whether the lender is a related person) as to the determination of a partner's distributive share of partnership items of a partnership under section 704, or a partner's share of partnership liabilities under section 752.

Under the House bill, the Senate amendment, and the conference agreement, convertible debt is not treated as qualified nonrecourse financing. The conferees believe that it is not appropriate to treat investors as at risk with respect to nonrecourse debt that is convertible and that consequently represents a right to an equity interest, because taxpayers are not intended to be treated as at risk for amounts representing others' rights to equity investments.

Clarification is also provided with respect to the definition of the activity of holding real property. Generally, to the extent an activity is not subject to the at-risk rules by virtue of sec. 465(c)(3)(D) of present law, it will be treated under the conference agreement as the activity of holding real property. The provision of services and the holding of personal property which is merely incidental to the activity of making real property available as living accommodations is treated as part of the activity of holding real property.

The extension of the at-risk rules to the activity of holding real property is effective for property placed in service after December 31, 1986, and for losses attributable to an interest in a partnership or S corporation or other pass-through entity that is acquired after December 31, 1986.

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

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

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

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

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

Definition of passive activities

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

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

Rental real estate

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

Under the phase-in rule, the amount disallowed under the passive loss rule during any year in the phase-in period equals the applicable percentage of the amount that would be disallowed for that year under the provision if fully effective. The applicable percentage is 35 percent for taxable years beginning in 1987, 60 percent in taxable years beginning in 1988, 80 percent in taxable years beginning in 1989, 90 percent in taxable years beginning in 1990, and 100 percent in taxable years beginning after 1990.

1. Overview

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

Passive activities that are not a trade or business.--The conference agreement provides that, to the extent provided in regulations, a passive activity may include an activity conducted for profit (within the meaning of sec. 212), including an activity that is not a trade or business. The conferees anticipate that the exercise of this authority may be appropriate in certain situations where activities other than the production of portfolio income are involved. This regulatory authority is meant to cause the passive loss rule to apply with respect to activities that give rise to passive losses intended to be limited under the provision, but that may not rise to the level of a trade or business.

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

Interaction with interest deduction limitation.--The conference agreement provides that interest deductions attributable to passive activities are treated as passive activity deductions, but are not treated as investment interest (see V.C., below). Thus, such interest deductions are subject to limitation under the passive loss rule, and not under the investment interest limitation. Similarly, income and loss from passive activities generally are not treated as investment income or loss in calculating the amount of the investment interest limitation.¹

^{Interaction with other Code sections.--It is clarified that the passive loss rule applies to all deductions that are from passive activities, including deductions allowed under sections 162, 163, 164, and 165. For example, deductions for State and local property taxes incurred with respect to passive activities are subject to limitation under the passive loss rule whether such deductions are claimed above-the-line or as itemized deductions under section 164.}

^{Personal services income not treated as from passive activity.--The conference agreement clarifies that income received by an individual from the performance of personal services with respect to a passive activity is not treated as income from a passive activity. Thus, for example, in the case of a limited partner who is paid for performing services for the partnership (whether by way of salary, guaranteed payment, or allocation of partnership income), such payments cannot be sheltered by passive losses from the partnership or from any other passive activity.}

In the case of closely held corporations, the passive loss rule permits passive losses (and credits, in a deduction equivalent sense) to offset net active income, but not portfolio income. Thus, for example, if a closely held corporation has $400,000 of passive losses from a rental activity, $500,000 of active business income, and $100,000 of portfolio income, the passive losses may be applied to reduce the active business income to $100,000, but may not be applied against the portfolio income.

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

The conference agreement provides that the rule applicable to a change in status of a closely held corporation also applies to a change in status of a personal service corporation. That is, if a personal service corporation ceases to meet the definition of a personal service corporation subject to the passive loss rule in any year, losses from a passive activity conducted by the corporation and previously suspended by reason of the application of the passive loss rule are not triggered by the change in status, but are allowed against income from that activity. Any previously suspended losses and (deduction equivalent) credits in excess of income from the activity continue to be treated as from a passive activity. Losses and credits from an activity arising in a year when the corporation does not meet the definition of a personal service corporation (or a closely held corporation are not subject to limitation under the passive loss rule).

Affiliated groups.--A limited version of the passive loss rule applies to closely held corporations, providing that passive losses of the corporation may not offset portfolio income. In the case of affiliated groups of corporations filing consolidated returns, it is intended that this rule apply on a consolidated group basis. Thus, it is intended that losses from any passive activity within the consolidated group may offset net active income, but not portfolio income, of any member of the group. An activity may be conducted by several corporations, and conversely, one corporation may be engaged in several activities. Portfolio income is accounted for separately from income or loss from each activity.

In determining whether an activity (other than a rental activity) conducted within the closely held consolidated group is a passive activity, the material participation test is intended to be applied on a consolidated basis. Thus, for example, if one or more individual shareholders holding stock representing more than 50 percent of a member's stock materially participate in an activity of any member of the group, the group is considered to materially participate. Similarly, if the requirements of section 465(c)(7)(C) (without regard to clause (iv) thereof) are met with respect to an activity by any member (or several members together), then the group is considered to materially participate in the activity.

In the case of a personal service corporation which is a member of a consolidated group, similar principles are intended to apply. For example, a corporation may be treated as a personal service corporation for purposes of the rule where the owners who render the requisite services are employees of a subsidiary, rather than of the parent corporation. Under the conference agreement, the definition of a personal service corporation is applied taking into account attribution of ownership of stock as provided in section 269A(b).

2. Treatment of losses and credits

Rental real estate in which taxpayer actively participates.--Clarification is provided with respect to the rule allowing up to $25,000 of losses and credits (in a deduction equivalent sense) from rental real estate activities in which the taxpayer actively participates to offset non-passive income of the taxpayer. The $25,000 allowance is applied by first netting income and loss from all of the taxpayer's rental real estate activities in which he actively participates. If there is a net loss for the year from such activities, net passive income (if any) from other activities is then applied against it, in determining the amount eligible for the $25,000 allowance.

It is clarified that, with respect to active participation, just as with respect to material participation, a change in the nature of the taxpayer's involvement does not trigger the allowance of deductions carried over from prior taxable years. Thus, if a taxpayer begins to actively participate in an activity in which, in prior years, he did not actively participate, the rule allowing up to $25,000 of losses from rental real estate activities against non-passive income does not apply to losses from the activity carried over from such prior years.² The same rule applies to credits, to the extent that active participation is relevant to their allowability.

The conference agreement provides that, for purposes of calculating the phase-out of the $25,000 allowance at adjusted gross income between $100,000 to $150,000 (or $200,000 to $250,000, in the case of certain credits), adjusted gross income is calculated without regard to IRA contributions and taxable social security benefits.

The conference agreement provides that in the case of an estate of a taxpayer who, in the taxable year in which he died, owned an interest in a rental real estate activity in which he actively participated, the estate is deemed to actively participate for the two years following the death of the taxpayer. Thus, the taxpayer's estate may continue to receive the same tax treatment with respect to the rental real estate activity as did the taxpayer in the taxable year of his death. This treatment applies to the taxpayer's estate during the two taxable years of the estate following his death, to facilitate the administration of the estate without requiring the executor or fiduciary to reach decisions with respect to the appropriate disposition of the rental real property within a short period following the taxpayer's death.

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

Married individuals filing separately.--The amount of the $25,000 allowance, and the adjusted gross income ranges in which the allowance is phased out (i.e., $100,000 to $150,000, except in the case of certain credits where the range is $200,000 to $250,000) is halved in the case of married individuals filing separate returns, under the Senate amendment. This rule is retained, with modification, in the conference agreement. The conference agreement provides that, in the case of married individuals filing separately, who, at any time during the taxable year, do not live apart, the amount of the $25,000 allowance is reduced to zero. Absent such a rule, married taxpayers where one spouse would be eligible for a portion of the $25,000 amount if they filed separately would have an incentive so to file; the conferees believe that rules that encourage filing separate returns give rise to unnecessary complexity and place an unwarranted burden on the administration of the tax system.

Credits.--The conference agreement provides that for the rehabilitation and low-income housing credits, the phase-out range for offsetting tax on up to $25,000 of non-passive income is increased to between $200,000 and $250,000 of adjusted gross income (calculated without regard to net passive losses, IRA contributions, or taxable social security benefits), and such credits are allowed under the $25,000 rule regardless of whether the taxpayer actively participates in the activity generating the credits. In the case of the low-income housing credit, the increase in the phase-out range (to between $200,000 and $250,000, as opposed to between $100,000 and $150,000 as for other rental real estate losses and credits), and the waiver of the requirement that the taxpayer actively participate in the activity generating the low-income housing credit, apply only to property placed in service before 1990, and only with respect to the original credit compliance period for the property, except if the property is placed in service before 1991, and 10 percent or more of the total project costs are incurred before 1989.

This increase in the adjusted gross income phase-out range may be illustrated as follows. Assume that an individual has $5,000 (deduction equivalent amount) of low-income housing credits from a limited partnership interest (in which, under the passive loss rule, he is considered not to materially or actively participate) in a rental real estate activity. His adjusted gross income (determined without regard to passive losses) is $200,000, and he has no other passive losses, credits or income for the year. The individual is permitted under the $25,000 allowance rule to take the low income housing credit.

Other credit limitations.--The interaction of the passive loss rules with other rules limiting the use of credits is clarified. The limitation on the credit for research and development activities to the tax on income from such activities is applied before the passive loss limitation is applied to such credits. The overall limitation on credits under the conference agreement (providing that credits generally cannot offset more than 75 percent of the taxpayer's tax liability for the year) is applied after the amount of credits allowable under the passive loss rule is determined. Once a credit is allowed for a year under the passive loss rule, it is treated as an active credit arising in that year.

Related party transactions.--The conference agreement provides that the taxpayer is not treated as having disposed of an interest in a passive activity, for purposes of triggering suspended losses, if he disposes of it in an otherwise fully taxable transaction to a related party (within the meaning of section 267(b) or 707(b)(1), including applicable attribution rules). In the event of such a related party transaction, because it is not treated as a disposition for purposes of the passive loss rule, suspended losses are not triggered, but rather remain with the taxpayer. Such suspended losses may be offset by income from passive activities of the taxpayer.

When the entire interest owned by the taxpayer and the interest transferred to the related transferee in the passive activity are transferred to a party who is not related to the taxpayer (within the meaning of section 267(b) or 707(b)(1), including applicable attribution rules) in a fully taxable disposition, then to the extent the transfer would otherwise qualify as a disposition triggering suspended losses, the taxpayer may deduct the suspended losses attributable to his interest in the passive activity.

Certain insurance transactions.--Clarification is provided with respect to certain transactions involving dispositions of interests in syndicates that insure U.S. risks. Generally, when an owner of an interest in such a syndicate that is treated as a passive activity enters into a transaction whereby he disposes of his interest in the syndicate in a fully taxable closing transaction, he is treated as having made a disposition of his interest in the passive activity.

Abandonment.--The scope of a disposition triggering suspended losses under the passive loss rule includes an abandonment, constituting a fully taxable event under present law, of the taxpayer's entire interest in a passive activity. Thus, for example, if the taxpayer owns rental property which he abandons in a taxable event which would give rise to a deduction under section 165(a) of present law, the abandonment constitutes a taxable disposition that triggers the recognition of suspended losses under the passive loss rule.

Similarly, to the extent that the event of the worthlessness of a security is treated under section 165(g) of the Code as a sale or exchange of the security, and the event otherwise represents the disposition of an entire interest in a passive activity, it is treated as a disposition. No inference is intended with respect to whether a security includes an interest in any entity other than a corporation.

Interaction with capital loss limitation.--Upon a fully taxable disposition of a taxpayer's entire interest in a passive activity, the passive loss rule provides that any deductions previously suspended with respect to that activity are allowed in full. However, to the extent that any loss recognized upon such a disposition is a loss from the sale or exchange of a capital asset, it is limited to the amount of gains from the sale or exchange of capital assets plus $3,000 (in the case of individuals). The limitation on the deductibility of capital losses is applied before the determination of the amount of losses allowable upon the disposition under the passive loss rule.

This rule may be illustrated as follows. A taxpayer places in service rehabilitation credit property generating an allowable credit of $50, and reduces the basis of the property by $50 as required by the provisions governing the rehabilitation credit, but is prevented under the passive loss rule from taking any portion of the credit. In a later year, having been allowed no portion of the credit by virtue of the passive loss rule, the taxpayer disposes of his entire interest in the activity, including the property whose basis was reduced. Immediately prior to the disposition, the taxpayer may elect to increase basis of the credit property by the amount of the original basis adjustment (to the extent of the amount of the unused credit) with respect to the property.

If the property is disposed of in a transaction that, under the passive loss rule, does not constitute a fully taxable disposition of the taxpayer's entire interest in the passive activity, then no basis adjustment may be elected at any time. To the extent the credit has been suspended by virtue of the passive loss rule, however, it may remain available to offset tax liability attributable to passive income.

Disposition of activity of limited partnership.--In general, under the passive loss rule, suspended deductions are allowed upon a taxable disposition of the taxpayer's entire interest in an activity, because it becomes possible at that time to measure the taxpayer's actual gain or loss from the activity. Under the Senate amendment, a special rule would apply to dispositions with respect to limited partnership interests. The special rule requires the taxpayer to dispose of his entire interest in the limited partnership (along with all other interests that are part of the passive activity) in order to trigger suspended deductions with respect to any activities conducted by the limited partnership.

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

The conferees do not, however, intend to change the rule that a limited partnership interest in an activity is (except as provided in Treasury regulations) treated as an interest in a passive activity. Because a limited partner generally is precluded from materially participating in the partnership's activities, losses and credits attributable to the limited partnership's activities are generally treated as from passive activities, except that items properly treated as portfolio income and personal service income are not treated as passive.

Changes in nature of activity.--The fact that the nature of an activity changes in the course of its development does not give rise to a disposition for purposes of the passive loss provision. For example, when a real estate construction activity becomes a rental activity upon the completion of construction and the commencement of renting the constructed building, the change is not treated as a disposition.

3. Treatment of portfolio income

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

The conferees anticipate that the Treasury will issue regulations setting forth standards for appropriate allocation of expenses and interest under the passive loss rule. The conferees anticipate that regulations providing guidance to taxpayers with respect to interest allocation will be issued by December 31, 1986. These regulations should be consistent with the purpose of the passive loss rules to prevent sheltering of income from personal services and portfolio income with passive losses. Moreover, the regulations should attempt to avoid inconsistent allocation of interest deductions under different Code provisions.⁴

^{In the case of entities, a proper method of allocation may include, for example, allocation of interest to portfolio income on the basis of assets, although there may be situations in which tracing is appropriate because of the integrated nature of the transactions involved. Because of the difficulty of recordkeeping that would be required were interest expense of individuals allocated rather than traced, it is anticipated that, in the case of individuals, interest expense generally will be traced to the asset or activity which is purchased or carried by incurring or continuing the underlying indebtedness.}

Under these circumstances, it is not appropriate to treat the transaction as giving rise both to portfolio interest income and to passive interest expense. Rather, to the extent that a taxpayer receives interest income with respect to a loan to a passthrough entity in which he has an ownership interest, such income should be allowed to offset the interest expense passed through to the taxpayer from the activity for the same taxable year.

The amount of interest income of the partner from the loan that is appropriately offset by the interest expense of the partnership on the loan should not exceed the taxpayer's allocable share of the interest expense to the extent not increased by any special allocation. For example, assume that an individual has a 40-percent interest in a partnership that conducts a business activity in which he does not materially participate, and the individual makes a loan to the partnership on which the partnership pays $100 of interest expense for the year. Since 40 percent of the partnership's interest expense is allocable to the individual, only $40 of the partner's $100 of interest income should be permitted to offset his share of the partnership interest expense, and the remaining $60 is properly treated as portfolio income that cannot be offset by passive losses.

The conferees anticipate that Treasury regulations will be issued to provide for the above result. Such regulations may also, to the extent appropriate, identify other situations in which netting of the kind described above is appropriate with respect to a payment to a taxpayer by an entity in which he has an ownership interest. Such netting should not, however, permit any passive deductions to offset non-passive income except to the extent of the taxpayer's allocable share of the specific payment at issue. Such regulations may, if appropriate, provide that taxpayer's allocable share of the payment for this purpose will be determined without regard to special allocations.

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

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

4. Material participation

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

This clarification is not intended to alter the description of material participation in the Senate Report in any respect. Rather, it recognizes the substantial likelihood that, despite the difficulty in many circumstances of ascertaining whether the management services rendered by an individual are substantial and bona fide, such services are likely to be so when the individual is rendering them on a full-time basis and the success of the activity depends in large part upon his exercise of business judgment.

It is also clarified that a taxpayer is likely to be materially participating in an activity, if he does everything that is required to be done to conduct the activity, even though the actual amount of work to be done to conduct the activity is low in comparison to other activities.

With respect to material participation in an agricultural activity, clarification is provided regarding the decision-making that, if bona fide and undertaken on a regular, continuous, and substantial basis, may be relevant to material participation. The types of decision-making that may be relevant in this regard include, without being limited to, decision-making regarding (1) crop rotation, selection, and pricing, (2) the incursion of embryo transplant or breeding expenses, (3) the purchase, sale, and leasing of capital items, such as cropland, animals, machinery, and equipment, (4) breeding and mating decisions, and (5) the selection of herd or crop managers who then act at the behest of the taxpayer, rather than as paid advisors directing the conduct of the taxpayer.

5. Definition of activity

It is clarified that a rental activity may include the performance of services that are incidental to the activity (e.g., a laundry room in a rental apartment building). However, if a sufficient amount of such services are rendered, they may rise to the level of a separate activity, or the entire activity may not constitute a rental activity under the provision (e.g., a hotel).

6. Working interest

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

7. Effective date and phase-in rules

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

The conferees intend that a contractual obligation to purchase an interest in a passive activity that is binding on the date of enactment be treated as an acquisition of the interest in the activity for this purpose. A binding contract qualifies under this rule, even if the taxpayer's obligation to acquire an interest is subject to contingencies, so long as the contingencies are beyond the reasonable control of the taxpayer. Thus, if the taxpayer has, by the date of enactment, signed a subscription agreement to purchase a limited partnership interest contingent upon the agreement of other purchasers to acquire interests in the limited partnership amounting to a particular total, then if the contingency is satisfied, he is eligible for the phase-in rule with respect to the interest he was contractually bound to acquire. On the other hand, a conditional obligation to purchase, or one subject to contingencies within the taxpayer's control, does not give rise to eligibility under the phase-in rule.

In the case where, after the date of enactment, investors in an activity contribute additional capital to the activity, their interests still qualify in full for relief under the phase-in to the extent that their percentage ownership interests do not change as a result of the contribution. However, if a taxpayer's ownership interest is increased after the date of enactment, then (except to the extent the increase in the taxpayer's interest arises pursuant to a pre-enactment date binding contract or partnership agreement), the portion of his interest attributable to such increase does not qualify for the phase-in relief. For example, if a taxpayer, after the date of enactment, increases his ownership interest in a partnership from 25 percent to 50 percent, then only the losses attributable to the 25 percent interest held prior to enactment will qualify for transitional relief.⁶

^{In general, in order to qualify for transition relief, the interest acquired by a taxpayer must be in an activity which has commenced by the date of enactment. For example, a rental activity has commenced when the rental property has been placed in service in the activity. When an entity in which the taxpayer owns an interest liquidates or disposes of one activity and commences another after the date of enactment, the new activity does not qualify for transition relief. In the case of property purchased for personal use but converted to business use (e.g., a home that the taxpayer converts to rental use), similar rules apply. The activity qualifies for phase-in relief if it commences by the date of enactment. In the case of a residence converted to rental use, for example, the residence must be held out for rental by the date of enactment.}

^{However, in the case of an activity that has not commenced by the date of enactment, phase-in treatment nevertheless applies if the entity (or an individual owning the activity directly) has entered into a binding contract effective on or before the date of conference action (August 16, 1986), to acquire the assets used to conduct the activity. Similarly, phase-in treatment applies in the case of self-constructed business property of an entity (or direct owner), where construction of the property to be used in the activity has commenced on or before the date of conference action (August 16, 1986).}

^{In the case of a taxpayer owning both pre-enactment and post-enactment interests in passive activities, clarification is provided regarding the calculation of the amount of passive loss qualifying for the phase-in. In order to determine this amount, it is necessary first to determine the amount that would be disallowed absent the phase-in. Phase-in relief then applies to the lesser of the taxpayer's total passive loss, or the passive loss taking into account only pre-enactment interests. Thus, for example, if a taxpayer has $100 of passive loss relating to pre-enactment interests, that would be disallowed in the absence of the phase-in, and has $60 of net passive income from post-enactment interests, resulting in a total passive loss of $40, then the phase-in treatment applies to the lesser of $100 or $40, (i.e., $40). For purposes of this rule, the pre-enactment and post-enactment losses are calculated by including credits, in a deduction-equivalent sense.}

^{Under the conference agreement, any passive loss that is disallowed for a taxable year during the phase-in period and carried forward is allowable in a subsequent year only to the extent that there is net passive income in the subsequent year (or there is a fully taxable disposition of the activity).}

Transition relief is provided in the case of low-income housing activities. Losses from certain investments after 1983 in low-income housing are not treated as from a passive activity, applicable for a period of up to seven years from the taxpayer's original investment.

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

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

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

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

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

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

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

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

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

Investment interest

The conference agreement provides that the deduction for investment interest is limited to the amount of net investment income. Interest disallowed under the provision is carried forward and treated as investment interest in the succeeding taxable year. Interest disallowed under the provision is allowed in a subsequent year only to the extent the taxpayer has net investment income in such year.

Definition of investment interest

The definition of investment interest is modified to include interest paid or accrued on indebtedness incurred or continued to purchase or carry property held for investment. Investment interest includes interest expense properly allocable to portfolio income under the passive loss rule (see B., above). Investment interest also includes interest expense properly allocable to an activity, involving a trade or business, in which the taxpayer does not materially participate, if that activity is not treated as a passive activity under the passive loss rule.

Investment interest also includes the portion of interest expense incurred or continued to purchase or carry an interest in a passive activity, to the extent attributable to portfolio income (within the meaning of the passive loss rule).

Investment interest does not include any interest that is taken into account in determining the taxpayer's income or loss from a passive activity. Investment interest does not include interest properly allocable to a rental real estate activity in which the taxpayer actively participates, within the meaning of the passive loss rule. Investment interest also does not include any qualified residence interest, as described below.

Net investment income

Investment income includes gross income from property held for investment, gain attributable to the disposition of property held for investment, and amounts treated as gross portfolio income under the passive loss rule. Investment income also includes income from interests in activities, involving a trade or business, in which the taxpayer does not materially participate, if that activity is not treated as a passive activity under the passive loss rule.

Net investment income is investment income net of investment expenses. Investment expenses are deductible expenses (other than interest) directly connected with the production of investment income. In determining deductible investment expenses, it is intended that investment expenses be considered as those allowed after application of the rule limiting deductions for miscellaneous expenses to those expenses exceeding 2 percent of adjusted gross income. In computing the amount of expenses that exceed the 2-percent floor, expenses that are not investment expenses are intended to be disallowed before any investment expenses are disallowed.

Property subject to a net lease is not treated as investment property under this provision, because it is treated as a passive activity under the passive loss rule. Income from a rental real estate activity in which the taxpayer actively participates is not included in investment income.

The investment interest limitation is not intended to disallow a deduction for interest expense which in the same year is required to be capitalized (e.g., construction interest subject to sec. 263A) or is disallowed under sec. 265 (relating to tax-exempt interest).

Personal interest

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

Under the conference agreement, personal interest is not deductible. Personal interest is any interest, other than interest incurred or continued in connection with the conduct of a trade or business (other than the trade or business of performing services as a employee), investment interest, or interest taken into account in computing the taxpayer's income or loss from passive activities for the year. Personal interest also generally includes interest on tax deficiencies.

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

Qualified residence interest

Under the conference agreement, qualified residence interest is not subject to the limitation on personal interest. Qualified residence interest generally means interest on debt secured by a security interest perfected under local law on the taxpayer's principal residence or a second residence of the taxpayer, not in excess of the amount of the taxpayer's cost basis for the residence (including the cost of home improvements), plus the amount of qualified medical and qualified educational expenses. Qualified residence interest does not include interest on any portion of such debt in excess of the fair market value of the residence.

Qualified residence interest is calculated as interest on debt secured by the residence, up to the amount of the cost basis of the residence, plus the amount incurred after August 16, 1986, for qualified medical and educational expenses. If the amount of any debt incurred on or before August 16, 1986, and secured by the residence on August 16, 1986 (reduced by any principal payments thereon) exceeds the taxpayer's cost basis for the residence, then such amount shall be substituted for the taxpayer's cost basis in applying the preceding sentence. Increases after August 16, 1986 in the amount of debt secured by the residence on August 16, 1986 (for example, in the case of a line of credit) are treated as incurred after August 16, 1986. Thus, interest on outstanding debt secured by the taxpayer's principal or second residence, incurred on or before August 16, 1986, is treated as fully deductible (to the extent the debt does not exceed the fair market value of the residence), regardless of the purpose for which the borrowed funds are used. Interest on debt secured by the taxpayer's principal or second residence, incurred after August 16, 1986, which debt exceeds the taxpayer's cost basis in the residence, is allowed only if the debt is incurred for qualified medical or educational expenses.

For purposes of determining qualified residence interest, the amount of the taxpayer's cost basis is determined without taking into account adjustments to basis under sec. 1034(e) (relating to rollover of gain upon the sale of the taxpayer's principal residence), or 1033(b) (relating to involuntary conversions). The cost basis for the residence includes the cost of improvements to the residence that are added to the basis of the residence. The taxpayer's cost basis is determined without regard to other adjustments to basis, such as depreciation. Thus, for example, if a taxpayer's second residence is rented to tenants for a portion of the year, and its basis is reduced by deductions for depreciation allowed in connection with the rental use of the property, the amount of his cost basis for the residence is not reduced by such deductions for purposes of this provision. Where the basis of a residence is determined under sec. 1014 (relating to the basis of property acquired from a decedent), the cost basis under this provision is the basis determined under sec. 1014. In general, under this provision, the amount of debt on which the taxpayer may deduct interest as qualified interest will not be less than his purchase price for the residence.

Generally, interest on debt secured by the taxpayer's principal or second residence (up to the amount of the taxpayer's cost basis) is treated as a qualified residence interest. Thus, for example, if the taxpayer's cost basis in his principal residence is $100,000 (and this amount does not exceed fair market value), and the residence is secured by debt in the amount of $60,000, interest on a refinancing for a total of $100,000 (including the original $60,000 plus an additional $40,000) is treated as qualified residence interest, regardless of the purpose for which the borrowed funds are used by the taxpayer.

Qualified medical expenses are those amounts paid for medical care within the meaning of sec. 213(d)(1)(A) and (B) (not including amounts paid for insurance covering medical care under sec. 213(d)(1)(C)), of the taxpayer, his spouse and dependents.

Qualified educational expenses are those amounts paid for reasonable living expenses while away from home, and for any tuition and related expenses incurred that would qualify scholarships (under sec. 117(b) as amended by the conference agreement), for the taxpayer, his spouse or dependent, while a student at an educational organization described in sec. 170(b)(1). Thus, tuition expenses for primary, secondary, college and graduate level education are generally included in qualified educational expenses. The qualified educational expenses or qualified medical expenses must be incurred within a reasonable period of time before or after the debt is incurred.

A principal residence of the taxpayer, and a second residence of the taxpayer, have the meanings set forth in the Senate amendment, except that if a second residence is not used by the taxpayer or rented at any time during the taxable year, the taxpayer need not meet the requirement of section 280A(d)(1) that the residence be used for personal (non-rental) purposes for the greater of 14 days or 10 percent of the number of days it is rented.

Interest on debt that is used to pay qualified medical or educational expenses, to be deductible as qualified residence interest, must be secured by the taxpayer's principal residence or second residence. Interest expense is so treated if the debt is so secured at the time the interest is paid or accrued. In the case of housing cooperatives, debt secured by stock held by the taxpayer as a tenant-stockholder is treated as secured by the residence the taxpayer is entitled to occupy as a tenant-stockholder. Where the stock may not be used as security by virtue of restrictions arising, for example, pursuant to local or State law, or pursuant to reasonable restrictions in the cooperative agreement, the stock may be treated as securing such debt, if the taxpayer establishes to the satisfaction of the Internal Revenue Service that the debt was incurred to acquire the stock. In addition, it is intended that the fact that State homestead laws may restrict the rights of secured parties with respect to certain types of residential mortgages will not cause interest on the debt to be treated as nondeductible personal interest, provided the lender's security interest is perfected and provided the interest on the debt is otherwise qualified residence interest.

Under the conference agreement, the amount of investment interest disallowed during the phase-in period under the provision is the excess over the amount of the present law $10,000 allowance ($5,000 in the case of a married individual filing a separate return, and zero in the case of a trust), plus the applicable portion of investment interest expense which would be disallowed without taking into account the present law allowance. Thus, for example, if an individual taxpayer has $20,000 of investment interest expense in excess of investment income 1987, 35 percent of the amount that does not exceed $10,000 or $3,500, plus the amount in excess of the $10,000 allowance. Thus, $13,500 would be disallowed, and $6,500 would be allowed for 1987 (assuming the taxpayer had no net passive loss for the year).

With respect to the investment interest limitation, for taxable years beginning on or after January 1, 1987 and before January 1, 1991, the amount of net investment income is reduced by the amount of losses from passive activities that is allowed as a deduction by virtue of the phase-in of the passive loss rule (other than net losses from rental real estate in which the taxpayer actively participates). For example, if a taxpayer has a passive loss which would be disallowed were the passive loss rule fully phased in (as in taxable years beginning after December 31, 1990), but a percentage of which is allowed under the passive loss phase-in rule, the amount of loss so allowed reduces the amount of the taxpayer's net investment income under the investment interest limitation for that year.

Further, any amount of investment interest that is disallowed under the investment interest limitation during the period that the investment interest limitation is phased in (that is, taxable years beginning on or after January 1, 1987 and before January 1, 1991) is not allowed as a deduction in a subsequent year except to the extent the taxpayer has net investment income in excess of investment interest in the subsequent year.⁷

                       Tax Rate

                      Tax Rate

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

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

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

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

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

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

The dividend exclusion for individuals does not apply to dividends received from an organization that was exempt from tax under section 501 or a tax-exempt farmers' cooperative in either the year of distribution or the preceding year (sec. 116(b)(1)), dividends received from a real estate investment trust (sec. 116(b)(2)), dividends received from a mutual savings bank that received a deduction for the dividend under section 591 (sec. 116(c)(1)), or to an ESOP dividend for which the corporation received a deduction (sec. 116(e)). The exclusion is limited with respect to dividends received from a regulated investment company (sec. 116(c)(2)).

In general, a distribution in redemption of stock that is essentially equivalent to a dividend is treated as a dividend for tax purposes (sec. 302). A redemption of the stock of a shareholder is essentially equivalent to a dividend if it does not result in a meaningful reduction in the shareholder's proportionate interest in the distributing corporation. Apart from certain cases in which a shareholder's interest is completely terminated or is reduced by more than 20 percent, present law is unclear regarding what constitutes a meaningful reduction in interest. The conferees understand that in some cases individual distributees take the position that a redemption is a sale or exchange, while corporate distributees take the position it is a dividend. Distributions in partial liquidation of the distributing corporation are not treated as dividends if the recipient is a noncorporate shareholder.

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

The determination of whether a dividend is extraordinary will be made under the present law percentage-of-adjusted-basis test, subject to the alternative fair market value test provided in the Senate amendment.¹ In lieu of the one-year post-acquisition holding period requirement of present law, the conference agreement provides a test based on the holding period of the distributee as of the date the distribution is declared or publicly announced by the distributing corporation's board of directors. Under this test, a distribution with respect to stock will constitute an extraordinary dividend if the taxpayer has not held the stock for more than two years on that date. If there is a formal or informal agreement to pay the particular dividend prior to the declaration date, the date of such agreement shall be treated as the dividend announcement date for purposes of applying the two-year holding period requirement. Whether there is such a formal or informal agreement is determined based on all the facts and circumstances. In general, a broad agreement in a joint venture arrangement that dividends will be paid as funds are available would not be considered an agreement to pay a particular dividend in the absence of other facts, such as facts showing a particular expectation that a large dividend would be paid after the acquisition of an interest in the venture by a new party.

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

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

The exception for qualifying preferred stock is intended to provide relief for certain transactions to the extent that there is no potential for effectively purchasing a dividend that accrued prior to the date of purchase ("dividend-stripping"). Preferred stock is treated as qualifying for this purpose if: (1) it provides for fixed (i.e. not varying) preferred dividends payable not less often than annually; (2) dividends were not in arrears when the taxpayer acquired the stock, and (3) the dividends received by the taxpayer during the period it owned the stock do not exceed an annualized rate of 15 percent of the lower of (a) the taxpayer's adjusted basis or (b) the liquidation preference of the stock.^la

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

^{To determine whether the taxpayer's dividends exceed the dividends it earned, the taxpayer's "actual dividend rate" is first computed. The actual dividend rate is the average annual amount of dividends received (or deemed received under section 305 or any other provision) during the period the taxpayer owned the stock, computed as a return on the taxpayer's adjusted basis or, if lesser, the stock's liquidation preference. This is then compared to the taxpayer's "stated dividend rate," which is the return represented by the annual fixed preferred dividends payable on the stock. If the actual dividend rate exceeds the stated dividend rate, a portion of each dividend received or deemed received will be an extraordinary dividend, and basis will be reduced by the untaxed portion of such dividend.}

Finally, under the conference agreement the term extraordinary dividend includes any redemption of stock that is non-pro rata (again, irrespective of the holding period of the stock or the relative size of the distribution).

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

In order to prevent double inclusions in earnings and profits, the conferees expect that the amount, if any, of earnings and profits resulting from gain on the disposition of stock shall be determined without regard to the basis adjustments made under this section.

The provision is generally effective for dividends declared after July 18, 1986. However, distributions constituting extraordinary dividends by virtue of being a distribution in partial liquidation or a non-pro rata distribution are subject to the provision only if announced or declared after date of enactment.

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

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

Some authority exists for the proposition that, in certain extraordinary circumstances, amounts paid by a corporation to repurchase its stock may be fully deductible in the year paid. The validity of this authority, however, has been questioned.

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

The conferees wish to clarify that, while the phrase "in connection with [a] redemption" is intended to be construed broadly, the provision is not intended to deny a deduction for otherwise deductible amounts paid in a transaction that has no nexus with the redemption other than being proximate in time or arising out of the same general circumstances. For example, if a corporation redeems a departing employee's stock and makes a payment to the employee in discharge of the corporation's obligations under an employment contract, the payment in discharge of the contractual obligation is not subject to disallowance under this provision.⁴ Payments in discharge of other types of contractual obligations, in settlement of litigation, or pursuant to other actual or potential legal obligations or rights, may also be outside the intended scope of the provision to the extent it is clearly established that the payment does not represent consideration for the stock or expenses related to its acquisition, and is not a payment that is a fundamental part of a "standstill" or similar agreement.

The conferees anticipate that, where a transaction is not directly related to a redemption but is proximate in time, the Internal Revenue Service will scrutinize the transaction to determine whether the amount purportedly paid in the transaction is reasonable. Thus, even where the parties have countervailing tax interests, the parties' stated allocation of the total consideration between the redemption and the unrelated transaction will be respected only if it is supported by all the facts and circumstances.⁵

^{However, the conferees intend that agreements to refrain from purchasing stock of a corporation or other similar types of "standstill" agreements in all events will be considered related to any redemption of the payee's stock. Accordingly, payments pursuant to such agreements are nondeductible under this provision provided there is an actual purchase of all or part of the payee's stock. The conferees intend no inference regarding the deductibility of payments under standstill or similar agreements that are unrelated to any redemption of stock owned by the payee.}

^{In denying a deduction for payments in connection with redemptions of stock, the conferees intend no inference regarding the deductibility of such payments under present law. Moreover, no inference is intended as to the character of such payments in the hands of the payee.}

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The conference agreement alters the character of the special limitations on the use of NOL carryforwards in a manner generally similar to the House bill and the Senate amendment. After an ownership change, as described below, the taxable income of a loss corporation available for offset by pre-acquisition NOL carryforwards is annually limited to a prescribed rate times the value of the loss corporation's stock on the date of the ownership change. In addition, NOL carryforwards are disallowed entirely unless the loss corporation satisfies continuity-of-business enterprise requirements for the two-year period following any ownership change. The conference agreement also expands the scope of the special limitations to include built-in losses and allows loss corporations to take into account built-in gains. The conference agreement also includes numerous technical changes and several anti-avoidance rules. Finally, the conference agreement applies similar rules to carryforwards other than NOLS, such as net capital losses and excess foreign tax credits.

Ownership change

Under the conference agreement, the special limitations apply after any ownership change. An ownership change occurs, in general, if the percentage of stock of the new loss corporation owned by any one or more 5-percent shareholders (described below) has increased by more than 50 percentage points relative to the lowest percentage of stock of the old loss corporation owned by those 5-percent shareholders at any time during the testing period (generally a three-year period).⁶ The determination of whether an ownership change has occurred is made by aggregating the increases in percentage ownership for each 5-percent shareholder whose percentage ownership has increased during the testing period. For this purpose, all stock owned by persons who own less than five percent of a loss corporation's stock is generally treated as stock owned by a single 5-percent shareholder. The determination of whether an ownership change has occurred is made after any owner shift involving a 5-percent shareholder or any equity structure shift.

Determinations of the percentage of stock in a loss corporation owned by any person are made on the basis of value. Except as provided in regulations to be prescribed by the Secretary, changes in proportionate ownership attributable solely to fluctuations in the relative fair market values of different classes or amounts of stock are not taken into account.

In determining whether an ownership change has occurred, changes in the holdings of certain preferred stock are disregarded. Except as provided in regulations, all "stock" (not including stock described in section 1504(a)(4)) is taken into account. Under this standard, the term stock does not include stock that (1) is not entitled to vote, (2) is limited and preferred as to dividends and does not participate in corporate growth to any significant extent, (3) has redemption and liquidation rights that do not exceed the stock's issue price upon issuance (except for a reasonable redemption premium), and (4) is not convertible to any other class of stock. If preferred stock carries a dividend rate materially in excess of a market rate, this may indicate that it would not be disregarded.

Under grants of regulatory authority in the conference agreement, the conferees expect the Treasury Department to publish regulations disregarding, in appropriate cases, certain stock that would otherwise be counted in determining whether an ownership change has occurred, when necessary to prevent avoidance of the special limitations. For example, it may be appropriate to disregard preferred stock (even though voting) or common stock where the likely percentage participation of such stock in future corporate growth is disproportionately small compared to the percentage value of the stock as a proportion of total stock value, at the time of the issuance or transfer. Similarly, the conferees are concerned that the inclusion of voting preferred stock (which is not described in section 1504(a)(4) solely because it carries the right to vote) in the definition of stock presents the potential for avoidance of section 382. As another example, stock such as that issued to the old loss company shareholders and retained by them in the case of Maxwell Hardware Company v. Commissioner, 343 F.2d 716 (9th Cir. 1969), is not intended to be counted in determining whether an ownership change has occurred.

In addition, the conferees expect that the Treasury Department will promulgate regulations regarding the extent to which stock that is not described in section 1504(a)(4) should nevertheless not be considered stock. For example, the Treasury Department may issue regulations providing that preferred stock otherwise described in section 1504(a)(4) will not be considered stock simply because the dividends are in arrears and the preferred shareholders thus become entitled to vote.

Owner shift involving a 5-percent shareholder

An owner shift involving a 5-percent shareholder is defined under the conference agreement as any change in the respective ownership of stock of a corporation that affects the percentage of stock held by any person who holds five percent or more of the stock of the corporation (a "5-percent shareholder") before or after the change. For purposes of this rule, all less-than-5-percent shareholders are aggregated and treated as one 5-percent shareholder. Thus, an owner shift involving a 5-percent shareholder includes (but is not limited to) the following transactions:

An equity structure shift is defined under the conference agreement as any tax-free reorganization within the meaning of section 368, other than a divisive reorganization or an "F" reorganization. In addition, to the extent provided in regulations, the term equity structure shift will include other transactions, such as public offerings not involving a 5-percent shareholder or taxable reorganization-type transactions (e.g., mergers or other reorganization-type transactions that do not qualify for tax-free treatment due to the nature of the consideration or the failure to satisfy any of the other requirements for a tax-free transaction). A purpose of the provision that considers only owner shifts involving a 5-percent shareholder is to relieve widely held companies from the burden of keeping track of trades among such shareholders. For example, a publicly traded company that is 60 percent owned by less-than-5-percent shareholders would not experience an ownership change merely because, within a three-year period, every one of such shareholders sold his stock to a person who was not a 5-percent shareholder. The conferees believe, however, that there are situations involving transfers of stock involving less-than-5-percent shareholders, other than tax-free reorganizations (for example, public offerings), in which it will be feasible to identify changes in ownership involving such shareholders, because, unlike public trading, the changes occur as part of a single, integrated transaction. Where identification is reasonably feasible or a reasonable presumption can be applied, the conferees intend that the Treasury Department will treat such transactions under the rules applicable to equity structure shifts.

Under the conference agreement, for purposes of determining whether an ownership change has occurred following an equity structure shift, the less-than-5-percent shareholders of each corporation that was a party to the reorganization will be segregated and treated as a single, separate 5-percent shareholder. Moreover, the conference agreement provides regulatory authority to apply similar segregation rules in cases, such as a public offering or recapitalization, that involve only a single corporation.

Multiple Transactions

As described above, the determination of whether an ownership change has occurred is made by comparing the relevant shareholders' stock ownership immediately after either an owner shift involving a 5-percent shareholder or an equity structure shift with the lowest percentage of such shareholders' ownership at any time during the testing period preceding either the owner shift involving a 5-percent shareholder or the equity structure shift. Thus, changes in ownership that occur by reason of a series of transactions including both owner shifts involving a 5-percent shareholder and equity structure shifts may constitute an ownership change. In determining whether an ownership change has occurred as a result of a transaction or transactions following an equity structure shift or owner shift involving a 5-percent shareholder that did not result in an ownership change, the conference agreement provides that, unless a different proportion is established, the acquisition of stock after such a shift shall be treated as being made proportionately from all the shareholders immediately before the acquisition.

Finally, except as provided in regulations, the holder of an option is treated as owning the underlying stock if such a presumption would result in an ownership change. (The subsequent exercise of such an option is, of course, disregarded if the owner of the option has been treated as owning the underlying stock.) This rule is to be applied on an option-by-option basis so that, in appropriate cases, certain options will be deemed exercised while others may not. Similarly, a person will be treated as owning stock that may be acquired pursuant to any contingency, warrant, right to acquire stock, conversion feature, or put, if such a presumption results in an ownership change. If the option or other contingency expires without a transfer of stock ownership, but the existence of the option or other contingency resulted in an ownership change under this rule, the loss corporation will be able to file amended tax returns (subject to any applicable statute of limitations) for prior years as if the corporation had not been subject to the special limitations.

In general, the relevant testing period for determining whether an ownership change has occurred is the three-year period preceding any owner shift involving a 5-percent shareholder or any equity structure shift. Thus, a series of unrelated transactions occurring during a three-year period may constitute an ownership change. A shorter period, however, may be applicable following any ownership change. In such a case, the testing period for determining whether a second ownership change has occurred does not begin before the day following the first ownership change.

In addition, the testing period does not begin before the first day of the first taxable year from which there is a loss carryforward or excess credit. Thus, transactions that occur prior to the creation of any attribute subject to limitation under section 382 or section 383 are disregarded. Except as provided in regulations, the special rule described above does not apply to any corporation with a net unrealized built-in loss. The conferees expect, however, that the regulations will permit such corporations to disregard transactions that occur before the year for which such a corporation establishes that a net unrealized built-in loss first arose.

Effect of ownership change

The conference agreement requires the Treasury Department to prescribe regulations regarding the application of the section 382 limitation in the case of a short taxable year. The conferees expect that these regulations will generally provide that the section 382 limitation applicable in a short taxable year will be determined by multiplying the full section 382 limitation by the ratio of the number of days in the year to 365. Thus, taxable income realized by a new loss corporation during a short taxable year may be offset by pre-change losses not exceeding a ratable portion of the full section 382 limitation.

The section 382 limitation for any taxable year is increased by the amount of any recognized built-in gains (determined under the rules described below) and any gain recognized by virtue of a section 338 election (to the extent such gain is not taken into account as a built-in gain). Finally, if the section 382 limitation for a taxable year exceeds the taxable income for the year, the section 382 limitation for the next taxable year is increased by such excess.

If two or more loss corporations are merged or otherwise reorganized into a single entity, separate section 382 limitations are determined and applied to each loss corporation that experiences an ownership change.

Value of loss corporation

The value of a loss corporation is generally the fair market value of the corporation's stock (including preferred stock described in section 1504(a)(4)) immediately before the ownership change. If a redemption occurs in connection with an ownership change--either before or after the change--the value of the loss corporation is determined after taking the redemption into account. Under the conference agreement, the Treasury Department is given regulatory authority to treat other corporate contractions in the same manner as redemptions for purposes of determining the loss corporation's value. The conference agreement also requires the Treasury Department to prescribe such regulations as are necessary to treat warrants, options, contracts to acquire stock, convertible debt, and similar interests as stock for purposes of determining the value of the loss corporation.

In determining value, the conferees intend that the price at which loss corporation stock changes hands in an arms-length transaction would be evidence, but not conclusive evidence, of the value of the stock. Assume, for example, that an acquiring corporation purchased 40 percent of loss corporation stock over a 12-month period. Six months following this 40 percent acquisition, the acquiring corporation purchased an additional 20 percent of loss corporation stock at a price that reflected a premium over the stock's proportionate amount of the value of all the loss corporation stock; the premium is paid because the 20-percent block carries with it effective control of the loss corporation. Based on these facts, it would be inappropriate simply to gross-up the amount paid for the 20-percent interest to determine the value of the corporation's stock. The conferees anticipate that, under regulations, the Treasury Department will permit the loss corporation to be valued based upon a formula that grosses up the purchase price of all of the acquired loss corporation stock if a control block of such stock is acquired within a 12-month period.

The long-term tax-exempt rate is defined under the bill as the highest of the Federal long-term rates determined under section 1274(d), as adjusted to reflect differences between rates on long-term taxable and tax-exempt obligations, in effect for the month in which the change date occurs or the two prior months. The conferees intend that the Treasury Department will publish the long-term tax-exempt rate by revenue ruling within 30 days after the date of enactment and monthly thereafter. The long-term tax-exempt rate will be computed as the yield on a diversified pool of prime, general obligation tax-exempt bonds with remaining periods to maturity of more than nine years.

The use of a rate lower than the long-term Federal rate is necessary to ensure that the value of NOL carryforwards to the buying corporation is not more than their value to the loss corporation. Otherwise there would be a tax incentive for acquiring loss corporations. If the loss corporation were to sell its assets and invest in long-term Treasury obligations, it could absorb its NOL carryforwards at a rate equal to the yield on long-term government obligations. Since the price paid by the buyer is larger than the value of the loss company's assets (because of the value of NOL carryforwards are taken into account), applying the long-term Treasury rate to the purchase price would result in faster utilization of NOL carryforwards by the buying corporation. The long-term tax-exempt rate normally will fall between 66 (1 minus the corporate tax rate of 34 percent) and 100 percent of the long-term Federal rate.

Following an ownership change, a loss corporation's NOL carryforwards (including any recognized built-in losses, described below) are subject to complete disallowance (except to the extent of any recognized built-in gains or section 338 gain, described below), unless the loss corporation's business enterprise is continued at all times during the two year period following the ownership change. If a loss corporation fails to satisfy the continuity of business enterprise requirements, no NOL carryforwards would be allowed to the new loss corporation for any post-change year. This continuity of business enterprise requirement is the same requirement that must be satisfied to qualify a transaction as a tax-free reorganization under section 368. (See Treasury regulation section 1.368-1(d)). Under these continuity of business enterprise requirements, a loss corporation (or a successor corporation) must either continue the old loss corporation's historic business or use a significant portion of the old loss corporation's assets in a business. Thus, the requirements may be satisfied even though the old loss corporation discontinues more than a minor portion of its historic business. Changes in the location of a loss corporation's business or the loss corporation's key employees, in contrast to the results under the business-continuation rule in the 1954 Code version of section 382(a), will not constitute a failure to satisfy the continuity of business enterprise requirements under the conference agreement.

Reduction in loss corporation's value for certain capital contributions

Any capital contribution (including a section 351 transfer) that is made to a loss corporation as part of a plan a principal purpose of which is to avoid any of the special limitations under section 382 shall not be taken into account for any purpose under section 382. For purposes of this rule, except as provided in regulations, a capital contribution made during the two-year period ending on the change date is irrefutably presumed to be part of a plan to avoid the limitations. The application of this rule will result in a reduction of a loss corporation's value for purposes of determining the section 382 limitation. The conferees intend that the regulations will generally except (i) capital contributions received on the formation of a loss corporation (not accompanied by the incorporation of assets with a net unrealized built-in loss) where an ownership change occurs within two years of incorporation, (ii) capital contributions received before the first year from which there is an NOL or excess credit carryforward (or in which a net unrealized built-in loss arose), and (iii) capital contributions made to continue basic operations of the corporation's business (e.g. to meet the monthly payroll or fund other operating expenses of the loss corporation). The regulations also may take into account, under appropriate circumstances, the existence of substantial nonbusiness assets on the change date (as described below) and distributions made to shareholders subsequent to capital contributions, as offsets to such contributions.

Reduction in value for corporations having substantial nonbusiness assets

If at least one-third of the fair market value of a corporation's assets consists of nonbusiness assets, the value of the loss corporation, for purposes of determining the section 382 limitation, is reduced by the excess of the value of the nonbusiness assets over the portion of the corporation's indebtedness attributable to such assets. The term nonbusiness assets includes any asset held for investment, including cash and marketable stock or securities. Assets held as an integral part of the conduct of a trade or business (e.g., assets funding reserves of an insurance company or similar assets of a bank) would not be considered nonbusiness assets. In addition, stock or securities in a corporation that is at least 50 percent owned (voting power and value) by a loss corporation are not treated as nonbusiness assets. Instead, the parent loss corporation is deemed to own its ratable share of the subsidiary's assets. The portion of a corporation's indebtedness attributable to nonbusiness assets is determined on the basis of the ratio of the value of nonbusiness assets to the value of all the loss corporation's assets.

Regulated investment companies, real estate investment trusts, and real estate mortgage investment conduits are not treated as having substantial nonbusiness assets under the conference agreement.

Losses subject to limitation

The term "pre-change loss" includes (i) for the taxable year in which an ownership change occurs, the portion of the loss corporation's NOL that is allocable (determined on a daily pro rata basis, without regard to recognized built-in gains or losses, as described below) to the period in such year before the change date, (ii) NOL carryforwards that arose in a taxable year preceding the taxable year of the ownership change and (iii) certain recognized built-in losses and deductions (described below). For any taxable year in which a corporation has income that, under section 172, may be offset by both a pre-change loss (i.e., an NOL subject to limitation) and an NOL that is not subject to limitation, taxable income is treated as having been first offset by the pre-change loss. This rule minimizes the NOLs that are subject to the special limitations.

Built-in gains and losses

If a loss corporation has a net unrealized built-in loss, the recognized built-in loss for any taxable year ending within the five-year period ending at the close of the fifth post-change year (the "recognition period") is treated as a pre-change loss.

Under the conference agreement, the amount of any recognized built-in loss that exceeds the section 382 limitation for any post-change year must be carried forward (not carried back) under rules similar to the rules applicable to net operating loss carryforwards and will be subject to the special limitations in the same manner as a pre-change loss.

Built-in gains

If a loss corporation has a net unrealized built in gain, the section 382 limitation for any taxable year ending within the five year recognition period is increased by the recognized built-in gain for the taxable year.

Bankruptcy proceedings

The special limitations do not apply after any ownership change of a loss corporation if (1) such corporation was under the jurisdiction of a bankruptcy court in a Title 11 or similar case immediately before the ownership change, and (2) the corporation's shareholders and creditors (determined immediately before the ownership change) own 50 percent of the value and voting power of the loss corporation's stock immediately after the ownership change. This special rule applies only if the stock-for-debt exchange, reorganization, or other transaction is ordered by the court or is pursuant to a plan approved by the court. For purposes of this rule, stock of a creditor that was converted from indebtedness is taken into account only if such indebtedness was held by the creditor for at least 18 months before the date the bankruptcy case was filed or arose in the ordinary course of the loss corporation's trade or business and is held by the person who has at all times held the beneficial interest in the claim. Indebtedness will be considered as having arisen in the ordinary course of the loss corporation's business only if the indebtedness was incurred by the loss corporation in connection with the normal, usual, or customary conduct of its business. It is not relevant for this purpose whether the debt was related to ordinary or capital expenditures of the loss corporation.

If the exception for bankruptcy proceedings applies, several special rules are applicable. First, the pre-change masses and excess credits that may be carried to a post-change year are reduced by one-half of the amount of any cancellation of indebtedness income that would have been included in the loss corporation's income as a result of any stock-for-debt exchanges that occur as part of the Title 11 or similar proceeding under the principles of section 108(e)(10) (without applying section 108(e)(10)(B)). Thus, the NOL carryforwards would be reduced by 50 percent of the excess of the amount of the indebtedness canceled over the fair market value of the stock exchanged. Second, the loss corporation's pre-change NOL carryforwards are reduced by the interest on the indebtedness that was converted to stock in the bankruptcy proceeding and paid or accrued during the period beginning on the first day of the third taxable year preceding the taxable year in which the ownership change occurs and ending on the change date. Finally, after an ownership change that qualifies for the bankruptcy exception, a second ownership change during the following two-year period will result in the elimination of NOL carryforwards that arose before the first ownership change. The special bankruptcy provisions do not apply to stock-for-debt exchanges in informal workouts, but the conference agreement directs the Secretary of the Treasury to study informal bankruptcy workouts under sections 108 and 382, and report to the tax-writing committees of the Congress before January 1, 1988.

Thrift institutions

A modified version of the bankruptcy exception (described above) applies to certain ownership changes of a thrift institution involved in a G reorganization by virtue of section 368(a)(3)(D)(ii). This rule also applies to ownership changes resulting from an issuance of stock or equity structure shift that is an integral part of a transaction involving such a reorganization, provided that the transaction would not have resulted in limitations under present law.^8a The bankruptcy exception is applied to qualified thrift reorganizations by requiring shareholders and creditors (including depositors) to retain a 20-percent (rather than 50-percent) interest. For this purpose, the deposits of the troubled thrift that become deposits in the acquiring corporation are treated as stock, as under present law. The general bankruptcy rules that eliminate from the NOL carryforwards both interest deductions on debt that was converted and income that would be recognized under the principles of section 108(e)(10) are not applicable to thrifts.

Transactions involving solvent thrifts, including a purchase of the stock of a thrift, or merger of a thrift into another corporation, will be subject to the general rules relating to ownership changes. The conversion of a solvent mutual savings and loan association into a stock savings and loan (or other transactions involving a savings and loan not entitled to special treatment), although not within the special rules applicable to troubled thrifts, will not necessarily constitute an ownership change under the conference agreement. In such a conversion, the mutual thrift converts to stock form as a preliminary step to the issuance of stock to investors for purposes of raising capital. Under existing IRS rulings, the entire transaction may qualify as a tax-free reorganization if certain conditions are met. For purposes of determining whether there has been an ownership change causing a limitation on the use of losses under the conference agreement, the issuance of stock generally will be treated under the rules applicable to owner shifts. For example, the depositors holding liquidation accounts would generally be considered a group of less-than-5-percent shareholders, and if the stock were issued entirely to less-than-5-percent shareholders, or 5-percent shareholders acquired less than 50 percent, no ownership change would occur. Treasury regulations may be issued, on a prospective basis, that would treat public offerings generally in the same manner as equity structure shifts and treat the old shareholders and the persons acquiring stock in the offering as separate 5-percent shareholder groups. If such regulations are issued and apply this same approach to the conversion of a solvent mutual savings and loan association to stock form and the issuance of new stock, an ownership change could result, however, if the value of the stock issued in the public offering exceeds the equity of the depositors in the mutual represented by liquidation accounts. The application of any such regulations to thrift institutions (whether solvent or insolvent) would not be effective before January 1, 1989.

Carryforwards other than NOLs

The conference agreement also amends section 383, relating to special limitations on unused business credits and research credits, excess foreign tax credits, and capital loss carryforwards. Under regulations to be prescribed by the Secretary, capital loss carryforwards will be limited to an amount determined on the basis of the tax liability that is attributable to so much of the taxable income as does not exceed the section 382 limitation for the taxable year, with the same ordering rules that apply under present law. Thus, any capital loss carryforward used in a post-change year will reduce the section 382 limitation that is applied to pre-change losses. In addition, the amount of any excess credit that may be used following an ownership change will be limited, under regulations, on the basis of the tax liability attributable to an amount of taxable income that does not exceed the applicable section 382 limitation, after any NOL carryforwards, capital loss carryforwards, or foreign tax credits are taken into account. The conference agreement also expands the scope of section 383 to include passive activity losses and credits and minimum tax credits.

Anti-abuse rules

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

The conference agreement provides that the Treasury Department shall prescribe regulations preventing the avoidance of the purposes of section 382 through the use of, among other things pass-through entities. For example, a special allocation of income to a loss partner should not be permitted to result in a greater utilization of losses than would occur if the principles of section 382 were applicable.

In the case of partnerships, for example, the conferees expect the regulations to limit the tax benefits that may be derived from transactions in which allocations of partnership income are made to a loss partner or to a corporation that is a member of a consolidated group with NOL carryovers (a "loss corporation partner") under an arrangement that contemplates the diversion of any more than an insignificant portion of the economic benefit corresponding to such allocation (or any portion of the economic benefit of the loss corporation partner's NOL) to a higher tax bracket partner.

This grant of authority contemplates any rules that the Treasury Department considers appropriate to achieve this objective. For example, regulations may provide, as a general rule, that the limitations of section 382 (and section 383) should be made applicable to restrict a loss corporation partner's use of losses against its distributive share of each item of partnership income and that any portion of the distributive share of partnership income so allocated which may not be offset by the loss corporation's NOLs should be taxed at the highest marginal tax rate. Such regulations could also provide that the allocation of income to the loss corporation may, in the discretion of the Secretary, be reallocated to the extent that other partners in the partnership have not been reasonably compensated for their services to the partnership. If the Treasury Department uses such a format to restrict the utilization of NOLS, the conferees believe it may be appropriate to exempt from these rules any partnership with respect to which, throughout the term of the partnership, (i) every allocation to every partner would be a qualified allocation as described in section 168(j)(9)(B) if it were made to a tax-exempt entity, with appropriate exceptions (e.g., section 704(c) allocations) and (ii) distributions are made to one partner only if there is a simultaneous pro rata distribution to all partners at the same time. Special rules would, of course, have to be provided to apply section 382 (and section 383) in this context.

The conferees do not intend any inference to be drawn whether allocations made to loss corporations by partnerships that involve transfers of the economic benefit of a loss partner's loss to another partner have substantial economic effect. As described in the report of the Committee on Finance, there are circumstances in which it appears to be questionable whether the economic benefit that corresponds to a special allocation to the NOL partner is fully received by such partner; however, some taxpayers nevertheless take the position that such allocations have substantial economic effect under section 704(b). The conferees expect the Treasury Department to review this situation.

The conferees expect that regulations issued under this grant of authority with respect to partnerships should be effective for transactions after the date of enactment. The conferees expect that any regulations addressing other situations, under the Treasury Department's general authority to limit the ability of other parties to obtain any portion of the benefit of a loss corporation's losses, may be prospective within the general discretion of the Secretary.

1976 Act amendments

The conference agreement generally repeals the amendments to section 382 and 383 made by the Tax Reform Act of 1976, effective retroactively as of January 1, 1986. Thus, the law that was in effect as of December 31, 1985, applies to transactions that are not subject to the new provisions because of the effective dates of the conference agreement. The conference agreement, by repealing the 1976 Act amendments, also retroactively repeals section 108(e)(10)(c), as included by the Tax Reform Act of 1984.

A reorganization plan will be considered adopted on the date that the boards of directors of all parties to the reorganization adopt the plans or recommend adoption to the shareholders, or on the date the shareholders approve, whichever is earlier. The parties' boards of directors may approve a plan of reorganization based on principles, and negotiations to date, and delegate to corporate officials the power to refine and execute a binding reorganization agreement, including a binding agreement subject to regulatory approval. Any subsequent board approval or ratification taken at the time of consummating the transaction as a formality (i.e., that is not required, because the reorganization agreement is already legally binding under prior board approval) may occur without affecting the application of the effective date rule for reorganizations. In the case of a reorganization that occurs as part of a Title 11 or other court-supervised proceeding, the amendments do not apply to any ownership change resulting from such a reorganization or proceeding if a petition in such case was filed with the court before August 14, 1986.

The earliest testing period under the conference agreement begins on May 6, 1986 (the date of Senate Finance Committee action). If an ownership change occurs after May 5, 1986, but before January 1, 1987, and section 382 and 383 (as amended by the conference agreement) do not apply, then the earliest testing date will not begin before the first day immediately after such ownership change. For example, assume 60 percent of a loss corporation's stock (wholly owned by X) is purchased by B on May 29, 1986, and section 382 under the 1954 Code does not apply (because, for example, the loss corporation's business is continued and section 269 is not implicated). Assume further that X's remaining 40 percent stock interest is acquired by B on February 1, 1987. Under the conference agreement, no ownership change occurs after the second purchase because the testing period begins on May 30, 1986, the day immediately after the ownership change; thus, an ownership change would not result from the second purchase. Conversely, if 40 percent of a loss corporation's stock (wholly owned by X) is purchased by D on July 1, 1986, and an additional 15 percent is purchased by P on January 15, 1987, then an ownership change would result from the second purchase, and the amendments would apply to limit the use of the loss corporation's NOL carryforwards. Moreover, if an ownership change that occurs after December 31, 1986 is not affected by the amendments to section 382 (because, for example, in the foregoing example the initial 40 percent stock purchase occurred on May 5, 1986, prior to the commencement of the testing period), the 1954 Code version of section 382 will remain applicable to the transaction.

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

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

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

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

Exceptions to requirement of recognition

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

S corporations

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

Nonliquidating distributions

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

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

Limitations on the recognition of losses

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

First, the conference agreement provides generally that no loss is recognized by a liquidating corporation with respect to any distribution of property to a related person (within the meaning of section 267), unless the property is distributed to all shareholders on a pro rata basis and the property was not acquired by the liquidating corporation in a section 351 transaction or as a contribution to capital during the five years preceding the distribution. Thus, for example, a liquidating corporation would not be permitted to recognize loss on a distribution of recently acquired property to a shareholder who, directly or indirectly, owns more than 50 percent in value of the stock of the corporation. Similarly, a liquidating corporation would not be permitted to recognize a loss on any property (regardless of when or how acquired) that is distributed to such a shareholder on a non-pro rata basis.

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

If the adoption of a plan of complete liquidation occurs in a taxable year following the date on which the tax return including the loss disallowed by this provision is filed, the conferees intend that, in appropriate cases, the liquidating corporation may recapture the disallowed loss on the tax return for the taxable year in which such plan of liquidation is adopted. In the alternative, the corporation could file an amended return for the taxable year in which the loss was reported.

The conferees intend that the Treasury Department will issue regulations generally providing that the presumed prohibited purpose for contributions of property two years in advance of the adoption of a plan of liquidation will be disregarded unless there is no clear and substantial relationship between the contributed property and the conduct of the corporation's current or future business enterprises. For example, assume that A owns Z Corporation which operates a widget business in New Jersey. That business operates exclusively in the northeastern region of the United States and there are no plans to expand those operations. In his individual capacity, A had acquired unimproved real estate in New Mexico that has declined in value. On March 22, 1988, A contributes such real estate to Z and six months later a plan of complete liquidation is adopted. Thereafter, all of Z's assets are sold to an unrelated party and the liquidation proceeds are distributed. A contributed no other property to Z during the two-year period prior to the adoption of the plan of liquidation. Because A contributed the property to Z less than two years prior to the adoption of the plan of liquidation, it is presumed to have been contributed with a prohibited purpose. Moreover, because there is no clear and substantial relationship between the contributed property and the conduct of Z's business, the conferees do not expect that any loss arising from the disposition of the New Mexico real estate would be allowed under the Treasury regulations.

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

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

Section 332 liquidations⁹

^{The conference agreement provides an exception for liquidating transfers within an affiliated group because the property (together with the other attributes of the liquidated subsidiary) is retained within the economic unit of the affiliated group. Because such an intercorporate transfer within the group is a nonrecognition event, carryover basis follows. As a result of the carryover basis, the corporate level tax will be paid if the distributed property is disposed of by the recipient corporation to a person outside of the group.}

^{The conference agreement modifies the exception for section 332 liquidations in which an 80-percent corporate shareholder receives property with a carryover basis, to provide for nonrecognition of gain or loss with respect to any property actually distributed to the controlling corporate shareholder (rather than a pro rata share of each gain or loss). If a minority shareholder receives property in such a liquidation, the distribution is treated in the same manner as a distribution in a nonliquidating redemption. Accordingly, gain (but not loss) is recognized to the distributing corporation.}

^{The conference agreement denies nonrecognition under the exception for 80-percent corporate shareholders where the shareholder is a tax-exempt organization, unless the property, received in the distribution is used by the organization in an unrelated trade or business immediately after the distribution. If such property later ceases to be used in an unrelated trade or business of the organization acquiring the property, the organization will be taxed at that time (in addition to any other tax imposed, for example, on depreciation recapture under section 1245) on the lesser of (a) the built-in gain in the property at the time of the distribution, or (b) the difference between the adjusted basis of the property and its fair market value at the time of the cessation.}

^{The conference agreement, in an amendment to section 367 of the Code, also denies nonrecognition under the section 332 carryover basis exception where the controlling corporate shareholder is a foreign corporation, except as provided in regulations. The conferees expect that regulations may permit nonrecognition if the appreciation on the distributed property is not being removed from the U.S. taxing jurisdiction prior to recognition.}

^{Nonliquidating distributions of appreciated property}

^{In general, the tax treatment of corporations with respect to nonliquidating distributions of appreciated property has historically been the same as liquidating distributions. In recent years, however, nonliquidating distributions have been made subject to stricter rules than liquidating distributions, and corporations have generally been required to recognize gain as a result of nonliquidating distributions of appreciated property. Consistent with this relationship, the conference agreement generally conforms the treatment of nonliquidating distributions with liquidating distributions. Accordingly, the conference agreement provides that gain must generally be recognized to a distributing corporation if appreciated property (other than an obligation of the corporation) is distributed to shareholders outside of complete liquidation.}

^{The present law exceptions to recognition that are provided for nonliquidating distributions to ten percent, long-term noncorporate shareholders, and for certain distributions of property in connection with the payment of estate taxes or in connection with certain redemptions of private foundation stock, are repealed. As under current law, no loss is recognized to a distributing corporation on a nonliquidating distribution of property to its shareholders.}

^{Conversion from C corporation to S corporation status}

^{The conference agreement modifies the treatment of an S corporation that was formerly a C corporation. A corporate-level tax is imposed on any gain that arose prior to the conversion ("built-in" gain) and is recognized by the S corporation, through sale or distribution, within ten years after the date on which the S election took effect. The total amount of gain that must be recognized by the corporation, however, will be limited to the aggregate net built-in gain of the corporation at the time of conversion to S corporation status. Gains on sales or distributions of assets by the S corporation will be presumed to be built-in gains, except to the extent the taxpayer can establish that the appreciation accrued after the conversion, such as where the asset was acquired by the corporation in a taxable acquisition after the conversion. Built-in gains will be taxed at the maximum corporate rate applicable to the particular type of income (i.e., the maximum rate on ordinary income under section 11 or, if applicable, the alternative rate on capital gain income under section 1201) for the year in which the disposition occurs. The corporation will be allowed to continue to take into account all of its subchapter C tax attributes in computing the amount of the tax on recognized built-in gains, permitting it, for example, to use unexpired net operating losses, capital loss carryovers and minimum tax carryover credits to offset such tax. These provisions will generally be effective with respect to S elections made after December 31, 1986. For S elections made before January 1, 1987, the amendments made by the conference agreement do not apply. Thus, for example, the prior version of section 1374 will apply to such corporations.}

^{Election to treat sales or distributions of certain subsidiary stock as asset transfers}

^{The conference agreement generally conforms the treatment of liquidating sales and distributions of subsidiary stock to the present law treatment of nonliquidating sales or distributions of such stock; thus, such liquidating sales or distributions are generally taxable at the corporate level. The conferees believe it is appropriate to conform the treatment of liquidating and nonliquidating sales or distributions and to require recognition when appreciated property, including stock of a subsidiary, is transferred to a corporate or an individual recipient outside the economic unit of the selling or distributing affiliated group.}

^{Section 338(h)(10) of present law, in certain circumstances, permits a corporate purchaser and a seller of an 80-percent-controlled subsidiary to elect to treat the sale of the subsidiary stock as if it had been a sale of the underlying assets. Among the requirements for the filing of an election under section 338(h)(10) are that the selling corporation and its target subsidiary are members of an affiliated group filing a consolidated return for the taxable year that includes the acquisition date. If an election is made, the underlying assets of the company that was sold receive a stepped-up, fair market value basis; the selling consolidated group recognizes the gain or loss attributable to the assets; and there is no separate tax on the seller's gain attributable to the stock. This provision offers taxpayers relief from a potential multiple taxation at the corporate level of the same economic gain, which may result when a transfer of appreciated corporate stock is taxed without providing a corresponding step-up in basis of the assets of the corporation. The conference agreement, following the House bill, retains this provision.}

^{In addition, the conference agreement permits the expansion of the section 338(h)(10) concept, to the extent provided in regulations, to situations in which the selling corporation owns 80 percent of the value and voting power of the subsidiary, but does not file a consolidated return. Moreover, the conference agreement provides that, under regulations, principles similar to those of section 338(h)(10) may be applied to taxable sales or distributions of controlled corporation stock. The conferees intend that the regulations under this elective procedure will account for appropriate principles that underlie the liquidation-reincorporation doctrine. For example, to the extent that regulations make available an election to treat a stock transfer of controlled corporation stock to persons related to such corporation within the meaning of section 368(c)(2), it may be appropriate to provide special rules for such corporation's section 381(c) tax attributes so that net operating losses may not be used to offset liquidation gains, earnings and profits may not be manipulated, or accounting methods may not be changed.}

^{The conferees do not intend this election to affect the manner in which a corporation's distribution to its shareholders will be characterized for purposes of determining the shareholder level income tax consequences.}

^{Regulatory authority to prevent the circumvention of General Utilities repeal}

^{The repeal of the General Utilities doctrine is designed to require the corporate level recognition of gain on a corporation's sale or distribution of appreciated property, irrespective of whether it occurs in a liquidating or nonliquidating context. The conferees expect the Secretary to issue, or to amend, regulations to ensure that the purpose of the new provisions is not circumvented through the use of any other provision, including the consolidated return regulations or the tax-free reorganization provisions of the Code (part III of Subchapter C).}

General transitional rules

In addition to the rule discussed above, the new provisions do not apply to the following transactions:

Although the special additional definitions of the term "adoption of a plan" provided in the House bill and Report of the Committee on Ways and Means continue to apply for purposes of determining whether the requisite action was taken prior to November 20, 1985, such special rules do not apply for purposes of determining whether a plan of liquidation is adopted before August 1, 1986.

For purposes of determining whether there was a binding written contract or contracts to sell substantially all the assets of a corporation before August 1, 1986, the term "substantially all the assets" shall generally mean 70 percent of the gross fair market value and 90 percent of the net fair market value of the assets. In addition, even though the contract or contracts cover a lesser amount of assets, if such contract or contracts would require shareholder approval under the applicable state law that may require such approval for a sale of substantially all of such corporation's assets, then they shall qualify as contracts to sell substantially all the assets and shall be considered binding even though shareholder approval has not yet been obtained.

An acquisition of stock or assets will be considered made pursuant to a binding written contract even though the contract is subject to normal commercial due diligence or similar provisions and the final terms of the actual acquisition may vary pursuant to such provisions.

For purposes of these rules, a liquidation is completed by a required date if it would be considered completed for purposes of section 337 of present law by that date. For example, there may be a distribution of assets to a qualified liquidating trust (See, e.g., Rev. Rul. 80-150, 1980-1 C.B. 316).

Certain closely held corporations

The conference agreement deletes the House bill exception for distributions to certain long-term noncorporate shareholders. The conference agreement provides an additional transitional rule for certain closely held corporations. Corporations eligible for this rule are generally entitled to present law treatment with respect to liquidating sales and distributions occurring before January 1, 1989, provided the liquidation is completed before that date. A liquidation will be treated as completed under the same standard that is applied under the general transitional rules. However, this special transitional rule requires the recognition of income on distributions of ordinary income property (appreciated property that would not produce capital gain if disposed of in a taxable transaction) and short-term capital gain property. Thus, the failure of an eligible closely held corporation to complete its liquidation by December 31, 1986, or otherwise to satisfy the general transitional rules, will result in the loss of nonrecognition treatment for the distribution of appreciated ordinary income and short-term capital gain property. Corporations eligible for this rule may also make an S election prior to January 1, 1989, without becoming subject to the special S corporation rules of the conference agreement. Such eligible, electing corporations, however, will be subject to the 1954 Code version of section 1374.

A corporation is eligible for this rule if its value does not exceed $10 million and more than 50 percent of its stock is owned by 10 or fewer individuals who have held their stock for five years or longer. Full relief is available under this rule only if the corporation's value does not exceed $5 million; relief is phased out for corporations with values between $5 million and $10 million. For purposes of this rule, a corporation's value will be the higher of the value on August 1, 1986, and its value as of the date of adoption of a plan of liquidation (or, in the case of a nonliquidating distribution, the date of such distribution), and aggregation rules similar to those in section 1563 apply, except that control is defined as 50 percent rather than 80 percent.

In the case of nonliquidating distributions, apart from changes in the case of ordinary income property and short-term capital gain property, present law is otherwise retained for distributions to qualified, long-term individual shareholders (but only during the transitional period) for corporations qualifying under the closely held corporation transitional rule.

Treasury study of subchapter C

The conference agreement directs the Treasury Department to consider whether changes to the provisions of subchapter C (relating to the income taxation of corporations and their shareholders) and related sections of the Code are desirable, and to report to the taxwriting committees no later than January 1, 1988.

Under one method of allocating purchase price to nondepreciable goodwill and going concern value, the value of such assets is determined as the excess of the purchase price over the aggregate fair market value of the tangible assets and the identifiable other intangible assets. This is the so-called "residual" method of allocation. Another method attempts to determine the value of goodwill and going concern value under a formula approach that capitalizes the apparent "excess" earning capacity of the business.

In some cases a taxpayer who has purchased a going business at a premium (that is, a price that it has determined exceeds the apparent aggregate fair market values of the tangible and intangible assets, including goodwill and going concern value) might take the position that it is entitled to allocate an amount in excess of fair market value to the basis of each of the individual assets. Relying on one interpretation of the judicial and administrative authorities, the taxpayer would separately value each of the acquired assets (including goodwill and going concern value) and allocate the premium among all the assets (other than cash and cash equivalents) in proportion to their relative fair market values in a so-called "second-tier allocation."

Proposed and temporary regulations recently issued by the Treasury Department under section 338 mandate a residual method of allocation (and prohibit a second-tier allocation) in determining the basis of assets acquired in a qualified stock purchase for which a section 338 election is made or is deemed to have been made, i.e., a stock purchase which is treated as a purchase of assets for tax purposes. These rules do not by their terms apply to actual asset acquisitions.

The amendment also authorizes the Treasury Department to require information reporting regarding allocations by the parties to such asset acquisitions.

The provision is effective for transactions completed after May 6, 1986, unless pursuant to a binding contract in effect on that date and at all times thereafter.

Related parties for these purposes include a person and all entities which are 80 percent owned, directly or indirectly, with respect to that person. Specified attribution rules apply.

The provision applies to sales after June 20, 1986, unless made pursuant to a binding contract in effect on that date.

The provision is effective for obligations acquired after date of enactment.

The tenant-stockholder's proportionate share of the cooperative's interest and taxes is that portion of such items that bears the same ratio to the cooperative's total interest and taxes that the portion of the cooperative's stock held by the tenant-stockholder bears to the total outstanding stock of the cooperative (sec. 216(b)(3)).

The provisions of the House bill are effective for taxable years beginning after December 31, 1985.

The provisions of the Senate amendment are effective for taxable years beginning after December 31, 1986. Special rules are provided for two limited profit cooperatives.

The conference agreement is effective for taxable years beginning after December 31, 1986. The conference agreement includes the special provisions contained in the Senate amendment for two limited profit cooperatives.

An entity that qualifies as a real estate investment trust ("REIT") is subject to a corporate tax but is allowed a deduction for dividends paid to shareholders. In general, to qualify as a REIT, an entity (1) must be taxable as a domestic corporation, (2) must have at least 100 shareholders, (3) must not have 50 percent or more of its stock held by five or fewer individuals, (4) must distribute most of its income currently, (5) must hold a minimum percentage of its assets in real estate related and other passive assets, and (6) must derive minimum percentages of its income from such assets (secs. 856, 857). A REIT is required to be a calendar year taxpayer unless it was in existence as a REIT for any taxable year beginning prior to October 4, 1976 (sec. 859).

Asset and income requirements

In general, in order to meet the asset requirements, at least 75 percent of the value of the REIT's assets at the close of each quarter of the taxable year, must be represented by real estate assets, cash and cash items, and Government securities (sec. 856(c)).

In general, in order to meet the income requirements, at least 75 percent of the REIT's gross income for the taxable year must be derived from rents on real property, interest on obligations secured by real property, gain from the sale of interests in real property (other than property held for sale in the ordinary course of a trade or business), dividends from a REIT, refunds of property taxes, and certain other limited sources. In addition, at least 95 percent of the REIT's gross income must be derived from these sources and interest, dividends, or gains from the sale of securities (sec. 856(c)).

In addition, less than 30 percent of the gross income of the REIT must be derived from the sale or other disposition of property held for less than certain specified periods.

Definition of rents

Rents from real property include rents from interests in real property and charges for services customarily furnished in connection with the rental of real property whether or not such charges are separately stated (sec. 856(d)(1)). Income is not considered to qualify as rents from real property if services are provided other than through an independent contractor (sec. 856(d)(2)(C)). In addition, rents are not considered to qualify if they are based on the net profits of the tenant (sec. 856(d)(2)(A)).

Distribution requirement

In general, the distribution requirement is satisfied if, for the taxable year, the REIT distributes at least 95 percent of its taxable income determined without regard to any net capital gain (sec. 857(a)). For this purpose, a REIT may treat certain dividends paid after the close of the taxable year as having been paid during the taxable year (sec. 858(a)). Shareholders receiving such "spillover dividends" recognize income attributable to such dividends in the year of payment (sec. 858(b)).

Capital gains

If the REIT has recognized any net capital gain during a taxable year, the REIT is taxable on the amount of such gain unless it elects to pay a capital gain dividend.

The REIT may elect to pay a capital gain dividend by designating in a notice mailed to shareholders within 30 days of the end of the REIT's taxable year, that a dividend or portion thereof paid during the taxable year is a capital gain dividend. The dividend or portion so designated may not exceed the REIT's net capital gain reduced by any net operating losses. Any dividend so designated is treated as a long-term capital gain by the recipient shareholder (sec. 857(b)(3)).

Prohibited transactions

A 100-percent tax is imposed on a REIT's net income from prohibited transactions (sec. 857(b)(6)). Any net loss from prohibited transactions is not deductible in computing taxable income.

In general, a prohibited transaction is the sale of property held primarily for sale in the ordinary course of business. A safe harbor is provided whereby a sale of property is not treated as a prohibited transaction if such property has been held by the REIT for at least four years (for the production of rental income if land and improvements), the aggregate expenditures during the four year period preceding the date of sale that are includible in the basis of the property do not exceed 20 percent of the selling price of the property, and the sale is one of not more than five sales of property by the REIT during the taxable year, excluding sales of foreclosure property (sec. 857(b)(6)(C)). In general, the disposition of property acquired pursuant to a foreclosure is not treated as a prohibited transaction.

Deficiency dividends

If it is determined that the taxable income of a REIT for a prior year is understated, then the REIT may avoid the imposition of tax at the REIT level and possible disqualification, by the prompt distribution of a "deficiency dividend" (sec. 860). A REIT for which such a deficiency is determined must pay interest on an amount equal to the deficiency dividend, as well as a penalty equal to the amount of interest not in excess of half of the amount of the deficiency dividend (sec. 6697).

Under the Senate amendment, a taxpayer without prior operating history is permitted to change its accounting year without consent in connection with its initial election of REIT status. The Senate amendment also provides that an entity is not disqualified from electing REIT status in the first taxable year of its existence because it was closely held. Partner to partner attribution is ignored in determining if the REIT is closely held. In order to elect REIT status under the Senate amendment, the electing entity must either have been treated as a REIT for all taxable years beginning after February 28, 1986, or must have no earnings and profits accumulated as a regular corporation.

Asset and income requirements

The Senate amendment provides that REITs are permitted to hold assets in wholly owned subsidiaries. The REIT and its REIT subsidiaries are treated as a single taxpayer under the Senate amendment (i.e., the separate corporate status of the REIT subsidiaries is ignored).

Under the Senate amendment, for a one-year period after the receipt of new equity capital, income from the temporary investment of the new capital that is derived from stock or debt instruments is treated as qualifying "75-percent income." Such stock or debt instruments are treated as qualifying assets for the same period under the Senate amendment.

Definition of rents

The Senate amendment permits REITs to provide, without being required to use independent contractors, those services that may be furnished in connection with the rental of real property by a tax-exempt organization without giving rise to unrelated business income.

The Senate amendment also permits REITs to receive rents based on the net income of the tenant, provided that the tenant's profits are derived only from sources that would be qualified rent if earned directly by the REIT.

Distribution requirement

Under the Senate amendment, any income that is accrued but not received with respect to original issue discount on a loan issued in exchange for nonpublicly traded property, or with respect to a deferred rental agreement, or any income that is recognized as the result of the failure of an exchange that the REIT intended in good faith to qualify, but that was ultimately determined not to qualify for treatment as a tax-free like kind exchange, is not subject to the distribution requirement to the extent that such amounts exceed five percent of the REIT's taxable income. The REIT is required to pay income tax on the undistributed amount.

The Senate amendment provides that the amount of a REIT's current earnings and profits will not be less than the REIT's taxable income for the purpose of determining whether a distribution was made out of earnings and profits.

Capital gains

The Senate amendment permits REITs to compute their capital gain dividends without offset for net operating losses (NOLs). NOLs not used to offset capital gain income are carried over according to the ordinary rules. REITs are permitted to send capital gain notices to shareholders with the mailing of their annual report, rather than 30 days after year end.

Prohibited transactions

Under the Senate amendment, the number of sales that a REIT is able to make within the prohibited transaction safe harbor is expanded from five to seven. The Senate amendment provides an alternative safe harbor whereby a REIT may make any number of sales during a taxable year provided that the gross income from such sales does not exceed 15 percent of the REIT's taxable income for such year (computed with certain adjustments). Any marketing or development activities with respect to properties that are sold is required to be performed by independent contractors where the REIT is taking advantage of the alternative safe harbor. The Senate amendment also increases the extent of improvements that a REIT is permitted to make from 20 percent to 30 percent of the property's adjusted basis. In addition, under the Senate amendment, losses from prohibited transactions are permitted to offset taxable income but are not permitted to offset gains from prohibited transactions.

Deficiency dividends

The Senate amendment eliminates the penalty tax under section 6697 on deficiency dividends paid by REITs.

Imposition of excise tax

For these purposes, the term required distribution means, with respect to any calendar year, the sum of (1) 85 percent of the REIT's "ordinary income" for the calendar year, (determined as if the calendar year were the REIT's taxable year), (2) 95 percent of the REIT's capital gain net income (within the meaning of sec. 1222(9)) for such calendar year, (determined as if the calendar year were the REIT's taxable year), and (3) the excess, if any, of the "grossed up required distribution" for the preceding calendar year over the distributed amount for such preceding calendar year. For this purpose, the term grossed up required distribution for any calendar year is the sum of the taxable income of the REIT for the calendar year (without regard to the deduction for dividends paid) and all amounts from earlier years that are not treated as having been distributed under the provision.

The REIT's ordinary income for this purpose means its real estate investment trust taxable income (as defined in sec. 857(b)(2)) determined (1) without taking into account the dividends paid deduction, (2) by not taking into account any gain or loss from the sale of any capital asset, and (3) by treating the calendar year as the REIT's taxable year.

In addition, for these purposes, the term distributed amount means, with respect to any calendar year, the sum of (1) the deduction for dividends paid (within the meaning of sec. 561) during such calendar year, (2) amounts on which the REIT is required to pay corporate tax, and (3) the excess (if any) of the distributed amount for the preceding taxable year over the grossed up required distribution for such preceding taxable year. The amount of dividends paid for these purposes is determined without regard to the provisions of section 858.

Under the conference agreement, for purposes of applying these provisions, any deficiency dividend, (as defined in sec. 860(f)), is taken into account at the time it is paid, and any income giving rise to the adjustment is treated as arising at the time the dividend is paid.

The conference agreement does not contain the provision from the Senate amendment under which a REIT's earnings and profits for a taxable year would not be less than its real estate trust taxable income for the taxable year (without regard to the dividends paid deduction), since the conferees believe that this provision is a restatement of present law.

^{Distribution requirement}

^{The conference agreement clarifies that the amount on which relief is provided from the 95 percent distribution requirement in the case of income derived from certain transactions to which section 467 or section 1274 applies, is based on the excess of those amounts that the REIT is required to recognize on account of either section 467 or section 1274 over the amounts that the REIT otherwise would recognize under its regular method of accounting. Thus, for example, in the case of a REIT using the accrual method of accounting, the provision would apply in the case of a section 467 rental agreement only to the extent that the income required to be recognized under section 467 exceeded the amount of income that the taxpayer would include under the accrual method if section 467 did not apply.}

^{Definition of rents and interest}

^{The conference agreement provides that for purposes of the income requirements for qualification as a REIT, and for purposes of the prohibited transactions provisions, any income derived from a "shared appreciation provision" is treated as gain recognized on the sale of the "secured property." For these purposes, a shared appreciation provision is any provision that is in connection with an obligation that is held by the REIT and secured by an interest in real property, which provision entitles the REIT to receive a specified portion of any gain realized on the sale or exchange of such real property (or of any gain that would be realized if the property were sold on a specified date). Secured property for these purposes means the real property that secures the obligation that has the shared appreciation provision.}

^{In addition, the conference agreement provides that for purposes of the income requirements for qualification as a REIT, and for purposes of the prohibited transactions provisions, the REIT is treated as holding the secured property for the period during which it held the shared appreciation provision (or, if shorter, the period during which the secured property was held by the person holding such property),2} and the secured property is treated as property described in section 1221(1) if it is such property in the hands of the obligor on the obligation to which the shared appreciation provision relates (or if it would be such property if held by the REIT). For purposes of the prohibited transaction safe harbor, the REIT is treated as having sold the secured property at the time that it recognizes income on account of the shared appreciation provision, and any expenditures made by the holder of the secured property are treated as made by the REIT.³

^{For example, under the conference agreement, if a REIT is the holder of an obligation under which it is paid a fixed percentage of interest on a fixed principal amount, and also is entitled to a payment equal to a portion of the appreciation in the property as of the time the property is sold (or at an earlier specified time), then the additional payment would be treated as gain on the sale of the property secured by the obligation for purposes of section 856(c), with the holding period of the property considered to be the shorter of the REIT's holding period of the obligation or the obligor's holding period for the secured property. This gain would be eligible for the prohibited transaction safe harbor if the applicable requirements are met.}

^{The conferees intend no inference regarding the treatment of any shared appreciation provision for any other purposes of Federal income taxation.}

^{The conferees wish to make certain clarifications regarding those services that a REIT may provide under the conference agreement without using an independent contractor, which services would not cause the rents derived from the property in connection with which the services were rendered to fail to qualify as rents from real property (within the meaning of section 856(d)). The conferees intend, for example, that a REIT may provide customary services in connection with the operation of parking facilities for the convenience of tenants of an office or apartment building, or shopping center, provided that the parking facilities are made available on an unreserved basis without charge to the tenants and their guests or customers. On the other hand, the conferees intend that income derived from the rental of parking spaces on a reserved basis to tenants, or income derived from the rental of parking spaces to the general public, would not be considered to be rents from real property unless all services are performed by an independent contractor. Nevertheless, the conferees intend that the income from the rental of parking facilities properly would be considered to be rents from real property (and not merely income from services) in such circumstances if services are performed by an independent contractor.}

^{The conferees also wish to clarify that a REIT may directly select, hire, and compensate those independent contractors who will provide the customary services that may be provided by a REIT in connection with the rental of real property, rather than hiring an independent contractor to hire other independent contractors.}

^{Income and asset requirements}

^{The conference agreement provides that the investment of the proceeds of the public offering of debt securities that have a maturity of at least five years receives the same treatment as the investment of new equity capital. The conferees intend that debt securities for which there is an intention to call before five years would not be treated as having a maturity of at least five years.}

^{The conferees wish to clarify that if a REIT purchases all of the stock of a corporation and makes an election under section 338 with respect to the purchased stock, then the corporation that is deemed to be newly formed pursuant to the section 338 election may qualify as a REIT subsidiary as of the time that the newly formed corporation is deemed to come into existence.}

^{Prohibited transactions}

^{Instead of measuring the alternative safe harbor for prohibited transactions by reference to the income of the REIT, the alternative safe harbor provided by the conference agreement is any number of sales provided that the adjusted basis of the property sold does not exceed 10 percent of the adjusted basis of all of the REIT's assets at the beginning of the REIT's taxable year. For this purpose, the total adjusted basis of all of the REIT's assets (including the property that is sold) is to be computed using depreciation deductions that are used for purposes of computing earnings and profits. The other requirements for use of the alternative safe harbor in the Senate bill continue to apply. The conferees intend no inference regarding whether sales that qualify under this safe harbor for the REIT are or are not properly considered to be sales of property held for sale to customers.}

Regulated investment companies ("RICs") and real estate investment trusts ("REITs") generally are treated as pass-through entities since they receive deductions for dividends paid to shareholders (secs. 561, 562, 852(b), 857(b)). Capital gains realized by a REIT or a RIC also may be passed through to its shareholders (secs. 852(b)(3), 857(b)(3)).

To qualify as a RIC, a corporation must derive most of its income from investments in securities, must distribute most of its income currently, and must meet certain other requirements (secs. 851, 852).

To qualify as a REIT, a corporation must derive most of its income from real estate related sources, must hold primarily real estate assets, must distribute most of its income currently, and must meet certain other requirements (secs. 856, 857). An interest in a corporate debt obligation that is secured by real property mortgages is not treated as a qualifying real estate asset for a REIT.

Certain requirements are imposed on both REITs and RICs that are intended to prevent these entities from engaging in the active conduct of a trade or business (see e.g., secs. 851(b)(3), 856(c)(4)).

Entity classification

Under Treasury regulations, certain noncorporate entities that have sufficient corporate characteristics are treated as corporations for Federal income tax purposes (Treas. Reg. sec. 301.7701-2).

In May, 1984, the Treasury Department issued proposed regulations addressing the treatment of trusts that have more than one class of ownership interest. Final regulations were issued in March, 1985 (Treas. Reg. sec. 301.7701-4(c)(1)). Under these regulations, a trust is treated as having one class of ownership if all of the beneficiaries of the trust have undivided interests in all of the trust property. More than one class of ownership may exist where, for example, some beneficiaries are entitled to receive more than their pro rata share of trust distributions in early years and other beneficiaries are entitled to more than their pro rata share in later years.

Under the regulations, an arrangement having more than one class of ownership interest generally may not be treated as a trust, but is treated as a corporation for Federal income tax purposes. Thus, if a trust held a portfolio of mortgages, and interests in the trust assets were divided so that one class of beneficiaries were to receive all principal collected by the trust and a specified rate of interest thereon until the trust had collected a specified amount of principal on the mortgages, and another class of beneficiaries were to receive all remaining amounts collected by the trust, then such trust would be treated as an association taxable as a corporation under the regulations. The regulations provide a limited exception for certain trusts with multiple classes, where the existence of multiple classes is incidental to the purpose of facilitating direct investment in the assets of the trust. The regulations apply to interests issued after April 27, 1984.

Original issue discount and market discount

Other

Certain thrift institutions are permitted to deduct a percentage of their taxable income as a bad debt deduction provided that a specified portion of the institution's assets are "qualifying assets," including "qualifying real property loans" (secs. 593, 7701(a)(19)). Corporate debt obligations secured by real property mortgages are not treated as qualifying real property loans.

Issuers of debt instruments that have original issue discount are required to report to certain holders, the amount of interest payments and the annual accrual of OID (sec. 6049).

Original issue discount and market discount rules

Other

Under the Senate amendment, an interest in a REMIC is treated as a real estate asset for purposes of the requirements for qualification as a REIT, and is treated as a qualifying real property loan for purposes of the requirements relating to bad debt deductions for certain thrift institutions. Reporting requirements are expanded under the Senate amendment to include reporting of interest and OID to corporate and certain other holders of debt instruments that are subject to the OID rules prescribed by the Senate amendment. In addition, the Senate amendment treats regular, but not residual interests as subject to the provisions of section 582, providing ordinary income or loss treatment upon the sale of such interests by certain financial institutions.

The Senate amendment treats "owners' debt pools" as corporations. In general, the Senate amendment provides that an owners, debt pool is an entity that is treated as a trust or partnership, the principal activity of which is the holding of assets the principal portion of which is real estate mortgages that directly or indirectly act as collateral for debt obligations having varying maturities.

In general, the conference agreement provides rules relating to "real estate mortgage investment conduits" or "REMICs." In general, a REMIC is a fixed pool of mortgages with multiple classes of interests held by investors. The conference agreement provides rules prescribing (1) the Federal income tax treatment of the REMIC, (2) the treatment of taxpayers who exchange mortgages for interests in the REMIC, (3) the treatment of taxpayers holding interests in the REMIC, and (4) the treatment of disposition of interests in the REMIC.

In general, if the specified requirements are met, the REMIC is not treated as a separate taxable entity. Rather, the income of the REMIC is allocated to, and taken into account by, the holders of the interests therein, under specified rules. Holders of "regular interests" generally take into income that portion of the income of the REMIC that would be recognized by an accrual method holder of a debt instrument that had the same terms as the particular regular interest; holders of "residual interests" take into account all of the net income of the REMIC that is not taken into account by the holders of the regular interests. Rules are provided that (1) treat a portion of the income of the residual holder derived from the REMIC as unrelated business income for tax-exempt entities or as subject to withholding at the statutory rate when paid to foreign persons, and (2) prevent such portion from being offset by net operating losses, other than net operating losses of certain thrift institutions.

The conference agreement also contains provisions relating to the application of the OID rules to certain debt instruments the timing of whose maturities is contingent upon the timing of payments on other debt instruments. In addition, the conference agreement imposes certain new information reporting requirements.

Further, the conference agreement treats as a corporation any entity or other arrangement, referred to as a "taxable mortgage pool" that is used primarily to hold mortgages, where maturities of debt instruments that are issued by the entity in multiple classes, are tied to the timing of payment on the mortgages.

Requirements for qualification as a REMIC

Under the conference agreement, any entity, including a corporation, partnership, or trust, that meets specified requirements would be permitted to elect to be treated as a REMIC. In addition, a segregated pool of assets also may qualify as a REMIC as if it were an entity meeting the requirements. To elect REMIC status, requirements relating to the composition of assets and the nature of the investors' interests must be satisfied, and an election to be treated as a REMIC must be in effect for the taxable year, and if applicable, all prior taxable years.

A "qualified mortgage" is any obligation (including any participation or certificate of beneficial ownership interest therein) that is principally secured directly or indirectly by an interest in real property, and that either (1) is transferred to the REMIC on or before the "startup day," or (2) is purchased by the REMIC within the three-month period beginning on the startup day.⁵ A qualified mortgage also includes a "qualified replacement mortgage." A qualified replacement mortgage is any property that would have been treated as a qualified mortgage if it were transferred to the REMIC on or before the startup day, and that is received either (1) in exchange for a defective qualified mortgage⁶ within a two-year period beginning on the startup day, or (2) in exchange for any other qualified mortgage within a three-month period beginning on the startup day. In addition, a regular interest in another REMIC that is transferred to the REMIC on or before the startup day is treated as a qualified mortgage. The startup day is any day selected by the REMIC that is on or before the first day on which interests in the REMIC are issued.

"Qualified reserve assets" are any intangible property held for investment that is part of a "qualified reserve fund." A qualified reserve fund is any reasonably required reserve that is maintained by the REMIC to provide for payments of certain expenses and to provide additional security for the payments due on regular interests in the REMIC that otherwise may be delayed or defaulted upon because of defaults (including late payments) on the qualified mortgages. In determining whether the amount of the reserve is reasonable, the conferees believe that it is appropriate to take into account the creditworthiness of the qualified mortgages and the extent and nature of any guarantees relating to the qualified mortgages. Further, amounts in the reserve fund must be reduced promptly and appropriately as regular interests in the REMIC are retired.

Under the conference agreement, a reserve is not treated as a qualified reserve unless for any taxable year (and all subsequent taxable years) not more than 30 percent of the gross income from the assets in such fund for the taxable year is derived from the sale or other disposition of property held for less than three months. For this purpose, gain on the disposition of a reserve fund asset is not taken into account if the disposition of such asset is required to prevent default on a regular interest where the threatened default resulted from a default on one or more qualified mortgages.

"Foreclosure property" is property that would be foreclosure property under section 856(e) if acquired by a real estate investment trust, and which is acquired by the REMIC in connection with the default or imminent default of a qualified mortgage. Property so acquired ceases to be foreclosure property one year after its acquisition by the REMIC.

The conferees intend that regular interests in REMICs may be issued in the form of debt, stock, partnership interests, interests in a trust, or any other form permitted by state law. Thus, if an interest in a REMIC is not in the form of debt, the conferees understand that the interest would not have a specified principal amount, but that the interest would qualify as a regular interest if there is a specified amount that could be identified as the principal amount if the interest were in the form of debt. For example, an interest in a partnership could qualify as a regular interest if the holder of the partnership interest were to receive a specified amount in redemption of the partnership interest, and that the amount of income allocated to such partnership interest were based on a fixed percentage of the specified outstanding redemption amount.

The conferees intend that an interest in a REMIC would not fail to be treated as a regular interest if the payments of principal (or similar) amounts with respect to such interest are subordinated to payments on other regular interests in the REMIC, and are dependent upon the absence of defaults on qualified mortgages. Thus, the conferees intend that regular interests in a REMIC may resemble the types of interests described in Treas. Reg. sec. 301.7701-4(c)(2) (Example 2).⁷

^{The conferees intend that an interest in a REMIC may not qualify as a regular interest if the amount of interest (or similar payments) is disproportionate to the specified principal amount. For example, if an interest is issued in the form of debt with a coupon rate of interest that is substantially in excess of prevailing market interest rates (adjusted for risk), the conferees intend that the interest would not qualify as a regular interest. Instead, the conferees intend that such an interest may be treated either as a residual interest, or as a combination of a regular interest and a residual interest.}

The conferees intend that the right to receive payment from the REMIC for goods or services rendered in the ordinary operation of the REMIC would not be considered to be an interest in the REMIC for these purposes.

Inadvertent terminations

The conference agreement provides regulatory authority to the Treasury Department to issue regulations that address situations where failure to meet one or more of the requirements for REMIC status occurs inadvertently, and disqualification of the REMIC would occur absent regulatory relief. The conferees anticipate that the regulations would provide relief only where the failure to meet any of the requirements occurred inadvertently and in good faith. The conferees also intend that the relief may be accompanied by appropriate sanctions, such as the imposition of a corporate tax on all or a portion of the REMIC's income for the period of time in which the requirements are not met.

Transfers of property to the REMIC

Under the conference agreement, no gain or loss is recognized to the transferor upon the transfer of property to a REMIC in exchange for regular or residual interests in the REMIC. Upon such a transfer, the adjusted bases of the regular or residual interests received in the transaction are to be equal in the aggregate to the aggregate of the adjusted bases of the property transferred. The aggregate basis of the interests received is allocated among the regular or residual interests received in proportion to their fair market values.⁸ The basis of any property received by a REMIC in exchange for regular or residual interests in the REMIC is equal to the fair market value of the property at the time of transfer (or earlier time provided by regulations).⁹

^{In the case of a REMIC that is not formed as a separate entity, but rather as a segregated pool of assets, the conferees intend that the transfer is deemed to occur and the REMIC is deemed to be formed only upon the issuance of regular and residual interests therein.}

^{Federal income tax treatment of the REMIC}

The pass-through status of the REMIC provided by the conference agreement applies regardless of whether the REMIC otherwise would be treated as a corporation, partnership, trust, or any other entity. The conferees intend that where the requirements for REMIC status are met, that the exclusive set of rules for the treatment of all transactions relating to the REMIC and of holders of interests therein are to be those set forth in the provisions of the conference agreement. Thus, for example, in the case of a REMIC that would be treated as a partnership if it were not otherwise a REMIC, the provisions of subchapter K of the Code would not be applicable to any transactions involving the REMIC or any of the holders of regular or residual interests.¹⁰

^{Taxation of the holders of regular interests}

^{The conferees intend that regular interests are to be treated as if they were debt instruments for all other purposes of the Internal Revenue Code, Thus, for example, regular interests would be treated as market discount bonds, where the revised issue price (within the meaning of section 1278) of the regular interest exceeds the holder's basis in the interest. Moreover, the conferees intend that the REMIC is subject to the reporting requirements of section 1275 with respect to the regular interests. In addition, the conferees intend that regular interests are to be treated as evidences of indebtedness under section 582(c)(1), so that gain or loss from the sale or exchange of regular interests by certain financial institutions would not be treated as gain or loss from the sale or exchange of a capital asset. In addition, any market premium on a regular interest could be amortized currently under section 171.}

^{The issue price of regular interests in the REMIC are determined under the rules of section 1273(b). In the case of regular interests issued in exchange for property, however, the issue price of the regular interest is equal to the fair market value of the property,14} regardless of whether the requirements of section 1273(b)(3) are met. A holder's basis in the regular interest generally is equal to the holder's cost therefor, but in the case of holders who received their interests in exchange for property, then as discussed above, the holder's basis is equal to the basis of the property exchanged for the REMIC interest. Where property is transferred in exchange for more than one class of regular or residual interest, the basis of the property transferred is allocated in proportion to the fair market value of the interests received.

Taxation of the holders of residual interests

For example, a REMIC's taxable income for a calendar quarter (determined as described below) is $1,000. There are two holders of residual interests in the REMIC. One holder of 60 percent of the residual holds such interest for the entire calendar quarter. Another holder has a 40 percent interest, and transfers the interest after exactly one half of the calendar quarter to another taxpayer. As of the end of the calendar quarter, the holder of the sixty percent interest would be treated as receiving $600 ratably over the quarter. Each holder of the 40 percent interest would be treated as receiving $200 ratably over the portion of the quarter in which the interest was held.

Distributions from the REMIC are not included in the gross income of the residual holder to the extent that such distributions do not exceed the adjusted basis of the interest. To the extent that distributions exceed the adjusted basis of the interest, the excess is treated as gain from the sale of the residual interest. Residual interests are treated as evidences of indebtedness for purposes of section 582(c).

The amount of any net loss of the REMIC that may be taken into account by the holder of a residual interest is limited to the adjusted basis of the interest as of the close of the quarter (or time of disposition of the interest if earlier), determined without taking into account the net loss for the quarter. Any loss that is disallowed on account of this limitation may be carried over indefinitely by the holder of the interest for whom such loss was disallowed and may be used by such holder only to offset any income generated by the same REMIC.

Except for adjustments arising from the nonrecognition of gain or loss on the transfer of mortgages to the REMIC (discussed below), the holders of residual interests take no amounts into account other than those allocated from the REMIC.¹⁵

^{If a REMIC distributes property with respect to any regular or residual interest, the REMIC recognizes gain in the same manner as if the REMIC had sold the property to such distributee at its fair market value. The conferees intend that the distribution is to be treated as an actual sale by the REMIC for purposes of applying the prohibited transaction rules and the rules relating to qualified reserve funds. The basis of the distributed property in the hands of the distributee is then the fair market value of the property.}

In addition, the conference agreement provides that the same portion of the net income of the REMIC that may not be offset by net operating losses, is treated as unrelated business income for any organization subject to the unrelated business income tax under section 511, and is not eligible for any reduction in the rate of withholding tax (by treaty or otherwise) in the case of a nonresident alien holder.

The portion of the income of the residual holder that is subject to these rules is the excess, if any, of the amount of the net income of the REMIC that the holder takes into account for any calendar quarter, over the sum of the daily accruals with respect to such interest while held by such holder. The daily accrual for any residual interest for any day in any calendar quarter is determined by allocating to each day in such calendar quarter a ratable portion of the product of the adjusted issue price of the residual interest at the beginning of such accrual period, and 120 percent of the long-term Federal rate. The long-term Federal rate used for this purpose is the Federal long-term rate that would have applied to the residual interest under section 1274(d) (without regard to section 1274(d)(2)) if it were a debt instrument, determined at the time that the residual interest is issued. The rate is adjusted appropriately in order to be applied on the basis of compounding at the end of each quarter.

For this purpose, (and for purposes of the treatment of gain or loss that is not recognized upon the transfer of property to a REMIC in exchange for a residual interest, as discussed below), the residual interest is treated as having an issue price that is equal to the amount of money paid for the interest at the time it is issued, or in the case of a residual interest that is issued in exchange for property, the fair market value of the interest at the time it is issued. The adjusted issue price of the residual interest is equal to the issue price of the interest increased by the amount of daily accruals for prior calendar quarters, and decreased (but not below zero) by the amount of any distributions with respect to the residual interest prior to the end of the calendar quarter.

In addition, the conference agreement provides that under regulations, if a REIT owns a residual interest in a REMIC, a portion of dividends paid by the REIT would be treated as excess inclusions for REIT shareholders. Thus, such income could not be offset by net operating losses, would constitute unrelated business taxable income for tax-exempt holders, and would not be eligible for and reduction in the rate of withholding tax in the case of a nonresident alien holder.

The conference agreement provides that to the extent provided in regulations, in the case of a residual interest that has does not have significant value, the entire amount of income that is taken into account by the holder of the residual interest is treated as unrelated business income and is subject to withholding at the statutory rate. In addition, in the case of such a residual, income allocated to the holder thereof may not be offset by any net operating losses, regardless of who holds the interest. The conferees intend that the regulations would take into account the value of the residual interest in relation to the regular interests, and that the regulations would not apply in cases where the value of the residual interest is at least two percent of the combined value of the regular and residual interests.¹⁷

^{The conference agreement provides that the partnership information return filed by the REMIC is to supply information relating to the daily accruals of the REMIC.}

Liquidation of the REMIC

Under the conference agreement, if a REMIC adopts a plan of complete liquidation, and sells all of its assets (other than cash) within the 90-day period beginning on the date of the adoption of the plan of liquidation, then the REMIC recognizes no gain or loss on the sale of its assets, provided that the REMIC distributes in liquidation all of the sale proceeds plus its cash (other than amounts retained to meet claims) to holders of regular and residual interests within the 90-day period.

Other provisions

In general, the OID rules provided by the conference agreement require OID for an accrual period to be calculated and included in the holder's income based on the increase in the present value of remaining payments on the debt instrument, taking into account payments includible in the instrument's stated redemption price at maturity received on the regular interest during the period. For this purpose, the present value calculation is made at the beginning of each accrual period (1) using the yield to maturity determined for the instrument at the time of its issuance (determined on the basis of compounding at the close of each accrual period and properly adjusted for the length of the accrual period), calculated on the assumption that, as prescribed by regulations, certain prepayments will occur, and (2) taking into account any prepayments that have occurred before the close of the accrual period.

The conferees intend that the regulations will provide that the prepayment assumption to be used in calculating present values as of the close of each accrual period, and in computing the yield to maturity used in the calculation of such present values, will be that used by the parties in pricing the particular transaction. The conferees intend that such prepayment assumption will be determined by the assumed rate of prepayments on qualified mortgages held by the REMIC and also the assumed rate of earnings on the temporary investment of payments on such mortgages insofar as such rate of earnings would affect the timing of payments on regular interests.²²

^{The conferees intend that the regulations will require these pricing assumptions to be specified in the first partnership return filed by the REMIC. In addition, the conferees intend that appropriate supporting documentation relating to the selection of the prepayment assumption must be supplied to the Internal Revenue Service with such return. Further, the conferees intend that the prepayment assumptions used must not be unreasonable based on comparable transactions, if comparable transactions exist.23}

^{The conferees intend that unless otherwise provided by regulations, the use of a prepayment assumption based on a recognized industry standard would be permitted. For example, the conferees understand that prepayment assumptions based on a Public Securities Association standard currently is such an industry recognized standard.}

^{The conferees intend that in no circumstances, would the method of accruing OID prescribed by the conference agreement allow for negative amounts of OID to be attributed to any accrual period. If the use of the present value computations prescribed by the conference agreement produce such a result for an accrual period, the conferees intend that the amount of OID attributable to such accrual period would be treated as zero, and the computation of OID for the following accrual period would be made as if such following accrual period and the preceding accrual period were a single accrual period.}

^{Regulatory authority}

^{The conference agreement grants the Treasury Department authority to prescribe such regulations as are necessary or appropriate to implement the provisions relating to REMICs. The conferees expect that, among other things, regulations will be issued to prevent unreasonable accumulations of assets in the REMIC, to require the REMIC to report information adequate to allow residual holders to compute taxable income accurately (including reporting more frequently than annually). Further, such regulations may require reporting of OID accrual more frequently than otherwise required by the conference agreement.}

^{Treasury study}

^{The conferees are concerned about the impact of the REMIC provisions upon the thrift industry. Accordingly, the conferees request that the Treasury Department conduct a study of the effectiveness of the REMIC provisions in enhancing the efficiency of the secondary market in mortgages, and the impact of these provisions upon thrift institutions.}

^{Taxable mortgage pools}

^{The conferees intend that REMICs are to be the exclusive means of issuing multiple class real estate mortgage-backed securities without the imposition of two levels of taxation. Thus, the conference agreement provides that a "taxable mortgage pool" ("TMP") is treated as a taxable corporation that is not an includible corporation for purposes of filing consolidated returns.}

^{Under the conference agreement, a TMP is any entity other than a REMIC if (1) substantially all of the assets of the entity consist of debt obligations (or interests in debt obligations) and more than 50 percent of such obligations (or interests) consist of real estate mortgages, (2) such entity is the obligor under debt obligations with two or more maturities,24} and (3) under the terms of such debt obligations on which the entity is the obligor, payment on such debt obligations bear a relationship to payments on the debt obligations (or interests therein) held by the entity.²⁵ Typically, the relationship between the assets of the entity and its debt obligations would be such that payments on the debt obligations must be made within a period of time from when payments on the assets are received.

Under the conference agreement, any portion of an entity that meets the definition of a TMP is treated as a TMP. For example, if an entity segregates mortgages in some fashion and issues debt obligations in two or more maturities, which maturities depend upon the timing of payments on the mortgages, then the mortgages and the debt would be treated as a TMP, and hence as a separate corporation. The TMP provisions are intended to apply to any arrangement under which mortgages are segregated from a debtor's business activities (if any) for the benefit of creditors whose loans are of varying maturities.

The conference agreement provides that no domestic building and loan association (or portion thereof) is to be treated as a TMP.

Special rule for REITs

The conferees intend that an entity that otherwise would be treated as a TMP may, if it otherwise meets applicable requirements, elect to be treated as a REIT. If so, the conference agreement provides that under regulations, a portion of the REIT's income would be treated in the same manner as income subject to the special rules provided for a portion of the income of the income interest in a REMIC. The conferees intend that this calculation is to be made as if the equity interests in the REIT were the residual interest in a REMIC and such interests were issued (i.e., the issue price of interests is determined) as of the time that the REIT becomes a TMP.²⁶

^{The conferees intend that the regulations would provide that dividends paid to the shareholders of a REIT would be subject to the same rules provided for a portion of the income of holders of residual interests in a REMIC. Thus, for example, the conferees intend that the regulations would provide that to the extent that dividends from the REIT exceed the daily accruals for the REIT (determined in the same manner as if the REIT were a REMIC) such dividends (1) may not be offset by net operating losses (except those of certain thrift institutions), (2) are treated as unrelated business income for certain tax-exempt institutions, and (3) are not eligible for any reduction in the rate of withholding when paid to foreign persons. The conferees also intend that the regulations would require a REIT to report such amounts to its shareholders.27}

A RIC may adopt any fiscal year as its taxable year. RICs are permitted to treat certain dividends paid after the close of a taxable year as paid during the preceding taxable year (sec. 855(a)). Shareholders receiving such "spillover dividends" recognize income attributable to such dividends in the year of payment (sec. 855(b)).

A RIC that has long-term capital gain income may designate a dividend as a capital gain dividend in a notice sent to shareholders within 45 days after the end of its taxable year (sec. 852(b)(3)). Shareholders treat such capital gain dividends as long-term capital gain regardless of their holding period for the RIC stock, and the RIC is not required to pay any capital gains tax on the amount so designated.

If a RIC, organized as a corporation, has several "series" of stock, with each series of stock representing an interest in the income and assets of a particular fund, the RIC generally is treated as a single corporation.²⁸ If the RIC is organized as a business trust, it is unclear whether the RIC properly is treated as a single corporation or whether each fund properly is treated as a separate corporation.

In the case of certain summonses served upon "third party recordkeepers," certain notice requirements are imposed on the Internal Revenue Service (sec. 7609). Third party recordkeepers generally include various types of financial institutions, and others such as attorneys, accountants, and brokers, but do not include RICs.

The Senate amendment clarifies the definition of "securities" by reference to the definition of securities in the Investment Company Act of 1940. In addition, permitted income for RICs is defined to include income from foreign currencies, and options and futures contracts, derived with respect to the RIC's business of investing. The Senate amendment provides regulatory authority, however, to exclude certain gains from investment in foreign currency.

The Senate amendment also provides that, in the case of RICs that have so-called series funds, each fund is treated as a separate corporation. Tax-free treatment is provided for the deemed formation of the separate corporations that are deemed to be formed under the provision.

The Senate amendment extends the time for filing notices for capital gain dividends and certain other purposes from 45 to 60 days. RICs are treated as third party recordkeepers under the Senate amendment.

The provisions of the Senate amendment relating to the adoption of a calendar year generally are effective for taxable years beginning after December 31, 1986. The provision of the Senate amendment relating to treatment of a RIC as a third party recordkeeper is effective for summonses served after the date of enactment. The other provisions of the Senate amendment are effective for taxable years of RICs beginning after the date of enactment.

Imposition of excise tax

For these purposes, the term required distribution means, with respect to any calendar year, the sum of (1) 97 percent of the RIC's "ordinary income" for such taxable year, (2) 90 percent of the RIC's capital gain net income (within the meaning of sec. 1222(9)) for the one year period ending on October 31 of such taxable year (as if the one year period ending on October 31 were the RIC's taxable year), ²⁹ and (3) the excess, if any, of the "grossed up required distribution" for the preceding calendar year over the distributed amount for such preceding calendar year. For this purpose, the term grossed up required distribution for any calendar year is the sum of the taxable income of the RIC for the calendar year (determined without regard to the deduction for dividends paid) and all amounts from earlier years that are not treated as having been distributed under the provision.

The RIC's ordinary income for this purpose means its investment company taxable income (as defined in sec. 852(b)(2)) determined (1) taking into account the net capital gain of the RIC and without taking into account the dividends paid deduction, (2) by not taking into account any gain or loss from the sale of any capital asset, and (3) by treating the calendar year as the RIC's taxable year.

In addition, for these purposes, the term distributed amount means, with respect to any calendar year, the sum of (1) the deduction for dividends paid (within the meaning of sec. 561) during such calendar year, (2) amounts on which the RIC is required to pay corporate tax, and (3) the excess (if any) of the distributed amount for the preceding taxable year over the required distribution for such preceding taxable year. The amount of dividends paid for these purposes is determined without regard to the provisions of section 855 and without regard to any exempt-interest dividend (as defined in sec. 852(b)(5)).

Under the conference agreement, for purposes of applying these provisions, any deficiency dividend (as defined in sec. 860(f)) is taken into account at the time it is paid, and any income giving rise to the adjustment is treated as arising at the time the dividend is paid.

^{Hedging exception}

^{The conferees believe that the requirement that a RIC derive less than 30 percent of its gross income from the sale or other disposition of stock or securities held for less than three months is an appropriate requirement to ensure that a RIC is a passive entity that is appropriately granted pass-through status. Nevertheless, the conferees recognize that this requirement may not necessarily reflect accurately the extent of the active business activities of a RIC where the RIC engages in certain hedging transactions that are otherwise consistent with the passive nature of the RIC. The conferees believe that in general, in the case of such hedging transactions, both the hedged and the hedging positions properly are considered to be single investment.}

^{Accordingly, the conference agreement modifies the computation of gross income of a RIC for purposes of the requirement of section 851(b)(3) that less than 30 percent of the gross income of the RIC is derived from the sale or exchange of stock or securities held for less than three months. Under the conference agreement, for purposes of applying this test, any increase in value on a position that is part of a designated hedge is offset by any decrease in value (whether or not realized) on any other position that is part of such hedge. For this purpose, increases and decreases in value are taken into account only to the extent attributable to increases or decreases in value (as the case may be) during the period of the hedge. This rule applies for purposes of calculating both gains from the sale or other disposition of stock or securities held for less than three months and also the gross income of the RIC for purposes of section 851(b)(3).}

^{For these purposes, there is a designated hedge where the taxpayer's risk of loss with respect to any position in property is reduced by reason of (1) the taxpayer having an option to sell, being under a contractual obligation to sell, or having made (and not closed) a short sale of substantially identical property, (2) the taxpayer being the grantor of an option to buy substantially identical property, or (3) under regulations prescribed by the Secretary, the taxpayer holding one or more other positions. The conferees intend that a qualified covered call (within the meaning of sec. 1092(c)) may be treated as part of a designated hedge. In addition, the positions that are part of the hedge must be clearly identified by the taxpayer in the manner prescribed by regulations.}

^{Prior to the issuance of such regulations, the conferees intend that the identification requirement would be treated as having been satisfied with identification by the close of the day on which the hedge is established, either (a) by the placing of the positions that are part of hedge in a separate account that is maintained by a broker, futures commission merchant, custodian or similar person, and that is designated as a hedging account, provided that such person maintaining such account makes notations identifying the hedged and hedging positions and the date on which the hedge is established, or (b) by the designation by such a broker, merchant, custodian or similar person, of such positions as a hedge for purposes of these provisions, provided that the RIC is provided with a written confirmation stating the date the hedge is established and identifying the hedged and hedging positions.}

^{Business development companies}

^{The conference agreement provides that a business development company registered under the Investment Company Act of 1940, as amended (15 U.S.C. 80a-1 to 80b-2) may qualify as a RIC.}

^{Preference dividends}

^{The conference agreement provides that differences in the rate of dividends paid to shareholders are not treated as preferential dividends (within the meaning of section 562(c)), where the differences reflect savings in administrative costs (but not differences in management fees), provided that such dividends are paid by a RIC to shareholders who have made initial investments of at least $10 million.}

Personal holding company income includes dividends, interest, royalties, and certain other types of income (sec. 543). No exceptions are provided for royalties or interest received in connection with the development of computer software, the development of biomedical products, or the brokering or dealing in securities.

In general, certain U.S. shareholders of a foreign personal holding company are treated as having received the amount of the foreign personal holding company's undistributed foreign personal holding company income as a dividend on the last day of the corporation's taxable year (sec. 551). A foreign personal holding company generally is a foreign corporation more than 50 percent of whose stock is owned by not more than five individuals who are U.S. citizens or residents, and at least 60 percent of the gross income of which is foreign personal holding company income (sec. 552). Foreign personal holding company income includes royalties (sec. 553).

The House bill also provides an exception from the definition of personal holding company income for interest on securities held in the inventory of a dealer in securities. In addition, under the House bill, a dealer in securities may deduct interest on certain "offsetting loans" in computing its gross interest income.

The provisions of the House bill are effective for royalties and interest received after December 31, 1985.

The Senate amendment also provides an exception from the definition of personal holding company income for royalties received on account of biomedical research products of a specified biomedical research company under rules similar to those applicable to computer software royalties. In addition, the Senate amendment excludes from the definition of personal holding company income certain interest received by a specified broker-dealer in securities.

The provisions of the Senate amendment are effective for royalties received on, before, or after December 31, 1986, and for interest received after the date of enactment.

The exception in the conference agreement for computer software royalties is effective for royalties received on, before, or after December 31, 1986. The exception for interest received by a specified broker-dealer in securities is effective for interest received on or after the date of enactment. In addition, the conference agreement excludes from the definition of passive investment income for purposes of subchapter S of the Code, computer software royalties derived by a specified taxpayer, which royalties would not be treated as personal holding company income under the conference agreement, effective for taxable years beginning after December 31, 1984. The conference agreement also contains an exception from the definition of personal holding company income for certain royalties derived by a specified toy manufacturer from the licensing of toys, under rules similar to those provided for computer software royalties, effective for royalties received or accrued in taxable years beginning after December 31, 1981.

A certain trust (Great Northern Iron Ore Trust) has been held to be taxable as a corporation due to the existence of certain business powers.

The provision is effective for taxable years beginning after the taxable year in which the election is made, provided that all conditions of the Senate amendment continue to be satisfied.

2. Tax rate

3. Exemption amount

4. Tax preferences